Chapter 15

1. LO# 1 Chapter 15 Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders′ Equity, and Income Statement Accounts ©2008 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin

2. Balance Sheet Assets Cash Investments Receivables Prepaids Inventory PP and E Other assets - intangibles Liabilities and Equity Accounts payable Accrued liabilities Debt Common stock Retained earnings

3. LO# 1 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.

4. Types of Long Term Debt • Notes • Bonds • Mortgages • Interest Rate Swaps

5. Inherent Risk

6. LO# 1 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.

7. Inherent Risks ( cont’d) • Off balance sheet financing ( Enron) • Complex transactions • Guarantees of debt ( FIN No 45) • Compliance with debt covenants

8. Control Risk Assessment

9. LO# 2 Control Risk Assessment – Long-Term Debt When a substantive strategy is followed, theauditor still needs a sufficient understandingof the entity’s internal control system over debt.

10. LO# 3 Assertions and Related Control Activities Occurrence and Authorization • Adequate documentation must verify that a note or bond was properly authorized. • 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.

11. LO# 3 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.

12. LO# 3 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 interestmethod 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).

13. LO# 3 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.

14. Substantive Analytical Procedures

15. Analytical procedures are useful because of the direct relationship between interest expense and the amount of long-term debt. LO# 4 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.

16. Tests of Details

17. LO# 4 Substantive Procedures of Long-Term Debt

18. LO# 4 Substantive Procedures of Long-Term Debt

19. The following three types of transactions are of importance to the auditor: • 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. • Repurchase of stock including both the reacquisition of stock and retirement of stock. • Payment of dividends including cash and stock dividends. LO# 5 Auditing Stockholders’ Equity

20. Large, publicly traded companies use a registrar and transfer agent to process and record equity transaction. Relevant information about equity transactions may be confirmed with the register and transfer agent. LO# 6 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.

21. LO# 7 Assertions and Related Control Activities OccurrenceVerify that stock and dividend transactions comply with corporate charter. AccuracyVerify that stock and dividend transactions have been properly posted and summarized in the accounting records. AuthorizationVerify that stock and dividend transactions have been properly approved. ValuationVerify that stock and dividend transactions have been properly valued.

22. LO# 8 Segregation of Duties • When possible, 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 among the preparation, recording, signing, and mailing of dividend checks.

23. LO# 9 Auditing Capital-Stock Accounts Occurrence and Completeness • 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.

24. LO# 9 Auditing Capital-Stock Accounts Valuation • When stock is issued for cash the valuation is straightforward. The proceeds from the sale are normally traced to the cash receipts records. • When stock 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.

25. LO# 9 Auditing Capital-Stock 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. • Preferred-stock sinking funds. • Stock option or purchase plans. • Restrictions on retained earnings and dividends. • Any completed or pending transactions that may affect stockholders’ equity.

26. LO# 10 Auditing Dividends All dividends declared and paid will be audited because of concerns of violations of corporate bylaws or debt covenants. When an independent dividend-disbursing agent 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 independent 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.

27. LO# 11 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 marketable securities and foreign currency translation.

28. The audit of revenue and expense accounts depends on the extent of work conducted on the entity’s control system and balance sheet accounts. Substantive procedures on selected income statement accounts include: • The results of testing controls for the various business processes. • The results of the detailed tests of balance sheet accounts and the related income statement accounts. • Performance of substantive analytical procedures on income statement accounts. • Detailed tests of selected income statement accounts. LO# 12 Auditing Income Statement Accounts

29. 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 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.

30. LO# 12 Direct Tests of Balance Sheet Accounts Income statement accounts are normally audited in the course of auditing the related balance sheet accounts.

31. LO# 12 Substantive Analytical Procedures Extensive use may be made of analytical procedures in the audit of revenue and expense accounts. Common sizeincome statementfor current andprevious years. Percentageincome statementfor current andprevious years. Trend and ratioanalysis.

32. LO# 12 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.

33. Questions

34. End of Chapter 15