CHAPTER 9
(REVIEW QUESTIONS)
1. The classes of transaction in the investing involve: Acquisitions and disposals of securities, for
temporary or long-term investments, corporate bonds and government securities, plant assets,
natural resources, intangible assets and other assets fall into this category of transaction. Lending
to others, excluding open trade accounts with customers.
2. Kickbacks, acquisitions of goods for personal use, appropriation of assets, and processing of
fictitious transactions can occur in the acquisition of property, plant, and equipment, just as they do
in the acquisition of goods. Related-party transactions to acquire investments or property, plant,
and equipment may result in improper valuation of the accounts. Securities may be stolen or
diverted. Historically, business entities have manipulated the accounting values at which assets
were recorded by acquiring assets from a related party or selling assets to a related party.
Acquiring assets at inflated values may result in draining cash from the acquiring entity. Selling
assets at inflated values to related parties results in increased revenue and assets to the selling
entity, and these may never be realized. All transactions conducted with related parties must be
examined carefully.
3. Critical controls include separating the responsibilities for authorizing transactions, keeping
records, and having custody of the asset. Generally, the board, or sometimes an investment
committee of the board, must approve individual investments. After obtaining board approval, the
treasurer or vice president for finance has authority to execute the purchase or sale of an
investment transaction. Due to their large peso value and susceptibility to misappropriation,
investment certificates (stocks or bonds) are often left in the custody of a broker or bank. When
the entity takes custody of investment certificates should be stored in a safe deposit box. Typically
the general ledger clerk maintains investment records unless the entity has a large volume of
investment transactions.
4. Asset impairment - unexpected decline in the usable value of the assets which is no longer
productive as it is expected. Asset is called impaired when market value of asset is worth less than
the value recorded in the balance sheet, this results write down the value in the accounts to the
market price. Inherent risk factors that associated with asset impairment are the following:
Normally, management is not interested in identifying and writing down assets. Sometimes,
management wants to write down every potentially impaired asset to a minimum realizable value
(although this will cause one-time reduction to current earnings, it will lead to higher reported
earnings in the future). Determining asset impairment requires a good information system, a
systematic process, effective controls, and professional judgement.
5. Natural resources present unique risks. First, it is often difficult to identify the cost associated
with discovery of natural resources. Second, once the natural resources has been discovered, it is
often difficult to estimate the amount of commercially available resources to be used in
determining a depletion rate. Third, the client may be responsible for restoring the property to its
original condition (reclamation) after the resources are removed. Reclamation cost may be difficult
to estimate.
6.
-The intangibility of intangible assets poses significant risk concerns.
-The accounting principles are complicated, and auditing the transactions is difficult.
-Different asset impairment assessments are needed for different types of intangible
assets, according to accounting principles.
-Because of the judgment and uncertainty involved in valuing and estimating intangible assets,
the auditor is likely to consider the inherent risk to be significant.
7. To identify fully depreciated equipment the auditor should use :
1. Perform substantive analytical procedures.
2. Inspect tangible assets.
3. Vouch additions to supporting documentation.
4. Review account activity for the year and vouch significant items.
To determine that such equipment is properly valued the auditor should:
1. Review depreciation policy and test depreciation calculations.
2. Inquire of management about assets that are idle.
3. Inquire of management as to whether there has been
any permanent impairment of assets.
4. Assess management’s impairment estimates.
8. The auditor will be aided in making necessary decisions by his or her cumulative knowledge of
industry product patterns, developments in client product lines, and technical changes. If an asset
does not produce as much cash flow in future years as it did in previous years, it can be
considered damaged. A tour of the plant could reveal that certain assets are not being used to
their full potential or are being used inefficiently. Prior to inspection, assets must be adequately
valued in compliance with GAAP. The research should be done on groups of identical properties,
with the lowest amount of recognizable cash flows deemed independent of other assets. The
carrying sum should be tested to see if it reaches the undiscounted cash flows relevant to the
asset's use and disposal. Unless otherwise omitted by the Internal Revenue Service or GAAP, the
asset may be impaired and written down if this can be proven.
9.
1- Obtain copies of lease agreements, read the agreements, and develop a schedule of lease
expenditures.
2- Review the lease expense account, select entries to the account, and determine if there are
entries that are not covered by the leases obtained from the client. Determine if the expenses are
properly accounted for.
3- Review the relevant criteria from the FASB’s codified standards (ASC) to determine which
leases meet the requirement of capital leases.
