Chapter 20: Audit of the Capital Acquisition and Repayment Cycle

1. Chapter 20: Audit of the Capital Acquisition and Repayment Cycle

2. Chapter 20 objectives • List the key characteristics of the capital acquisition and repayment cycle • Describe the methodology for designing tests of details of balances for notes payable • Discuss analytical review for notes payable • Provide examples of common internal controls for owners’ equity transactions • Identify main concerns when auditing capital stock

3. Characteristics of the capital acquisition and repayment cycle • Relatively few transactions affect the account balances, but each transaction is often highly material in amount • The exclusion of a single transaction could be material in itself • There is a legal relationship between the client entity and the holder of the stock, bond or similar debt or equity • There is a direct relationship between the interest and dividends accounts and debt and equity

4. Methodology for designing tests of balances for notes payable

5. Important internal controls over notes payable • Proper authorization for the issue of new notes • Adequate controls over the repayment of principal and interest • Proper documents and records (controlling blank notes and canceling paid ones) • Periodic, independent verification (reconciliation of notes outstanding to the general ledger)

6. Practice problem 20-17 (p. 584) • Identify the purpose of particular internal controls, potential misstatements, and audit procedures to audit the control

7. Analytical procedures for notes payable

8. Analytical procedures for notes payable (cont’d)

9. Practice problem 20-25 (p. 586) • How does becoming public affect a corporation’s accounts? • Explain how stock price changes affect the records and the audit

10. Tests of details for notes payable and interest: detail tie-in • Foot (add) the notes payable list for notes payable and accrued interest • Trace the totals to the general ledger • Trace the individual notes payable to the master file

11. Tests of details for notes payable and interest: existence • Confirm notes payable (normally with a positive confirmation) • Examine duplicate copy of notes for authorization • Examine corporate minutes for loan approval

12. Tests of details for notes payable and interest: completeness • Examine notes paid after year end to determine whether they were liabilities as at the balance sheet date • Review the bank confirmation for notes payable details • Review the bank reconciliation for new notes • Obtain confirmations from prior creditors • Analyze interest expense to identify notes • Examine past notes for cancellation • Review minutes of board meeetings

13. Tests of details for notes payable and interest: accuracy • Examine notes for principal and interest rates • Confirm notes payable, interest rates, and last date interest paid to • Recalculate accrued interest

14. Tests of details for notes payable and interest: classification • Examine due dates of notes to allocate liability among current or long-term • Review notes to determine whether any are related-party notes or accounts payable

15. Tests of details for notes payable and interest: cut-off • Examine notes to determine whether notes were dated on or before the balance sheet date

16. Tests of details for notes payable and interest: rights and obligations • Examine notes to determine whether the company has obligations for payment

17. Tests of details for notes payable and interest: presentation and disclosure • Examine notes, minutes, and confirmation for restrictions • Examine balance sheet for proper disclosure of noncurrent portions, related parties, and restrictions resulting from notes payable

18. Practice problem 20-24 (pp. 585-86) • Audit procedures for the audit of bond indebtedness and interest expense

19. Internal controls in owners’ equity • Proper authorization of transactions: • Issuance of capital stock: type of equity, number of shares, issue price, privileges or conditions • Repurchase or redemption: timing, amount to pay • Declaration of dividends: form (cash or stock), amount per share, record and payment dates

20. Internal controls in owners’ equity (cont’d) • Proper record keeping and segregation of duties objectives: • Owners of the stock recognized in corporate records • Correct amount of dividends is paid to shareholders as of record date • Potential for employee fraud is minimized

21. Internal controls in owners’ equity (cont’d) • Proper record keeping and segregation of duties important procedures: • (1) well-defined policies for preparing stock certificates and recording capital stock transactions • (2) independent internal verification of information in the records

22. Internal controls in owners’ equity (cont’d) • Independent registrar and stock transfer agent: • Employed to prevent the improper issue of share certificates and to maintain shareholder records • Ensures that stock is issued by a corporation in accordance with the capital stock provisions in the articles of incorporation • Tends to be used by public corporations • Smaller organizations may use their lawyer or maintain the stock register themselves

23. Main concerns in auditing capital stock • 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

24. Auditing capital stock: completeness • If a registrar or transfer agent is used: auditor can confirm the nature of transactions and their valuation • For a smaller client: review records held by the lawyer or client • Review the minutes of the board of directors to uncover issuances and repurchases

25. Auditing capital stock: occurrence and accurate recording (transactions) • Normal to verify all capital stock transactions because of their materiality and permanence in the records • Examine minutes of the board of directors’ meetings for proper authorization • Cash received can be confirmed with the transfer agent and traced to cash receipts • Valuation of stock dividends or stock used to purchase assets is more difficult

26. Auditing capital stock: accuracy (of ending balance) • Based upon number of shares outstanding at the balance sheet date • Confirmation from transfer agent (or trace to shareholder records) • Value is par value or value received (complex when there are convertible securities, stock options, or warrants outstanding)

27. Auditing capital stock: presentation and disclosure • Most important sources are articles of incorporation, minutes of board of directors’ meetings and auditor’s analyses • Need to ensure that each class of stock is properly described • Disclosure of stock options, stock warrants and convertible securities can be verified by examining legal documents

28. Audit of dividends • Existence can be checked by examining the minutes of board of directors’ meetings • Accuracy is audited by computing the amount on the basis of the dividend per share by the number of shares outstanding • May be possible to trace to cash disbursement records, or confirm with stock registrar

29. Practice problem 20-23 (p.585) • Assess an audit of dividends • Identify additional audit procedures required

30. Audit of retained earnings • Normally, the only transactions are net earnings and dividends declared • May also be corrections or other adjustments (key then is to determine whether they should be recorded in the prior year or whether they are applicable to prior periods)