CHAPTER SEVEN

AUDIT OF DEBT AND EQUITY

CAPITAL

1
7.1. Introduction

• Long-term liabilities are debts or obligations owed by an entity to outsiders

which are repayable either in whole or in part more than one year from the
date of the balance sheet.
• Are most often issued in accordance with terms specified on agreement.
• The provisions of these agreements vary generally in relation to the business
of the issuer, the purpose of the issue, and the particular needs of the lender.
• Included in this category is a wide range of bonds, notes, and other long-term
obligations.
• Generally applicable during the audit of mass organizations, Associations and
partially commercial oriented Government Departments.
• In particular, the audit procedures for long-term loans, should be of great
help to auditors who may have to audit the accounts of the Investment and
Credit Department of MOFED.
Types of Long-Term Liabilities

There are two types of long-term liabilities in the account of the government
which is held by the Ministry of Finance.
1. External Loans: These are loans owed by central government and
other public sectors from various governments and international
organizations.
2. Domestic Loans: These are loans which the central government gets
from local banks and pension authority.
Example:
 Treasury bills,
 direct advance,
 saving bond,
 special bond
In both types of loans, the mainframe of the agreement, i.e.,:
 amount to be granted,
 grace period,
 principal,
 interest etc. is declared on Negarit Gazetta.
7.2. Internal Control Principles For Long-term Liability

The function of internal control is to provide control at each phase of the

transaction and independent checks to ensure that this order is being properly
followed.
Because of the significance of amounts of long-term obligations, a summary of
the significant provisions of each agreement should be maintained in both the
accounting and administrative departments.
Some of the more important feature of a sound system of internal control over
long-term liabilities are set out below:
1. Initial Authorization
a) Because of their future-nature and obligatory, there should be
specific authorization procedures for incurring long-term
liabilities.
b) Since long-term liabilities are usually material in amount, the
authorization should require approval of stockholders, directors,
or authorized government body, such as National Planning.
c) The authority for the issuance of long-term liabilities should be
appropriately documented.
d) The authority should confirm to legal requirements.
Cont…
2. Issuance of Obligation
• Notes, bonds, etc. shall be serially numbered and maintained, until issued in
the custody of an independent officer not involved in the approval of or
accounting for the obligation.
3. Consideration Received
• Cash should be deposited in bank immediately upon receipt.
• Real or other property received should be listed in detail, showing its type,
valuation, location, and useful life in order that it may be physically identified
and properly accounted for.
4. Activity during term
Control during the term of obligation is necessary in order to avoid penalties
established
There should be independence of responsibility between those performing functions of
record keeping, those making cash disbursements, and those reconciling detail
records.
Procedure to ensure that interest payments are properly computed and that the accrual
of, or amortization of interest or discount to or from the payment dates is recorded in
the accounting records in accordance with (GAAP),
Bond or notes that have been redeemed should be effectively concealed to prevent their
reissuance and should be safely stored to provide the documentation of their payment,
Procedure to ensure timeliness of payments of principal and interest made under the
agreement,
7.3. Audit objectives relating to long term liabilities

The audit objectives in the validation of long-term liabilities are to determine whether:
a) There is adequate system of internal control;
b) All material liabilities existing at the balance sheet date have been recorded;
c) There is satisfactory evidence of the authority to incur long-term obligations;
d) Interest (including amortization of premiums and discounts) is proper;
e) The debtor has conformed to all requirements in accordance with contracts; and
f) Assets pledged as security to loans are properly disclosed.
7.4. Audit Procedures for Long-Term Liabilities
Some of the audit procedures for validation of long-term liabilities are as follows:
A. Examine all loan agreements and mortgage documents and record the main terms
in the permanent audit file;
B. Vouch proceeds of loans received during the year with supporting documents and
entries in the cash book;
C. Vouch payments of principal and interest made during the year;
D. Check whether interest charges debited to the profit and cash account, where
applicable, are consistent with the outstanding loan balances during the year and
the terms of the loans;
Cont…
E. Review repayments in respect of existing loans with the loan
agreements and secure confirmation of the outstanding balances
(both principal and interest) from the lending organizations;
F. Enquire from lenders whether the loans are secured and if so the
nature of the security obtained;
G. Verify transfer of installments due within twelve months of the
year-end from long-term loans to current maturity;
H. Ensure that long-term liabilities are shown in the ‘financed by’
section of the balance sheet, below the sub-total of capital and
reserves.
I. In respect of each loan, see that the annual financial statements
disclose the following information:
• Amount of the loan and name of the lender;
• Year obtained and the period of the loan;
• Terms of payment of interest and repayment of capital;
• Nature and amount of security given.
7.5. Audit for Owners’ Equity of sole proprietorship or partnerships

