1. Copyright © 2010 South-Western/Cengage Learning
Chapter 14
Audit of Long-Term Liabilities, Equity, Acquisitions, and Related-Entity Transactions
Copyright © 2010 South-Western/Cengage Learning

2. Audit Opinion Formulation Process

3. LO 1 Long-Term Liabilities and Owners Equity
Liabilities with significant subjective judgments:
Warranty reserves
Pension obligations
Other postretirement benefits
Restructuring reserves

4. Warranty Reserves
The warranty reserve represents expected future cost related to sales of a company's product; it is estimated and recorded when the product is sold
The estimate is typically based on past experience of the company and adjusted for
Changes in the product, including those that change its quality

5. Warranty Reserves (continued)
Changes in the nature of warranty
Changes in sales volume
Changes in the average cost of repairing products under warranty
The auditor can examine the account by
Testing the information system used by the client
Developing an estimate based on the factors above

6. Pension Obligations
The amount of pension obligations are based on a number factors:
Projected lifetime of pensioners
Nature of the pension plan
Future earnings of employees prior to retiring
Earnings rate on invested pension assets
Long-term interest rates used to discount future costs
Changes in pension plans

7. Pension Obligations (continued)
The client will usually hire an actuarial firm to help make the estimates
The auditor must determine that the actuarial firm is independent, competent, and has sufficient reliable information to develop the estimates

8. LO 2 Bonds and Stockholders' Equity
Companies issue capital stock (equity) and bonds (borrowing) to raise long-term funds
Other financing activity accounts include:
Notes payable
Mortgages payable
Special bonds
Payment-in- kind bonds
Convertible bonds

9. LO 2 Bonds and Stockholders' Equity (continued)
Mandatory redeemable preferred stock
Stock options and warrants
Stock options - employee stock compensation program

10. Auditing Bonds Payable
Bonds are issued to finance major expansions or refinance existing debt. While bond issues are infrequent, each transaction is material
Primary considerations in auditing bonds or other long-term debt:
Valuation and amortization of premium or discount
Auditor will review loan documents

11. Auditing Bonds Payable (continued)
If debt is issued during the audit period, receipt of cash may be traced to cash receipts journal and bank
Computation of interest expense
Auditor will usually recalculate interest expense including amortization of any discount or premium
Accounting for gains or losses on debt refinancing

12. Auditing Bonds Payable (continued)
Disclosure of major restrictions in bond indentures
Auditor typically reviews loan documents and makes inquiries of client

13. Common Stock and Owners' Equity
Transactions affecting stockholders' equity:
New stock issues
Purchase of treasury stock
Payment of stock dividends or issuance of stock splits
Sale of treasury stock and proper accounting for the proceeds
Donated capital
Declaration and payment of cash dividends
Transfer of net income to retained earnings
Prior period adjustments

14. Common Stock and Owners' Equity: Audit Procedures
Since most equity transactions require Board approval, auditor should review the minutes of Board meetings for approval and intent
Valuation of equity transactions is fairly straight forward, except when shares are issued for non-cash assets

15. Common Stock and Owners' Equity: Audit Procedures (continued)
Disclosure items:
Number of shares of stock authorized, issued, and outstanding
Stock options outstanding
Convertible features
Existence of stock warrants

16. Integrated Audit Issues Concerning Bond and Stockholders’ Equity Accounts
Phases I and II of the Audit Opinion Formulation Process
Continually update information on business risk
Analyze potential motivations to misstate term debt and shareholders' equity accounts
Perform preliminary analytical procedures and document how the audit testing should be modified
Develop understanding of the internal controls in long-term debt and shareholders’ equity accounts

17. Integrated Audit Issues Concerning Bond and Stockholders’ Equity Accounts
Phases III and IV of the Audit Opinion Formulation Process
Determine the important controls that need to be tested
Develop a plan for testing internal controls and perform the tests of key controls over these accounts
Analyze the results of the tests of controls
Perform planned substantive procedures

18. LO 3 Mergers and Acquisitions
There are three valuation issues associated with acquisitions:
Valuing the assets and associate liabilities upon acquisition
Measuring restructuring charges and recognition of the liability
Measuring impairment of assets after operation begins

19. Acquisition - Asset Valuation Issues
Major issues associated with valuing an acquisition are:
Determining the cost of the acquisition
Valuing identifiable tangible and intangible assets and liabilities
Valuing the goodwill

