Chapter 7

Audit of Debt & Equity

 Audit of Debt and Equity capital

 Internal control over interest bearing debt
 Audit programs for interest bearing debt
 Internal control over equity capital and dividends
 Audit program for capital stock
 Audit of sole proprietorships, and partnerships
 Disclosure of contingencies

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 …Audit of Debt & Equity

 Business organizations (corporations) obtain

significant amount of their financial resources by
issuing Interest bearing debts and capital stocks
 Major transactions in the capital acquisition and
repayment cycle, include:
 Bank loans, mortgages, bonds payables and the
repayment of loan, and interest
 Issuance of capital stock and payment of dividend.

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 …Audit of Debt & Equity
Accounts affected by transactions in the capital acquisition
& Repayment Cycle

3
 …Audit of Debt & Equity

Four characteristics of this cycle that influence the audit:

1. Relatively few transactions affect the account balances,
but each transaction is usually highly material.
2. The exclusion or misstatement of a single transaction can
be material. As a result, the auditor’s primary focus on
the completeness and accuracy balance-related audit
objectives
3. A legal relationship exists between the client entity and the
holder of the stock, bond, or similar ownership document
4. A direct relationship exists between the interest and
dividends accounts and debt and equity.
4
 Audit of Debt Obligation

 Long-term debts are usually significant in amount and

extends for many years
The following are Relevant Accounts in the audit of Debt
Obligation:
 Notes Payable
 Contracts Payable
 Bonds payable
 Interest expense , Accrued Interest
 Gains or losses on refinancing debt
 Notes payable
 Mortgages payable
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 …Audit of Debt Obligation

Internal Controls over Debt Obligation (eg. On Notes payable)

include:
1. Proper authorization for the issue of new notes
 Top management should authorize the loan agreement
2. Adequate controls over the repayment of principal and interest.
 Controls in the payment and acquisition cycle should be applied
in verifying payment of principal and interest
3. Proper documents and records
 Supporting documents and records should be kept properly
4. Periodic independent verification
 Accuracy of computation, the record keeping and details tie in
should be checked by an independent person

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 …. Audit of Debt Obligation

The auditors objectives in the audit of debt obligation is to determine:

 Internal controls over debt obligations are adequate.
 Transactions for principal and interest are properly authorized and
recorded in accordance with the six transaction-related audit
objectives.
 Account balances of debt obligations (eg. notes payable), interest
expense and accrued interest payables are properly stated in
accordance with seven of the eight balance-related audit objectives.
(Note: Realizable value is not applicable to liability accounts)
 Auditors are more concerned on ensuring whether all obligations are
recorded (completeness) and properly classified (classification)

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 …. Audit of Debt Obligation

The following are considered to be relevant assertions

in the of debt & obligation:
1. Proper valuation of premium or discount
2. Valuation of gains or losses on refinancing debt
3.Proper presentation and disclosure, including
important restrictions contained in the debt
obligations

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 …. Audit of Debt Obligation

Activities related to debt obligations (eg. Bonds

Payable)
 Bond issuance and preparation of amortization
schedules
 Recording periodic payments and interest expense
 Explanations of certain restrictions or covenants
attached to the liability.

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 …. Audit of Debt Obligation

Bond Indenture
This is a contract between an issuer of bonds and the
bondholder stating:
 Time period before repayment
 Amount of interest paid
 Bond being convertible (eg. If they are converted to
equity security and if so, at what price or what ratio)
 Bond being callable (Callable bonds give the issuer the right to call
and retire the bonds prior to maturity).
 Amount of money that is to be repaid

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 …. Audit of Debt Obligation

Debt Covenants
These are:
 Restrictions in debt agreements aimed at protecing the
lender by restricting the activities of the borrower
Common Restrictions include:
 Maintenance of a minimum level of retained earnings
before dividends can be paid
 Maintenance of a minimum working-capital ratio
 Specification of a maximum debt-equity ratio
 Specific callable provisions identifying procedures for
calling and retiring debt at prespecified prices and dates
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 …. Audit of Debt Obligation

Audit program for Debt Obligation

 As usual, audit program is prepared after
performing risk assessment on:
Inherent risk
Fraud Risk
Control Risk

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 …. Audit of Debt Obligation

Risk Assessment Procedures

Inherent risk related to debt obligation
 Risks related to authorization of debt:
 Debt obligation may not be properly authorized or reviewed
 New debt, debt extinguishments, or debt payment transactions may
not be properly authorized
 Risks related to recording of debt transactions
 Interest expense may not be properly recorded or accrued
 Debt may not be recorded in accordance with accepted accounting
principles
 Risks related to compliance with any debt covenants
 Debt covenants may not be calculated accurately
 Debt covenants may not be appropriately reviewed and disclosed

