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Copyright © 2007 Pearson Education Canada
1
Chapter 20: Audit of the Capital Acquisition and
Repayment Cycle
Copyright © 2007 Pearson Education Canada
20-2
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
Copyright © 2007 Pearson Education Canada
20-3
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
Copyright © 2007 Pearson Education Canada
20-4
Methodology for designing tests of balances for notes payable
Copyright © 2007 Pearson Education Canada
20-5
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)
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20-6
Practice problem 20-17 (p. 584)
Identify the purpose of particular internal controls, potential misstatements, and audit procedures to audit the control
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20-7
Analytical procedures for notes payable
Analytical procedure Possible misstatement
Recalculate approximate interest expense on the basis of average interest rates and overall monthly notes payable
Misstatement of interest expense or accrued interest, or omission of an outstanding note payable
Copyright © 2007 Pearson Education Canada
20-8
Analytical procedures for notes payable (cont’d)
Analytical procedure Possible misstatement
Compare individual notes outstanding with the prior year
Omission or misstatement of a note payable
Compare total balance in notes payable, interest expense, and accrued interest with prior year
Misstatement of notes payable, interest expense or accrued interest
Copyright © 2007 Pearson Education Canada
20-9
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
Copyright © 2007 Pearson Education Canada
20-10
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
Copyright © 2007 Pearson Education Canada
20-11
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
Copyright © 2007 Pearson Education Canada
20-12
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
Copyright © 2007 Pearson Education Canada
20-13
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
Copyright © 2007 Pearson Education Canada
20-14
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
Copyright © 2007 Pearson Education Canada
20-15
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
Copyright © 2007 Pearson Education Canada
20-16
Tests of details for notes payable and interest: rights and obligations
Examine notes to determine whether the company has obligations for payment
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20-17
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
Copyright © 2007 Pearson Education Canada
20-18
Practice problem 20-24 (pp. 585-86)
Audit procedures for the audit of bond indebtedness and interest expense
Copyright © 2007 Pearson Education Canada
20-19
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
Copyright © 2007 Pearson Education Canada
20-20
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
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20-21
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
Copyright © 2007 Pearson Education Canada
20-22
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
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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
Copyright © 2007 Pearson Education Canada
20-24
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
Copyright © 2007 Pearson Education Canada
20-25
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
Copyright © 2007 Pearson Education Canada
20-26
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)
Copyright © 2007 Pearson Education Canada
20-27
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
Copyright © 2007 Pearson Education Canada
20-28
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
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20-29
Practice problem 20-23 (p.585)
Assess an audit of dividends
Identify additional audit procedures required
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20-30
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)