ACCT 4123 Chapter 10

Transactions in the financing and investment cycle ______.

- are for large dollar amounts - vary greatly in type - occur infrequently

Material misstatements can incur when ______.

- assets are overstated due to impairment - impairment write-offs have been delayed

ASC 718 requires that employee stock-based compensation plans be ______.

- credited to paid-in-capital - expensed over the compensation period - recorded when the award is granted

When auditing employee share option plans, auditors must ______.

- ensure Board of Director approval of the plan - follow standards for auditing fair value estimates (ASC 718) - follow standards for auditing accounting estimates - complex estimates must be used because no market value exists

When considering controls over those who do record keeping in the finance and investment cycle ______.

- evidence from prior audits can indicate employee competence levels - employee turnover is a significant risk factor - hiring practices may be considered

Transactions in the finance and investment cycle ______.

- have been a leading cause of financial statement restatements - can be inherently risky for the auditor - must be understood by the client's accountants - are often large and complex - include transactions that are difficult to value - may require third parties to control management

Off-balance sheet transactions ______.

- include operating leases but exclude capital leases - have been reduced by new accounting standards - include fixed price commitments - often cause financial reporting and disclosure problems

Difficult-to-value assets include ______.

- investments in unique assets - financial instruments - goodwill - pension assets and liabilities - intangible assets - debt and equity securities - derivatives

Complex transactions that can be used as vehicles to hide fraud include ______.

- mergers and acquisitions - instruments with both debt and equity characteristics

When auditing long-term liabilities and related accounting, the most important balance sheet assertions are ______.

- presentation and disclosure - completeness

Common problems in the finance and investment cycle are often the result of failure to ______.

- record and disclose transactions - appropriately adjust asset valuations for either changes in fair value on marketable securities or impairments

Off-balance sheet transactions include ______.

- repurchase agreements - letters of credit - endorsements on discounted notes

New leasing standards ______.

- require all leases > 12 mos to be recognized as assets with their matching liabilities - increase disclosure requirements - reduce ability of management to structure lease transactions - increase risk for lease auditing - require all leases to be accounted for using imputed present value estimates

Assertion: Investments are properly valued at the balance-sheet date.

Audit Procedure(s): d. Determine whether any other-than-temporary impairments in the carrying value of investments have been properly recorded.

Assertion: Investments are properly described and classified in the financial statements.

Audit Procedure(s): e. Verify that transfers from the trading portfolio to the held-to-maturity investment portfolio have been properly recorded. g. Trace investment transactions to minutes of the board of directors meetings to determine that transactions were properly authorized.

Assertion: Recorded investments represent investments actually owned at the balance-sheet date.

Audit Procedure(s): f. Obtain positive confirmations as of the balance sheet date of investments held by independent custodians.

The typical business activity of the finance and investment cycle would not include A. analysis of excess cash funds. B. proposals for cash forecasts, capital budgets, and business expansion. C. reconciliation of cash. D. sale of stocks, bonds, or notes.

C. reconciliation of cash.

True or false: Reliance on controls normally reduces the extent of auditors' substantive procedures on finance and investment cycle accounts.

False [Reason: Because transactions are often individually significant, each transaction is usually audited using substantive procedures.]

Which of the following controls would be most effective in ensuring that the proper custody of assets in the investing cycle is maintained?

Independent personnel periodically compare the recorded balances in the investment subsidiary ledger with the contents of the safety deposit box.

Internal Control: Review and test reports of investment activity for the investment committee

Objective: Ensure policies written are being followed

Internal Control: Inspect monthly brokerage reports on securities owned, purchased, and sold

Objective: Ensure reports tie to client activity

Internal Control: Inspect reports by internal auditors on their review of securities and derivatives

Objective: Verify that internal auditors' observations are consistent with those of external auditors

Internal Control: Trace several transactions for purchases and sales of investments through the accounting system.