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 …. Audit of Debt Obligation

…..Risk Assessment Procedures

Fraud risks related to debt obligation
 Violating debt covenants
 Entering in to a debt agreement that is not properly
authorized
 Misclassifying long-term or short-term debt
 Not recording interest expense,
 Recording interest expense in the wrong period
 Charging entire loan payments to either principal or
interest

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 …. Audit of Debt Obligation

…..Risk Assessment Procedures

Control risk
Control risk is low if:
 All new debts are approved by Board of directors
 Debt and interest accounts are updated and reconciled to
the general ledger on a monthly basis
 Draft financial statements are reviewed for proper
disclosure of debt obligations before they are issued
 A debt amortization schedule is:
 Prepared for each new debt obligation
 Updated as appropriate
 Reviewed by appropriate personnel 15
 …. Audit of Debt Obligation

Use of Preliminary Analytical Procedures

 These procedures help to identify areas of potential misstatements
For example in the audit of Notes Payable:
 Perform trend analysis of:
▪ Balances in notes payable
▪ Interest expense
▪ Accrued interest with prior periods
 Estimate interest expense based on average interest rates and average debt
outstanding
 Calculate debt-to-equity ratios and perform a trend analysis with prior
periods
 Calculate the times interest earned ratio and perform a trend analysis with
prior periods
 If there is no unusual fluctuation, tests of details of balance can be
eliminated 16
 RESPONDING TO IDENTIFIED RISKS OF MATERIAL
MISSTATEMENT

Auditors response to identified risk

Normally, auditors develop audit procedures that contain:
1. Tests of controls : To test the effectiveness of the internal controls
related to debt obligation .
2. Substantive procedures: To test the accuracy of transaction amounts
However, it is believed that these procedures are less important for
designing tests of details of balances for debt obligation accounts such
as notes payable, since the cycle usually contains few transactions.


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Substantive Tests for Debt Obligation Balances

 As in the audit of other cycles, tests of details

of balances for accounts in this cycle, eg, notes
payable, the auditor considers:
 business risk, tolerable misstatement,
 inherent risk, control risk,
 the results of tests of controls and substantive tests of
transactions, and
 the results of analytical procedures.

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 …Substantive Tests for Debt Obligation
Transactions & Balances
Tolerable misstatement (low)
 Auditors often set tolerable misstatement at a low level because it
is usually possible to audit 100% of the account balance and
transactions affecting the notes payable account balance.
Inherent risk (low)
 They also set inherent risk at a low level because it is usually easy
to determine the correct value of the account

Focused balance related objective for debt (eg. notes payable

account) include:
 Completeness,
 Accuracy,
 Presentation & disclosure objectives such as collateral and covenant
restrictions for notes payable.
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…Substantive Tests for Debt Obligation
Balances
Substantive Tests of Details of Balances
 The amount of testing of details of balance depends heavily on:
1. The materiality of the debt balance (eg notes payable) and
2. The effectiveness of internal controls.

Substantive tests are performed to test the following Balance related

objectives:
 Existence, Completeness, Accuracy, Classification, Detail tie-in, and
Rights and obligations. (obligation aspect)Valuation

 Therefore, except realizable value, which is not applicable to

liability, all balance related objectives are important in the audit of
notes payable. However, completeness and accuracy are very
important.
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 …Substantive Tests for Debt Obligation
Transactions & Balances

 Completeness and accuracy are vital because

omission or incorrect calculation of even a
single note can result in material misstatement
of f/s.
 Presentation and disclosure is also important
since accounting standards require the
disclosure of the terms of debt (eg. notes
payable)

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 FRAUD-RELATED SUBSTANTIVE PROCEDURES FOR
DEBT OBLIGATIONS

 Search public records to identify debt obligations

 Vouch and trace loan proceeds and debt payments
 Send confirmations to lenders and creditors, and
confirmation of compliance with any debt
covenants
 Require original supporting documents
 Agree detail of debt terms to authorization in
minutes of board meetings

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DOCUMENTING SUBSTANTIVE
PROCEDURES - FOR DEBT OBLIGATIONS

 Copies of the debt agreements

 Identification of specific items tested
 Schedule of debt obligations and interest
 A summary of the calculations supporting
compliance with debt covenants
 Confirmations or documentation of alternative
procedures performed

