Chapter 15 Auditing the

Financing/Investing Process: Long-Term

Liabilities, Stockholders′ Equity,

and Income Statement Accounts

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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.

LO# 1

15-2

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.

LO# 1

15-3

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.

LO# 2

15-4

Assertions and Related

Control Activities

Occurrence and Authorization

Completeness

Valuation

Disclosure - Classification

LO# 3

15-5

Substantive Procedures

of Long-Term Debt

Assertions Substantive Tests of Transactions

Occurrence Examine copies of new note or bond agreements. Examine board of

directors' minutes for approval of new lending agreements.

Completeness

Trace large cash receipts and payments to source documents and the

general ledger. Review interest expense for payments to debt holders not

listed on the debt analysis schedule. Review notes paid or renewed after

the balance sheet date to determine if there are unrecorded liabilities at

year-end. Evaluate lease contracts to determine if leases are properly

accounted for as an operating or capital lease.

AuthorizationExamine board minutes for evidence of proper authorization of notes or

bonds.

Accuracy Test a sample of receipts and payments.

CutoffReview debt activity for a few days before and after year-end to determine

if the transactions are included in the proper period.

ClassificationExamine the due dates on notes or bonds for proper classification

between current and long-term debt.

LO# 4

15-6

Substantive Procedures

of Long-Term Debt

LO# 4

15-7

Auditing Stockholders’ Equity

The following three types of transactions are

of importance to the auditor:

1. Issuance of stock including transactions such as

sale of stock for cash; the exchange of stock for

assets, services, or convertible debt; and

issuance of stock for stock splits.

2. Repurchase of stock including both the

reacquisition of stock and retirement of stock.

3. Payment of dividends including cash and stock

dividends.

LO# 5

15-8

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

understand the types of controls that are in place to

prevent the misstatement of equity transactions.

Large, publicly traded companies use an

independent registrar, transfer agent, and

dividend-disbursing agent to process and

record equity transaction. Relevant information

about equity transactions may be confirmed

with those parties.

LO# 6

15-9

Assertions and Related

Control Activities 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.

Authorization

Verify that stock and

dividend transactions

have been properly

approved.

Valuation

Verify that stock and

dividend transactions

have been properly

valued.

LO# 7

15-10

Segregation of Duties When possible, 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

among the preparation, recording, signing, and mailing of

dividend checks.

LO# 8

15-11

Auditing Capital-Stock Accounts

Occurrence and Completeness

Valuation

Completeness of Disclosure

LO# 9

15-12

Auditing Dividends

All dividends declared and paid will be audited

because of concerns of violations of corporate

bylaws or debt covenants.

When an independent

dividend-disbursing

agent 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 independent agent is

not used, the auditor can

recomputed the amount of the

dividend authorized by the

board of directors and trace the

amount to cash disbursements

or dividends payable.

LO# 10

15-13

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 exceptions are the existence of prior period

adjustments, correction of errors, stock retirements,

and changes in appropriations of retained earnings.

LO# 11

15-14

Auditing Income Statement

Accounts The audit of revenue and expense accounts

depends on the extent of work conducted on the

entity’s control system and balance sheet accounts.

Substantive procedures on selected income

statement accounts include:

o The results of testing controls for the various business

processes.

o The results of the detailed tests of balance sheet accounts

and the related income statement accounts.

o Performance of substantive analytical procedures on income

statement accounts.

o Detailed tests of selected income statement accounts.

LO# 12

15-15

End of Chapter 15

15-16