CHAPTER 13 Substantive Audit Testing: Financing & Investing Cycle& Completing the Audit

1. CHAPTER 13Substantive Audit Testing: Financing & Investing Cycle& Completing the Audit

2. What are the major accounts of the capital acquisition and repayment cycle? -Long term liabilities - stock accounts - donated capital - retained earnings and appropriations - dividends declared and payable

3. In auditing the capital acquisition and repayment cycle, the auditor should consider: Relatively few transactions affect the account balances, but each transaction is often highly material in amount.

4. In auditing the capital acquisition and repayment cycle, the auditor should consider: The exclusion of a single transac- tion could be material in itself.

5. In auditing the capital acquisition and repayment cycle, the auditor should consider: There is a legal relationship be- tween the client and the holder of the stock, bond, or similar ownership document.

6. In auditing the capital acquisition and repayment cycle, the auditor should consider: There is a direct relationship be- tween the interest and divi- dends account and debt and equity.

7. In auditing the internal controls related to long-term liabilities, the auditor will consider: - proper authorization for issues of notes or bonds - adequate controls over payment of interest and principal - adequate documents and records - periodic independent verification

8. What are the primary audit objectives with regard to long-term liability account balances? - completeness - accuracy - presentation and disclosure

9. long-term liabilities audit procedures perform analytical procedures to test the reasonableness of long-term liabilities and interest expense

10. long-term liabilities audit procedures inquire of management regarding: - completeness of liabilities - debt-related restrictions on assets - ability to pay interest

11. long-term liabilities audit procedures review contractual provisions of long-term liabilities - consider pledging of assets related to debt (disclosure) - determine client adherence to contractual requirements (payment dates, working capital, ratios)

12. long-term liabilities audit procedures confirm debt balances, interest payments, and client compliance with contractual agreements with the creditors auditor 32 creditor

13. long-term liabilities audit procedures for all long-term liabilities, recalculate interest expense, interest payable, and amortizations of discounts or premiums

14. Bank Statement 5/31/x7 cash receipts journal description _ $$ _ May 23, 19x7 Wachovia loan 14,000 Deposits: 5/23 $14,000 long-term liabilities audit procedures Trace receipt of borrowed amounts from cash receipts journal to bank statement

15. Bank Statement 5/31/x7 cash receipts journal description _ $$ _ May 23, 19x7 Wachovia loan 14,000 Deposits: 5/23 $14,000 Deposit Slip 5/23/x7 14,000 long-term liabilities audit procedures Trace receipt of borrowed amounts from cash receipts journal to bank statementto deposit slips

16. Bank Statement 5/31/x7 cash receipts journal description _ $$ _ May 23, 19x7 Wachovia loan 14,000 Deposits: 5/23 $14,000 Debt Covenant Wachovia Bank hereby loans Ace Co. $14,000 on 5/23/x7 Deposit Slip 5/23/x7 14,000 long-term liabilities audit procedures Trace receipt of borrowed amounts from cash receipts journal to bank statement to deposit slipsto debt agreement.

17. Bank Statement 11/30/x7 cash payments journal description _ $$ _ November 23, 19x7 interest payment- Wachovia loan 700 Deposits: Payments: 11/26 $700 long-term liabilities audit procedures Trace payments of principal and interest from cash payments journal to bank statement

18. Debt Covenant Ace agrees to pay semi-annual interest of 10% on principal. long-term liabilities audit procedures Trace payments of principal and interest from cash payments journal to bank statement to cancelled checks to debt agreement. Bank Statement 11/30/x7 cash payments journal description _ $$ _ November 23, 19x7 interest payment- Wachovia loan 700 Deposits: Payments: 11/26 $700 Ace Corporation 324 date 11/23/x7 $ 700.00 Wachovia Bank pay to the order of

19. What are the auditor’s primary concerns with regard to owners’ equity? - authorization - presentation and disclosure - accuracy

20. owners’ equity audit procedures perform analytical procedures to test the reasonableness of owners’ equity accounts (including dividends)

21. READ: - articles of incorporation, bylaws - minutes to meetings owners’ equity audit procedures Note discussion of dividends, stock options, stock issues, etc.

22. owners’ equity audit procedures Confirm shares outstanding with the independent registrar and the stock transfer agent. - independent registrar - a third party paid by the client to ensure that stock is issued in accordance with the char- ter and board’s directions (required for SEC companies)

23. owners’ equity audit procedures Confirm shares outstanding with the independent registrar and the stock transfer agent. - stock transfer agent - a third party paid by the client to maintain stockholder records and, possibly, to disburse dividends

24. owners’ equity audit procedures If the client does not use an independent registrar and stock transfer agent, the auditor must examine the stock certificate records and test any changes.

25. Bank Statement 5/31/x7 Board Minutes ... sell Joe Ace 2300 additional common... owners’ equity audit procedures Trace receipts from stock issues from cash receipts journal to bank statement to deposit slips to board minutes. cash receipts journal description _ $$ _ May 23, 19x7 Joe Ace 23,000 Deposits: 5/23 $23,000 Deposit Slip 5/23/x7 23,000

26. owners’ equity audit procedures Trace payments related to dividends and treasury stock from cash payments journal to bank statement to cancelled checks to board minutes. Bank Statement 1/31/x7 cash payments journal description _ $$ _ January 23, 19x7 dividend distribution 4300 Deposits: Payments: 1/26 $4300 Board Minutes Ace Corporation 324 date 1/23/x7 ... declare dividends of $4300... $4300.00 Stockholders pay to the order of

27. preferred common owners’ equity audit procedures Recalculate dividend distribution to common and preferred shareholders. consider features of preferred (cumulative, participating)

28. Ace Company 1 share of common Ace Company 1 share of common Ace Company 1 share of common Ace Company 1 share of common stock stock stock stock owners’ equity audit procedures Inspect treasury stock; recalculate treasury stock transactions.

