1. 1 CHAPTER 13 Substantive Audit Testing: Financing & Investing Cycle& Completing the Audit

2. 2 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

3. 3 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.

4. 4 In auditing the capital acquisition and repayment cycle, the auditor should consider: The exclusion of a single transac- tion could be material in itself.

5. 5 In auditing the capital acquisition and repayment cycle, the auditor should consider: There is a legal relationship be- tween the client and the holder of the stock, bond, or similar ownership document.

6. 6 In auditing the capital acquisition and repayment cycle, the auditor should consider: There is a direct relationship be- tween the interest and divi- dends account and debt and equity.

7. 7 - proper authorization for issues of notes or bonds - adequate controls over payment of interest and principal - adequate documents and records - periodic independent verification In auditing the internal controls related to long-term liabilities, the auditor will consider:

8. 8 - completeness - accuracy - presentation and disclosure What are the primary audit objectives with regard to long- term liability account balances?

9. 9 long-term liabilities audit procedures perform analytical procedures to test the reasonableness of long-term liabilities and interest expense

10. 10 long-term liabilities audit procedures inquire of management regarding: - completeness of liabilities - debt-related restrictions on assets - ability to pay interest

11. 11 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)

12. 12 long-term liabilities audit procedures confirm debt balances, interest payments, and client compliance with contractual agreements with the creditors auditor creditor 32

13. 13 long-term liabilities audit procedures for all long-term liabilities, recalculate interest expense, interest payable, and amortizations of discounts or premiums

14. 14 Trace receipt of borrowed amounts from cash receipts journal to bank statement long-term liabilities audit procedures cash receipts journal description _ $$ _ May 23, 19x7 Wachovia loan 14,000 Bank Statement 5/31/x7 Deposits: 5/23 $14,000

15. 15 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 long-term liabilities audit procedures Bank Statement 5/31/x7 Deposits: 5/23 $14,000 Deposit Slip 5/23/x7 14,000

16. 16 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 long-term liabilities audit procedures Bank Statement 5/31/x7 Deposits: 5/23 $14,000 Debt Covenant Wachovia Bank hereby loans Ace Co. $14,000 on 5/23/x7 Deposit Slip 5/23/x7 14,000

17. 17 Trace payments of principal and interest from cash payments journal to bank statement long-term liabilities audit procedures cash payments journal description _ $$ _ November 23, 19x7 interest payment- Wachovia loan 700 Bank Statement 11/30/x7 Deposits: Payments: 11/26 $700

18. 18 Trace payments of principal and interest from cash payments journal to bank statement to cancelled checks to debt agreement. cash payments journal description _ $$ _ November 23, 19x7 interest payment- Wachovia loan 700 long-term liabilities audit procedures Bank Statement 11/30/x7 Deposits: Payments: 11/26 $700 Debt Covenant Ace agrees to pay semi-annual interest of 10% on principal. Ace Corporation 324 $ 700.00 Wachovia Bank pay to the order of date 11/23/x7

19. 19 What are the auditor’s primary concerns with regard to owners’ equity? - authorization - presentation and disclosure - accuracy

20. 20 owners’ equity audit procedures perform analytical procedures to test the reasonableness of owners’ equity accounts (including dividends)

21. 21 READ: - articles of incorporation, bylaws - minutes to meetings Note discussion of dividends, stock options, stock issues, etc. owners’ equity audit procedures

22. 22 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 char- ter and board’s directions (required for SEC companies) owners’ equity audit procedures

23. 23 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 owners’ equity audit procedures

24. 24 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. owners’ equity audit procedures

25. 25 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 Bank Statement 5/31/x7 Deposits: 5/23 $23,000 Deposit Slip 5/23/x7 23,000 Board Minutes... sell Joe Ace 2300 additional common... owners’ equity audit procedures

26. 26 Trace payments related to dividends and treasury stock from cash payments journal to bank statement to cancelled checks to board minutes. cash payments journal description _ $$ _ January 23, 19x7 dividend distribution 4300 Bank Statement 1/31/x7 Deposits: Payments: 1/26 $4300 Ace Corporation 324 $4300.00 Stockholders pay to the order of date 1/23/x7 Board Minutes... declare dividends of $4300... owners’ equity audit procedures

27. 27 Recalculate dividend distribution to common and preferred shareholders. preferred common consider features of preferred (cumulative, participating) owners’ equity audit procedures

28. 28 Ace Company 1 share of common stock Ace Company 1 share of common stock Ace Company 1 share of common stock Inspect treasury stock; recalculate treasury stock transactions. Ace Company 1 share of common stock owners’ equity audit procedures

29. 29 Is the audit of retained earnings necessary? 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.

30. 30 Analyze all changes in retained earnings. owners’ equity audit procedures

31. 31 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

32. 32 Audit Completion Procedures Search for unrecorded contingent liabilities. What is a contingent liability and what are the related SFAS 5 rules? probable and reason- ably estimated - accrual with foot- note disclosure reasonably possible - footnote disclosure remote - no financial statement effect

33. 33 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 manage- ment regarding the expected outcome.

34. 34 32 Jill Auditor, CPA Joe Lawyer 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

35. 35 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 Attorney Inquiry (AU 337)

36. 36 The client’s letter to the attorney should request that the law firm describe any reasons for limiting their response. 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.

37. 37 If an attorney refuses to respond or refuses to provide adequate information, the audit opinion will be qualified or disclaimed. Attorney Inquiry (AU 337)

38. 38 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period types of subsequent events 1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets)

39. 39 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period 1.events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realiza- tion of assets) types of subsequent events Client financial statements for the period under audit must be adjusted to reflect this subsequent event information.

40. 40 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period 2. events that occur after the balance sheet date and do not relate to condi- tions that existed at year-end (e.g., bond/stock issue, acquisition, fire/flood loss, major customer/vendor bankruptcy) types of subsequent events

41. 41 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period 2. events that occur after the balance sheet date and do not relate to condi- tions that existed at year-end disclose 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 types of subsequent events

42. 42 32 Joe Lawyer Jill Auditor, CPA 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

43. 43 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period - the auditor is not responsible for dis- covering subsequent events during this period - if, however, auditors learn of a subsequent event during this period, they are responsible for its disclosure What responsibility does the auditor have for subsequent events that occur between field work completion and the issue date?

44. 44 If auditors learn of a subsequent event during this period, they are responsible for its disclosure. 12/31 2/14 2/28 balance sheet field work report date completion issue date period under audit subsequent events period 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

45. 45 If the answer to any of these questions is no, the auditors do not need to take any action. With regard to this information, auditors must determine: - did the information exist at the report date? - is this information reliable? - would the audit report have been different if the informa- tion had been available prior to the report date? - are persons still relying on the audit report? period subsequent events period under audit 12/31 2/14 2/28 balance sheet field work report date completion issue date

46. 46 If the answer to all of these questions is yes, the auditors must act to prevent future reliance on the audit report. With regard to this information, auditors must determine: - did the information exist at the report date? - is this information reliable? - would the audit report have been different if the informa- tion had been available prior to the report date? - are persons still relying on the audit report? period subsequent events period under audit 12/31 2/14 2/28 balance sheet field work report date completion issue date

47. 47 the client must revise and reissue the financial statements 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

48. 48 the client must notify persons known to be (and those likely to be) relying on the financial statements 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

49. 49 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

50. 50 Client Representation Letter (AU 333) The auditor must obtain a letter from the client documenting the client’s represen- tations 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 work completion date.

51. 51 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

52. 52 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.

53. 53 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