Auditing Principles - CH 15 - Debt & Equity Capital

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  1. Source and Nature of Debt
    ØLong-term debt

    -Substantial in amount and often extend for periods of 20 years or more

    lExamples: Debentures, secured bonds and notes payable

    • lFormal document creating bond indebtedness is indenture or trust indenture
    • •May contain restrictive covenants
  2. Financing cycle
    • ØActivities of company designed to obtain
    • capital funds

    lInvolves issuance and repayment of debt and equity

    Payment of interest and dividends
  3. Primary concern
    Proper authorization by appropriate official in the company or by board of directors
  4. Inherent Risk
    • ØSimilar to accounts payable in that
    • understatement of debt is a major potential audit problem

    ØDisclosure of debt

    • lAuditor
    • must determine whether company has met all requirements and restrictions of
    • debt agreement
  5. Internal Control Over Interest
    --     Bearing Debt
    ØAuthorization by the board of directors

    ØUse of an independent trustee

    • ØInterest Payments on Bonds and Notes
    • Payable--Cash disbursement controls
  6. Internal Control

    lAre amounts of new debt authorized by appropriate management?

    lIs an independent trustee used for all bond issues?

    lDoes a company official monitor compliance with debt provisions?
  7. Audit Documentation
    • ØCopy of loan agreement or indenture
    • related to bond placed in permanent file

    • ØExtract list of restrictions placed on
    • company for auditor to test compliance

    ØCurrent workpapers

    lAnalyses of ledger accounts for notes and bonds payable

    lRelated accounts of interest and discount or premium
  8. Substantive Tests of Interest-
    Bearing Debt - 1 of 6
    • ØObtain analyses of interest-bearing
    • debt and related accounts

    a.Payment or other disposition of notes listed as outstanding in the previous year’s audit can be verified

    b.Propriety of individual debits and credits can be established

    c.Amount of year-end balance of the account is proved through the step-by-step examination of all changes in the account during the year

    • d.Misstatements may be due to improper reporting of debt, incomplete recording of debt or
    • improper amortization

    • ØExamine copies of notes payable and
    • supporting documents
  9. Substantive Tests of Interest-  
    Bearing Debt - 2 of 6
    ØConfirm interest-bearing debt

    lConfirmed by financial institution

    lIncluded with standard confirmation form for cash

    lFor others, use letter drafted on client’s letterhead

    • lConfirm dates of origin, due dates, unpaid balances of notes, interest rates, dates to
    • which interest has been paid and collateral for notes

    lConfirm bonds with trustee
  10. Substantive Tests of Interest-  
    Bearing Debt - 3 of 6
    ØVouch borrowing and repayment transactions

    lTrace cash received from issuance  of notes or bonds to validated copy of bank deposit slip and to bank statement

    lExamine payments and agree to repayment schedule

    lExamine canceled notes for retired notes

    lTrace disposition of any collateral used to secure canceled notes

    ØPerform analytical procedures

    • lDetermine overall reasonableness of interest expense by examining relationship of
    • recorded interest to average principal amount of debt outstanding during year
  11. Substantive Tests of Interest-  
    Bearing Debt - 4 of 6
    ØTest computations of interest expense, interest payable, and amortization of discount and premium

    ØEvaluate compliance with debt provisions

    lVouch payments to sinking fund

    lMaintenance of stipulated minimum levels of working capital

    lExamine evidence of insurance of pledged property

    lCompare amounts of management compensation and dividends paid to amounts allowed by agreements

    ØVerify authority for issuance of debt to corporate minutes
  12. Substantive Tests of Interest-  
    Bearing Debt - 5 of 6
    ØReview notes payable paid or renewed after the balance sheet date

    ØPerform procedures to identify notes payable to related parties

    ØSend confirmation letters about financing arrangements

    • lSeparate confirmation letter to verify details of financing arrangements.
    • lExamples:
    • Lines of credit or contingent liabilities

    ØEvaluate financial statement presentation and disclosure
  13. Substantive Tests of Interest-  
    Bearing Debt - 6 of 6
    ØEvaluate financial statement presentation and disclosure

    lAdequately describe:

    lLong-term debt payable in the current period

    lRestrictions imposed by long-term debt agreements

    lUnamortized bond premium or discount
  14. Time of examination
    ØSmall number of entries