4- For all capital leases, determine that the assets and lease obligations are recorded at their
present value. Determine the economic life of the asset. Calculate amortization expense and
interest expenses, and determine any adjustments to correct the financial statements
5- Develop a schedule of all future lease obligations or determine whether the client’s schedule is
correct by referring to underlying lease agreements.
6- Review the client’s disclosure of lease obligations to determine that it is in accordance with
GAAP
(EXERCISES)
EXERCISE 1
A. Management uses different method to overstate fixed asset, it overvalued the assets by using
different techniques. Following are the few methods:
 By including fictitious long-lived assets in their financial statements
 By capitalizing costsuch as repairs and maintainance, overhauling etc which should be
expensed
 Overstatement also involves proper and complete recording of depreciation and impairment.
The scope of overvaluation may also arise here.
 Lastly the overstatement may be in the form of management estimates.
B. The other factors that the auditor should consider when assessing fraud risk relating to the
long-lived assets are the following:
 Auditor can identify, and inventory, the existing assets and also he can compare assets and
also he can compare asset inventory with property ledger
 Check that all purhases are authorized and valued properly
 Classify all equipments on the basis of use and expected life
 Time to assess the appropriate categories of depreciation
 Determine impairment of assets and review management strategy
EXERCISE 2
Management adjust their earning by manipulating the fixed assets account. Management uses the
following methods to manipulate:
 Assets sold out are not recorded
 Sold assets are not removed from the books
 Wrong and inappropriate residual values of assets for miscalculation of depreciation
 Cost which need to be capitalized is recorded as expense
 Miscalculation of amortization of intagible assets
 Fair value of asset estimates is unreasonable
EXERCISE 3
-Sales of assets are not recorded, and proceeds are misappropriated.
-Assets that have been sold are not removed from the books
-impairment losses on long-lived assets are not recognized.
-Fair value estimates are unreasonable or unsupportable.
EXERCISE 4
Consider the risks typically associate with tangible long-lived assets and identify the
internal controls over these assets that you would expect a client to have in place
The internal controls over assets that a client should have implemented are having a (1) formal
budget process with an appropriate follow up analysis, (2) having a proof or evidence that all
purchase are authorized and properly value as well as (3) written policies for acquisition and
disposals of long lived assets with approvals. I would also have wanted to see if the (4) new
equipment are appropriately classified to its used and the estimate of useful life is calculated
correctly as well as (5) reassessing the appropriateness of depreciation categories and (6) have a
periodic comparison of physical assets to subsidiary records. Finally, (7) having a periodic
reconciliation of subsidiary records with the general ledger; I do think that having these internal
controls over the assets would lower the risk of fraud and misstatements.
EXERCISE 5 (Same as Exercise number 4)
EXERCISE 6
1. Periodic inventory of physical property:
Purpose of the control: To make sure that all the records show equipment that is in use.
Impact on substantive audit procedures: Auditor should either take a sample of properties from the
ledger or should verify the existence by visiting the plant facility.
2. Policy for classifying equipment and calculating depreciation:
Purpose of the control: To make sure that the method of charging depreciation is applied
consistently and that it is based on the client's experience.
Impact on substantive audit procedures: Auditor should review the life of every piece of equipment
to ensure consistency.
3. Policy on minimum amounts to be capitalized:
Purpose of the control: Promoting efficiency by selecting items with a small value in dollar terms.
Impact on substantive audit procedures: It would not have any impact on the audit except th
smaller value items would be the part of the samples.
4. Mechanism to identify equipment designated for scrap
Purpose of the control: To make sure that records are updated as a result of changes in the
economic life of the assets.
Impact on substantive audit procedures: Auditor would increase his tour of the facilities to identify
assets that are not productive.
5. Mechanism to differentiate major renovations from repair and maintenance:
Purpose of the control: To make sure that appropriate accounting is implemented, as renovations
may lead to extending the economic life of an asset.
Impact on substantive audit procedures: Auditors should properly review repair and maintenance
expenses.
6. Self-construction of assets:
Purpose of the control: To make sure that appropriate accounting is implemented for self
constructed assets.
Impact on substantive audit procedures: Auditors should review all self-constructed assets in detail.
7. Systematic review of asset impairment
Purpose of the control: To make sure that appropriate accounting is implemented for asset
impairment.
Impact on substantive audit procedures: Auditors should review productivity of each asset every
year.
8. Periodic review by management of the impact of the disposal of assets on economic life for the
purpose of charging depreciation:
Purpose of the control: To make sure that appropriate and updated accounting is implemented.
