Chapter 15Chapter 15

Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders′ Equity, and Income Statement

Accounts

LO# 1

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Balance Sheet

AssetsCashInvestmentsReceivablesPrepaidsInventoryPP and EOther assets -

intangibles

Liabilities and EquityAccounts payableAccrued liabilitiesDebtCommon stockRetained earnings

15-3

Auditing Long-Term DebtThe auditor must be assured that the amounts shown

on the balance sheet for the various types of long-term debt are not materially misstated. This assurance

extends to the recognition of interest expense. For the vast majority of entities, it is more efficient to follow a

strategy of conducting substantive testing.

The auditor must be assured that the amounts shown on the balance sheet for the various types of long-term

debt are not materially misstated. This assurance extends to the recognition of interest expense. For the vast majority of entities, it is more efficient to follow a

strategy of conducting substantive testing.

LO# 1

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Types of Long Term Debt

Notes

Bonds

Mortgages

Interest Rate Swaps

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Inherent Risk

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Inherent Risk Assessment – Long-Term Debt

The inherent risk for notes and bonds would normally be assessed as low to moderate because the volume of transactions are low, the accounting is not complex, and the client often receives third-party statements or amortization tables. However, the amounts are usually

large and the financial markets have developed sophisticated instruments that have characteristics of

both debt and equity. The inherent risk associated with these instruments is normally high.

LO# 1

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Inherent Risks ( cont’d)

Off balance sheet financing ( Enron)

Complex transactions

Guarantees of debt ( FIN No 45)

Compliance with debt covenants

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Control Risk Assessment

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Control Risk Assessment – Long-Term Debt

When a substantive strategy is followed, theauditor still needs a sufficient understanding

of the entity’s internal control system over debt.

LO# 2

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Assertions and Related Control Activities

Occurrence and AuthorizationOccurrence and Authorization1. Adequate documentation must verify that a note or

bond was properly authorized.

2. Any significant debt commitments should be approved by the board of directors or by executives who have been delegated this authority.

When the entity has proper controls for issuing debt transactions, it is generally easy for the auditor to test those transactions for occurrence and authorization

at the end of the period.

When the entity has proper controls for issuing debt transactions, it is generally easy for the auditor to test those transactions for occurrence and authorization

at the end of the period.

LO# 3

15-11

Assertions and Related Control Activities

CompletenessCompletenessThe client should maintain a subsidiary ledger that contains information about all the long-term debt owed by the entity. The debt amount recorded in the subsidiary ledger should be reconciled to the

general ledger control account regularly.

LO# 3

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Assertions and Related Control Activities

ValuationValuationNotes and bonds are recorded at their face value

less any unamortized discount or plus any unamortized premium. The effective interest

method should be used to amortize discounts and premiums (the straight-line method may be used if

the results are not materially different from the effective interest amounts).

LO# 3

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Assertions and Related Control Activities

Disclosure - ClassificationDisclosure - ClassificationControls should ensure that notes and bonds are properly classified in the financial statements. The major issue is to properly classify as a short-term liability the portion of long-term debt that is due in

the next year.

LO# 3

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Substantive Analytical Procedures

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Substantive Procedures of Long-Term Debt

The auditor should examine any new debt agreements, determine the status of prior debt agreements, and confirm balances and other

relevant information with outside parties.

Analytical procedures are useful because of the direct

relationship between interest expense and the amount of

long-term debt.

LO# 4

15-16

Tests of Details

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Substantive Procedures of Long-Term Debt

Assertions Substantive Tests of Transaction

Occurrence Examine copies of new note or bond agreements. Examine board of directors' minutes for approval of new lending agreements.

Completeness

Trace large cash receipts and payments to source documents and the general ledger. Review interest expense for payments to debt holders not listed on the debt analysis schedule. Review notes paid or renewed after the balance sheet date to determine if there are unrecorded liabilities at year-end. Evaluate lease contracts to determine if leases are properly accounted for as an operating or capital lease.

AuthorizationExamine board minutes for evidence of proper authorization of notes or bonds.

Accuracy Test a sample of receipts and payments.

CutoffReview debt activity for a few days before and after year-end to determine if the transactions are included in the proper period.

ClassificationExamine the due dates on notes or bonds for proper classification between current and long-term debt.

Assertions Substantive Tests of Transaction

Occurrence Examine copies of new note or bond agreements. Examine board of directors' minutes for approval of new lending agreements.

