MODERN AUDITING 7th Edition Developed by: Dr. Raymond N. Johnson, CPA Gregory K. Lowry, MBA, CPA John Wiley & Sons, Inc. William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan

CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES u Nature of the Investing and Financing Cycles u The Investing Cycle u Substantive Tests of Plant Asset Balances

u The Financing Cycle u Substantive Tests of Long- Term Debt Balances u Substantive Tests of Stockholders Equity Balances u Value-Added Services in the Investing and Financing Cycles CHAPTER 17 AUDITING 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

CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES u Nature of the Investing and Financing Cycles u The Investing Cycle u Substantive Tests of Plant Asset Balances

u The Financing Cycle u Substantive Tests of Long- Term Debt Balances u Substantive Tests of Stockholders Equity Balances u Value-Added Services in the Investing and Financing Cycles CHAPTER 17 AUDITING 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

CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES u Nature of the Investing and Financing Cycles u The Investing Cycle u Substantive Tests of Plant Asset Balances

u The Financing Cycle u Substantive Tests of Long- Term Debt Balances u Substantive Tests of Stockholders Equity Balances u Value-Added Services in the Investing and Financing Cycles CHAPTER 17 AUDITING 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

CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES u Nature of the Investing and Financing Cycles u The Investing Cycle u Substantive Tests of Plant Asset Balances

u The Financing Cycle u Substantive Tests of Long- Term Debt Balances u Substantive Tests of Stockholders Equity Balances u Value-Added Services in the Investing and Financing Cycles CHAPTER 17 AUDITING 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

A Summary of Net Fixed Assets and How They Are Financed for Selected Industries Figure 17-1

Important Fixed Asset Transactions and Issues Acquisition of plant and equipment, including capital leases Disposal of plant and equipment Repair and maintenance transactions Depreciation (matching) Capital / operating lease disclosures

Selected Specific Audit Objectives for the Investing Cycle Figure 17-2

Materiality Plant assets are normally a material aspect of the financial statements. 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

Investing Cycle Inherent risk –Fixed assets are not vulnerable to theft –Complexity of determining capital lease –Valuation challenges with constructed assets –Accounting estimate involved in depreciation –Impairment test for old assets still on the books –Classification issues with repair an maintenance

Analytical Procedures Commonly Used to Audit Plant Assets Figure 17-3

Investing Cycle Control risk –Key cycle related to initial accounting for fixed asset is related to controls over purchases and acquisitions –Does management have high level controls to: Review the productivity of fixed assets Review the reasonableness of depreciation estimates based on actual useful lives and gains / losses on disposal of fixed 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.

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 The auditor should maintain an appropriate level of professional skepticism and investigate abnormal results – Level of fixed assets – impairment of fixed assets – Reasonableness of depreciation 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, and 2. examine title documents and contracts.

Substantive Tests of Plant Asset Balances Test of Details of Balances: Accounting Estimates 2 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:

The Financing Cycle Materiality Financing liabilities are normally a material aspect of the financial statements. 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. The auditor also needs to consider the significance of omissions of debt or obligations.

The Financing Cycle Inherent Risk –Long-term debt is not usually vulnerable to theft –Complexity of determining capital lease –Consolidation of variable interest entities and “off balance sheet” financing –Calculation and reporting of interest expense

The Financing Cycle Control Risk – Part 1 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.

Analytical Procedures Commonly Used to Audit the Financing Cycle Figure 17-7

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 Irrespective of whether financing transactions are infrequent, the auditor should always be alert for unrecorded liabilities. A primarily substantive approach emphasizing tests of details is cost effective. Emphasis on the confirmation.

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 audit evidence.

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 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.

Analytical Procedures Commonly Used to Audit Shareholders’ Equity Figure 17-11

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.

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. Value-Added Services in the Investing and Financing Cycles

CHAPTER 17 AUDITING THE INVESTING AND FINANCING CYCLES

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