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 Audit of the Shareholders Equity
Accounts
Relevant Accounts in the audit of Shareholders
equity include:
 Stock accounts (Common, Preferred, Treasury),
 Additional Paid in capital,
 Dividend accounts,
 Retained earnings

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 ...Audit of the Shareholders Equity
Accounts
Transactions affecting Shareholders equity
include:
 Issuance of New stock
 Purchase of treasury stock
 Declaration and payment of dividends
 Grants of stock options and warrants
 Exercises and expirations of stock options and warrants
 Transfer of net income to retained earnings
 Recording of prior-period adjustments to retained
earnings
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...Audit of the Shareholders Equity
Accounts

Objectives of the audit: To determine whether:

 Internal controls over capital stock and related
dividends are adequate
 Owners’ equity transactions are correctly
recorded, as defined by the six transaction-related
audit objectives
 Owners’ equity balances are properly in stated
and disclosed in accordance with the balance
related audit objectives, and presentation and
disclosure-related audit objectives
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 ...Audit of the Shareholders Equity
Accounts
Internal Controls over Common Stock and related account
1. Proper authorization of transactions.
 BODs should authorize: Issuance of Capital Stock;
Repurchase of Capital Stock and Declaration of Dividends
2. Proper record keeping and segregation of duties: This helps
to ensure :
 SHE accounts are updated and reconciled with general ledger
 Corporate records show the actual owners of the stock,
 Correct amount of dividends is paid to eligible stockholders
 The potential for misappropriation of assets is minimized

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 ...Audit of the Shareholders Equity
Accounts
…Internal Controls over Common Stock and related account

3. Review of Draft F/statements by Mgt & BODs

 Top management and the board of directors
should review draft financial statements prior to
issuance for proper disclosure of equity accounts

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 ...Audit of the Shareholders Equity
Accounts
…Internal Controls over Common Stock and related account

4. Independent Registrar and Stock Transfer Agent

 An outside party should maintain details of shares issued,
repurchased, and cancelled
 These controls help
 To make sure that stock is issued by a corporation in accordance with
the requirements
 To update records when there is a change in the ownership of the stock
5. Analysis of stock options
Accountant should analyze proper accounting for stock option
grants . Organization’s legal counsel and CFO review and
approve the analysis
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 ...Audit of the Shareholders Equity
Accounts
Audit of Capital Stock and Paid-in Capital
 Focus area:
1. Existing capital stock transactions are recorded (completeness)
2. Recorded capital stock transactions occurred and are accurately
recorded (occurrence and accuracy)
3. Capital stock is accurately recorded (accuracy balance-related
objectives).
4. Capital stock is properly presented and disclosed (presentation
and disclosure objectives).
Audit of Dividends
 The emphasis in the audit of dividends is on dividend transactions
rather than on the ending balance.
 Tests of details of balance is needed for dividends payable.
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 Audit Program for Shareholders Equity
Accounts
Audit program for Shareholders Equity Accounts
 As usual, audit program is prepared after
performing risk assessment on:
Inherent risk
Fraud Risk
Control Risk

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 ...Audit of the Shareholders Equity
Accounts
Risk Assessment Procedures
Inherent risks related to Shareholders equity account
 Risks related to inaccurate valuation:
 Stocks issued in exchange for non cash asset may not be
properly valued
 Risks related to inaccurate presentation & disclosure of
 Each class of stock outstanding and number of shares authorized,
issued, and outstanding and special rights associated with them
 Stock options outstanding and convertible features
 Existence of stock warrants
 Any restrictions or appropriations of retained earnings
 Prior-period adjustments and other comprehensive income
adjustments 32
 …. Audit of Debt Obligation

…..Risk Assessment Procedures

Fraud risks related to Shareholders equity account
 Expenses may be charged directly to retained earnings rather
than to appropriate expense accounts
 Stock sales or issuances may not authorized
 Stock sales or issuances may not be recorded
 Stock options may not be authorized or in accordance with
terms of options granted
 Stock options may be backdated
 Dividends may be paid in violation of restrictive covenants
 Dividends may be paid to wrong parties or at incorrect
amounts
 Proceeds from stock sales may be misappropriated 33
 …. Audit of Shareholders Equity

Use of Preliminary Analytical Procedures

 These procedures help to identify areas of
potential misstatements
For example in the audit of stockholders’ equity
accounts :
 Compare current year account balances with
prior-year account balances

