Chapter 15

List two common disclosures for stockholders' equity and why such disclosures are necessary.

-The two most common disclosures for stockholders' equity are (1) the number of shares authorized, issued, and outstanding for each class of stock and (2) restrictions on retained earnings and dividends. -These disclosures are necessary so that stockholders can determine what share of the company they own and whether there are any restrictions on the declaration of dividends. Other disclosures for stockholders' equity include: -Call privileges, prices, and dates for preferred stock. -Preferred stock sinking funds. -Stock option or purchase plans. -Any completed or pending transactions (e.g., stock dividends or splits) that may affect stockholders' equity.

Describe how substantive analytical procedures may be used to provide evidence on the reasonableness of interest expense.

-The auditor can estimate interest expense by multiplying the twelve monthly balances for long-term debt by the average interest rate. -The reasonableness of interest expense can then be assessed by comparing this estimate to the interest expense amount recorded in the general ledger. -If the two amounts are not materially different, the auditor can conclude that interest expense is fairly stated. -If the estimated amount of interest expense is materially higher than the recorded amount, the auditor might conclude that the entity has failed to record a portion of interest expense. -On the other hand, if the recorded amount of interest expense was materially higher than the estimated amount, the entity may have failed to record debt. -It is important to remember that the inputs (i.e., interest rates, monthly balances) must be audited in order to obtain assurance from the substantive analytical procedure.

What documents would normally contain the authorization to issue long-term debt?

-The documents that normally contain the authorization to issue long-term debt include a properly signed lending agreement and the minutes of board of directors' meetings.

What are the most important assertions for long-term debt?

-The most important assertions to the auditor for long-term debt are occurrence, authorization, completeness, valuation, and classification.

*WORD PROBLEM:* The Brant Group reported total interest expense for the year of $2,000. The table below provides the monthly balance of their long-term debt. Interest is paid monthly on the average daily balance during the month. The annual interest rate for the debt is 6%. Balance of long-term debt @ Jan 31 100,000 Balance of long-term debt @ Feb 28 90,000 Balance of long-term debt @ Mar 31 80,000 Balance of long-term debt @ Apr 30 70,000 Balance of long-term debt @ May 31 90,000 Balance of long-term debt @ June 30 85,000 Balance of long-term debt @ July 31 80,000 Balance of long-term debt @ Aug 31 70,000 Balance of long-term debt @ Sept 30 60,000 Balance of long-term debt @ Oct 31 65,000 Balance of long-term debt @ Nov 30 75,000 Balance of long-term debt @ Dec 31 50,000 a) Based on the data provided, if you were auditing The Brant Group would you consider the reported interest expense fairly stated? Why or why not?

-To test the reasonableness of the amount of reported interest expense, the auditor could multiply (6%/12) by each of the monthly balances for long-term debt and add them together to estimate interest expense for the year. - This estimate equals $4,575, which is significantly higher than the reported amount of $2,000. -The auditor should investigate further as it appears the interest expense is likely misstated.

Describe common audit procedures to audit dividends and retained earnings.

1) When the entity uses an independent dividend-disbursing agent, the auditor can confirm the amount disbursed to the agent by the entity. This amount is agreed with the amount authorized by the board of directors. The auditor can recompute the dividend amount by multiplying the number of shares outstanding on the record date by the amount of the per share dividend approved by the board of directors. This amount should agree to the amount disbursed to shareholders and accrued at year-end. 2) The auditor begins the audit of retained earnings by obtaining a schedule of the activity in the account for the period. The beginning balance is agreed to the prior year's working papers and financial statements. Net income or loss can be traced to the income statement. The amounts for any cash or stock dividends can be verified as in the previous paragraph. If there are any prior-period adjustments, the auditor must be certain that the transactions satisfy the requirements of the relevant accounting standards. Any new appropriations or changes in existing appropriations should be traced to the contractual agreement that required the appropriation. 3) Last, the auditor must make sure that all necessary disclosures related to retained earnings are made in the footnotes.

Confirmations of long-term debt provide evidence about which assertions?

Confirmation of long-term debt provides evidence for the existence, completeness, and valuation assertions.

