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

Chapter Fifteen
Auditing the
Financing/Investing
Process:
Long-Term Liabilities,
Stockholders’ Equity
and Income
Statement Accounts

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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.

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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.

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Control Risk Assessment –
Long-Term Debt
When a substantive strategy is followed, the
auditor still needs a sufficient understanding
of the entity’s internal control system over debt.

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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
When the
the entity
entity has
has proper
proper controls
controls for
for issuing
issuing
debt
debt transactions,
transactions, itit is
is generally
generally easy
easy for
for the
the
auditor
auditor to
to test
test those
those transactions
transactions for
for validity
validity and
and

authorization
authorization at
at the
the end
end of
of the
the period.
period.
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Assertions and Related Control Activities
Completeness
The client should maintain a subsidiary ledger
that contains information about all the longterm debt owed by the entity. The debt amount
recorded in the subsidiary ledger should be
reconciled to the general ledger control account
regularly.

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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

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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.

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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.

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Substantive Procedures –
Long-Term Debt

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Substantive Procedures –
Long-Term Debt

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Auditing Stockholders’ Equity

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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.
Large companies may use an independent outside
agent such as a registrar, transfer agent and
dividend-disbursing agent to process and record
equity transactions. Relevant information about
equity transactions may be confirmed with the
registrar and transfer agent.
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Assertions and Related
Control Activities
Occurrence
Occurrence
Verify
Verify that
that stock
stock and
and

dividend
dividend
transactions
transactions comply
comply
with
with corporate
corporate
charter.
charter.
Authorization
Authorization
Verify
Verify that
that stock
stock and
and
dividend
dividend
transactions
transactions have
have
been
been properly
properly
approved.
approved.
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Accuracy
Accuracy
Verify
Verify that
that stock
stock and
and
dividend
dividend
transactions
transactions have
have
been
been properly
properly
posted
posted and
and
summarized
summarized in
in the
the
accounting
accounting records.
records.
Valuation
Valuation
Verify
Verify that

that stock
stock and
and
dividend
dividend
transactions
transactions have
have
been
been properly
properly
valued.
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.

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Auditing Equity Capital Accounts
Occurrence and Completeness
When
When outside
outside agents
agents are
are used,
used, the
the auditor
auditor confirms
confirms information
information
relevant
relevant to
to year
year end
end amounts.
amounts.
When
When outside
outside agents
agents are
are not
not used,
used, the

the auditor
auditor should:
should:
•• Trace
Trace the
the transfers
transfers of
of shares
shares between
between stockholders
stockholders to
to the
the stock
stock
register
register and/or
and/or stock
stock certificate
certificate book.
book.
•• Foot
Foot the
the shares
shares outstanding
outstanding in
in the
the stock
stock register
register and/or
and/or stock

stock
certificate
certificate book
book and
and agree
agree them
them to
to total
total shares
shares outstanding
outstanding in
in
the
the general
general ledger.
ledger.
•• Examine
Examine any
any canceled
canceled stock
stock certificates.
certificates.
•• Account
Account for
for and
and inspect
inspect any
any unissued
unissued stock
stock certificates

certificates in
in the
the
stock
stock certificate
certificate book.
book.

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Auditing Equity Capital Accounts
Valuation
 When
When equity
equity capital
capital is
is issued
issued for
for cash
cash the
the valuation
valuation
is
is straightforward.
straightforward. The
The proceeds
proceeds from

from the
the sale
sale are
are
normally
normally traced
traced to
to the
the cash
cash receipts
receipts records.
records.
 When
When equity
equity capital
capital is
is exchanged
exchanged for
for property,
property,
goods,
goods, or
or services,
services, the
the valuation
valuation issue
issue is
is more
more
complex.

complex. Generally,
Generally, fair
fair market
market value
value is
is an
an issue
issue
and
and the
the accounting
accounting may
may involve
involve aa gain
gain or
or loss.
loss.
 Stock
Stock dividends
dividends may
may also
also create
create complex
complex auditing
auditing
issues.
issues. The
The auditor
auditor must
must recompute

recompute the
the dividend
dividend
and
and trace
trace the
the entries
entries to
to the
the general
general ledger.
ledger.

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Auditing Equity Capital Accounts
Completeness of Disclosures
Examples
Examples of
of disclosure
disclosure items
items include:
include:
 Number
Number of
of shares
shares authorized,

authorized, issued
issued and
and
outstanding
outstanding for
for each
each class
class of
of stock.
stock.
 Call
Call privileges,
privileges, prices
prices and
and dates
dates of
of preferred
preferred
stock.
stock.
 Stock
Stock option
option or
or purchase
purchase plans.
plans.
 Restrictions
Restrictions on
on retained
retained earnings

earnings and
and dividends.
dividends.
 Any
Any completed
completed or
or pending
pending transactions
transactions that
that may
may
affect
affect stockholders’
stockholders’ equity.
equity.

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Auditing Dividends
All dividends declared and paid will be audited
because of concerns of violations of corporate
bylaws or debt covenants.
When
When an
an outside
outside agent
agent

for
for dividend-disbursing
dividend-disbursing is
is
used,
used, the
the auditor
auditor can
can
confirm
confirm the
the amount
amount
disbursed
disbursed with
with the
the agent.
agent.
This
This amount
amount is
is agreed
agreed
with
with the
the amount
amount
authorized
authorized by
by the

the board
board
of
of directors.
directors.
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When
When an
an outside
outside agent
agent is
is
not
not used,
used, the
the auditor
auditor can
can
recompute
recompute the
the amount
amount of
of
the
the dividend
dividend authorized
authorized by

by
the
the board
board of
of directors
directors and
and
trace
trace the
the amount
amount to
to cash
cash
disbursements
disbursements or
or
dividends
dividends payable.
payable.


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.

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Auditing Income Statement Accounts

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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.

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Direct Tests of Balance Sheet Accounts
Income statement accounts are normally audited

in the course of auditing the related balance
sheet accounts.

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Substantive Analytical Procedures
Extensive use may be made of analytical
procedures in the audit of revenue and expense
accounts.
Common
Common size
size
income
income statement
statement
for
for current
current and
and
previous
previous years.
years.

Percentage
Percentage
income
income statement

statement
for
for current
current and
and
previous
previous years.
years.

Trend
Trend and
and ratio
ratio
analysis.
analysis.
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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.

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