20. Determining the Cost of the Acquisition
Normally, cost is amount paid to acquire the company
However, there are things that make the assessment more complicated:
Acquisitions made via stock rather than cash
Where the final price is contingent on the assets received (post-audit)

21. Determining the Cost of the Acquisition (continued)
Where the final price is contingent on acquired entity's performance
Auditor must assess likelihood of acquired entity meeting performance objectives - if highly likely, the full cost should be recognized at the time of acquisition

22. Valuing Identifiable Tangible & Intangible Assets
Acquiring company records assets at their fair market value at time of acquisition:
Company usually hires appraiser to value tangible assets
Intangibles should be valued at net present value of future cash flows
Auditor cannot simply accept appraisal and management's assessment of fair value of assets
Auditor must gather independent evidence to determine whether assessed values are appropriate

23. Valuing Identifiable Tangible & Intangible Assets (continued)
Auditor may rely on the specialist hired by management or hire their own specialist. Either way, the auditor should:
Evaluate qualifications of the specialist
Determine if specialist is independent of management
Review the methodology used by the specialist

24. Valuation of Goodwill
Goodwill is the excess of purchase cost over the fair market value of tangible and intangible assets acquired in a purchase
SFAS 142 requires goodwill be specifically identified with an operating or reporting unit
Important so goodwill can be tested for impairment on an yearly basis
Valuation and testing of impairment is facilitated if company uses capital budgeting process

25. LO 4 Restructuring Charges
When companies restructure operations, GAAP requires companies recognize the cost of restructuring and associated liabilities
The auditor should examine restructuring charges though these procedures:
Review FASB pronouncements and EITF statements
Review how company estimated restructuring charges

26. Restructuring Charges (continued)
Review actions taken by management that indicate restructuring has moved beyond a plan
Test estimates by reviewing contracts, property appraisals, severance contracts, and other restructuring documents
Mathematically test estimates
Develop conclusion as to reasonableness of liability and appropriateness of client accounting

27. Testing for Goodwill Impairment
GAAP requires goodwill must be tested every year for impairment
SFAS 142 requires the impairment of goodwill to be evaluated by the client in a two-step process:
The fair value of the reporting unit as a whole is compared to the book value of the reporting unit (including goodwill) and, if a deficiency exists, impairment would need to be calculated

28. Testing for Goodwill Impairment (continued)
The impairment is measured as the difference between the implied fair value of goodwill and its carrying amount.
The company must determine the fair market value of the reporting unit and compare it to the reporting unit's carrying value (including goodwill)
If fair market value is less than carrying value, it is inferred that goodwill has been impaired and must be written down

29. Testing for Goodwill Impairment (continued)
If fair market value is less than carrying value, it is inferred that goodwill has been impaired and must be written down
The reporting unit may be the company or a sub-unit of the company
The auditor must evaluate:
Management's methodology for assessing impairment
Whether an objective evaluation supports the client's conclusion

30. Annual Audits: Risk Factors and Goodwill Impairment
In addition to the annual review, situations may arise which impair goodwill:
Significant adverse change in legal factors or the business environment
Adverse action or assessment by regulator
Competition that significantly reduces value of company's products
Significant loss of key personnel

31. Annual Audits: Risk Factors and Goodwill Impairment (continued)
Expectation that reporting unit will be disposed of
Significant asset group within a reporting unit tested for recoverability
Impairment recognized by subsidiary
Significant decline in operations for the industry/economy
Audit tests for goodwill impairment will require considerable judgment and business knowledge

32. LO 5 Transactions with Related Parties
Related party transactions have been used to manipulate financial reporting and should, therefore, be considered high risk
Auditor must consider that a client may not want to have its related party transactions discovered

33. Transactions with Related Parties (continued)
To uncover these transactions, the auditor will:
Obtain a list of all related parties; then develop a list of all transactions with those parties
Carefully examine all unusual transactions to determine whether the transactions involved a related party

34. Variable Interest Entities
Describe a wide variety of ownership relationships a company may have with another entity
The audit approach for all these variable interest entities
Develop an understanding of the business purpose
Examine all contractual relationships associated with the entity

35. Variable Interest Entities (continued)
Determine the proper accounting for the entity
Review the current financial status of the entity
Summarize findings and review financial statement disclosure