Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders

1
Chapter Fifteen
Auditing the Financing/Investing Process
Long-Term Liabilities, Stockholders
Equity and Income Statement Accounts
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.
3
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.
4
Control Risk Assessment Long-Term Debt
When a substantive strategy is followed,
theauditor still needs a sufficient
understandingof the entitys internal control
system over debt.
5
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 by 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.
6
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.
7
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
8
Assertions and Related Control Activities
Disclosure - Classification
Controls 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.
9
Substantive Procedures 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.
10
Substantive Procedures Long-Term Debt
11
Substantive Procedures Long-Term Debt
12
Auditing Stockholders Equity
13
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.
14
Assertions and Related
Control Activities
15
Segregation of Duties

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

16
Auditing Equity Capital Accounts
Occurrence and Completeness

• When outside agents are used, the auditor
  confirms information relevant to year end
  amounts.
• When outside agents are not used, the auditor
  should
• Trace the transfers of shares between
  stockholders to the stock register and/or stock
  certificate book.
• Foot the shares outstanding in the stock register
  and/or stock certificate book and agree them to
  total shares outstanding in the general ledger.
• Examine any canceled stock certificates.
• Account for and inspect any unissued stock
  certificates in the stock certificate book.

17
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.

18
Auditing Equity Capital Accounts
Completeness of Disclosures

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

19
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.
20
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.
21
Auditing Income Statement Accounts
22
Assessing Control Risk for Business Processes
23
Direct Tests of Balance Sheet Accounts
Income statement accounts are normally audited in
the course of auditing the related balance sheet
accounts.
24
Substantive Analytical Procedures
Extensive use may be made of analytical
procedures in the audit of revenue and expense
accounts.
25
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.
26
End of Chapter 15