Completeness

Trace large cash receipts and payments to source documents and the general ledger. Review interest expense for payments to debt holders not listed on the debt analysis schedule. Review notes paid or renewed after the balance sheet date to determine if there are unrecorded liabilities at year-end. Evaluate lease contracts to determine if leases are properly accounted for as an operating or capital lease.

AuthorizationExamine board minutes for evidence of proper authorization of notes or bonds.

Accuracy Test a sample of receipts and payments.

CutoffReview debt activity for a few days before and after year-end to determine if the transactions are included in the proper period.

ClassificationExamine the due dates on notes or bonds for proper classification between current and long-term debt.

LO# 4

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Substantive Procedures of Long-Term Debt

Year-End Balances Tests of Details of Account BalancesExistence Confirm notes or bonds directly with creditors.Rights and obligations Examine copies of note and bond agreements.

Completeness

Obtain an analysis of notes and bonds payable, and accrued interest; foot schedule and agree totals to the general ledger. Obtain a standard bank confirmation requesting specific information on notes from banks. Confirm notes or bonds with creditors. Inquire or management about "off-balance sheet" activities. Review board meeting minutes for debt-related activities.

Valuation and allocation

Examine new debt agreements to ensure that they were recorded at the proper value. Confirm the outstanding balance for notes or bonds and the last date on which interest has been paid. Recompute accrued interest. Verify computation of the amortization of premium or discount.

LO# 4

15-19

Auditing Stockholders’ Equity

The following three types of transactions are The following three types of transactions are of importance to the auditor:of importance to the auditor:The following three types of transactions are The following three types of transactions are of importance to the auditor:of importance to the auditor:1.1. Issuance of stock including transactions such as sale Issuance of stock including transactions such as sale

of stock for cash; the exchange of stock for assets; of stock for cash; the exchange of stock for assets; and issuance of stock for stock splits.and issuance of stock for stock splits.

2.2. Repurchase of stock including both the reacquisition Repurchase of stock including both the reacquisition of stock and retirement of stock.of stock and retirement of stock.

3.3. Payment of dividends including cash and stock Payment of dividends including cash and stock dividends.dividends.

1.1. Issuance of stock including transactions such as sale Issuance of stock including transactions such as sale of stock for cash; the exchange of stock for assets; of stock for cash; the exchange of stock for assets; and issuance of stock for stock splits.and issuance of stock for stock splits.

2.2. Repurchase of stock including both the reacquisition Repurchase of stock including both the reacquisition of stock and retirement of stock.of stock and retirement of stock.

3.3. Payment of dividends including cash and stock Payment of dividends including cash and stock dividends.dividends.

LO# 5

15-20

Control Risk Assessment – Stockholders’ Equity

A substantive strategy is often used to audit stockholders’ equity because the number of

transactions is usually small. The auditor must still be aware of the types of controls that are in place to

prevent the misstatement of equity transactions.

Large, publicly traded companies use a Large, publicly traded companies use a registrar and transfer agent to process and registrar and transfer agent to process and

record equity transaction. Relevant information record equity transaction. Relevant information about equity transactions may be confirmed about equity transactions may be confirmed

with the register and transfer agent.with the register and transfer agent.

LO# 6

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Assertions and Related Control Activities

OccurrenceOccurrenceVerify that stock and Verify that stock and dividend transactions dividend transactions

comply with comply with corporate charter.corporate charter.

OccurrenceOccurrenceVerify that stock and Verify that stock and dividend transactions dividend transactions

comply with comply with corporate charter.corporate charter.

AccuracyAccuracyVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

posted and posted and summarized in the summarized in the

accounting records.accounting records.

AccuracyAccuracyVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

posted and posted and summarized in the summarized in the

accounting records.accounting records.

AuthorizationAuthorizationVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

approved.approved.

AuthorizationAuthorizationVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

approved.approved.

ValuationValuationVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

valued.valued.

ValuationValuationVerify that stock and Verify that stock and dividend transactions dividend transactions have been properly have been properly

valued.valued.

LO# 7

15-22

Segregation of DutiesWhen possible, the following duties should be segregated:When possible, the following duties should be segregated:1.1. The individuals responsible for issuing, transferring, and The individuals responsible for issuing, transferring, and

canceling stock certificates should not have any accounting canceling stock certificates should not have any accounting responsibilities.responsibilities.

