MODERN AUDITING 7th Edition William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan Developed by: Gregory K. Lowry, MBA, CPA Saint Paul’s College John Wiley & Sons, Inc. CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES Nature of the Investing and Financing Cycles The Investing Cycle Substantive Tests of Plant Asset Balances The Financing Cycle CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES Substantive Tests of LongTerm Debt Balances Substantive Tests of Stockholders Equity Balances Value-Added Services in the Investing and Financing Cycles Nature of the Investing and Financing Cycles The auditor usually wants to obtain answers to the following questions when auditing investing and financing activities: 1. What assets are necessary to support the operations of the entity, and what are management’s long-range plans for growing the entity’s asset base? 2. What assets were acquired, or disposed of, during the period? 3. How were newly acquired assets financed and what are management’s long-range plans for financing the entity’s growth? Nature of the Investing and Financing Cycles Investing activities are the purchase and sale of land, buildings, equipment, and other assets not generally held for resale. In addition, investing activities include the purchase and sale of financial instruments not intended for trading purposes. Nature of the Investing and Financing Cycles Financing activities include transactions and events whereby cash is obtained from or repaid to creditors (debt financing) or owners (equity financing). Financing activities would include acquiring debt, capital leases, issuing bonds, or issuing preferred or common stock. Financing activities would also include payments to retire debt, reacquiring stock (treasury stock), and the payment of dividends. Nature of the Investing and Financing Cycles Using the Understanding of the Business and Industry to Develop Audit Strategy When an auditor develops a bottom-up, transactions-based audit strategy for the audit of investments in plant assets, and other longterm assets, it is usually a byproduct of the expenditure cycle. Figure 17-1 provides summary financial information related to financing and investing activities for the industries that have been discussed throughout Part 4 of the text. A Summary of Net Fixed Assets and How They Are Financed for Selected Industries Figure 17-1 School District Retail Grocer Appliance Manufacturer Electronic Computers 75% 25% 65% 10% 100% 57% 23% 19% 58% 100% 42% 36% 33% 31% 100% 36% 47% 23% 30% 100% 16% 56% 10% 34% 100% 0.80 0.60 1.30 0.80 1.60 0.70 3.70 1.40 17.30 2.80 Hotel Net fixed assets as a % of total assets Operating debt as a % of total assets Financing debt as a % of total assets Equity as a % of total assets Sales to net fixed assets Sales to total assets The Investing Cycle Audit Objectives The specific audit objectives for the audit of fixed assets in the investing cycle are presented in Figure 17-2. Each of the objectives is derived from management’s implicit or explicit assertions about investing cycle transactions as they relate to long-term assets. These objectives are the primary ones for this cycle in most audits. They are not intended to be all-inclusive for all client situations. Selected Specific Audit Objectives for the Investing Cycle Figure 17-2 Assertion Category Transaction Class Audit Objectives Account Balance Audit Objectives Existence or occurrence Recorded acquisitions of plant assets, disposals of plant assets, and repair and maintenance transactions represent transactions that occurred during the year. Recorded plant assets represent productive assets that are in use at the balance sheet date. Completeness All acquisitions of plant assets, disposals of plant assets, and repair and maintenance transactions that occurred during the period were recorded. Plant asset balances include the effects of all applicable transactions during the period. Assertion Category Transaction Class Audit Objectives Rights and Obligations Account Balance Audit Objectives The entity owns or has rights to all recorded plant assets at the balance sheet date. Valuation or allocation Transactions for depreciation expense and impairments to the value of plant assets are properly valued. Plant assets are stated at cost less accumulated depreciation and are written down for material impairments. Presentation and disclosure Depreciation, repair and maintenance transactions, and operating leases are properly identified and classified in the financial statements. Plant assets and capital leases are properly identified and classified in the financial statements. Disclosures pertaining to the cost, book value, depreciation methods, and useful lives of major classes of plant assets, the pledging of plant assets as collateral, and the major terms of capital lease contracts are adequate. The Investing Cycle Materiality Plant assets are normally a material aspect of the financial statements. The allocation of materiality to accounts affected by transactions in this cycle will vary according to considerations explained in Chapter 8. The primary consideration in evaluating the allocation of materiality is the determination of the magnitude of misstatement that will influence the decisions of a reasonable financial statement user. A secondary consideration is the relationship to the cost of detecting errors. The Investing Cycle Inherent Risk Inherent risk related to the existence