Objective: Ensure transactions are recorded and classified properly

Substantive Procedure: Performing analytical procedures on debt and related accounts to ensure that all debt is properly included in the period under audit and that some notes have not been omitted

Primary Audit Objective: Completeness

Substantive Procedure: Vouching borrowing and repayment terms

Primary Audit Objective: Cutoff

Substantive Procedure: Confirming debt

Primary Audit Objective: Existence

Substantive Procedure: Evaluating whether debt provisions and covenants have been met

Primary Audit Objective: Presentation and disclosure

Substantive Procedure: Examining copies of the actual signed note payable to determine the correct dollar amount of the liability

Primary Audit Objective: Valuation

When the client holds a large amount of negotiable securities, auditors need to plan to guard against

Substitution of securities already counted for other securities that should be on hand but are not.

True or false: Authorization is a critical issue for most of the transactions in the financing and investing cycle.

True [Reason: This is true because most of the transactions involve large amounts of cash or other assets.]

An approximation of a financial statement element, item or account is called a(n) _____ _____.

accounting estimate

Salvage values, security valuations, goodwill impairment and imputed interest rates are all examples of _____ _____.

accounting estimates

The auditors should insist that a representative of the client be present during the inspection and count of securities to:

acknowledge the receipt of securities returned.

Financial planning starts with the ______.

cash flow forecast

In auditing long-term bonds payable, an auditor most likely would:

compare interest expense with the bond payable amount for reasonableness.

An activity used because a specific standard control activity is not in place is called a(n) _____ control.

compensating

When auditing long-term liabilities and related accounting, the most important balance sheet assertions are _____ along with _____ and _____.

completeness; presentation; disclosure

"Are interest payments and accruals monitored for due dates and financial statement dates?" is an internal control questionnaire item that is related to the ASB transaction assertion of:

cutoff.

Complex transactions are ______ the balance sheet.

difficult to audit even if they reach

Only high-ranking officers should have access to negotiable certificates and two people should be required to access the documents which is known as _____ _____ or in its strictest form, joint custody.

dual control

Auditing fair value measurements is similar to auditing accounting _____.

estimates

Selecting a sample of notes payable transactions and vouching payments to canceled checks is a test of the ASB balance assertion of:

existence.

The classification of a derivative instrument as a(n) _____ influences the presentation and characterization of fluctuations in value.

hedge

Regarding the finance and investment cycle, most relevant assertions and the amount of work to be done is _______.

hugely impacted by the type of investment

A written agreement between bond issuers and bondholders is called a bond _____.

indenture

The amount and terms of bonds payable, mortgages payable, and other formal debt instruments can be verified by reading the bond _____.

indenture

Sometimes auditors may ____ securities on hand.

inspect

In an audit test of recorded interest expense and accrued interest, the auditor was able to detect that the recorded interest expense was higher than the calculations showed. This may indicate:

interest was paid on an unknown debt or unrecorded liability.

When it is not possible for one person to access a safe, cabinet or drawer, a strict form of dual control, known as _____ _____ has been implemented.

joint custody

Clauses in borrowing agreements intended to keep the borrower's financial position at a level that will ensure repayment are called _____ _____.

loan covenants

With the exception of stock-based compensation plans, audits of stockholders' equity are considered to be ______ risk.

low

Record keeping complications for many types of investments and intangibles arise from ______.

maintenance of the accounts over time

After testing internal controls related to investments, it may be necessary to _____ the risk of material misstatement.

modify

Related party transactions:

must be disclosed in the financial statements.

A notes payable analysis shows the beginning balance, additional notes, and the ending balance of each individual _____.

note

Debits to a mortgage payable account typically are _______ on the account.

payments

Actual signed copies of the notes are often put in the auditors' ________ file.

permanent

One that can exert significant influence over another is a(n) ______ party.

related

A sample internal control questionnaire question may ask about __________ inherent in the investment policy.

risk

To determine whether facts support management's intent to hold securities to maturity, an auditor might:

study the entity's cash flow forecasts.

When the client holds a large amount of negotiable securities, auditors need to plan to guard against:

substitution of securities already counted for other securities that should be on hand but are not.

GAAP requires that impairments to asset values should normally be ______.

taken as losses when they occur

Record keeping for many types of investments and intangibles ______.

- involve complex accounting standards - require management estimates - are ripe areas for understatement of expenses

Loan covenant violations ______.

