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Chapter Fifteen
Auditing Financing Process: Long-Term Liabilities, Stockholders Equity and Income Statement Accounts

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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.

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15-3

Control Risk Assessment Long-Term Debt

When a substantive strategy is followed, the auditor still needs a sufficient understanding of the entitys internal control system over debt.

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15-4

Assertions and Related Control Activities

Occurrence 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 transactions, it is generally easy for the auditor to test those transactions for validity and authorization at the end of the period.
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15-5

Assertions and Related Control Activities

Completeness
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.

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15-6

Assertions and Related Control Activities

Valuation
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

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15-7

Assertions and Related Control Activities

Disclosure - 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.

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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.
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15-9

Substantive Procedures of Long-Term Debt

Assertions
Occurrence

Substantive Tests of Transaction

Examine copies of new note or bond agreements. Examine board of directors' minutes for approval of new lending agreements. 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. Examine board minutes for evidence of proper authorization of notes or bonds. Test a sample of receipts and payments. Review debt activity for a few days before and after year-end to determine if the transactions are included in the proper period. Examine the due dates on notes or bonds for proper classification between current and long-term debt.
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Completeness

Authorization Accuracy Cutoff Classification

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15-10

Substantive Procedures of Long-Term Debt

Year-End Balances Tests of Details of Account Balances
Existence Confirm notes or bonds directly with creditors. Rights and obligations Examine copies of note and bond agreements. 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 Completeness 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. Examine new debt agreements to ensure that they were recorded at the proper value. Confirm the outstanding balance for notes or Valuation and bonds and the last date on which interest has been paid. allocation Recompute accrued interest. Verify computation of the amortization of premium or discount.

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15-11

Auditing Stockholders Equity

The following three types of transactions are of importance to the auditor:
1. Issuance of stock including transactions such as sale of stock for cash; the exchange of stock for assets; and issuance of stock for stock splits. 2. Repurchase of stock including both the reacquisition of stock and retirement of stock. 3. Payment of dividends including cash and stock dividends.

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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.

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15-13

Assertions and Related Control Activities

Occurrence Verify that stock and dividend transactions comply with corporate charter. Accuracy Verify that stock and dividend transactions have been properly posted and summarized in the accounting records.

Authorization Verify that stock and dividend transactions have been properly approved.
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Valuation Verify that stock and dividend transactions have been properly valued.
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15-14

Segregation of Duties
The following duties should be segregated:
1. The individuals responsible for issuing, transferring and canceling stock certificates should not have any accounting responsibilities. 2. The individual responsible for maintaining the detailed stockholders records should be independent of the maintenance of the general ledger control accounts. 3. The individual responsible for maintaining the detailed stockholders records should not also process cash receipts or disbursements. 4. Appropriate segregation of duties should be established among the payment and recording of dividend payments.

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15-15

Auditing Equity Capital Accounts

Occurrence and Completeness
When outside agents are not used the auditor should:
o Trace the transfers of shares between stockholders to the stock register and/or stock certificate book.

o Foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares outstanding in the general ledger. o Examine any canceled stock certificates.
o Account for and inspect any unissued stock certificates in the stock certificate book.
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15-16

Auditing Equity Capital Accounts

Valuation
When equity capital is issued for cash the valuation is straightforward. The proceeds from the sale are normally traced to the cash receipts records.
When equity capital is exchanged for property, goods, or services, the valuation issue is more complex. Generally, fair market value is an issue and the accounting may involve a gain or loss. Stock dividends may also create complex auditing issues. The auditor must recompute the dividend and trace the entries to the general ledger.
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Auditing Equity Capital Accounts

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

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

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15-19

Auditing Retained Earnings

Under normal circumstances, retained earnings are affected by the current years 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.

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15-20

Auditing Income Statement Accounts

The audit of revenue and expense accounts depends on the extent of work conducted on the entitys control system and balance sheet accounts. Substantive procedures on selected income statement accounts include: o The results of testing controls for the various business
processes. o The results of the detailed tests of balance sheet accounts and the related income statement accounts. o Performance of substantive analytical procedures on income statement accounts. o Detailed tests of selected income statement accounts.
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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.
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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
Accounts receivable/allowance for uncollectible accounts Notes receivable/ investments/ accrued interest receivable PP&E/accumulated depreciation Prepaid insurance Long-term debt/accrued interest payable

Related Income Statement Account

Bad-debt expense Interest income Depreciation expense, gain/losses on sales or retirement of assets Insurance expense Interest expense

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15-23

Substantive Analytical Procedures

Extensive use may be made of analytical procedures in the audit of revenue and expense accounts. Common size income statement for current and previous years. Percentage income statement for current and previous years.

Trend and ratio analysis.

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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.

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End of Chapter 15

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