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
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