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
YA AAUSC 1
…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.
YA AAUSC 2
…Audit of Debt & Equity
Accounts affected by transactions in the capital acquisition
& Repayment Cycle
YA AAUSC 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.
YA AAUSC 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
YA AAUSC 5
…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
YA AAUSC 6
…. 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)
YA AAUSC 7
…. 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
[Link] presentation and disclosure, including
important restrictions contained in the debt
obligations
YA AAUSC 8
…. 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.
YA AAUSC 9
…. 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
YA AAUSC 10
…. 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
YA AAUSC 11
…. 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
YA AAUSC 12
…. 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
YA AAUSC 13
…. 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 is
Not recording interest expense,
Recording interest expense in the wrong period
Charging entire loan payments to either principal or
interest
YA AAUSC 14
…. 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
YA AAUSC 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
YA AAUSC 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.
YA AAUSC 17
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.
YA AAUSC 18
…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.
YA AAUSC 19
…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.
YA AAUSC 20
…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)
YA AAUSC 21
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
YA AAUSC 22
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
YA AAUSC 23
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
YA AAUSC 24
...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
YA AAUSC 25
...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
YA AAUSC 26
...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
YA AAUSC 27
...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
YA AAUSC 28
...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
YA AAUSC 29
...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.
YA AAUSC 30
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
YA AAUSC 31
...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
YA AAUSC 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 yo wrong parties or at incorrect amounts
Proceeds from stock sales may be misappropriated
YA AAUSC 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
YA AAUSC 34
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
YA AAUSC 35
….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
YA AAUSC 36
….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
YA AAUSC 37
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
YA AAUSC 38
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
YA AAUSC 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
[Link] 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
YA AAUSC 40
…. 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.
YA AAUSC 41
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)
YA AAUSC 42
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
YA AAUSC 43
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
YA AAUSC 44
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
YA AAUSC 45
…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.
YA AAUSC 46
…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.
YA AAUSC 47
..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.
YA AAUSC 48
..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
YA AAUSC 49
..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
YA AAUSC 50
..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.
YA AAUSC 51
..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).
YA AAUSC 52
..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
YA AAUSC 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.
YA AAUSC 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
YA AAUSC 55