assertion is often low because fixed assets are not vulnerable to theft. However, the inherent risk may be increased to moderate or high because of the potential that scrapped or retired assets may not be written off. The completeness assertion may be moderate to high in the case of constructed assets, or capital leases that may be recorded as operating leases due to the complexity of accounting for leases. The Investing Cycle Analytical Procedures Risk Analytical procedures risk is the element of detection risk that analytical procedures will fail to detect material errors. Analytical procedures are cost effective and they may assist the auditor in evaluating the reasonableness of the financial statements. Figure 17-3 presents some example analytical procedures along with an explanation of the problems that they might identify. Analytical Procedures Commonly Used to Audit Plant Assets Figure 17-3 Ratio Formula Audit Significance Fixed asset turnover Net sales ÷ average fixed assets An unexpected increase in fixed asset turnover may indicate the failure to record or capitalize depreciable assets. Total asset turnover Net sales ÷ average total assets An unexpected increase in total asset turnover may indicate the failure to record or capitalize depreciable assets. Return on total assets (Net income ÷ (interest x (1 – tax rate))) ÷ average total assets An unexpected increase in return on assets may indicate the failure to record or capitalize depreciable assets. Depreciation expense as a percentage of property, plant, and equipment Depreciation expense ÷ average property, plant, and equipment An unexpected increase or decrease in the depreciation expense as a percentage of depreciable assets may indicate an error in calculating depreciation. Repair expenses to net sales Repair and maintenance expenses ÷ net sales An unexpected increase in repair and maintenance expense may indicate the possibility that assets that should be capitalized have been expensed. The Investing Cycle Control Risk The same aspects of internal controls that establish a high level of control consciousness such as a strong control environment, effective risk assessment, effective accountability for the use of resources, and monitoring of the control system are important in the context of accounting for plant assets. One of the key transactions associated with plant assets is the initial accounting for the acquisition of plant assets. Substantive Tests of Plant Asset Balances Determining Detection Risk The auditor’s substantive tests will be much more extensive in an initial audit of a client than in a repeat engagement. In a first audit, evidence must be obtained on the propriety of the beginning balances in the accounts and the ownership of the assets comprising the balances. When the client has previously been audited by another independent auditor, the acquisition of such evidence is facilitated when the successor auditor is able to review the predecessor auditor’s working papers. Substantive Tests of Plant Asset Balances Designing Substantive Tests Possible substantive tests for plant asset balances in a recurring engagement and the specific account balance audit objectives to which the tests relate are shown in Figure 17-4. Risk considerations usually result in greater emphasis being placed on the existence or occurrence and valuation or allocation assertions. Substantive Tests of Plant Asset Balances Initial Procedures An important initial procedure involves obtaining an understanding of the business and industry. Industries that are very capital intensive usually have heavy fixed operating costs and require significant volume to break even. Before performing other substantive tests in the audit program, the auditor determines that the beginning general ledger balance for plant asset accounts agrees with the prior period’s working papers. Substantive Tests of Plant Asset Balances Analytical Procedures An important part of the investing cycle is determining that the financial information subjected to audit is consistent with the auditor’s expectations. When performing analytical procedures, the auditor should maintain an appropriate level of professional skepticism and investigate abnormal results. If the results of analytical procedures are consistent with the auditor’s expectations, audit strategy might be modified to reduce the extent of details tests of transactions and balances. Substantive Tests of Plant Asset Balances Test of Details of Transactions These substantive tests cover 3 types of transactions related to plant assets: 1. additions, 2. disposals, and 3. repairs and maintenance. Substantive Tests of Plant Asset Balances Test of Details of Balances 2 procedures in this category of substantive tests are: 1. inspect plant assets, 2. examine title documents and contracts, and 3. Review provisions for depreciation. Substantive Tests of Plant Asset Balances Test of Details of Balances: Accounting Estimates 3 important tests of accounting estimates include substantive tests to: 1. Review provisions for depreciation, and 2. evaluate impairments of plant assets. The Financing Cycle Significant investing transactions are usually accompanied by significant financing transactions. The financing cycle includes 2 major transaction classes as follows: 1. Long-term debt transactions include borrowings from bonds, mortgages, notes, and loans, and the related principal and interest payments. 