Impact on substantive audit procedures: Auditors should properly review the impact of the disposal
of assets on economic life for the purpose of charging depreciation.
EXERCISE 7
• After evaluating all the assets, total depreciation for the current year should be $65.835 but given
Current year's depreciation is $60,500.
Ending Balance of Equipment = $438,900
Salvage value = 438,900×10% = $43,890
$438,900 - $43,890/6 = $65,835 Depreciation
• No, the given depreciation is not acceptable because given amount is lower than the original
amount. This represents wrong information, so it needs to be rectified.
• Auditor has determined after performing analytical procedures that there are discrepancies. So,
auditor should perform substantive procedures and prepare analysis of depreciation account in
detail to find out other problems and discrepancies.
• Auditor should check every account himself and should perform calculations.
CHAPTER 10
(REVIEW QUESTIONS)
1. Financing activities are transactions in which an entity (1) obtains long-term (capital) funds by
issuing long-term loans or capital stock; (2) makes payments related to long-term funds, such
as interest and dividend payments; and (3) retires long-term funds by paying off or reacquiring
debt or equity obligations. Notes, mortgages, and bonds are examples of long-term debt.
Common and preferred stock are all types of capital stock. These transactions are often
reported in the sales and collections cycle, but they are so relevant that they are subject to
additional controls.
2. The advantage of this method is that it lessens the checking period and reduces the likelihood
of making misstatements in the balance. It is basic and easy to test the accuracy of accrued
interest. It is standard practice to audit the balance of notes payable, including the audit of
interest expense and interest payable because it reduces verification time and the risk of
making balance misstatements. It is simple to verify the accuracy of accrued interest once the
auditor is satisfied with the balance of notes payable, as well as the associated interest rates
and due dates on each note. When the year's interest payment is still examined, the likelihood
of omitting a notice from notes payable on which interest has been paid is minimized. When
there are a significant number of notes or transactions during the year, it is typically too timeconsuming to completely attach the interest expense as part of the audit of notes payable and
associated accrued interest.
3. During the audit of notes payables. The most important controls that the auditor should
consider are the following:
o Appropriate authorization for the issuing of new notes (or renewals) to guarantee that
the company is not committed to illegal debt agreements.
o Maintains control over the repayment of principal and interest to assure that no more
than the required amount is paid on the note.
o Appropriate records and procedure to ensure that all amounts in all transactions are
correctly documented.
o Periodic independent verification to check that all notes payable controls are working
effectively.
4. Long-term creditors also put four types of restrictions on companies when issuing them a loan:
1)
2)
3)
4)
Financial ratio restrictions
Dividend payment restrictions
Operational limitations
The issue of additional debt restrictions
The auditor can know about these restrictions by reviewing the loan arrangement and
relevant correspondence, and by confirmation. To determine if the entity has complied with
the restrictions, the auditor must conduct calculations and monitor activities and operations.
5. The major internal controls on owners' equity are as follows:
o Transactions must be properly approved by the board of directors and corporate officers.
o The segregation of duties in dealing with these transactions (preferably the use of
independent agents for stock registration and transfer and for dividend payments)
o Records-keeping practices that are appropriate
6. A comparison of a random sample of canceled dividend checks to a dividend list prepared by
management will be insufficient because it is essential to verify that properly approved
dividends have been paid to stockholders as of the dividend record date. This audit phase is
useless unless the dividend list has been double-checked to ensure that all stockholders of
record at the dividend record date are included. A better test is to obtain the total number of
shares outstanding at the dividend date from the stock registrar and recalculate the total
dividends that could have been paid in order to compare the total sum actually paid. After that,
a random sample of canceled checks should be linked to the records of the independent
registrar to ensure that the payments were made to legitimate shareholders.
7. The relevant accounts for auditing the debt obligation are the following:
a. Bonds Payable
b. Interest Expense
c. Gain or loss in refinancing debts
d. Notes Payable
e. Mortgages Payable
8. Stock accounts (common, preferred, and treasury), additional paid-in-capital, dividend
accounts, and retained earnings are all examples of stockholders' equity accounts. The
primary goal of auditing equity accounts is to determine if the shares are correctly priced,
properly listed, and presented and disclosed.
9. The common transactions affecting shareholder’s equity accounts are Issuance of new stock,
Purchase of treasury stock, Declaration and payment of dividends, Grants of stock options and
warrants, Exercises and expiration of stock options and warrants, Transfer of net income to
retained earnings, and Recording of prior-period adjustments to retained earnings.
