Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 15-1...

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

15-1

Chapter FifteenAuditing Financing Process:

Long-Term Liabilities, Stockholders’ Equity and

Income Statement Accounts

Chapter FifteenAuditing Financing Process:

Long-Term Liabilities, Stockholders’ Equity and

Income Statement Accounts


15-2

Auditing Long-Term Debt

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.

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.


15-3

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.


15-4

Assertions and Related Control Activities

Occurrence and AuthorizationOccurrence and Authorization

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

end of the period.end of the period.

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

end of the period.end of the period.


15-5

Assertions and Related ControlActivities

CompletenessCompleteness

The 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.


15-6


ValuationValuation

Notes 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


15-7


Disclosure - ClassificationDisclosure - Classification

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

due in the next year.


15-8

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.


15-9


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.


15-10


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 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.


15-11

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.


15-12

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.


15-13


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.


15-14

Segregation of Duties

The following duties should be segregated:The following duties should be segregated:1.1. The individuals responsible for issuing, transferring and canceling The individuals responsible for issuing, transferring and canceling

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

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

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

4.4. Appropriate segregation of duties should be established among the Appropriate segregation of duties should be established among the payment and recording of dividend payments.payment and recording of dividend payments.


15-15

Auditing Equity Capital 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.


15-16


Valuation

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

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

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

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

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

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


15-17


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 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 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.


15-18

Auditing Dividends

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

bylaws or debt covenants.

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

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

When an outside agent is When an outside agent is not used, the auditor can not used, the auditor can recompute the amount of recompute the amount of the dividend authorized by the dividend authorized by the board of directors and the board of directors and trace the amount to cash trace the amount to cash disbursements or dividends disbursements or dividends payable.payable.

When an outside agent is When an outside agent is not used, the auditor can not used, the auditor can recompute the amount of recompute the amount of the dividend authorized by the dividend authorized by the board of directors and the board of directors and trace the amount to cash trace the amount to cash disbursements or dividends disbursements or dividends payable.payable.


15-19

Auditing Retained Earnings

Under 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 financial instruments

and foreign currency translation.


15-20

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.


15-21

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.


15-22

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 AccountAccounts 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


15-23

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


PercentagePercentageincome statementincome statement


PercentagePercentageincome statementincome statement


Trend and ratioTrend and ratioanalysis.analysis.

Trend and ratioTrend and ratioanalysis.analysis.


15-24

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.


15-25

End of Chapter 15

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