2 Liabilities and Equity Balance SheetAssetsCashInvestmentsReceivablesPrepaidsInventoryPP and EOther assets - intangiblesLiabilities and EquityAccounts payableAccrued liabilitiesDebtCommon stockRetained earnings
3 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.
4 Types of Long Term DebtNotesBondsMortgagesInterest Rate Swaps
6 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.
7 Inherent Risks ( cont’d) Off balance sheet financing ( Enron)Complex transactionsGuarantees of debt ( FIN No 45)Compliance with debt covenants
9 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.
10 Assertions and Related Control Activities LO# 3Assertions and Related Control ActivitiesOccurrence and AuthorizationAdequate 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 this authority.When the entity has proper controls for issuing debt transactions, it is generally easy for the auditor to test those transactions for occurrence and authorization at the end of the period.
11 Assertions and Related Control Activities LO# 3Assertions and Related Control ActivitiesCompletenessThe client should maintain a subsidiary ledger that contains information about all the long-term debt owed by the entity. The debt amount recorded in the subsidiary ledger should be reconciled to the general ledger control account regularly.
12 Assertions and Related Control Activities LO# 3Assertions and Related Control ActivitiesValuationNotes 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 (the straight-line method may be used if the results are not materially different from the effective interest amounts).
13 Assertions and Related Control Activities LO# 3Assertions and Related Control ActivitiesDisclosure - ClassificationControls 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.
15 Substantive Procedures of 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.
19 Auditing Stockholders’ Equity LO# 5Auditing Stockholders’ EquityThe following three types of transactions are of importance to the auditor:Issuance of stock including transactions such as sale of stock for cash; the exchange of stock for assets; and issuance of stock for stock splits.Repurchase of stock including both the reacquisition of stock and retirement of stock.Payment of dividends including cash and stock dividends.
20 Control Risk Assessment – Stockholders’ Equity LO# 6Control Risk Assessment – Stockholders’ EquityA 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, publicly traded companies use a registrar and transfer agent to process and record equity transaction. Relevant information about equity transactions may be confirmed with the register and transfer agent.
21 Assertions and Related Control Activities LO# 7Assertions and Related Control ActivitiesOccurrence 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.
22 Segregation of DutiesLO# 8When possible, 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 among the preparation, recording, signing, and mailing of dividend checks.
23 Auditing Capital-Stock Accounts LO# 9Auditing Capital-Stock AccountsOccurrence and CompletenessWhen outside agents are not used, the auditor should:Trace the transfers of shares between stockholders to the stock register and/or stock certificate book.Foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares outstanding in the general ledger.Examine any canceled stock certificates.Account for and inspect any unissued stock certificates in the stock certificate book.
24 Auditing Capital-Stock Accounts LO# 9ValuationWhen stock is issued for cash the valuation is straightforward. The proceeds from the sale are normally traced to the cash receipts records.When stock is exchanged for property, goods, or services, the valuation issue is more complex. Generally, fair market value is an issue and the accounting may involve a gain or loss.Stock dividends may also create complex auditing issues. The auditor must recompute the dividend and trace the entries to the general ledger.
25 Auditing Capital-Stock Accounts LO# 9Auditing Capital-Stock AccountsCompleteness of DisclosuresExamples of disclosure items include:Number of shares authorized, issued, and outstanding for each class of stock.Call privileges, prices, and dates of preferred stock.Preferred-stock sinking funds.Stock option or purchase plans.Restrictions on retained earnings and dividends.Any completed or pending transactions that may affect stockholders’ equity.
26 LO# 10Auditing DividendsAll 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 recompute the amount of the dividend authorized by the board of directors and trace the amount to cash disbursements or dividends payable.
27 Auditing Retained Earnings LO# 11Under 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 marketable securities and foreign currency translation.
28 Auditing Income Statement Accounts LO# 12Auditing Income Statement AccountsThe 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:The results of testing controls for the various business processes.The results of the detailed tests of balance sheet accounts and the related income statement accounts.Performance of substantive analytical procedures on income statement accounts.Detailed tests of selected income statement accounts.
29 Assessing Control Risk for Business Processes LO# 12Assessing Control Risk for Business ProcessesIf 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.
30 Direct Tests of Balance Sheet Accounts LO# 12Direct Tests of Balance Sheet AccountsIncome statement accounts are normally audited in the course of auditing the related balance sheet accounts.
31 Substantive Analytical Procedures LO# 12Substantive Analytical ProceduresExtensive use may be made of analytical procedures in the audit of revenue and expense accounts.Common size income statement for current and previous years.Percentage income statement for current and previous years.Trend and ratio analysis.
32 Tests of Selected Account Balances LO# 12Tests of Selected Account BalancesThe 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.