CHAPTER 13
Substantive Audit
Testing: Financing
& Investing Cycle&
Completing the
Audit
1
What are the major accounts
of the capital acquisition and
repayment cycle?
-Long term liabilities
- stock accounts
- donated capital
- retained earnings and
appropriations
- dividends declared and payable
2
In auditing the capital acquisition
and repayment cycle, the auditor
should consider:
Relatively few
transactions affect the
account balances, but each
transaction is often highly
material in amount.
3
In auditing the capital acquisition
and repayment cycle, the auditor
should consider:
The exclusion
of a single transaction could be material
in itself.
4
In auditing the capital acquisition
and repayment cycle, the auditor
should consider:
There is a
legal relationship between the client and the
holder of the stock, bond,
or similar ownership
document.
5
In auditing the capital acquisition
and repayment cycle, the auditor
should consider:
There is a
direct relationship between the interest and dividends account and debt
and equity.
6
In auditing the internal controls
related to long-term liabilities,
the auditor will consider:
- proper authorization for issues of
notes or bonds
- adequate controls over payment of
interest and principal
- adequate documents and records
- periodic independent verification
7
What are the primary audit
objectives with regard to longterm liability account balances?
- completeness
- accuracy
- presentation and
disclosure
8
long-term liabilities audit procedures
perform
analytical
procedures
to test the
reasonableness
of long-term
liabilities and
interest
expense
9
long-term liabilities audit procedures
inquire of
management
regarding:
- completeness of
liabilities
- debt-related
restrictions on
assets
- ability to pay
interest
10
long-term liabilities audit procedures
review contractual
provisions of
long-term liabilities
- consider pledging of assets related to
debt (disclosure)
- determine client adherence to
contractual requirements (payment
dates, working capital, ratios)
11
long-term liabilities audit procedures
confirm debt balances,
interest payments, and
client compliance with
contractual agreements
with the creditors
auditor
32
creditor
12
long-term liabilities audit procedures
for all long-term
liabilities,
recalculate
interest expense,
interest payable,
and amortizations
of discounts or
premiums
13
long-term liabilities audit procedures
Trace receipt of borrowed amounts from cash
receipts journal to bank statement
cash receipts journal
description
_ $$ _
May 23, 19x7
Wachovia loan 14,000
Bank Statement
5/31/x7
Deposits:
5/23
$14,000
14
long-term liabilities audit procedures
Trace receipt of borrowed amounts from cash
receipts journal to bank statement to deposit
slips
cash receipts journal
description
_ $$ _
May 23, 19x7
Wachovia loan 14,000
Bank Statement
5/31/x7
Deposits:
5/23
$14,000
Deposit
Slip
5/23/x7
14,000
15
long-term liabilities audit procedures
Trace receipt of borrowed amounts from cash
receipts journal to bank statement to deposit
slips to debt agreement.
cash receipts journal
description
_ $$ _
May 23, 19x7
Wachovia loan 14,000
Deposit
Slip
5/23/x7
14,000
Bank Statement
5/31/x7
Deposits:
5/23
$14,000
Debt Covenant
Wachovia Bank
hereby loans
Ace Co. $14,000
on 5/23/x7
16
long-term liabilities audit procedures
Trace payments of principal and interest from
cash payments journal to bank statement
Bank Statement
11/30/x7
cash payments journal
description
_ $$ _
November 23, 19x7
interest paymentWachovia loan
700
Deposits:
Payments:
11/26
$700
17
long-term liabilities audit procedures
Trace payments of principal and interest from
cash payments journal to bank statement to
cancelled checks to debt agreement.
Bank Statement
11/30/x7
cash payments journal
description
_ $$ _
November 23, 19x7
interest paymentWachovia loan
700
Ace Corporation
pay to the order of
Wachovia Bank
324
date 11/23/x7
$ 700.00
Deposits:
Payments:
11/26
$700
Debt Covenant
Ace agrees to
pay semi-annual
interest of 10%
on principal.
18
What are the auditor’s primary concerns
with regard to owners’ equity?
- authorization
- presentation
and disclosure
- accuracy
19
owners’ equity audit procedures
perform
analytical
procedures
to test the
reasonableness
of owners’
equity accounts
(including
dividends)
20
owners’ equity audit procedures
READ:
- articles of incorporation, bylaws
- minutes to meetings
Note
discussion of dividends, stock
options, stock issues, etc.
21
owners’ equity audit procedures
Confirm shares outstanding with
the independent registrar and the
stock transfer agent.
