Auditing Principles - CH 15 - Debt & Equity Capital

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

• ØActivities of company designed to obtain
• capital funds

lInvolves issuance and repayment of debt and equity

Payment of interest and dividends

Proper authorization by appropriate official in the company or by board of directors

• 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

ØAuthorization by the board of directors

ØUse of an independent trustee

• ØInterest Payments on Bonds and Notes
• Payable--Cash disbursement controls

ØQuestions

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?

• 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

• 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

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

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

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

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

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

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

ØCorporate accounts

lCapital stock accounts

•Preferred and common

lRetained earnings

•Prior period adjustments

lTransactions generally few in number but material in amount

• 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

• ØProper authorization of transactions by
• board of directors an corporate officers

• ØSegregation of duties in handling
• transactions

ØMaintenance of adequate records

• 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

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

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

• 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?

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

• 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

• 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

ØComplete description of each issue

lTitle

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

ØFew transactions but material in amount

• ØAnalysis most efficient after close of
• period

• ØMore time for first audit then continuing
• audit client

ØPartnership contract

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

• lMaintenance of partners’  capital accounts at
• prescribed levels

lDrawings

lLoan accounts for partners

ØCapital accounts

lNet income

lWithdrawals


lCapital investments and additions traced to the cash and asset records

lEnsure segregation of personal transactions from business