- may lead to an audit report modification - may cause managers to misstate other accounts - allow the lender to call the debt - allow the lender to force a borrower into bankruptcy

When auditing fair value measurements the auditor must determine if the valuation principles used are ______.

- supported by documentation - consistently applied - properly disclosed - GAAP requires proper disclosure. The valuation principles must be acceptable under the financial reporting framework.

Market valuation is required for securities classified as ______.

- trading - available for sale

Problems in the finance and investment cycle can occur because ______.

- transactions are infrequent - of intentional errors in management estimates - complex transactions make accounting difficult

Which of the following statements are correct? A. Reliance on controls does not normally reduce the extent of substantive procedures on finance and investment cycle accounts. B. A lack of controls in the finance and investment cycle can lead to significant extended procedures. C. Auditors normally examine samples of significant finance and investment transactions for tests of controls. D. Tests of controls in the finance and investment cycle for nonpublic clients may be limited to entity level.

A, B, D

Which of the following statements are true? A. Investment type can have a huge influence on the effort required by the auditor. B. The majority of companies in the U.S. are entirely equity financed. C. There is not a "typical" finance and investment cycle that applies to all companies. D. Government debentures are relatively complex to audit.

A, C [Reason: B. Some are equity-financed, but some are largely debt-financed. D. They are relatively simple due to their short-term nature and publicly available valuations.]

When a company keeps its own stock records, which of the following procedures is not required? A. Confirm outstanding common stock with stock registrar agent. B. Inspect the stock record stubs for certificate numbers and number of shares. C. Inspect the unissued certificates. D. Obtain written representation about the number of shares issued and outstanding.

A. Confirm outstanding common stock with stock registrar agent.

Which of the following approaches is most suitable for auditing the finance and investment cycle? A. Ignore internal controls and limit substantive procedures to analytical procedures. B. Gain an understanding of internal controls and perform extensive substantive procedures. C. Perform extensive tests of controls and limit substantive procedures to analytical procedures. D. Ignore internal controls and perform extensive substantive procedures.

B. Gain an understanding of internal controls and perform extensive substantive procedures.

The typical assertion relating to investments and related accounts in a manufacturing company would not include the assertion that: A. investment income has been properly recorded. B. all investments are valued at cost. C. investments are adequately classified and described in the balance sheet, including disclosures. D. investment securities are on hand or held in safekeeping by a trustee.

B. all investments are valued at cost.

In Case 10.4 (No Treasure in This Treasure Planet), Disney overvalued net assets by capitalizing unrecoverable production costs. The lesson for the auditors in this case was to: A. always recalculate the client's figures regardless of how simple they appear. B. maintain professional skepticism when evaluating clients' estimates. C. always look into the background of the client before accepting an engagement. D. none of the above.

C. always look into the background of the client before accepting an engagement.

Derivative instruments include: A. stocks. B. preferred stocks. C. stock options. D. all of the above.

C. stock options.

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 2. On January 3, 2019, Sorenson purchased two licensing agreements; at that time they were believed to have unlimited useful lives. The balance in the Licensing Agreement No. 1 account included its purchase price of $48,000 and $2,000 in acquisition expenses. Licensing Agreement No. 2 also was purchased on January 3, 2019, for $50,000, but it has been reduced by a credit of $1,000 for the advance collection of revenue from the agreement.

Dr COGS $4K Cr Patents $4K Amortized Value = Value of Patents / Number of Years = $68K / 17 years = $4K Dr Licensing Agreement No. 2 $1K Cr Revenue received in advance $1K

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 4. A study of Licensing Agreement No. 2 made by Sorenson in January 2020 revealed that its estimated remaining life expectancy was only 10 years as of January 1, 2020.

Dr COGS $5000 Cr Licensing Agreement No. 2 $5000 $50,000 / 10 years = $5000/year

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 6. The Leasehold Improvement account includes (a) the $15,000 cost of improvements with a total estimated useful life of 12 years, which Sorenson, as tenant, made to leased premises in January 2019; (b) movable assembly-line equipment costing $8,500, which was installed in the leased premises in December 2020; and (c) real estate taxes of $2,500 paid by Sorenson, which, under the terms of the lease, should have been paid by the landlord. Sorenson paid its rent in full during 2020. A 10-year nonrenewable lease was signed January 3, 2019, for the leased building that Sorenson used in manufacturing operations.

