1. Audit of the Capital Acquisition and Repayment Cycle
Chapter 22

2. Characteristics of the Capital Acquisition and Repayment Cycle
1. Relatively few transactions affect the
account balances, but each one is
often highly material in amount.
2. The exclusion of a single transaction
could be material in itself.

3. Characteristics of the Capital Acquisition and Repayment Cycle
3. A legal relationship exists between the
client entity and the holder of the stock,
bond, or similar ownership document.
4. A direct relationship exists between the
interest and dividends accounts and
debt and equity.

4. Learning Objective 1
Identify the accounts and the unique characteristics of the capital acquisition and repayment cycle.

5. Accounts in the Cycle Notes payable Contracts payable
Mortgages payable
Bonds payable
Interest expense
Accrued interest
Appropriations of retained earnings
Treasury stock
Dividends declared
The methodology for designing tests of details of balances for accounts in the capital acquisition and repayment cycle is the same as that followed for other accounts.

6. Accounts in the Cycle Cash in the bank Capital stock – common
Capital stock – preferred
Paid-in capital in excess of par
Donated capital
Retained earnings
Dividends payable
Proprietorship – capital account
Partnership – capital account

7. Methodology for Designing Tests of Balances for Notes Payable
Identify client
business risks
affecting notes payable
Phase I
Set tolerable misstatement
and assess inherent
risk for notes payable
Phase I
Auditors often set tolerable misstatement at a low level because it is usually possible to completely audit the account balance and transactions affecting the notes payable account balance and the correct account value is easy to determine.
Assess control
risk for
notes payable
Phase I

8. Methodology for Designing Tests of Balances for Notes Payable
Design and perform
tests of controls and
substantive tests of
transactions for
capital acquisition and
repayment cycle
Phase II

9. Methodology for Designing Tests of Balances for Notes Payable
Design and perform
analytical procedures
for notes payable
Phase III
Design tests of
details of notes
payable to satisfy
balance-related
audit objectives
Audit procedures
Phase III
Sample size
Items to select
Timing

10. Learning Objective 2
Design and perform audit test of notes payable and related accounts and transactions.

11. Notes Payable Secured or Legal unsecured Obligation by assets
Typically, a note is issued for a period somewhere between one month and one year, but longer term notes exist.

12. Notes Payable Objectives of the audit of notes payable:
Internal controls are adequate
Transactions are properly authorized
and recorded
The related liabilities and expenses are
properly stated
There are four important controls over notes payable:
Proper authorization
Adequate controls over the repayment of principal and interest
Proper documents and records
Periodic independent verification

13. Internal Controls 1. Proper authorization for the issue of new notes.
2. Adequate controls over the repayment
of principal and interest.
Proper documents and records.
Periodic independent verification.
Responsibility for issuance of new notes should be vested in the board of directors.
The periodic payment of interest and principal should be subject to the controls in the acquisition and payment cycle.
Proper documents include subsidiary records and control over blank and paid notes by an authorized person.
Periodically the detailed note records should be reconciled with the general ledger and compared with the note holders records.

14. Notes Payable and the Related Interest Accounts
Interest Expense
Payments of
principal
Beginning balance
Interest
expense
Issue of new notes
Interest Payable
Ending balance
Payments of
interest
Beginning
balance
Cash in Bank
Interest
expense
Issue of
new notes
Payments of
principal
Ending
balance
Payments of
interest

15. Tests of Controls and Substantive Tests of Transactions
Tests of notes payable transactions
involve the issue of notes and the
repayment of principal and interest.
These audit tests are a part of tests of controls and substantive tests of transactions for cash receipts and cash disbursements.

16. Analytical Procedures for Notes Payable
Possible misstatement
Recalculate approximate
interest expense on the
basis of average interest
rates and overall monthly
notes payable
Misstatement of
interest expense and
accrued interest, or
omission of a
note payable
Analytical procedures are essential for notes payable because tests of details for interest expense and accrued interest can often be eliminated when results are favorable.
The auditor’s independent prediction of interest expense helps the auditor evaluate the reasonableness of interest expense and also tests for omitted notes payable.