2.2. The individual responsible for maintaining the detailed The individual responsible for maintaining the detailed stockholders’ records should be independent of the stockholders’ records should be independent of the maintenance of the general ledger control accounts.maintenance of the general ledger control accounts.

3.3. The individual responsible for maintaining the detailed The individual responsible for maintaining the detailed stockholders’ records should not also process cash receipts or stockholders’ records should not also process cash receipts or disbursements.disbursements.

4.4. Appropriate segregation of duties should be established among Appropriate segregation of duties should be established among the preparation, recording, signing, and mailing of dividend the preparation, recording, signing, and mailing of dividend checks.checks.

LO# 8

15-23

Auditing Capital-Stock Accounts

Occurrence and Completeness

When outside agents are When outside agents are notnot used, the auditor should: used, the auditor should:

o Trace the transfers of shares between stockholders to Trace the transfers of shares between stockholders to the stock register and/or stock certificate book.the stock register and/or stock certificate book.

o Foot the shares outstanding in the stock register and/or Foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares stock certificate book and agree them to total shares outstanding in the general ledger.outstanding in the general ledger.

o Examine any canceled stock certificates.Examine any canceled stock certificates.

o Account for and inspect any unissued stock certificates Account for and inspect any unissued stock certificates in the stock certificate book.in the stock certificate book.

When outside agents are When outside agents are notnot used, the auditor should: used, the auditor should:

o Trace the transfers of shares between stockholders to Trace the transfers of shares between stockholders to the stock register and/or stock certificate book.the stock register and/or stock certificate book.

o Foot the shares outstanding in the stock register and/or Foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares stock certificate book and agree them to total shares outstanding in the general ledger.outstanding in the general ledger.

o Examine any canceled stock certificates.Examine any canceled stock certificates.

o Account for and inspect any unissued stock certificates Account for and inspect any unissued stock certificates in the stock certificate book.in the stock certificate book.

LO# 9

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Auditing Capital-Stock Accounts

Valuationo When stock is issued for cash the valuation is When stock is issued for cash the valuation is

straightforward. The proceeds from the sale are straightforward. The proceeds from the sale are normally traced to the cash receipts records.normally traced to the cash receipts records.

o When stock is exchanged for property, goods, or When stock is exchanged for property, goods, or services, the valuation issue is more complex. services, the valuation issue is more complex. Generally, fair market value is an issue and the Generally, fair market value is an issue and the accounting may involve a gain or loss.accounting may involve a gain or loss.

o Stock dividends may also create complex auditing Stock dividends may also create complex auditing issues. The auditor must recompute the dividend and issues. The auditor must recompute the dividend and trace the entries to the general ledger.trace the entries to the general ledger.

o When stock is issued for cash the valuation is When stock is issued for cash the valuation is straightforward. The proceeds from the sale are straightforward. The proceeds from the sale are normally traced to the cash receipts records.normally traced to the cash receipts records.

o When stock is exchanged for property, goods, or When stock is exchanged for property, goods, or services, the valuation issue is more complex. services, the valuation issue is more complex. Generally, fair market value is an issue and the Generally, fair market value is an issue and the accounting may involve a gain or loss.accounting may involve a gain or loss.

o Stock dividends may also create complex auditing Stock dividends may also create complex auditing issues. The auditor must recompute the dividend and issues. The auditor must recompute the dividend and trace the entries to the general ledger.trace the entries to the general ledger.

LO# 9

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Auditing Capital-Stock Accounts

Completeness of Disclosures

Examples of disclosure items include:Examples of disclosure items include:o Number of shares authorized, issued, and outstanding Number of shares authorized, issued, and outstanding for each class of stock.for each class of stock.o Call privileges, prices, and dates of preferred stock.Call privileges, prices, and dates of preferred stock.o Preferred-stock sinking funds.Preferred-stock sinking funds.o Stock option or purchase plans.Stock option or purchase plans.o Restrictions on retained earnings and dividends.Restrictions on retained earnings and dividends.o Any completed or pending transactions that may affect Any completed or pending transactions that may affect

stockholders’ equity.stockholders’ equity.

Examples of disclosure items include:Examples of disclosure items include:o Number of shares authorized, issued, and outstanding Number of shares authorized, issued, and outstanding for each class of stock.for each class of stock.o Call privileges, prices, and dates of preferred stock.Call privileges, prices, and dates of preferred stock.o Preferred-stock sinking funds.Preferred-stock sinking funds.o Stock option or purchase plans.Stock option or purchase plans.o Restrictions on retained earnings and dividends.Restrictions on retained earnings and dividends.o Any completed or pending transactions that may affect Any completed or pending transactions that may affect

stockholders’ equity.stockholders’ equity.