- independent registrar - a third party
paid by the client to ensure that stock
is issued in accordance with the charter and board’s directions (required for
SEC companies)
22
owners’ equity audit procedures
Confirm shares outstanding with
the independent registrar and the
stock transfer agent.
- stock transfer agent - a third party paid
by the client to maintain stockholder
records and, possibly, to disburse
dividends
23
owners’ equity audit procedures
If the client does not use
an independent registrar
and
stock transfer agent, the
auditor must examine the
stock certificate records
and test any changes.
24
owners’ equity audit procedures
Trace receipts from stock issues from cash
receipts journal to bank statement to deposit
slips to board minutes.
cash receipts journal
description
_ $$ _
May 23, 19x7
Joe Ace
23,000
Deposit
Slip
5/23/x7
23,000
Bank Statement
5/31/x7
Deposits:
5/23
$23,000
Board
Minutes
... sell Joe
Ace 2300
additional
common...
25
owners’ equity audit procedures
Trace payments related to dividends and treasury
stock from cash payments journal to bank
statement to cancelled checks to board minutes.
Bank Statement
1/31/x7
cash payments journal
description
_ $$ _
January 23, 19x7
dividend
distribution
4300
Ace Corporation
pay to the order of
Stockholders
324
date 1/23/x7
$4300.00
Deposits:
Payments:
1/26
$4300
Board
Minutes
... declare
dividends
of $4300...
26
owners’ equity audit procedures
Recalculate dividend
distribution to common and
preferred shareholders.
common
preferred
consider features of preferred
(cumulative, participating)
27
owners’ equity audit procedures
Inspect treasury stock;
recalculate treasury stock
transactions.
Ace Ace Ace
AceCompany
Company
Company
Company
1 share of common
1 share of common
1 share of common
stock
stock
1 share of
common
stock
stock
28
If all other accounts have been audited
with satisfactory results,
Is the audit of
retained earnings
necessary?
Possibly not, but the audit of retained
earnings is typically not time-consuming
and may serve as a check on the audit
of other accounts.
29
owners’ equity audit procedures
Analyze all
changes in
retained
earnings.
30
Audit Completion Procedures
Search for unrecorded contingent liabilities.
What is a
contingent
liability
and what
are the
related SFAS
5 rules?
a potential future
obligation to an
outside party for an
unknown amount
resulting from
activities that have
already taken place
31
Audit Completion Procedures
Search for unrecorded contingent liabilities.
What is a
contingent
liability
and what
are the
related SFAS
5 rules?
probable and reasonably estimated accrual with footnote disclosure
reasonably possible footnote disclosure
remote - no financial
statement effect 32
Audit Completion Procedures
Search for unrecorded contingent liabilities.
What is a
contingent
liability
and what
are the
related SFAS
5 rules?
Footnote disclosure
should describe the
contingency and the
opinion of legal
counsel or management regarding the
expected outcome.
33
Audit Completion Procedures
Search for unrecorded contingent liabilities.
- inquire of management
- review:
~ client copies of IRS correspondence
~ minutes to board and stockholder
meetings
~ invoices from client attorneys
~ existing audit workpapers
- obtain letters of confirmation from all
client attorneys
Joe Lawyer
32
Jill Auditor, CPA
34
Attorney Inquiry (AU 337)
The auditor should ask the client to prepare
a letter (on client letterhead, signed by
client officer) asking the attorney to respond
directly to the auditor concerning:
- all material pending threatened litigation,
claims, or assessments with which the
attorney has been involved
- all likely, material unasserted claim or
assessments with which the attorney has
been involved
- the status of each claim or assessment
- any additional, unlisted legal actions
35
Attorney Inquiry (AU 337)
The client’s letter to the attorney should also
remind the law firm that they are responsible
for telling the client when a legal matter
should be disclosed.
The client’s letter to the attorney should
request that the law firm describe any
reasons for limiting their response.
36
Attorney Inquiry (AU 337)
If an attorney refuses to respond
or refuses to provide adequate
information, the audit opinion
will be qualified or disclaimed.
37
types of subsequent events
1.events that provide additional evidence
about conditions that existed at the
balance sheet date (e.g., settlement of
liabilities, realization of assets)
period under audit
12/31
subsequent events period
balance sheet
date
2/14
field work
completion
2/28
report
issue date
38
types of subsequent events
1.events that provide additional evidence
about conditions that existed at the
balance sheet date (e.g., settlement of
liabilities, realization of assets)
period under audit
12/31
2/14
subsequent events period
balance sheet
date
field work
completion
2/28
report
issue date
Client financial statements for the period
under audit must be adjusted to reflect
this subsequent event information.