*WORD PROBLEM:* 1) Lee, CPA, the continuing auditor of Wu, Inc., is beginning to audit the common stock and treasury stock accounts. Lee has decided to design substantive procedures without relying on the company's internal control system. 2) Wu has no par and no stated-value common stock, and it acts as its own registrar and transfer agent. During the past year, Wu both issued and reacquired shares of its own common stock, some of which the company still owned at year-end. Additional common stock transactions occurred among the shareholders during the year. 3) Common stock transactions can be traced to individual shareholders' accounts in a subsidiary ledger and to a stock certificate book. The company has not paid any cash or stock dividends. There are no other classes of stock, stock rights, warrants, or option plans. a. What substantive audit procedures should Lee apply in examining the common stock and treasury stock accounts? (AICPA, adapted)

The substantive audit procedures that Lee should apply in examining the common stock and treasury stock accounts of Wu, Inc., are as follows: -Review the corporate charter to verify details of the common stock such as authorized shares, par value, etc. -Obtain or prepare an analysis of changes in common stock and treasury stock accounts. -Compare opening balances with prior year's working papers. -Foot the total shares outstanding in the stockholders' ledger and stock certificate book. -Determine authorization for common-stock issuances and treasury-stock transactions by inspecting the minutes of board of directors' meetings. -Verify capital-stock issuances by examining supporting documentation and tracing entries into the records. -Verify treasury-stock transactions by examining supporting documentation and tracing entries into the records. -Examine all certificates canceled during the year. -Inspect all treasury-stock certificates owned by the entity. -Reconcile the details of the individual certificates in the stock certificate book with the individual shareholders' accounts in the stockholders' ledger. -Compare the totals in the stockholders' ledger and the stock certificate book to the balance sheet presentation. -Recompute the weighted average number of shares outstanding. -Compare the financial statement presentation and disclosure with GAAP. -Determine the existence of and proper accounting for common-stock and treasury-stock transactions occurring since year-end. -Obtain written representations concerning common and treasury stock in the client representation letter.

*WORD PROBLEM:* 1) The long-term debt working paper shown below was prepared by entity personnel and audited by Andy Fogelman, an audit assistant, during the calendar year 2015 audit of American Widgets, Inc., a continuing audit client. The engagement supervisor is reviewing the working paper thoroughly. 2) There are a number of deficiencies in the working paper. For example, the subject of the working paper is not properly indicated in the title and there is no indication that the unusually high average interest rate (20% = $281,333/$1,406,667) was noted or investigated. a) Identify at least five additional deficiencies that the engagement supervisor should discover.

The working paper contains the following deficiencies: • The subject of the working paper is not properly indicated in the title. • There is no indication of any follow-up on the identified error in the accrued interest payable computation. • There is no indication as to whether the confirmation exception was resolved. • The loan with the unwaived violation of a provision of the debt agreement is misclassified as long-term. • The liability activities of Lender's Capital Corporation and the working paper totals do not crossfoot. • There is no indication of cross-referencing of the stockholder loan to the related-party transactions working papers. • There is no investigation of the payment on the stockholder loan that was reborrowed soon after year-end. • There is no consideration of the need to impute interest expense on the 0 percent stockholder loan. • There is no indication that the dates under "Interest paid to" were audited. • There is no indication that the unusually high average interest rate ($281,333/$1,406,667 = 20%) was noted and investigated. • The working paper does not support the overall conclusions expressed. • The tick mark "R" is used but not explained in the tick mark legend. • There is no indication that the working paper was prepared by entity personnel.

List three substantive analytical procedures that the auditor might use in auditing the income statement.

Three substantive analytical procedures that the auditor might use in auditing the income statement include: 1) Use the prior years' trends in quarterly dollar amounts for each significant revenue and expense account (e.g., disaggregate revenue by product or location) to develop an expectation for the current year. 2) Calculate the ratio of individual expense accounts to net sales and comparing these percentages across years. 3) Perform substantive analytical procedures of specific revenue or expense accounts (e.g., sales commissions can be tested by using the entity's commission schedule and multiplying the commission rates times eligible sales).

