Chapter 14

Audit of Long-Term Liabilities,

Equity, Acquisitions, and

Related-Entity Transactions

Copyright © 2010 South-Western/Cengage Learning

Audit Opinion Formulation Process

LO 1 Long-Term Liabilities and Owners Equity

Liabilities with significant subjective judgments:– Warranty reserves– Pension obligations– Other postretirement benefits– Restructuring reserves

Warranty Reserves

• The warranty reserve represents expected future cost related to sales of a company's product; it is estimated and recorded when the product is sold

• The estimate is typically based on past experience of the company and adjusted for– Changes in the product, including those that

change its quality

Warranty Reserves (continued)

– Changes in the nature of warranty – Changes in sales volume– Changes in the average cost of repairing products

under warranty

• The auditor can examine the account by – Testing the information system used by the client– Developing an estimate based on the factors above

Pension Obligations

• The amount of pension obligations are based on a number factors:

– Projected lifetime of pensioners– Nature of the pension plan– Future earnings of employees prior to retiring– Earnings rate on invested pension assets– Long-term interest rates used to discount future

costs– Changes in pension plans

Pension Obligations (continued)

• The client will usually hire an actuarial firm to help make the estimates

• The auditor must determine that the actuarial firm is independent, competent, and has sufficient reliable information to develop the estimates

LO 2 Bonds and Stockholders' Equity

Companies issue capital stock (equity) and bonds (borrowing) to raise long-term funds

Other financing activity accounts include:– Notes payable– Mortgages payable– Special bonds

• Payment-in- kind bonds

• Convertible bonds

LO 2 Bonds and Stockholders' Equity (continued)

– Mandatory redeemable preferred stock– Stock options and warrants– Stock options - employee stock compensation

program

Auditing Bonds Payable

• Bonds are issued to finance major expansions or refinance existing debt. While bond issues are infrequent, each transaction is material

• Primary considerations in auditing bonds or other long-term debt:– Valuation and amortization of premium or

discount• Auditor will review loan documents

Auditing Bonds Payable (continued)

• If debt is issued during the audit period, receipt of cash may be traced to cash receipts journal and bank

• Computation of interest expense– Auditor will usually recalculate interest expense

including amortization of any discount or premium

• Accounting for gains or losses on debt refinancing

Auditing Bonds Payable (continued)

• Disclosure of major restrictions in bond indentures– Auditor typically reviews loan documents and

makes inquiries of client

Common Stock and Owners' Equity

Transactions affecting stockholders' equity:– New stock issues

– Purchase of treasury stock

– Payment of stock dividends or issuance of stock splits

– Sale of treasury stock and proper accounting for the proceeds

– Donated capital

– Declaration and payment of cash dividends

– Transfer of net income to retained earnings

– Prior period adjustments

Common Stock and Owners' Equity: Audit Procedures

• Since most equity transactions require Board approval, auditor should review the minutes of Board meetings for approval and intent

• Valuation of equity transactions is fairly straight forward, except when shares are issued for non-cash assets

Common Stock and Owners' Equity: Audit Procedures (continued)

• Disclosure items:– Number of shares of stock authorized, issued, and

outstanding– Stock options outstanding– Convertible features– Existence of stock warrants

Integrated Audit Issues Concerning Bond and Stockholders’ Equity Accounts

• Phases I and II of the Audit Opinion Formulation Process– Continually update information on business risk– Analyze potential motivations to misstate term

debt and shareholders' equity accounts– Perform preliminary analytical procedures and

document how the audit testing should be modified– Develop understanding of the internal controls in

long-term debt and shareholders’ equity accounts

Integrated Audit Issues Concerning Bond and Stockholders’ Equity Accounts

• Phases III and IV of the Audit Opinion Formulation Process– Determine the important controls that need to be

tested– Develop a plan for testing internal controls and

perform the tests of key controls over these accounts

– Analyze the results of the tests of controls– Perform planned substantive procedures

LO 3 Mergers and Acquisitions

• There are three valuation issues associated with acquisitions:– Valuing the assets and associate liabilities upon

acquisition– Measuring restructuring charges and recognition of

the liability– Measuring impairment of assets after operation

begins

Acquisition - Asset Valuation Issues

• Major issues associated with valuing an acquisition are:– Determining the cost of the acquisition– Valuing identifiable tangible and intangible assets

and liabilities– Valuing the goodwill

Determining the Cost of the Acquisition

• Normally, cost is amount paid to acquire the company

• However, there are things that make the assessment more complicated:– Acquisitions made via stock rather than cash– Where the final price is contingent on the assets

received (post-audit)

