Audit of the Capital Acquisition and Repayment Cycle Chapter 22

Characteristics of the Capital Acquisition and Repayment Cycle 1. Relatively few transactions affect the account balances, but each one is often highly material in amount. 2. The exclusion of a single transaction could be material in itself.

Characteristics of the Capital Acquisition and Repayment Cycle 3. A legal relationship exists between the client entity and the holder of the stock, bond, or similar ownership document. 4. A direct relationship exists between the interest and dividends accounts and debt and equity.

Learning Objective 1 Identify the accounts and the unique characteristics of the capital acquisition and repayment cycle.

Accounts in the Cycle Notes payable Contracts payable Mortgages payable Bonds payable Interest expense Accrued interest Appropriations of retained earnings Treasury stock Dividends declared The methodology for designing tests of details of balances for accounts in the capital acquisition and repayment cycle is the same as that followed for other accounts.

Accounts in the Cycle Cash in the bank Capital stock – common Capital stock – preferred Paid-in capital in excess of par Donated capital Retained earnings Dividends payable Proprietorship – capital account Partnership – capital account

Methodology for Designing Tests of Balances for Notes Payable Identify client business risks affecting notes payable Phase I Set tolerable misstatement and assess inherent risk for notes payable Phase I Auditors often set tolerable misstatement at a low level because it is usually possible to completely audit the account balance and transactions affecting the notes payable account balance and the correct account value is easy to determine. Assess control risk for notes payable Phase I

Methodology for Designing Tests of Balances for Notes Payable Design and perform tests of controls and substantive tests of transactions for capital acquisition and repayment cycle Phase II

Methodology for Designing Tests of Balances for Notes Payable Design and perform analytical procedures for notes payable Phase III Design tests of details of notes payable to satisfy balance-related audit objectives Audit procedures Phase III Sample size Items to select Timing

Learning Objective 2 Design and perform audit test of notes payable and related accounts and transactions.

Notes Payable Secured or Legal unsecured Obligation by assets Typically, a note is issued for a period somewhere between one month and one year, but longer term notes exist.

Notes Payable Objectives of the audit of notes payable: Internal controls are adequate Transactions are properly authorized and recorded The related liabilities and expenses are properly stated There are four important controls over notes payable: Proper authorization Adequate controls over the repayment of principal and interest Proper documents and records Periodic independent verification

Internal Controls 1. Proper authorization for the issue of new notes. 2. Adequate controls over the repayment of principal and interest. Proper documents and records. Periodic independent verification. Responsibility for issuance of new notes should be vested in the board of directors. The periodic payment of interest and principal should be subject to the controls in the acquisition and payment cycle. Proper documents include subsidiary records and control over blank and paid notes by an authorized person. Periodically the detailed note records should be reconciled with the general ledger and compared with the note holders records.

Notes Payable and the Related Interest Accounts Interest Expense Payments of principal Beginning balance Interest expense Issue of new notes Interest Payable Ending balance Payments of interest Beginning balance Cash in Bank Interest expense Issue of new notes Payments of principal Ending balance Payments of interest

Tests of Controls and Substantive Tests of Transactions Tests of notes payable transactions involve the issue of notes and the repayment of principal and interest. These audit tests are a part of tests of controls and substantive tests of transactions for cash receipts and cash disbursements.

Analytical Procedures for Notes Payable Possible misstatement Recalculate approximate interest expense on the basis of average interest rates and overall monthly notes payable Misstatement of interest expense and accrued interest, or omission of a note payable Analytical procedures are essential for notes payable because tests of details for interest expense and accrued interest can often be eliminated when results are favorable. The auditor’s independent prediction of interest expense helps the auditor evaluate the reasonableness of interest expense and also tests for omitted notes payable.

Analytical Procedures for Notes Payable Possible misstatement Compare individual notes outstanding with those of the prior year Omission or misstatement of a note payable Compare total balance in notes payable, interest expense, and accrued interest with prior-year balances Misstatement of interest expense and accrued interest or notes payable

Major Balance-related Audit Objectives in Notes Payable The two most important balance- related audit objectives in notes payable are: 1. Completeness: Existing notes payable are included. 2. Accuracy: Notes payable in the schedule are accurately recorded. These objectives are vital because a misstatement can be material if even one note is omitted or incorrect.

Types of Audit Tests for Capital Acquisition and Repayment Cycle Cash in Bank Notes Payable Payments of principal Audited by TOC and STOT Ending balance Issue of new notes Audited by TOC and STOT Audited by AP and TDB Payments of interest In addition to balance related objectives, the four presentation and disclosure related objective are important for notes payable because accounting standards require that the footnotes adequately describe the terms of notes payable outstanding and the assets pledged as collateral for the loans. Interest Payable Audited by TOC, STOT, and AP TOC + STOT + AP + TDB = Sufficient appropriate evidence

Types of Audit Tests for Notes Payable Interest Payable Interest Expense Interest expense Audited by TOC, STOT, and AP Ending balance Ending balance Audited by AP and TDB Audited by AP TOC + STOT + AP + TDB = Sufficient appropriate evidence

Learning Objective 3 Identify the primary concerns in the audit of owners’ equity transactions.

Owners’ Equity Publicly Closely held held corporation corporation Versus Many shareholders Frequent transactions Simple, few transactions Few shareholders Occasional transactions

Owners’ Equity and Dividend Accounts Cash in Bank Capital Stock – Common Paid-in Capital in Excess of Par – Common Redemption of stock Beginning balance Redemption of stock Beginning balance Issue of stock Issue of stock Ending balance Ending balance

Internal Controls Proper authorization of transactions Proper record keeping and segregation of duties Independent registrar and stock transfer agent Many of equity transactions must be approved by the board of directors. Transactions such as the issuance of capital stock, stock repurchases sands declaration of dividends require board approval. When a company maintains its own records of stock transactions and outstanding stock, the internal controls must be adequate to ensure that the actual owners are recognized in the records, the correct amount of dividends is paid to the stockholders and the potential for misappropriation of assets is minimized. Any company with listed stock is required to engage an independent registrar as a control to prevent the improper issue of stock certificates. Many companies employ a stock transfer agent to maintain the stockholder records.

Learning Objective 4 Design and perform tests of controls, substantive tests of transactions, and tests of details of balances for capital stock and retained earnings.

Audit of Capital Stock and Paid-in Capital Auditor concerns in auditing Capital Stock and Paid-in-Capital accounts Completeness Occurrence and Accuracy Completeness: Existing capital stock transactions are recorded. Occurrence and accuracy: Recorded capital stock transactions exist and are accurately recorded. Accuracy: Capital stock is accurately recorded. Presentation and disclosure: Capital stock is properly presented and disclosed. Presentation and disclosure Accuracy

Audit of Dividends 1. Occurrence: Recorded dividends occurred. 2. Completeness: Existing dividends are recorded. Auditors can verify the occurrence of recorded dividends by examining the minutes of board of directors meetings. For authorization of the amount of the dividend per share and the dividend date. 3. Accuracy: Dividends are accurately recorded.

Audit of Dividends 4. Occurrence: Dividends are paid to stockholders that exist. 5. Completeness: Dividends payable are recorded. The accuracy of a dividend declaration can be audited by recalculating the amount on the basis of the dividend per share times the number of shares outstanding. Tests of dividends payable should be done in conjunction with declared dividends and unpaid dividend should be included as a liability. 6. Accuracy: Dividends payable are accurately recorded.

Audit of Retained Earnings Transactions involving retained earnings: Net earnings for the year Dividends declared There may be corrections to: Prior-period earnings Prior-period adjustments Appropriations of retained earnings

End of Chapter 22