29. If all other accounts have been audited with satisfactory results,Is the audit of retained earnings necessary? Possibly not, but the audit of retained earnings is typically not time-consuming and may serve as a check on the audit of other accounts.

30. owners’ equity audit procedures Analyze all changes in retained earnings.

31. Audit Completion Procedures Search for unrecorded contingent liabilities. What is a contingent liability and what are the related SFAS 5 rules? a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place

32. Audit Completion Procedures Search for unrecorded contingent liabilities. probable and reason- ably estimated - accrual with foot- note disclosure reasonably possible - footnote disclosure remote - no financial statement effect What is a contingent liability and what are the related SFAS 5 rules?

33. Audit Completion Procedures Search for unrecorded contingent liabilities. What is a contingent liability and what are the related SFAS 5 rules? Footnote disclosure should describe the contingency and the opinion of legal counsel or manage- ment regarding the expected outcome.

34. Audit Completion Procedures Search for unrecorded contingent liabilities. - inquire of management - review: ~ client copies of IRS correspondence ~ minutes to board and stockholder meetings ~ invoices from client attorneys ~ existing audit workpapers - obtain letters of confirmation from all client attorneys Joe Lawyer 32 Jill Auditor, CPA

35. Attorney Inquiry (AU 337) The auditor should ask the client to prepare a letter (on client letterhead, signed by client officer) asking the attorney to respond directly to the auditor concerning: - all material pending threatened litigation, claims, or assessments with which the attorney has been involved - all likely, material unasserted claim or assessments with which the attorney has been involved - the status of each claim or assessment - any additional, unlisted legal actions

36. Attorney Inquiry (AU 337) The client’s letter to the attorney should also remind the law firm that they are responsible for telling the client when a legal matter should be disclosed. The client’s letter to the attorney should request that the law firm describe any reasons for limiting their response.

37. Attorney Inquiry (AU 337) If an attorney refuses to respond or refuses to provide adequate information, the audit opinion will be qualified or disclaimed.

38. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date types of subsequent events 1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets)

39. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date types of subsequent events 1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets) Client financial statements for the period under audit must be adjusted to reflect this subsequent event information.

40. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date types of subsequent events 2. events that occur after the balance sheet date and do not relate to condi- tions that existed at year-end (e.g., bond/stock issue, acquisition, fire/flood loss, major customer/vendor bankruptcy)

41. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date types of subsequent events 2. events that occur after the balance sheet date and do not relate to condi- tions that existed at year-end disclose These subsequent events must be disclosed in the footnotes of the period under audit. The auditor may also consider: - pro forma financial statements - additional paragraph in audit report

42. Subsequent Events Auditing Procedures Near field work completion, auditors should: - read post-balance sheet interim statements - obtain a management representation letter - read minutes to board and stockholder meetings that have occurred since year-end - obtain letter from client’s attorney Joe Lawyer 32 Jill Auditor, CPA

43. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date What responsibility does the auditor have for subsequent events that occur between field work completion and the issue date? - the auditor is not responsible for dis- covering subsequent events during this period - if, however, auditors learn of a subsequent event during this period, they are responsible for its disclosure

44. 12/31 2/14 2/28 period under audit subsequent events period balance sheet field work report date completion issue date If auditors learn of a subsequent event during this period, they are responsible for its disclosure. The auditors then have two options: - expand all subsequent events tests to the date of the event and change the report date to the date of the event (e.g., 2/21) - restrict testing only to matters relating to the new event and dual-date the report: Taylor & Tower, CPAs February 14, 19x1, except for Note 3, as to which the date is February 21, 19x1

45. 12/31 2/14 2/28 period subsequent events period under audit balance sheet field work report date completion issue date With regard to this information, auditors must determine: - did the information exist at the report date? - is this information reliable? - would the audit report have been different if the informa- tion had been available prior to the report date? - are persons still relying on the audit report? If the answer to any of these questions is no, the auditors do not need to take any action.

46. 12/31 2/14 2/28 period subsequent events period under audit balance sheet field work report date completion issue date With regard to this information, auditors must determine: - did the information exist at the report date? - is this information reliable? - would the audit report have been different if the informa- tion had been available prior to the report date? - are persons still relying on the audit report? If the answer to all of these questions is yes, the auditors must act to prevent future reliance on the audit report.

47. If the financial statement effect of the subsequently-discovered information can be determined promptly How do auditors prevent future reliance on a previously-issued audit report? the client must revise and reissue the financial statements

48. How do auditors prevent future reliance on a previously-issued audit report? If the financial statement effect of the subsequently-discovered information cannot be determined promptly the client must notify persons known to be (and those likely to be) relying on the financial statements

49. What should the auditor do if the client refuses to reissue the statements or contact those relying on the auditors’ report? - first, notify each board member of management’s refusal - then: ~ inform client management that the audit report may no longer be associated with the statements ~ notify regulatory agencies that the audit report may not be relied upon ~ notify persons known to be relying on the statements that the audit report may not be relied upon

50. Client Representation Letter (AU 333) The auditor must obtain a letter from the client documenting the client’s represen- tations during the engagement. The primary purposes are to: - confirm and document oral statements - reduce auditor-client misunderstanding The letter should be signed by the client CFO and CEO and dated with the field work completion date.