*WORD PROBLEM:* Maslovskaya, CPA, has been engaged to examine the financial statements of Broad- wall Corporation for the year ended December 31, 2015. During the year, Broadwall obtained a long-term loan from a local bank pursuant to a financing agreement that provided that: 1. The loan was to be secured by the company's inventory and accounts receivable. 2. The company was not to pay dividends without permission from the bank. 3. Monthly installment payments were to commence July 1, 2015. In addition, during the year, the company borrowed various short-term amounts from the president of the company, including substantial amounts just prior to year-end. a. For purposes of the audit of the financial statements of Broadwall Corporation, what procedures should Maslovskaya employ in examining the described loans? b. The loans from the president represent a related-party transaction. What financial statement disclosures do you believe would be appropriate for the loans from the president?

a) The procedures that Maslovskaya should employ in examining the loans are as follows: -Obtain an understanding of the business purpose of the loans made by the president. -Confirm the loans, including terms, by direct communication. -Recompute (or verifying) interest expense and interest payable. -Recompute the long-term and short-term portions of the debt. -Review minutes of meetings of the board of directors for proper authorization. -Verify payments made during the year and transactions after year-end. -Read the financial statements, including footnotes and loan agreements, and evaluating the adequacy of disclosure and compliance with restrictions. -Consider any tax implications for the interest on the loan from the company's president. -Obtain a management representation letter. b) Broadwall's financial statements should disclose the following information concerning the loans from its president: -The nature of the related-party relationship. -The dollar amounts of the loans. -Amounts due the president and, if not otherwise apparent, the terms and manner of settlement. Subject to certain limited exceptions, loans to or from executives are prohibited for public companies.

Which of the following comparisons would be *most useful* to an auditor in evaluating the *overall financial results* of an entity's operations? a. Prior-year accounts payable to current-year accounts payable. b. Prior-year payroll expense to budgeted current-year payroll expense. c. Current-year revenue to budgeted current-year revenue. d. Current-year warranty expense to current-year contingent liabilities.

c. Current-year revenue to budgeted current-year revenue.

Which of the following questions would an auditor most likely include on a *control questionnaire for notes payable*? a. Are assets that collateralize notes payable critically needed for the entity's continued existence? b. Are two or more authorized signatures required on checks that repay notes payable? c. Are the proceeds from notes payable used to purchase noncurrent assets? d. Are direct borrowings on notes payable authorized by the board of directors?

d. Are direct borrowings on notes payable authorized by the board of directors?

The primary responsibility of a *bank acting as a registrar of capital stock* is to a. Ascertain that dividends declared do not exceed the statutory amount allowable in the state of incorporation. b. Account for stock certificates by comparing the total shares outstanding to the total in the shareholders' subsidiary ledger. c. Act as an independent third party between the board of directors and outside investors concerning mergers, acquisitions, and the sale of treasury stock. d. Verify that stock has been issued in accordance with the authorization of the board of directors and the articles of incorporation.

d. Verify that stock has been issued in accordance with the authorization of the board of directors and the articles of incorporation.

What are the functions of the registrar, the transfer agent, and the dividend-disbursing agent?

-The *registrar* is responsible for ensuring that all stock issued is in compliance with the corporate charter and for maintaining control totals for total shares outstanding. -The *transfer agent* is responsible for preparing stock certificates and maintaining adequate stockholders' records. -The *dividend-disbursing agent* prepares and mails dividend checks to the stockholders of record.

Why does the auditor generally follow a *substantive strategy* when auditing *long-term debt* and *capital accounts*?

-A substantive audit strategy is normally followed when auditing the long-term debt and capital accounts because, although the number of transactions is smaller, *each transaction is usually material*. -Thus, it is normally *more cost-effective* to conduct substantive tests of the transactions that compose the account balance.

Why might the auditor do an account analysis and vouch selected transactions in income statement accounts such as legal expense, travel and entertainment, and other income/expenses?

-The auditor conducts a detailed analysis and vouches the transactions in legal expense, travel and entertainment, and other income/expense accounts because these are accounts that are not directly affected by an accounting process, accounts which contain sensitive information or unusual transactions, or accounts for which detailed information is needed for the tax return or other schedules included with the financial statements.

Derivative.