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 SUBSTANTIVE TESTS OF DETAILS -STOCKHOLDERS’
EQUITY TRANSACTIONS
 Reviewing a copy of client’s articles of
incorporation
 Preparing, or asking client to prepare, an analysis of
all capital stock transactions
 Inspecting documentation related to client’s record
keeping of capital stock and contributed capital
maintained by the client or held by a transfer agent
 Transfer agent: is an organization used by a client to:
Maintain records of investors and account balances and transactions
 Cancel and issue certificates and process investor mailings

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….SUBSTANTIVE TESTS OF DETAILS -STOCKHOLDERS’
EQUITY TRANSACTIONS

 Obtaining evidence related to the valuation of

capital stock
 Reviewing the minutes of the board of directors
meetings
 Examining the stock records books
 Obtaining evidence for all capital stock
transactions
 Tracing proceeds to cash receipts journal and
reviewing documentation
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….SUBSTANTIVE TESTS OF DETAILS -STOCKHOLDERS’
EQUITY TRANSACTIONS

 For stock issued in a nonmonetary transaction,

determine that client has properly recorded
issuance in accordance with accepted
accounting principles (Valuation)

 For clients with treasury stock,examine

documentation supporting changes in number of
shares since prior year

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FRAUD-RELATED SUBSTANTIVE PROCEDURES
FOR STOCKHOLDERS’ EQUITY ACCOUNTS

 Confirm terms of equity arrangements and

shares held directly with shareholders
 Confirm with shareholders regarding any side
agreements
 Employ an appropriate level of professional
skepticism and carefully analyze transactions
 Confirm with the transfer agent information on
issued stock
 Account for and vouch all proceeds from stock
issues
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 AUDIT OF DIVIDEND
 Since dividend transactions are few, it is subject to 100%
audit.
SUBSTANTIVE TESTS OF DETAILS-for DIVIDEND
 Examine minutes of board of directors meetings for
authorization of dividend per share amount and dividend
declaration date
 For clients maintaining their own records and paying the
dividends, auditors need to recalculate the amount of the
dividends and agree that amount to the cash disbursements
journal

 For client using a transfer agent: Trace the payment to a cash

disbursement made by the client to the agent 39
 …. Audit of Dividend

 All six transaction-related audit objectives for transactions are

relevant for dividends.
 Dividends are audited on a 100%basis.
The most important objectives, including those concerning dividends
payable, are:
Occurrence:
1. Recorded dividends occurred
2.Dividends are paid to stockholders that exist
Completeness
1. Existing dividends are recorded
2. Dividends payable are recorded
Accuracy
1. Dividends are accurately recorded
2. Dividends payable are accurately recorded
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…. Audit of Shareholders Equity

Summary of Audit Procedures

 For occurrence - Examining the minutes of
BODs meetings (to see authorizations)
 For accuracy of a dividend - recalculating the
amount
 Tests of dividends payable should be done in
accordance with declared dividends.
 Any unpaid dividend should be included as a
liability.
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Audit of Retained Earnings

Audit of Retained Earnings

 The audit begins with the analysis of retained earnings for the
entire year.
 The audit schedule showing the analysis, is usually a part of the
permanent file, and includes a description of every transaction
affecting the account.
 Accounting standards require presentation and disclosure of
information related to retained earnings.
 Disclosures are required for any restrictions on the payment of
dividends. (eg. If there are agreements with bankers,
stockholders, and other creditors that prohibit or limit the
amount of dividends the client can pay, this has to be disclosed)
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 SUBSTANTIVE TESTS OF DETAILS - RETAINED
EARNINGS

 Examine transactions recorded in retained

earnings account during audit period
 Common entries include net income or loss
These amounts are tested through substantive
audit procedures related to revenues and
expenses
 Other common entry includes dividends
 Auditor should review documentation for any
additional entries
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DOCUMENTING SUBSTANTIVE PROCEDURES -
FOR SHAREHOLDERS EQUITY ACCOUNTS

 Client’s articles of incorporation

 A summary of changes in equity accounts
 Verification of authorization with respect to
any changes in capitalization or declaration of
dividends
 Confirmations with transfer agent or
shareholders

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AUDIT OF SOLE PROPRIETERSHIPS &
PARTNERSHIPS

 AUDIT OF SOLE PROPRIETERSHIPS

 Small business may be required to present audited financial
statements to obtain bank loan.
 In such audits, auditors may face difficulty of getting
access to the all information of the business
 To minimize such problems, arranging a joint meeting of
the auditor, the banker and the owner of a business is
helpful to discuss the objective & scope of the examination
 Such meetings help the owners of small business that
auditors must have access to all information about the
business
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…AUDIT OF SOLE PROPRIETERSHIPS
& PARTNERSHIPS