39
types of subsequent events
2. events that occur after the balance
sheet date and do not relate to conditions that existed at year-end
(e.g., bond/stock issue, acquisition,
fire/flood loss, major customer/vendor
bankruptcy)
period under audit
12/31
2/14
subsequent events period
balance sheet
date
field work
completion
2/28
report
issue date
40
types of subsequent events
2. events that occur after the balance
sheet date and do not relate to conditions that existed at year-end
period under audit
12/31
2/14
subsequent events period
balance sheet
date
disclose
field work
completion
2/28
report
issue date
These subsequent events must be disclosed
in the footnotes of the period under audit. The
auditor may also consider:
- pro forma financial statements
- additional paragraph in audit report
41
Subsequent Events Auditing Procedures
Near field work completion, auditors should:
- read post-balance sheet interim statements
- obtain a management representation letter
- read minutes to board and stockholder
meetings that have occurred since year-end
- obtain letter from client’s attorney
Joe Lawyer
32
Jill Auditor, CPA
42
period under audit
12/31
2/14
subsequent events period
balance sheet
date
field work
completion
2/28
report
issue date
- the auditor is not
responsible for discovering subsequent
events during this
period
What
responsibility
does the auditor
have for
subsequent
- if, however, auditors
events that
learn of a subsequent
occur between
event during this period,
field work
they are responsible for completion and
its disclosure
the issue date?
43
If auditors learn of a subsequent event
during this period, they are responsible for
its disclosure.
period under audit
12/31
2/14
subsequent events period
balance sheet
date
field work
completion
2/28
report
issue date
The auditors then have two options:
- expand all subsequent events tests to the
date of the event and change the report date
to the date of the event (e.g., 2/21)
- restrict testing only to matters relating to the
new event and dual-date the report:
Taylor & Tower, CPAs
February 14, 19x1, except for Note 3, as to which
the date is February 21, 19x1
44
12/31
2/14
period
subsequent events period
under audit
balance sheet
field work
date
completion
2/28
report
issue date
With regard to this information,
If the
auditors must determine:
answer to
- did the information exist at
any of these
the report date?
questions is
- is this information reliable?
no, the
- would the audit report have
auditors do
been different if the informanot need to
tion had been available prior
take any
to the report date?
action.
- are persons still relying on
45
the audit report?
12/31
2/14
period
subsequent events period
under audit
balance sheet
field work
date
completion
2/28
report
issue date
If the
With regard to this information,
answer to
auditors must determine:
all of these
- did the information exist at
questions is
the report date?
yes, the
- is this information reliable?
auditors must
- would the audit report have
act to prevent
been different if the informafuture
reliance on the
tion had been available prior
audit report.
to the report date?
- are persons still relying on
46
the audit report?
How do auditors prevent future
reliance on a previously-issued
audit report?
If the financial statement effect of the
subsequently-discovered information
can be determined promptly
the client must revise
and reissue the
financial statements
47
How do auditors prevent future
reliance on a previously-issued
audit report?
If the financial statement effect of the
subsequently-discovered information
cannot be determined promptly
the client must notify
persons known to be (and
those likely to be) relying
on the financial statements
48
What should the auditor do if the client
refuses to reissue the statements or contact
those relying on the auditors’ report?
- first, notify each board member of
management’s refusal
- then:
~ inform client management that the audit
report may no longer be associated with
the statements
~ notify regulatory agencies that the audit
report may not be relied upon
~ notify persons known to be relying on the
statements that the audit report may not
be relied upon
49
Client Representation Letter (AU 333)
The auditor must obtain a letter from the
client documenting the client’s representations during the engagement.
The primary purposes are to:
- confirm and document oral statements
- reduce auditor-client misunderstanding
The letter should be signed by the client
CFO and CEO and dated with the field
50
work completion date.
Client Representation Letter (AU 333)
If the client refuses to
give the auditor a
representation letter,
the auditor must qualify
or disclaim the opinion.
probable
51
Final Audit Steps
1. Incorporating all audit evidence,
materiality, and judgment, the
auditor draws overall conclusions
and prepares the audit report.
2. The auditor prepares the
management letter.
3. The auditor communicates the results
to the audit committee and gives them
the audit report and management
letter.
52
AU 380 requires auditors to
communicate (oral or written) to the
audit committees of SEC Companies:
- the auditor’s responsibilities under GAAS
- significant accounting policies selected by
management
- significant financial statement adjustments
- disagreements with management
- difficulties in
performing the
audit
53