2. Stockholders’ equity transactions include the issuance and redemption of preferred and common stock, treasury stock transactions, and dividend payments. The Financing Cycle The financing cycle interfaces with the expenditure cycle when cash is disbursed for bond interest, the redemption of bonds, cash dividends, and the purchase of treasury stock. The accounts used in recording financial cycle transactions include: LONG-TERM DEBT TRANSACTIONS Bonds, Mortgages, Notes, and Loans Payable Bond Premium (Discount) Interest Payable Interest Expense Gain (Loss) on Retirement of Bonds STOCKHOLDERS’ EQUITY TRANSACTIONS Preferred Stock Common Stock Treasury Stock Paid-in Capital Retained Earnings Dividends Dividends Payable Selected Specific Audit Objectives for the Financing Cycle Figure 17-6 Assertion Category Existence or occurrence Completeness Transaction Class Audit Objectives Account Balance Audit Objectives Recorded interest expense and other income statement transactions represent the effects of long-term debt transactions and events that occurred during the period. Recorded long-term debt balances represent debt that exists at the balance sheet date. All interest expense and other income transactions related to long-term debt that occurred during the period were recorded. Long-term debt balances represent all payables to long-term creditors at the balance sheet date. Shareholders’ equity balances represent the owners’ interests that exist at the balance sheet date. Shareholders’ equity balances represent owner’s claims on the reporting entity’s assets. Assertion Category Transaction Class Audit Objectives Rights and Obligations Account Balance Audit Objectives All recorded long-term debt balances are obligations of the reporting entity. Stockholders’ equity balances represent owners’ claims on the reporting entity’s assets. Valuation or allocation Interest expense and other income transactions related to long-term debt are properly valued in accordance with GAAP. Long-term debt and stockholders’ equity balances are properly valued in accordance with GAAP. Presentation and disclosure Long-term debt and stockholders’ equity transactions are properly identified and classified in the financial statements. Long-term debt and stockholders’ equity balances are properly identified and classified in the financial statements. All terms, covenants, commitments, and related provisions pertaining to long-term debt are adequately disclosed. All facts concerning stock issues such as the par or stated value of the shares, shares authorized and issued, and the number shares held as treasury stock or subject to options are disclosed. The Financing Cycle Materiality There is considerable variation in the importance of long-term debt to the fair presentation of financial position. In some major corporations, long-term debt is immaterial to total liabilities and stockholders’ equity, whereas in many public utilities such liabilities represent more than 50% of the total claims on corporate assets. The Financing Cycle Inherent Risk The risk of misstatements in executing and recording financing cycle transactions is usually low. In many companies, these transactions occur infrequently, except for the payment of dividends and interest, which are often handled by outside agents. In addition, board of director authorizations are required for most transactions, and company officers participate in their execution. The Financing Cycle Analytical Procedures Risk Analytical procedures risk is the element of detection risk that analytical procedures will fail to detect material errors. Given that the auditor understands the entity’s investing activities and the nature of the business, the entity’s financing activities should be predictable. Figure 17-7 presents some example analytical procedures along with an explanation of the problems that they might identify. Analytical Procedures Commonly Used to Audit the Financing Cycle Figure 17-7 Ratio or Other Financial Information Formula Audit Significance Free Cash Flow Cash Flow from Operations — Capital Expenditures Negative free cash flows indicate the need for, and approximate amount of, expected financing to prevent drawing down on cash or investments. Interest-Bearing Debt to Total Assets Interest-Bearing Debt ÷ Total Assets Provides a reasonableness of the entity’s proportion of debt that may be compared with prior years’ experience or industry data. Shareholders’ Equity to Total Assets Shareholders’ Equity ÷ Total Assets Provides a reasonableness of the entity’s proportion of equity that may be compared with prior years’ experience or industry data. Ratio or Other Financial Information Formula Audit Significance Comparing Return on Assets with the Incremental Cost of Debt Is ROA > the incremental cost of debt? Return on Common Equity (Net Income – Preferred Dividends) ÷ Average Common Shareholders’ Equity Provides a reasonableness test of shareholders’ equity given the company’s earnings and financing structure. Cash Flow from Operations to Current Portion of Debt and Dividends Cash Flow from Operations ÷ (Current Portion of Debt + Dividends) A test of the entity’s ability to service its financing obligations. Ratios less than 1.0 indicate potential liquidity problems. Times Interest Earned Income Before Interest and Income Taxes ÷ (Interest Expense + Capitalized Interest) A test of the entity’s ability to generate earnings to cover cost of debt service. Ratios less than 1.0 indicate that the