    • ØEnd of the year – often wait until after
    • balance sheet date for many procedures

    lTest for unrecorded liabilities cannot usually be done before the balance sheet date

    lEvaluation of compliance with debt provisions

    lTests of interest expense

    lInvestigation of notes paid after year-end
  15. Sources of owner’s equity
    ØCorporate accounts

    lCapital stock accounts

    •Preferred and common

    lRetained earnings

    •Prior period adjustments

    lTransactions generally few in number but material in amount
  16. Objectives for the Audit of Owners’ Equity
    • 1.Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to owners’ equity.
    • 2.Obtain an understanding of internal control over owners’ equity.
    • 3.Assess the risks of material misstatement of and design tests of controls and substantive procedures that:
    • a.Substantiate the existence of owners’ equity and the occurrence of the related transactions
    • b.Establish the completeness of recorded owners’ equity
    • c.Verify the cutoff of transactions affecting owners’ equity
    • d.Determine that the client has obligations to pay the recorded debt
    • e.Establish the proper valuation of owners’ equity and the accuracy of transactions affecting owners’ equity
    • f.Determine that the presentation and disclosure of owners’ equity are appropriate
  17. Internal Control - Capital Stock (1 of 2)
    • ØProper authorization of transactions by
    • board of directors an corporate officers

    • ØSegregation of duties in handling
    • transactions

    ØMaintenance of adequate records
  18. Internal Control - Capital Stock (2 of 2)
    • ØBoard
    • of director control of capital stock transactions

    • ØLarge
    • companies—Independent registrar and stock transfer agent control issuance of
    • stock

    • ØSmall
    • companies--Control achieved by segregation of duties of authorization of
    • transactions, custody of stock certificates, and recordkeeping

    lStock certificate book

    lStockholders’ ledger

    ØControl over dividend payment
  19. Audit Documentation
    ØLead schedule for equity accounts

    • ØAnalysis of each equity account for the
    • permanent file

    lStock option plan

    lPermanent file list of shareholders and number of shares
  20. Permanent File
    ØExamine articles of incorporation, bylaws, and minutes for provisions relating to capital stock

    lInformation for each issue of capital stock

    •Number of share authorized and issued

    •Par or stated value

    •Dividend rates

    •Call and conversion procedures

    •Stock splits

    •Stock options, if any
  21. Understanding of Internal Control
    • ØObtain an understanding of internal
    • control over capital stock transactions

    • lWritten
    • description or flowchart from questionnaire

    • •Does the company utilize the services of
    • an independent registrar and stock transfer agent?

    • •Are stockholders ledgers and transfer
    • journals maintained?

    • •Are entries in owners’ equity accounts
    • reviewed periodically by an appropriate officer?
  22. Substantive Tests of Capital Stock
    ØObtain analyses of capital stock accounts

    lIncluding treasury stock

    ØAccount for proceeds of stock issues

    ØConfirm shares outstanding

    • lRequest written by client on client’s
    • letterhead but mailed by auditors

    ØReconcile shares outstanding with general ledger

    lAccounting for stock certificate numbers

    lExamining canceled certificates

    • lReconciling the stockholders ledger and
    • stock certificate book with the general ledger

    ØDetermine the appropriate accounting is applied to employee stock compensation plans

    lAccounting at fair value

    • ØDetermine compliance with restrictions and preferences related to capital stock and
    • disclosures are appropriate 

    lStock options
  23. Retained Earnings
    • ØAnalysis of retained earnings and any
    • appropriations of retained earnings

    ØFirst year

    lAnalysis covers the entire history of the retained earnings account

    lCredits from income summary

    lDebits from net losses, cash and stock dividends, appropriate reserves

    •Appropriates require specific authorization by board of directors
  24. Dividends
    • ØDetermine the dates and amounts of
    • dividends authorized

    ØVerify the amounts paid

    • ØDetermine the amount of any preferred
    • dividends in arrears

    • ØReview the treatment of unclaimed
    • dividend checks
  25. Presentation
    ØComplete description of each issue


    lPar or stated value

    lDividend rate

    lConversion and call provisions

    lNumber of shares authorized, issued and in treasury

    lDividends in arrears

    lShares reserved for stock options or conversions
  26. Time of Examination
    ØFew transactions but material in amount

    • ØAnalysis most efficient after close of
    • period

    • ØMore time for first audit then continuing
    • audit client
  27. Partnerships
    ØPartnership contract

    lAuditor verifies distribution of net income in accordance with profit-sharing provisions

    • lMaintenance of partners’  capital accounts at
    • prescribed levels


    lLoan accounts for partners
  28. Sole Proprietorship
    ØCapital accounts

    lNet income


    lCapital investments and additions traced to the cash and asset records

    lEnsure segregation of personal transactions from business
Card Set:
Auditing Principles - CH 15 - Debt & Equity Capital
2014-11-16 21:34:45
Auditing Principles 15 Debt Equity Capital

Auditing Principles - CH 15 - Debt & Equity Capital
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