CHAPTER 13 AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS ’ EQUITY TRANSACTIONS

1. CHAPTER 13AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

2. Learning Objectives • Identify the significant accounts, disclosures, and relevant assertions in auditing debt obligations and stockholders’ equity transactions • Identify and assess inherent risks of material misstatement associated with debt obligations and stockholders’ equity transactions • Identify and assess fraud risks of material misstatement associated with debt obligations and stockholders’ equity transactions

3. Learning Objectives • Identify and assess control risks of material misstatement associated with debt obligations and stockholders’ equity transactions • Describe how to use preliminary analytical procedures to identify possible material misstatements associated with debt obligations and stockholders’ equity transactions • Determine appropriate responses to identified risks of material misstatement in auditing debt obligations and stockholders’ equity transactions

4. Learning Objectives • Determine appropriate tests of controls and consider the results of tests of controls in auditing debt obligations and stockholders’ equity transactions • Determine and apply sufficient appropriate substantive audit procedures in auditing debt obligations and stockholders’ equity transactions

5. Learning Objectives • Apply the frameworks for professional decision making and ethical decision making to issues involving the audit of debt obligations and stockholders’ equity transactions

6. THE AUDIT OPINION FORMULATION PROCESS

7. 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

8. 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

9. 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

10. 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)

11. Learning objective 1 IDENTIFY THE SIGNIFICANT ACCOUNTS, DISCLOSURES, AND RELEVANT ASSERTIONS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

12. Relevant accounts when auditing debt obligations • Bonds payable • Interest expense • Gains or losses on refinancing debt • Notes payable • Mortgages payable

13. auditing debt obligations • Objective - Determining whether all obligations are recorded and properly classified • Relevant assertions • Proper valuation of premium or discount • Valuation of gains or losses on refinancing debt • Proper presentation and disclosure, including important restrictions contained in the debt obligations

14. ACTIVITIES RELATED TO DEBT OBLIGATIONS Bond issuance and amortization schedules Periodic payments and interest expense Debt covenants

15. Bond indenture • Contract between an issuer of bonds and the bondholder stating: • Time period before repayment • Amount of interest paid • Bond being convertible (and if so, at what price or what ratio) • Bond being callable • Amount of money that is to be repaid

16. Debt Covenants • Restrictions in debt agreements aimed at protecting the lender by restricting the activities of the borrower • Common Restrictions • Maintenance of a minimum level of retained earnings before dividends can be paid • Maintenance of a minimum working-capital ratio • Specification of a maximum debt-equity ratio • Specific callable provisions identifying procedures for calling and retiring debt at prespecified prices and dates

17. RELEVANT ACCOUNTS FOR AUDITING STOCKHOLDERS’ EQUITY Stock accounts (common, preferred, and treasury) Additional paid-in capital Dividend accounts Retained earnings

18. TRANSACTIONS AFFECTING STOCKHOLDERS’ EQUITY

19. 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

20. 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

21. EXHIBIT 13.1 - BALANCE SHEET DISCLOSURE OF STOCKHOLDERS’ EQUITY

22. 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

23. EXHIBIT 13.2 - Income Statement Disclosure of Earnings per Share, Assuming Dilution

24. Learning objective 2 IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

25. performing risk assessment procedures • Obtaining information about inherent risks • At financial statement level and at account and assertion levels • Fraud risks including feedback from audit team brainstorming sessions • Strengths and weaknesses in internal control • Results from preliminary analytical procedures

26. 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 Recording of debt transactions • Interest expense not being properly recorded or accrued • Debt not being recorded in accordance with GAAP Compliance with any debt covenants • Risk of debt covenants not being calculate accurately • Risk of compliance with debt covenants not being appropriately reviewed and disclosed

27. EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS’ EQUITY ACTIVITIES

28. EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS’ EQUITY ACTIVITIES

29. Learning objective 3 IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

30. Identifying Fraud Risk Factors - Debt Obligations Violations of debt covenants are not disclosed Debt obligations are not properly authorized Long-term or short-term debt is misclassified Interest expense either not recorded, misclassified, or recorded: • In the wrong period • At the wrong amount Entire loan payments are charged to either principal or interest

31. IDENTIFYING FRAUD RISK FACTORS -STOCKHOLDERS’ EQUITY • Expenses charged directly to retained earnings rather than to appropriate expense accounts • Stock sales or issuances: • Not authorized or recorded • Violate debt covenants • Stock options are: • Not authorized or in accordance with terms of options granted • Backdated

32. 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

33. Learning objective 4 IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

34. Identifying Control Risks • At entity-wide level, auditor considers: • Control environment • Commitment to financial accounting competencies • Independence of the board of directors • Other entity-wide components of internal control • Risk assessment • Information and communication • Monitoring controls

35. Controls - Debt Obligations • Board of directors approves all new debt • Debt and interest accounts are updated and reconciled to the general ledger on a monthly basis • Review of draft financial statements prior to issuance for proper disclosure of debt obligations • A debt amortization schedule is: • Prepared for each new debt obligation • Updated as appropriate • Reviewed by appropriate personnel

36. 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

37. 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

38. Documenting Controls • Can be done in any of the following formats • Control matrix • Control risk assessment questionnaire • Memo

39. Learning objective 5 DESCRIBE HOW TO USE PRELIMINARY ANALYTICAL PROCEDURES TO IDENTIFY POSSIBLE MATERIAL MISSTATEMENTS ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITYTRANSACTIONS.

40. Preliminary Analytical Procedures • Help identify areas of potential misstatements • For debt obligations • Trend analysis of: • Balances in notes payable • Interest expense • Accrued interest with prior periods • Estimate interest expense based on average interest rates and average debt outstanding

41. 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

42. Learning objective 6 DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

43. determining appropriate audit procedures • Debt accounts - Substantive procedures are typically appropriate because: • Number of transactions is relatively small • Dollar amounts involved are usually quite material • Stockholders’ equity transactions - Substantive approach using only tests of details is typically appropriate • Number of equity transactions with outside parties is normally small

44. Learning objective 7 DETERMINE APPROPRIATE TESTS OF CONTROLS AND CONSIDER THE RESULTS OF TESTS OF CONTROLS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

45. Obtaining Evidence about Internal Control Operating Effectiveness • Involves testing both entity-wide and transaction controls • Tests of transaction controls • Inquiry of personnel performing the control • Observation of control being performed • Inspection of documentation confirming that the control has been performed • Reperformance of the control by the auditor testing the control

46. Learning objective 8 DETERMINE AND APPLY SUFFICIENT APPROPRIATE SUBSTANTIVE AUDIT PROCEDURES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS

47. Substantive Analytical Procedures - Debt Obligations • Involves developing an independent expectation of interest expense • Expectation based on: • Average debt outstanding • Average interest rates • Use data disaggregated by type of debt • If test of controls are not performed • Information used to perform analytical procedure is confirmed with an independent outside party

48. EXHIBIT 13.4 - Panel A: Substantive Analytical Procedures Approach to Obtaining Audit Evidence for Completeness of Interest Expense

49. EXHIBIT 13.4 - Panel B: Substantive Analytical Procedures and Tests of Details Approach to Obtaining Audit Evidence for Completeness of Interest Expense

50. Substantive Tests of Details - Debt Obligations Reading new loan agreements Determining any changes that have been made to prior loan agreements Confirming with relevant outside parties the significant factors and transactions that have occurred