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A RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
CHAPTER 13
AUDITING DEBT OBLIGATIONS AND
STOCKHOLDERS’ EQUITY TRANSACTIONS
13-2
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LEARNING OBJECTIVES
13-4
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LEARNING OBJECTIVES
13-5
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THE AUDIT OPINION FORMULATION
PROCESS
13-6
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PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES
IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY ACCOUNTS
• Debt Obligations
• It was identified that Soyo group was not in
compliance with three of its six debt covenants with
UCB as of December 31, 2007
• Audit team:
• Did not follow up on identified debt covenant violations
• Did not obtain evidence indicating whether a waiver had
been granted by UCB
13-7
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PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES
IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY ACCOUNTS
• Audit work papers did not provide any evidence that
audit team considered whether these violations could
impact the going concern status of Soyo
• Audit report for 2007 included an unqualified opinion
13-8
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PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES
IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY ACCOUNTS
• Adjustments to Stockholders’ Equity Accounts:
Delphi Corporation
• Accused of violations related to improperly accounting
for an increase in warranty reserves related to
warranty claims made by its former parent company
• Misclassification of the reserve (as a direct adjustment
to retained earnings) increase resulted in materially
overstating its net income for 2000 by $69 million
13-9
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PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES
IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY ACCOUNTS
• What are the risks of material misstatement
associated with debt obligations and stockholders’
equity accounts? (LO 2, 3, 4)
• What are the typical substantive procedures that
auditors should perform when auditing debt
obligations and stockholders’ equity accounts? (LO
8)
• How could a lack of appropriate professional
skepticism by auditors lead to material
misstatements related to debt obligations and
stockholders’ equity accounts? (LO 2, 3, 5, 6, 8)
Copyright © 2014 South-Western/Cengage Learning
13-10
LEARNING OBJECTIVE 1
13-12
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AUDITING DEBT OBLIGATIONS
13-13
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ACTIVITIES RELATED TO DEBT
OBLIGATIONS
Bond issuance and amortization
schedules
Debt covenants
13-14
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BOND INDENTURE
13-15
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DEBT COVENANTS
13-16
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RELEVANT ACCOUNTS FOR AUDITING
STOCKHOLDERS’ EQUITY
Stock accounts (common, preferred,
and treasury)
Dividend accounts
Retained earnings
13-17
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TRANSACTIONS AFFECTING
STOCKHOLDERS’ EQUITY
New stock issuances
13-18
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VALUATION ASSERTION FOR
STOCKHOLDERS’ EQUITY
• When issuing stock for noncash, difficulties arise in
determining
• Whether the market value of the stock issued or of the
asset acquired is a better representation of value
• The proper accounting for an exchange of stock to
acquire another business
• Stock options - Measured at the fair value of the
option
13-19
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PRESENTATION AND DISCLOSURE
ASSERTION FOR STOCKHOLDERS’ EQUITY
• Requires proper description of:
• Each class of stock outstanding and number of shares
authorized, issued, and outstanding and special rights
associated with them
• Stock options outstanding and convertible features
• Existence of stock warrants
• Any restrictions or appropriations of retained earnings
• Prior-period adjustments and other comprehensive
income adjustments
13-20
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EXHIBIT 13.1 - BALANCE SHEET
DISCLOSURE OF STOCKHOLDERS’ EQUITY
13-21
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PRESENTATION AND DISCLOSURE
ASSERTION FOR STOCKHOLDERS’ EQUITY
• Potential dilutive effect of following should be
disclosed in accordance with relevant accounting
guidance
• Convertible debt or preferred stock
• Stock options
• Warrants
13-22
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EXHIBIT 13.2 - INCOME STATEMENT DISCLOSURE
OF EARNINGS PER SHARE, ASSUMING DILUTION
13-23
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LEARNING OBJECTIVE 2
13-25
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IDENTIFYING INHERENT RISKS - DEBT
OBLIGATIONS
Authorization of debt
•Incurring debt that is not properly authorized or reviewed
Receipt of funds
•New debt, debt extinguishments, or debt payment
transactions not being properly authorized
13-27
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EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED
WITH STOCKHOLDERS’ EQUITY ACTIVITIES
13-28
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LEARNING OBJECTIVE 3
13-31
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IDENTIFYING FRAUD RISK FACTORS -
STOCKHOLDERS’ EQUITY
• Dividends are paid:
• In violation of restrictive covenants
• To wrong parties or at incorrect amounts
• Proceeds from stock sales are misappropriated
13-32
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LEARNING OBJECTIVE 4
13-34
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CONTROLS - DEBT OBLIGATIONS
13-35
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CONTROLS - STOCKHOLDERS’ EQUITY