 AUDIT OF PARTNERSHIPS
 In the audit of partnership, the most important document
is the article of partnership (partnership contract.
 The contract normally includes
 Net income/loss sharing agreement
 Maintaining specified level of partners capital,
 Restrictions of drawings by partners to specified amount,
 Auditors are required to ensure compliance with the
partnership contract.
 For Partnerships operating without written agreement,
auditors suggest to have written agreement.
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…DISCLOSURE OF CONTINGENCIES

,,,,,, AUDIT OF PARTNERSHIPS

 In general, in the audit of sole proprietorships &
partnerships, the most difficult issue is identifying
personal transactions from business transactions.

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..DISCLOSURE OF CONTINGENCIES

Review of contingent liabilities and Commitments

A contingent liability is a potential future obligation to an outside
party for an unknown amount resulting from activities that have
already taken place.
Eg.
 Pending or threatened litigation
 Actual or possible claims and assessments
 Income tax disputes
 Product warranties and defects
 Guarantee of obligations to others
 Agreement to repurchase receivables that have been sold

Material contingent liabilities must be disclosed in the footnotes.

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..DISCLOSURE OF CONTINGENCIES

What do accounting standards state regarding

contingent liabilities?
 Accounting standards describe three levels of
likelihood of occurrence (Probable, Reasonably
possible, and remote) and the appropriate
financial statement treatment (adjustment of
accounts, disclosure, no disclosure,), for each
likelihood

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..DISCLOSURE OF CONTINGENCIES

Likelihood of Appropriate financial statement

occurrence treatment
Probable (likely to occur) If the amount can be reasonably estimated, financial
•The future event is likely statement accounts can be adjusted
to occur If the amount can not be reasonably estimated, footnote
disclosure is necessary
Reasonably possible Footnote disclosure is necessary
•The chances of the future
event occurring is more
than remote, but less than
probable
Remote No disclosure
•The chances that future
event is occurring is slight

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..DISCLOSURE OF CONTINGENCIES

Whose responsibility (management’s or the auditor’s),

is the task of identifying and deciding the appropriate
accounting treatment for contingent liabilities?
 Auditing standards make it clear that company’s
management is responsible for identifying and
deciding the appropriate accounting treatment for
contingent liabilities.
 In many audits, it is impractical for auditors to
uncover contingencies without management’s
cooperation.
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..DISCLOSURE OF CONTINGENCIES

Assessment of control risk

 Due to the unique nature of disclosures related to contingent
liabilities and subsequent events, auditors often assess the risks
as high that all required information may not be completely
disclosed in the footnotes.
Auditors focus in the audit of contingent liability:
 Evaluating the accounting treatment of identified contingent
liabilities to determine whether management has properly
classified the contingency (classification presentation and
disclosure objective).
 Identifying to the extent practical any contingencies not
already identified by management (completeness presentation
and disclosure objective).
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..DISCLOSURE OF CONTINGENCIES

Audit Procedures for Finding Contingencies:

 Reading minutes of meetings of the BODs’,
committees under the board, and shareholders
 Review contracts, loan agreements, leases,
and correspondence from government
agencies
 Review income tax liability, tax returns and
reports of Inland Revenue Agents
 Review letters of credits
 Inspect other related documents 53
…Completing the Audit
Commitments
 Commitments are closely related to contingent liabilities.
 They are agreements to commit the company to a set of fixed
conditions in the future regardless of what happens to profits
or the economy as a whole.
 Though the entity agrees to commitments to better its own interests,
they may turn out to be less or more advantageous than originally
anticipated.
 Eg, Agreements to purchase raw materials or to lease
facilities at a certain price,
 Agreements to sell merchandise at a fixed price,
 Bonus plans, profit-sharing and pension plans, and royalty
agreements.
54
..DISCLOSURE OF CONTINGENCIES

 All commitments are disclosed either in a separate footnote or in

combination with them with a footnote related to contingencies.

Audit Procedures for commitments:

 The search for unknown commitments is usually performed as a part of
the audit of each audit area.
 Eg. Searching for sales commitment while auditing sales and collection
cycle; searching for purchase commitment while auditing acquisition and
payment cycle; searching for any kind of commitment when reading
minutes, contracts and correspondence files.

Inquiry of Client’s Attorneys: this is a common audit procedure for

commitments

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