Determining the Cost of the Acquisition (continued)

– Where the final price is contingent on acquired entity's performance

• Auditor must assess likelihood of acquired entity meeting performance objectives - if highly likely, the full cost should be recognized at the time of acquisition

Valuing Identifiable Tangible & Intangible Assets

• Acquiring company records assets at their fair market value at time of acquisition:– Company usually hires appraiser to value tangible

assets– Intangibles should be valued at net present value

of future cash flows– Auditor cannot simply accept appraisal and

management's assessment of fair value of assets– Auditor must gather independent evidence to

determine whether assessed values are appropriate

Valuing Identifiable Tangible & Intangible Assets (continued)

• Auditor may rely on the specialist hired by management or hire their own specialist. Either way, the auditor should:

– Evaluate qualifications of the specialist– Determine if specialist is independent of

management– Review the methodology used by the specialist

Valuation of Goodwill

• Goodwill is the excess of purchase cost over the fair market value of tangible and intangible assets acquired in a purchase

• SFAS 142 requires goodwill be specifically identified with an operating or reporting unit– Important so goodwill can be tested for

impairment on an yearly basis– Valuation and testing of impairment is facilitated if

company uses capital budgeting process

LO 4 Restructuring Charges

• When companies restructure operations, GAAP requires companies recognize the cost of restructuring and associated liabilities

• The auditor should examine restructuring charges though these procedures:– Review FASB pronouncements and EITF

statements– Review how company estimated restructuring

charges

Restructuring Charges (continued)

– Review actions taken by management that indicate restructuring has moved beyond a plan

– Test estimates by reviewing contracts, property appraisals, severance contracts, and other restructuring documents

– Mathematically test estimates– Develop conclusion as to reasonableness of

liability and appropriateness of client accounting

Testing for Goodwill Impairment

• GAAP requires goodwill must be tested every year for impairment

• SFAS 142 requires the impairment of goodwill to be evaluated by the client in a two-step process:– The fair value of the reporting unit as a whole is compared

to the book value of the reporting unit (including goodwill) and, if a deficiency exists, impairment would need to be calculated

Testing for Goodwill Impairment (continued)

– The impairment is measured as the difference between the implied fair value of goodwill and its carrying amount.

• The company must determine the fair market value of the reporting unit and compare it to the reporting unit's carrying value (including goodwill)– If fair market value is less than carrying value, it is inferred

that goodwill has been impaired and must be written down

Testing for Goodwill Impairment (continued)

– If fair market value is less than carrying value, it is inferred that goodwill has been impaired and must be written down

– The reporting unit may be the company or a sub-unit of the company

• The auditor must evaluate:– Management's methodology for assessing impairment

– Whether an objective evaluation supports the client's conclusion

Annual Audits: Risk Factors and Goodwill Impairment

• In addition to the annual review, situations may arise which impair goodwill:– Significant adverse change in legal factors or the

business environment– Adverse action or assessment by regulator– Competition that significantly reduces value of

company's products– Significant loss of key personnel

Annual Audits: Risk Factors and Goodwill Impairment (continued)

– Expectation that reporting unit will be disposed of– Significant asset group within a reporting unit

tested for recoverability– Impairment recognized by subsidiary– Significant decline in operations for the

industry/economy

• Audit tests for goodwill impairment will require considerable judgment and business knowledge

LO 5 Transactions withRelated Parties

• Related party transactions have been used to manipulate financial reporting and should, therefore, be considered high risk

• Auditor must consider that a client may not want to have its related party transactions discovered

Transactions withRelated Parties (continued)

• To uncover these transactions, the auditor will:– Obtain a list of all related parties; then develop a

list of all transactions with those parties– Carefully examine all unusual transactions to

determine whether the transactions involved a related party

Variable Interest Entities

• Describe a wide variety of ownership relationships a company may have with another entity

• The audit approach for all these variable interest entities– Develop an understanding of the business purpose– Examine all contractual relationships associated

with the entity

Variable Interest Entities (continued)

– Determine the proper accounting for the entity– Review the current financial status of the entity– Summarize findings and review financial

statement disclosure