TRANSACTIONS
• Board of directors approves all stock transactions
• CEO and CFO authorize approved stock transactions
• Stockholders’ equity accounts are updated and
reconciled to the general ledger on a timely basis
• Top management and the board of directors review
draft financial statements prior to issuance for
proper disclosure of equity accounts
13-36
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CONTROLS - STOCKHOLDERS’ EQUITY
TRANSACTIONS
• An outside party maintains details of shares issued,
repurchased, and cancelled
• Accountant researches and analyzes proper
accounting for stock option grants
• Organization’s legal counsel and CFO review and
approve the analysis
13-37
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DOCUMENTING CONTROLS
13-38
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LEARNING OBJECTIVE 5
13-40
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PRELIMINARY ANALYTICAL
PROCEDURES
• Calculate debt-to-equity ratios and perform a trend
analysis with prior periods
• Calculate the times interest earned ratio and perform a
trend analysis with prior periods
• For stockholders’ equity accounts
• Compare current year account balances with prior-
year account balances
13-41
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LEARNING OBJECTIVE 6
13-43
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LEARNING OBJECTIVE 7
13-45
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LEARNING OBJECTIVE 8
13-47
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EXHIBIT 13.4 - PANEL A: SUBSTANTIVE ANALYTICAL PROCEDURES
APPROACH TO OBTAINING AUDIT EVIDENCE FOR COMPLETENESS
OF INTEREST EXPENSE
13-48
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EXHIBIT 13.4 - PANEL B: SUBSTANTIVE ANALYTICAL PROCEDURES
AND TESTS OF DETAILS APPROACH TO OBTAINING AUDIT
EVIDENCE FOR COMPLETENESS OF INTEREST EXPENSE
13-49
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SUBSTANTIVE TESTS OF DETAILS - DEBT
OBLIGATIONS
13-50
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EXHIBIT 13.5 - RELEVANT MANAGEMENT ASSERTIONS
AND SUBSTANTIVE PROCEDURES FOR DEBT OBLIGATIONS
13-51
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SUBSTANIVE PROCEDURES - DEBT AND
BOND COVENANTS
• Auditor should:
• Obtain an understanding of the procedures the client
uses to determine whether they are in compliance
with their debt covenants
• Then independently determine if the client is in
compliance
• If not in compliance, auditor should assess the effects
of the violation
13-52
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SUBSTANTIVE TESTS OF DETAILS -
STOCKHOLDERS’ EQUITY TRANSACTIONS
• Reviewing a copy of client’s articles of incorporation
• Preparing, or asking client to prepare, an analysis of all
capital stock transactions
• Inspecting documentation related to client’s record
keeping of capital stock and contributed capital
maintained by the client or held by a transfer agent
• Transfer agent: An organization used by a client to:
• Maintain records of investors and account balances and
transactions
• Cancel and issue certificates and process investor mailings
13-53
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SUBSTANTIVE TESTS OF DETAILS -
STOCKHOLDERS’ EQUITY TRANSACTIONS
• Obtaining evidence related to the valuation of capital
stock
• Reviewing the minutes of the board of directors
meetings
• Examining the stock records books
• Obtaining evidence for all capital stock transactions
• Tracing proceeds to cash receipts journal and reviewing
documentation
13-54
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SUBSTANTIVE TESTS OF DETAILS -
STOCKHOLDERS’ EQUITY TRANSACTIONS
• For stock issued in a nonmonetary transaction
• Determining that client has properly recorded issuance in
accordance with GAAP
• For clients with treasury stock
• Examining documentation supporting changes in
number of shares since prior year
13-55
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AUDITING IN PRACTICE - DEFICIENCIES IN SUBSTANTIVE
PROCEDURES RELATED TO EQUITY TRANSACTIONS:
INSIGHTS FROM THE PCAOB
13-56
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AUDITING IN PRACTICE - DEFICIENCIES IN SUBSTANTIVE
PROCEDURES RELATED TO EQUITY TRANSACTIONS:
INSIGHTS FROM THE PCAOB
• Address and evaluate the substance, business purpose,
or significant terms of the equity arrangements
• Consider the accounting principles potentially
applicable to the equity transactions
13-57
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SUBSTANTIVE TESTS OF DETAILS -
DIVIDENDS
• Examine minutes of board of directors meetings for
authorization of dividend per share amount and
dividend record date
• For clients maintaining their own records and paying
the dividends
• Auditor need to recalculate the amount of the
dividends and agree that amount to the cash
disbursements journal
• For client using a transfer agent:
• Trace the payment to a cash disbursement made by
the client to the agent 13-58
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SUBSTANTIVE TESTS OF DETAILS -
RETAINED EARNINGS
• Examine transactions recorded in retained earnings
account during audit period
• Common entries include net income or loss
• These amounts tested through substantive audit
procedures related to revenues and expenses
• Other common entry includes dividends
• Auditor should review documentation for any
additional entries
13-59
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FRAUD-RELATED SUBSTANTIVE
PROCEDURES FOR DEBT OBLIGATIONS
Search public records to identify debt obligations
13-60
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FRAUD-RELATED SUBSTANTIVE PROCEDURES
FOR STOCKHOLDERS’ EQUITY ACCOUNTS
13-62
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DOCUMENTING SUBSTANTIVE PROCEDURES -
FOR STOCKHOLDERS’ EQUITY TRANSACTIONS
13-63
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