17. Analytical Procedures for Notes Payable
Possible misstatement
Compare individual notes
outstanding with those
of the prior year
Omission or
misstatement of
a note payable
Compare total balance in
notes payable, interest
expense, and accrued
interest with prior-year
balances
Misstatement of interest
expense and accrued
interest or notes
payable

18. Major Balance-related Audit Objectives in Notes Payable
The two most important balance-
related audit objectives in notes
payable are:
1. Completeness:
Existing notes payable are included.
2. Accuracy:
Notes payable in the schedule are
accurately recorded.
These objectives are vital because a misstatement can be material if even one note is omitted or incorrect.

19. Types of Audit Tests for Capital Acquisition and Repayment Cycle
Cash in Bank
Notes Payable
Payments of principal
Audited by
TOC and STOT
Ending
balance
Issue of new notes
Audited by
TOC and STOT
Audited by
AP and TDB
Payments
of interest
In addition to balance related objectives, the four presentation and disclosure related objective are important for notes payable because accounting standards require that the footnotes adequately describe the terms of notes payable outstanding and the assets pledged as collateral for the loans.
Interest Payable
Audited by
TOC, STOT,
and AP
TOC + STOT + AP + TDB
= Sufficient appropriate evidence

20. Types of Audit Tests for Notes Payable
Interest Payable
Interest Expense
Interest expense
Audited by
TOC, STOT,
and AP
Ending
balance
Ending
balance
Audited by
AP and TDB
Audited
by AP
TOC + STOT + AP + TDB
= Sufficient appropriate evidence

21. Learning Objective 3
Identify the primary concerns in the audit of owners’ equity transactions.

22. Owners’ Equity Publicly Closely held held corporation corporation
Versus
Many shareholders
Frequent transactions
Simple, few transactions
Few shareholders
Occasional transactions

23. Owners’ Equity and Dividend Accounts
Cash in Bank
Capital Stock –
Common
Paid-in Capital in Excess
of Par – Common
Redemption
of stock
Beginning
balance
Redemption
of stock
Beginning
balance
Issue of
stock
Issue of
stock
Ending
balance
Ending
balance

24. Internal Controls Proper authorization of transactions
Proper record keeping and segregation of duties
Independent registrar and stock transfer agent
Many of equity transactions must be approved by the board of directors. Transactions such as the issuance of capital stock, stock repurchases sands declaration of dividends require board approval.
When a company maintains its own records of stock transactions and outstanding stock, the internal controls must be adequate to ensure that the actual owners are recognized in the records, the correct amount of dividends is paid to the stockholders and the potential for misappropriation of assets is minimized.
Any company with listed stock is required to engage an independent registrar as a control to prevent the improper issue of stock certificates. Many companies employ a stock transfer agent to maintain the stockholder records.

25. Learning Objective 4
Design and perform tests of controls, substantive tests of transactions, and tests of details of balances for capital stock and
retained earnings.

26. Audit of Capital Stock and Paid-in Capital
Auditor concerns in auditing Capital
Stock and Paid-in-Capital accounts
Completeness
Occurrence
and
Accuracy
Completeness:
Existing capital stock transactions
are recorded.
Occurrence and accuracy:
Recorded capital stock transactions
exist and are accurately recorded.
Accuracy:
Capital stock is accurately recorded.
Presentation and disclosure:
Capital stock is properly presented and
disclosed.
Presentation
and
disclosure
Accuracy

27. Audit of Dividends 1. Occurrence: Recorded dividends occurred.
2. Completeness:
Existing dividends are recorded.
Auditors can verify the occurrence of recorded dividends by examining the minutes of board of directors meetings. For authorization of the amount of the dividend per share and the dividend date.
3. Accuracy:
Dividends are accurately recorded.

28. Audit of Dividends 4. Occurrence: Dividends are paid to stockholders
that exist.
5. Completeness:
Dividends payable are recorded.
The accuracy of a dividend declaration can be audited by recalculating the amount on the basis of the dividend per share times the number of shares outstanding.
Tests of dividends payable should be done in conjunction with declared dividends and unpaid dividend should be included as a liability.
6. Accuracy:
Dividends payable are accurately
recorded.

29. Audit of Retained Earnings
Transactions involving retained earnings:
Net earnings for the year
Dividends declared
There may be corrections to:
Prior-period earnings
Prior-period adjustments
Appropriations of retained earnings

30. End of Chapter 22