A derivative is a contract between two or more parties and its value is determined by fluctuations in the underlying asset. The price of a derivative is dependent upon or derived from one or more underlying assets. Common underlying assets include commodities, stocks, bonds, and interest rates.

Tests of controls.

Audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level.

Analytical procedures.

Evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data.

Assertions.

Expressed or implied representations by management regarding the recognition, measurement, presentation, and disclosure of information in the financial statements and related disclosures.

Tests of details of account balances and disclosures.

Substantive tests that concentrate on the details of items contained in the account balance and disclosure.

Substantive tests of transactions.

Tests to detect errors or fraud in individual transactions.

Under what conditions might the auditor follow a *reliance strategy*?

The auditor may follow a reliance strategy for entities that engage in *frequent financing activities*

Reliance strategy.

The auditor's decision to rely on the entity's controls, test those controls, and reduce the direct tests of the financial statement accounts.

Confirmation.

The process of obtaining and evaluating direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions.

What is the major segregation of duties that should be maintained when the entity does not use a registrar or transfer agent and sufficient personnel are available to perform the stock transactions?

When the entity does not use a registrar or transfer agent and a sufficient number of personnel are available, the following segregation of duties should be maintained: -The individuals responsible for issuing, transferring, and canceling stock certificates should not have any accounting responsibilities. -The individual responsible for maintaining the detailed stockholders' records should be independent of the maintenance of the general ledger control accounts. -The individual responsible for maintaining the detailed stockholders' records should not also process cash receipts or disbursements. -The preparation, recording, signing, and mailing of dividend checks should be appropriately segregated.

An entity has established a bond sinking fund to *repurchase a portion of the outstanding bonds* each year. The auditor can *best verify* the entity's bond sinking fund transactions and year-end bond balance by a. Confirmation of retired bonds with individual holders. b. Confirmation with the bond trustee. c. Recomputation of interest expense, interest payable, and amortization of bond discount or premium. d. Examination and count of the bonds retired during the year.

b. Confirmation with the bond trustee.

An audit program for *long-term debt* would most likely include steps that require a. Comparing the carrying amount of the debt to its year-end market value. b. Correlating the interest expense recorded for the period with the debt outstanding for the period. c. Verifying the existence of the holders of the debt by direct confirmation. d. Inspecting the accounts payable subsidiary ledger for unrecorded long-term debt.

b. Correlating the interest expense recorded for the period with the debt outstanding for the period.

An auditor's *primary purpose* in examining a letter received from the bank shortly after the *balance sheet date* that *renews and extends an entity's note payable* is most likely to obtain evidence concerning management's assertions about a. Existence. b. Presentation and disclosure-classification. c. Accuracy. d. Valuation and allocation.

b. Presentation and disclosure-classification.

An auditor compares the current-year revenues and expenses with those of the prior year and *investigates all changes exceeding 5 percent*. By this procedure, the auditor would be most likely to learn that a. Fourth-quarter payroll taxes in the current year were not paid. b. The entity changed its capitalization policy for small tools in the current year. c. A current-year increase in property tax rates has not been recognized in the entity's accrual. d. The current-year provision for uncollectible accounts is inadequate because of worsening economic conditions.

b. The entity changed its capitalization policy for small tools in the current year.

When an entity does not maintain its own stock records, the auditor should obtain *written confirmation* from the transfer agent and registrar concerning a. Restrictions on the payment of dividends. b. The number of shares issued and outstanding. c. Guarantees of preferred stock liquidation value. d. The number of shares subject to agreements to repurchase.

b. The number of shares issued and outstanding.

Although the quantity and content of audit working papers vary with each particular engagement, an auditor's *permanent files* most likely include a. Schedules that support the current year's adjusting entries. b. Prior years' accounts receivable confirmations that were classified as exceptions. c. Documentation indicating that the audit work was adequately planned and supervised. d. Information regarding the different classes of stock and the number of shares of each class that are authorized to be issued.

d. Information regarding the different classes of stock and the number of shares of each class that are authorized to be issued.

To obtain evidence on the *authorization assertion*, an auditor should trace corporate stock issuances and treasury stock transactions to the a. Numbered stock certificates. b. Articles of incorporation. c. Transfer agent's records. d. Minutes of the board of directors.

d. Minutes of the board of directors.