entity’s earnings are insufficient to cover financing costs. Interest Expense to Interest-Bearing Debt (Interest Expense + Capitalized Interest) ÷ Average Interest-Bearing Debt A reasonableness test of recorded interest expense that should approximate the entity’s average cost of debt capital. ROA = (Net Income + (Interest x (1 – tax rate ))) ÷ Average Total Assets If a company is able to generate a higher rate of return on assets than its incremental cost of debt, this is a signal that an entity may use debt financing to expand the assets and earnings of the entity. The Financing Cycle Control Risk The applicability of the internal control components to financing cycle transactions and balances is similar in many respects to that described for the investing cycle. The accounting system element of the information and communication component will normally provide for subsidiary ledgers for both bonds payable and capital stock. These may be maintained by entity personnel or outside agents. The Financing Cycle Common Documents and Records Several of the documents described in the investing cycle, such as stock and bond certificates and a bond indenture, are also important in the financing cycle except the perspective is from that of the issuer. As previously noted, separate bondholder and stockholder subsidiary ledgers may be maintained. In addition, financing cycle transactions may involve entries in the general journal and cash receipts and disbursements journals for the issuance and retirement of debt and equity securities, the accrual and payment of interest, and the declaration and payment of dividends. The Financing Cycle Functions and Related Controls The following financing functions and related control activities are associated with the financing cycle: 1. Authorizing bonds and capital stock. The board of directors usually authorizes financing transactions based on its strategic plans and investing activities. 2. Issuing bonds and capital stock. Issues are made in accordance with board of directors authorizations and legal requirements, and proceeds are promptly deposited intact; unissued bond and stock certificates are physically safeguarded. 3. Paying bond interest and cash dividends. Payments are made to proper payees in accordance with board of directors or management authorizations. The Financing Cycle 4. Redeeming financing transactions. Transactions are executed in accordance with board of directors authorizations; treasury stock certificates are physically safeguarded. 5. Recording financing transactions. Transactions are correctly recorded as to amount, classification, and accounting period based on supporting authorizations and documentation; the duties of executing and recording financing transactions are segregated; periodic independent checks are made of agreement of subsidiary ledgers and control accounts, including confirmation with the bond trustee or transfer agent, if applicable. Substantive Tests of Long-Term Debt Balances From an auditing standpoint, notes payable, mortgages payable, and bonds payable have similar characteristics. Generally, these forms of debt: 1. involve interest-bearing contractual agreements, 2. require approval by the board of directors, and 3. May be secured by the pledging of collateral. Substantive Tests of Long-Term Debt Balances Determining Detection Risk Because of the nature and infrequency of most types of long-term debt transactions, inherent risk is often low for all related account balance assertions except completeness and valuation or allocation. Irrespective of whether financing transactions are infrequent, the auditor should always be alert for unrecorded liabilities. Inherent risk for this assertion may be moderate or high due to complexities involved in computing amortization of bond discount or premium. Substantive Tests of Long-Term Debt Balances Designing Substantive Tests Figure 17-8 shows a list of possible substantive tests of long-term debt balances together with the specific audit objectives to which each test relates. From the possible tests, the auditor designs an audit program to meet the acceptable level of detection risk for each significant assertion. Substantive Tests of Long-Term Debt Balances The auditor relies primarily on: 1. direct communication with outside independent sources, 2. review of documentation, and 3. recomputations in obtaining sufficient competent evidential matter about the assertions pertaining to long-term debt balances. Substantive Tests of Long-Term Debt Balances Initial Procedures As shown in Figure 17-8, the familiar initial procedures are applicable to long-term debt balances. It is important to obtain an understanding of the business and industry, determine the entity’s need for external financing, and its ability to service debt. Because financing is so clearly linked to investing activities, the auditor may perform these procedures simultaneously. The schedules associated with long-term debt may include separate schedules of long-term notes payable to banks, obligations under capital leases, and listings of registered bondholders prepared by bond trustees. Substantive Tests of Long-Term Debt Balances Analytical Procedures An important part of auditing long-term debt is determining that the financial information subjected to audit is consistent with the auditor’s expectations. The auditor should also evaluate the disclosures regarding the maturities of debt and debt covenants. When