10. Common inherent risks associated with debt obligations are the authorization of debt, receipt
of funds, recording of debt transactions, and compliance with any debt covenant.
11. The potential frauds related to debt obligations are:
A. Debt obligations are not properly authorized.
B. Debt is misclassified as long-term or short-term.
C. Interest expense is registered on the incorrect date, at the incorrect number, not at all, or
is incorrectly classified.
D. Entire loan payments are charged to either principal or interest.
E. Mathematical error in computing interest.
12. The potential frauds related to Shareholder’s equity accounts are:
o Stock sales or issuances are not authorized.
o Stock sales or issuances violate debt covenants.
o Stock sales or issuances are not recorded.
o Stock options exercised are not authorized or are not by the terms of options granted.
o Stock options are backdated.
o Dividends are paid in violation of restrictive covenants.
o Dividends are paid to the wrong parties or at incorrect amounts.
o Proceeds from stock sales are misappropriated.
13. Before issuing an audit opinion, an auditor must have a comprehensive grasp of internal
controls. Review of the client's documentation, questioning of the management and executives
interacting with the records, and system monitoring are all techniques to gain this insight.
To overcome the inherent and control risks an auditor is required to ensure the certain controls
are in place:
-The Board of Directors has approved all the new debts.
- There should be reconciliation at regular intervals for debt and interest with general ledger
accounts.
-The debt amortization schedule should be prepared for each and every new debt and it should
be updated as appropriate. The same is to be reviewed by top management personnel.
-A debt amortization schedule is prepared for each new debt obligation, updated as appropriate,
and is reviewed by the appropriate personnel.
14. The controls that an auditor would expect an organization to have implemented are:
-Board of directors approves all stock transactions including options and warrants.
-CEO and CFO authorize approved stock transactions.
-Stockholders’ equity accounts are updated and reconciled to the general ledger on a timely basis.
-Top management and the board of directors review draft financial statements before issuance for
proper disclosure of equity accounts.
-An outside party maintains details of shares issued, repurchased, and canceled.
-Payment of dividends to the correct parties of the appropriate amounts as per the rules laid down.
-To get in place a system where backdating, authorization and compliance with covenants is
observed.
15. For debt obligations
•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 trend analysis with prior periods
-Calculate the time's interest earned ratio and perform trend analysis with prior period
(EXERCISES)
EXERCISE 1
EXERCISE 2
A. The bond indenture contains essential information about the bond, such as the period of time
before maturity/repayment and the amount of interest charged. The information that would be
relevant to conduct an audit in regards with bond indenture are the following:
(1) stated interest rate
(2) maturity date of bond
(3) callable provisions
(4) amount to be repaid, and
(5) time period before repayment
B. The liability does not need to be confirmed with individual bondholders since the bond trustees can
verify it. If the auditors want to double-check the existence of the liability, they will look at the money
collected and repayment reduction transactions.
C. By comparing the net proceeds available to the bond offering with the stated interest rate, the
discount amount can be calculated. The auditor will determine if the sums are correctly amortized per
year by calculating the net proceeds' effective interest rate.
D. The majority of organizations have arrangements with bond trustees to manage existing
bondholders' registration to obtain annual interest payments. This means that the auditor could ask
the bond trustee to confirm the semiannual interest payments made on the bond each year.
E. The auditor should obtain copies of the debt agreement and any legal documents related to the
bond, as well as the schedule of debt obligations and interest, to assess the required classification of
the bond. Since the bond is due next year, it should be listed as a current liability for now until it is
refinanced.
EXERCISE 3
The individual audit steps follow:
1. Check balance sheets at the beginning and through the previous fiscal year for working capital
ratio. If under 2 to 1, check the compensation of officers for compliance with limitations.
2. Examine client's copies of insurance policies or certificates of insurance for compliance with
the covenant, preparing a schedule of book value, appraised or estimated actual value, and
coverage for the report. Confirm policies held with the trustee.
3. Examine vouchers supporting tax payments on all property covered by the indenture. By
reference to the local tax laws and the vouchers, determine that all taxes have been paid
before the penalty-free period expired. If vouchers, in any case, are inadequate, confirm with a
trustee who holds the tax receipts.
4. Vouch for payments to a sinking fund. Confirm bond purchases and sinking fund balance with
the trustee. Observe cremation certificates or equal evidence of destruction of bonds for bonds
canceled. Report the fund as an asset, preferably giving the composition as to cash and bonds
held alive, if any.