Lecture Auditing and assurance services (Second international edition) Chapter 15 Auditing the financinginvesting process

Chapter 15 Auditing the financinginvesting process Long term liabilities, stockholders’ equity and income statement accounts. In this chapter, the learning objectives are Understand the types and features of longterm debt, be familiar with assessing control risk for longterm debt, be familiar with key control activities for longterm debt, know how to conduct substantive audit procedures for longterm debt.

Auditing the Financing/Investing Process:

Long-Term Liabilities, Stockholders’ Equity

and Income Statement Accounts

Chapter Fifteen

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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

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

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

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

Control Risk Assessment –

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

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

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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

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

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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

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

Analytical procedures are useful

because of the direct relationship between interest expense and the amount of

long-term debt.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

Substantive Procedures –

Long-Term Debt

Substantive Procedures –

Long-Term Debt

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

Auditing Stockholders’ Equity

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

registrar and transfer agent.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

Assertions and Related

Control Activities

Occurrence Verify that stock and

dividend transactions comply with corporate

charter.

Occurrence Verify that stock and

dividend transactions comply with corporate

charter.

Accuracy Verify that stock and

dividend transactions have been properly posted and summarized in the accounting records.

Accuracy Verify that stock and

dividend transactions have been properly posted and summarized in the accounting records.

Authorization Verify that stock and

dividend transactions have been properly approved.

Authorization Verify that stock and

dividend transactions have been properly approved.

Valuation Verify that stock and

dividend transactions have been properly

valued.

Valuation Verify that stock and

dividend transactions have been properly

valued.

Segregation of Duties

The following duties should be segregated:

1 The individuals responsible for issuing, transferring and canceling stock certificates should not have any accounting responsibilities.

2 The individual responsible for maintaining the detailed stockholders’ records should be independent of the maintenance of the general ledger control accounts.

3 The individual responsible for maintaining the detailed stockholders’ records should not also process cash receipts or disbursements.

4 Appropriate segregation of duties should be established between dividend payments and recording of dividend payments.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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.

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.

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.

 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.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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.

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.

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 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.

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.

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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 financial instruments and foreign currency

translation.

Auditing Income Statement Accounts

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

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.

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.

Direct Tests of Balance Sheet Accounts

Income statement accounts are normally audited

in the course of auditing the related balance

sheet accounts

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

Substantive Analytical Procedures

Extensive use may be made of analytical

accounts

Common sizeincome statementfor current andprevious years

Common sizeincome statementfor current andprevious years

Percentageincome statementfor current andprevious years

Percentageincome statementfor current andprevious years

Trend and ratio

analysis

Trend and ratio

analysis

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

McGraw-Hill/Irwin © The McGraw-Hill Companies 2010

End of Chapter 15