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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.
Chapter Fifteen Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity and Income Statement Accounts 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 – 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 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 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 longterm debt owed by the entity The debt amount recorded in the subsidiary ledger should be reconciled to the general ledger control account regularly McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Auditing Stockholders’ Equity McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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: 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 between dividend payments and recording of dividend payments McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 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 McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 ... 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... 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 McGraw-Hill/Irwin... 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