Dr Equipment $8,500 Dr A/R - Non-Trade $2,500 Cr Leasehold Improvement $11K Dr Amortization Expense - Current Year $1,500 Dr Amortization Expense - Error correction $1,500 Cr Leasehold Improvement $3,000 $15,000 / 10 years = $1,500

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 1. Patents for Sorenson's manufacturing process were purchased January 2, 2020, at a cost of $68,000. An additional $17,000 was spent in December 2020 to improve machinery covered by the patents and charged to the Patents account. The patents had a remaining legal term of 17 years.

Dr Machinery $17K Cr Patents $17K

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 5. The balance in the Goodwill account includes $24,000 paid December 30, 2019, for an advertising program, which it is estimated will assist in increasing Sorenson's sales over a period of four years following the disbursement.

Dr Retained Earnings $24K Cr Goodwill $24K

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 7. The balance in the Organization Expenses account includes preoperating costs incurred during the organizational period.

Dr Retained Earnings $29K Cr Organizational Expenses $29K

Sorenson Manufacturing Corporation was incorporated on January 3, 2019. The corporation's financial statements for its first year's operations were not examined by a CPA. You have been engaged to audit the financial statements for the year ended December 31, 2020, and your work is substantially completed. A partial trial balance of the company's accounts follows: SORENSON MFG CORP Trial Balance at Dec. 31, 2020 DEBIT Cash $11K AR $42.5K Inventories $38.5K Machinery $75K Equipment $29K Patents $85K Leasehold improvements $26K Prepaid expenses $10.5K Organization expenses $29K Goodwill $24K Licensing Agreement No. 1* $50K Licensing Agreement No. 2* $49K CREDIT Allowance for doubtful accts $500 Accum. Dep $10K *An intangible asset representing the right to use a patent. The following information relates to accounts that may yet require adjustment: 3. In December 2019, an explosion caused a permanent 60 percent reduction in the expected revenue-producing value of Licensing Agreement No. 1 and, in January 2020, a flood caused additional damage, which rendered the agreement worthless.

Dr Retained Earnings $30K Dr Loss from flood $20K Cr Licensing Agreement No. 1 $50K 60% x $50K 40% x $50K

When auditing the valuation assertion of an equity method investment, which of the following is the auditor most likely to do?

Obtain audited financial statements of the investee company.

If a company keeps investments in a bank safe deposit box, which of the following two people ideally should have access to the safe deposit box?

The president and vice president for finance

Auditors must ensure that a sale made to related parties is the equivalent of a(n) _____-_____ transaction.

arm's-length one division of a company selling a product to another division of the same company should have the same terms as sales made to outside customers

The classification of a security as trading or _____ _____ _____ affects whether changes in value influence net income.

available for sale

When the market is down, managers are motivated to classify securities as ______ to remove the losses from net income.

available for sale

An important step in testing investments is to ensure all persons with access to investments are properly _____.

bonded

A related party is a person or entity that:

can exert significant influence over or be influenced by the company.

Plans for asset purchases and business acquisitions are detailed in a(n) _____ budget.

capital

The authorization for the purchase of large assets will likely reside in the ______.

capital budget

Notes payable to financial institutions are often confirmed together with the _______ accounts.

cash

An audit team would most likely verify the interest earned on bond investments by:

recomputing the interest earned on the basis of face amount, interest rate, and period held.

A client has a large and active investment portfolio that is kept in a bank safe deposit box. If the auditors are unable to count securities at the balance-sheet date, they most likely will:

request the client to have the bank seal the safe deposit box until the auditors can count the securities at a subsequent date.

Auditors typically approach audits of ______ transactions with a reliance approach.

routine

An investment committee is a standing committee of _____.

the board of directors

When a client company does not maintain its own capital stock records, the auditors should obtain written confirmation from the transfer agent and registrar concerning:

the number of shares issued and outstanding.

Bond transactions are typically confirmed directly with the _____.

trustee