performing analytical procedures, the auditor should maintain an appropriate level of professional skepticism and investigate abnormal results. Substantive Tests of Long-Term Debt Balances Test of Details of Transactions For bonds, the auditor should obtain evidence on both the face value and net proceeds of the obligation at the date of issuance. Issuances of debt instruments should be traced to cash receipts as evidenced by brokers’ advices. When bond interest is paid by an independent agent, the auditor should examine the agent’s reports on payments. Vouching recorded entries will not reveal unrecorded long-term debt. Substantive Tests of Long-Term Debt Balances Test of Details of Balances There are 3 substantive tests in this category: 1. review authorizations and contracts for long-term debt, 2. confirm debt with lenders and bond trustee, and 3. recalculate interest expense. Substantive Tests of Stockholders’ Equity Balances Determining Detection Risk Inherent risk assessments for assertions pertaining to stockholders’ equity balances depend on the nature and frequency of transactions affecting the accounts. Routine stock transactions for publicly held companies are often handled by a registrar and transfer agent. In such cases, both inherent and control risk assessments for account balance assertions affected by these transactions may be low. Inherent and control risk assessments may be higher when there are nonroutine transactions involving stock issued in acquisitions, convertible securities, or stock options. Substantive Tests of Stockholders’ Equity Balances Designing Substantive Tests A list of possible substantive tests of stockholders’ equity balances and the specific audit objectives to which each test relates is illustrated in Figure 17-10. Substantive Tests of Stockholders’ Equity Balances Initial Procedures The auditor should obtain an understanding of the business and industry and determine: 1. the entity’s need for external financing and 2. The desirability of using equity financing to support the growth of the entity. Substantive Tests of Stockholders’ Equity Balances Analytical Procedures Figure 17-11 presents several ratios commonly used to evaluate the reasonableness of stockholders’ equity. The financial relationships expressed in these ratios may be helpful in evaluating the reasonableness of stockholders’ equity balances. The evidence obtained from these analytical procedures pertains to the existence or occurrence, completeness, and valuation or allocation assertions. Analytical Procedures Commonly Used to Audit Shareholders’ Equity Figure 17-11 Ratio Formula Audit Significance Return on common stockholders’ equity (Net income — preferred dividends) ÷ Average common stockholders’ equity Provides a measure of the rate of return generated on the common shareholders’ investment. Auditors should understand the competitiveness factors that allow a company to obtain unusually high returns. Equity to total liabilities and equity Stockholders’ equity ÷ (Stockholders’ equity + total liabilities) Provides a reasonableness of the entity’s proportion of equity that may be compared with prior years’ experience or Industry data. Ratio Formula Audit Significance Dividend payout rate Cash dividends ÷ Net income Auditors would normally expect low dividend payout rates for high growth companies that need reinvested earnings to fund investments in working capital and long-term assets. Earnings per share Net income ÷ Weighted average common shares outstanding Earnings per share is useful for comparisons with price per share. This ratio can be compared with industry price earnings ratios for reasonableness. Sustainable growth rate Return on common equity x (1 – Dividend payout rate) Provides an estimate of rate of sales growth that can be obtained without changing the entity’s profitability or financing structure. The auditor should expect changes in the financing structure when sales grow significantly faster than the sustainable growth rate. Substantive Tests of Stockholders’ Equity Balances Test of Details of Transactions This category of tests includes: 1. vouching entries to paid-in capital accounts and 2. vouching entries to retained earnings. Substantive Tests of Stockholders’ Equity Balances Test of Details of Balances This category of tests includes: 1. reviewing articles of incorporation and bylaws, 2. reviewing authorizations and terms of stock issues, 3. confirming shares outstanding with the registrar and the transfer agent, 4. inspecting the stock certificate book, and 5. inspecting certificates of shares held in the treasury. Value-Added Services in the Investing and Financing Cycles When the auditor has completed the audit of investing activities, he or she is in a position to evaluate the entity’s investments relative to others in the industry. Auditors are uniquely positioned to provide the following 2 important value-added services: 1. The auditor can evaluate how effectively the entity has been utilizing its assets to generate sales, profits, and cash flows, and accomplishing the entity’s goals. 2. The auditor is then positioned to provide independent advice by evaluating the entity’s planned investing activities and determining whether the planned steps best support its goals. CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES Copyright Copyright 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. 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