LO# 9

15-26

Auditing Dividends

All dividends declared and paid will be audited because of concerns of violations of corporate

bylaws or debt covenants.

When an independent When an independent dividend-disbursing dividend-disbursing agent is used, the auditor agent is used, the auditor can confirm the amount can confirm the amount disbursed with the agent. disbursed with the agent. This amount is agreed This amount is agreed with the amount with the amount authorized by the board authorized by the board of directors.of directors.

When an independent When an independent dividend-disbursing dividend-disbursing agent is used, the auditor agent is used, the auditor can confirm the amount can confirm the amount disbursed with the agent. disbursed with the agent. This amount is agreed This amount is agreed with the amount with the amount authorized by the board authorized by the board of directors.of directors.

When an independent agent is When an independent agent is notnot used, the auditor can used, the auditor can

recompute the amount of the recompute the amount of the dividend authorized by the dividend authorized by the

board of directors and trace the board of directors and trace the amount to cash disbursements amount to cash disbursements

or dividends payable.or dividends payable.

When an independent agent is When an independent agent is notnot used, the auditor can used, the auditor can

recompute the amount of the recompute the amount of the dividend authorized by the dividend authorized by the

board of directors and trace the board of directors and trace the amount to cash disbursements amount to cash disbursements

or dividends payable.or dividends payable.

LO# 10

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Auditing Retained EarningsUnder normal circumstances, retained earnings are affected by the current year’s income or loss and the dividends declared and or paid. The major exception

is the existence of prior period adjustments, valuation accounts for certain marketable securities

and foreign currency translation.

LO# 11

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Auditing Income Statement Accounts

The audit of revenue and expense accounts The audit of revenue and expense accounts depends on the extent of work conducted on the depends on the extent of work conducted on the entity’s control system and balance sheet accounts. entity’s control system and balance sheet accounts. Substantive procedures on selected income Substantive procedures on selected income statement accounts include:statement accounts include:o The results of testing controls for the various business The results of testing controls for the various business processes.processes.o The results of the detailed tests of balance sheet accounts The results of the detailed tests of balance sheet accounts

and the related income statement accounts.and the related income statement accounts.o Performance of substantive analytical procedures on income Performance of substantive analytical procedures on income

statement accounts.statement accounts.o Detailed tests of selected income statement accounts.Detailed tests of selected income statement accounts.

LO# 12

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Assessing Control Risk for Business Processes

If control risk is set at the maximum – the auditor does not rely on controls. Instead extensive substantive procedures are used.

If a reliance strategy is followed – the auditor determines if controls may be relied upon.

If controls are operating effectively – the auditor may reduce control risk below the maximum.

LO# 12

15-30

Direct Tests of Balance Sheet Accounts

Income statement accounts are normally audited in the course of auditing the related balance sheet accounts.Balance Sheet Account Audited Related Income Statement Account

Accounts receivable/allowance for uncollectible accounts

Bad-debt expense

Notes receivable/ investments/ accrued interest receivable

Interest income

PP&E/accumulated depreciationDepreciation expense, gain/losses on sales or retirement of assets

Prepaid insurance Insurance expenseLong-term debt/accrued interest payable

Interest expense

LO# 12

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Substantive Analytical Procedures

Extensive use may be made of analytical procedures in the audit of revenue and expense accounts.

Common sizeCommon sizeincome statementincome statement

for current andfor current andprevious years.previous years.

Common sizeCommon sizeincome statementincome statement

for current andfor current andprevious years.previous years.

PercentagePercentageincome statementincome statement

for current andfor current andprevious years.previous years.

PercentagePercentageincome statementincome statement

for current andfor current andprevious years.previous years.

Trend and ratioTrend and ratioanalysis.analysis.

Trend and ratioTrend and ratioanalysis.analysis.

LO# 12

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Tests of Selected Account Balances

The auditor may wish to examine key revenue and expense accounts in some detail. Usually, the

auditor verifies the transactions in the account by examining the supporting documentation. Accounts audited in this manner may be related to income tax reporting and include legal and audit expense, travel

and entertainment, charitable contributions, and other income and expense.

LO# 12

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Questions

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End of Chapter 15