Chapter 17 Auditing the Investing and Financing Cycles Spring 2007

How are the investing & financing cycles linked? Generally companies need to acquire debt or equity financing to make major capital expenditures From a business perspective, the cost of capital should be less than the expected rate of return on the asset

Investing Cycle Debit Credit Fixed Assets Depreciation Expense Asset Impairment Exp Cash & Loss on Disposal LTD (Bonds or Notes), AP or Cash Accumulated Depreciation Fixed Asset Fixed Asset & Gain on Disposal

Financing Cycle: Impact on Financial Statements Balance Sheet Bonds, notes and mortgages payable Bond premium (discount) Interest Payable Capital lease obligations Pension fund obligations Preferred Stock Common Stock Treasury Stock Retained Earnings Dividend Payable Income Statement & Cash Flows Interest expense Gain (loss) on the retirement of debt Pension expenses Dividends

Preliminary Audit Strategies for Obtaining Audit Assurance Analytical Procedures Substantive Tests Tests of Controls What should the initial audit strategy be for the various parts of the investing & financing cycle? PP&E Depreciation Leases New Debt Interest Exp New Equity Dividends

Investing & Financing Cycle: Initial Audit Procedures Understanding Business Aspects of Cycle How capital intensive is the industry in general and the company in specific? Useful life of equipment? What are managements’ plans for growth How are acquisitions financed? See Cash Flows!

Investing & Financing Cycle: Initial Audit Procedures Understanding a SCFs Does the entity have positive cash flow from operations? Can op cash pay current portion of LTD and dividends? Does the company have free cash flow? (op cash flow – cap exp) Financing Cash Flows What were major sources of financing? How were financing sources retired? Investing Cash Flows  How were financing inflows invested?  What assets were sold?  Were assets converted into different assets (e.g., investments => plant and equip.)?

Investment & Financing Cycles: Initial Audit Procedures Consider Management Incentives to Manage Earnings through PPE and Debt Methods related to the cycles Useful life and residual values (Waste Management) Incorrect capitalization of expenditures (Worldcom) Asset Impairment (Bigger risk now with FAS 142) Timing disposal of assets and classification of gain/loss Leases Pension estimates

Investment and Financing: Initial Audit Procedures Analytical Procedures General Analyze Statement of Cash Flows Return on Assets vs Average Cost of Debt Capital Investments Return on total assets Depreciation expense as a % of PPE Depreciation reasonableness test Repair expense to net sales

Investment and Financing: Initial Audit Procedures continued Analytical Procedures Financing Free cash flow Debt to equity Return on common equity Cash flow from ops to crt LTD + dividends Interest expense to interest bearing debt

Investment & Financing Cycle Audit Objectives Assertion Completeness Existence & Occurrence Valuation Rights and Obligations Presentation and Disclosure Specific Audit Objective Completeness Cutoff / Timeliness Validity Cutoff / Timeliness Valuation at Historical Cost / GAAP Valuation at Net Realizable Value Posting and Summarization Ownership Classification Disclosure

Strategy for Auditing Fixed Assets Test controls (404) Control environment Risk Assessment Activities Initiation function for purchases separate from final approval PPE detailed records separate from G/L PPE detailed records separate from custody Periodic inventory of PPE by individual independent of custody and recordkeeping Given you know the audited value of fixed assets at the beginning of the year, how predictable is the value of fixed assets at year end?

Substantive Tests of Details Fixed Assets Beginning Acquisition Sale of Ending Balance + of Fixed - Fixed = Balance Assets Assets Audited Last Year Audit Completeness Existence and Occurrence Valuation Ownership Presentation and Disclosure

Fixed Asset: Initial Procedures Compare subsidiary records with general ledger for fixed assets. Trace beginning balance to prior year workpapers

Fixed Asset Tests (Completeness) Completeness Review board of director authorizations for new plant and equipment purchases. Review records of what has been authorized, and what has been acquired. Cutoff Search for unrecorded liabilities. Are all capital leases recorded.

Fixed Asset Tests (existence) Validity Vouch major fixed asset additions to supporting documents.

Fixed Asset Tests (valuation) Historical Cost Vouch recorded transactions to supporting documents. Valuation at N.R.V. Use computer to test depreciation calculations or Recalculate depreciation on test basis Consider rate of return on assets. Are there assets that are being utilized? Posting and Summarization See initial procedures. Computer tests summarization.

Fixed Asset Tests (rights and obligations) Ownership Assess risk of issues related to title of assets. How were major assets financed?

Fixed Asset Tests (presentation and disclosure) Classification Review items classified as Operating leases v. Capital leases Repair and maintenance v. Capitalized assets Check F/S disclosures against disclosure check-list. Are assets collateral for debt? Depreciation expense stated

Financing Cycle: Key audit objectives Completeness: All debts (including pension fund obligations) are included on the balance sheet. Shareholders equity includes all capital paid into the company and all retained earnings. Existence and Occurrence Recorded debt exists at balance sheet date. All cash flows occurred during the period. Get final signed copies of agreements.

Financing Cycle: Key audit objectives Rights and Obligations All debt is the obligation of the entity. Guarantees!!! Valuation and Allocation Debt and equity obligations are reported on the balance sheet in accordance with GAAP. Debt and equity are properly summarized in the balance sheet. Pension plan obligations are reported on the balance sheet in accordance with GAAP.

Financing Cycle: Key audit objectives Presentation and disclosure Debt is properly classified (current or LT) Terms, covenants, commitments, and retirement provisions are adequately disclosed. Pension disclosures Equity disclosures, including stock options

Financing Cycle: Equity Control Risk Assessment Equity control activities Stock and dividend transaction approved only if in compliance w/ corporate charter (validity and authorization) S/H records reconciled w/ # shares o/s & dividends paid Segregation of duties Issuing/transferring/canceling stk certificates separate from acctg Detailed s/h records separate from G/L and cash handling Segregate preparation, recording, signing & mailing div checks

Financing Cycle: Equity Substantive Tests Assume company uses outside agent, confirm activity and balances (Completeness, Cutoff / Timeliness, Validity, Ownership) Recalculate new issues (Valuation) Review terms of equity instruments, for example convertible instruments (Classification) Read through footnotes/vouch for (Disclosure) # shares authorized, issued and outstanding by class Call privileges, prices and dates for preferred stock Preferred-stock sinking funds Stock option or purchase plans Restrictions on retained earnings and dividends Recalculate stock options activity (valuation, classification, disclosure) FAS 123(R)

Financing Cycle: Debt audit strategy Beginning Acquisition Repay Ending Balance + of New Debt - Debt = Balance Audited Last Year Completeness Existence and Occurrence Valuation Ownership Presentation and Disclosure Audit

Financing cycle: Debt Controls and Risk Assessment Control activities LT borrowing properly initiated and documented by authorized individuals (top exec’s and BOD if large) Detailed subsidiary records reconciled to G/L control regularly Adequate personnel are involved with valuation

Financing cycle: Substantive tests Initial procedures Verify beginning balance agrees to prior year workpapers Test detailed schedules Tests of transactions Vouch significant transactions Tests of balances Review authorizations for LTD Confirm debt w/ lenders and bond trustees Recalculate interest expense Examine due dates to ensure proper classification Tests of disclosure Review agreements for any restrictions that should be disclosed