7.5.1. Introduction
The most common reason for a small business to arrange for an independent audit is
the need for audited financial statement in order to obtain a bank loan.
Often, a banker, when approached by the owner of a small business applying for a
loan, will request audited financial statements as an aid to reaching a decision a loan
application.
7.5.1. Procedure for Audit Partners' Accounts
A most significant document underlying the partnership form of organization is the
partnership contract.
You will be particularly interested in determining that the distribution of net income
has been carried out in accordance with the profit-sharing provisions of the partnership
contract.
Occasionally, you may find that a partnership is operating without any written
agreement of partnership.
This situation raises a question of whether profits have been divided in accordance
with understanding existing between the partners.
You may obtain from each partner a written statement confirming the balance in his or
her capital account and approval of the method used in dividing the year's earnings.
You may also suggest a written partnership contract be developed.
Cont…
• In general, the same principles described for the audit of corporate capital are
applicable to the examination of the capital accounts and drawing accounts of
a sole proprietorship or partnership.
• The following are the major audit procedures in auditing owner's equity of a
sole proprietorship or/and partnership
 Analyze all proprietorship accounts from the beginning of the business;
 Trace the initial capital investment and any addition to the cash and asset
records;
 Verify the net income or loss for the period and any withdrawals are verified.
• In the case of a sole proprietorship, it is common that the personal and
business financial activities are mixed in preparing financial statements.
• In such cases, you have to segregate personal net worth from business capital.
• Adjustments may also be required to transfer from expense accounts to the
owner's drawing account any personal expenditure paid with company funds.
7.6. Audit for Owners’ Equity of Corporation

• 7.6.1. Introduction
Businesses are classified in to three based on their formation:
corporation, partnership and sole proprietorship.
One of the differences among the three forms of business is the
owners' equity part.
There are two types of shares in a corporation: common shares
and preferred shares.
Preferred shares, as a rule, are entitled to a fixed dividend out of
profits.
Preferred shares may also carry a preferential right as regards
capital.
That is they are entitled to the return of their capital before there
is any return on the ordinary shares in the event of liquidation, and
possibly they may also be entitled to a premium on liquidation.
7.6.2. Audit Procedure for Stockholders' Equity

Below are the appropriate procedures for audit of stockholders'

Equity:
1. Obtain an understanding of internal control over capital stock
transactions.
2. Review the articles of incorporation, bylaws, and minutes for
provisions relating to capital stock.
3. Obtain and prepare analysis of the capital stock accounts.
4. Check authorized capital limit to legislation and company
constitution documents.
5. Trace all transactions involving cash to the book and bank
statement.
6. Ensure that ant necessary registrations have been made and that
the company's register of members has been updated.
7. For a corporation acting as its own stock registrar and transfer
agent, reconcile the stockholder records with the general ledger.
Cont…
8. Ensure appropriate disclosures as either debt or equity.
9. Ensure that all transactions are legal and that premiums in
particular have been accounted for properly.
The stockholders' equity of a corporation consists of contributed
capital (both preferred and common), retained earnings and
dividends.
You have seen the audit procedures for contributed capital both
preferred and common shares.
7.6.3. Audit procedures for Retained Earnings and dividends
Audit work on retained earnings and dividends include two major
steps:
1. The analysis of retained earnings and any appropriations of
retained earnings, and
2. The review of dividend procedures for both cash and stock
dividend.
Cont…
In the verification of cash dividends, you should perform the
following steps:
a) Determine the dates and amounts of dividends authorized;
b) Verify the amounts paid;
c) Determine the amount of any preferred dividends in arrears;
d) Review the treatment of unclaimed dividend checks.
When reviewing minutes of board of directors' meetings, you
should note the date and amount of each dividend declaration.
This serves to establish the authority for dividend disbursements.
The dividend payment may be verified by multiplying the total
number of shares as shown by the general ledger controlling
account by the dividend per share.
When reviewing dividend declaration, you may discover the
existence of cash dividends declared but not paid.
These declared but unpaid dividends must be shown as liabilities in
the balance sheet.
Cont…
The final procedure in auditing stockholders is ensuring its
presentation in the financial statements.
The presentation of capital stock in the balance sheet should
include a complete description of:
 each issue;
 par or stated value;
 dividend rate if any;
 dividend preference;
 conversion and call provision;
 number of shares authorized' issued' and in treasury;
 dividends in arrears if any; and
 shares reserved for stock options and for conversions.
THE END!!!