Chapter 15 Audit

Questions included on a typical questionnaire are the following:

(1) Are amounts of new debt authorized by appropriate management? (2) Is an independent trustee used for all bond issues? (3) Does a company official monitor compliance with debt provisions?

Three principal elements of strong internal control over capital stock and dividends:

(1) the proper authorization of transactions by the board of directors and corporate officers, (2) the segregation of duties in handling these transactions (preferably the use of independent agents for stock registration and transfer and for dividend payments), and (3) the maintenance of adequate records.

An analysis of the Notes Payable account will serve the following purposes

(a) The payment or other disposition of notes listed as outstanding in the previous year's audit can be verified, (b) the propriety of individual debits and credits can be established, and (c) the amount of the year-end balance of the account is proved through the step-by-step examination of all changes in the account during the year. -Misstatements may be due to improper reporting of debt, incomplete recording of debt or improper amortization

Audit Documentation for Owners' Equity

- lead schedule for owners' equity accounts -auditors prepare an analysis of each equity account for the permanent file -corporation not served by a transfer agent, the auditors will often prepare for the permanent file a list of shareholders and the number of shares owned by each Lead Schedule = A document that serves as a summary or index of information contained in specific accounting schedules

Audit procedure: Account for All Proceeds from Stock Issues.

- proceeds should be traced to the cash records and bank statements. -SEC registration statements and contracts with underwriters may also be available as evidence of the amounts received from stock issues.

If there's no stock registrar/agent for a corporation, the following controls are needed:

Board of directors should designate officers who are authorized to (1) sign stock certificates, (Two signatures) (2) maintain records of stockholders, (3) maintain custody of unissued certificates, and (4) sign dividend checks

Audit procedure: Obtain or Prepare Analyses of Debt Accounts and Related Interest, Premium, and Discount Accounts.

notes payable analysis shows the beginning balance of each individual note, including related interest.

Internal control for registered bonds,

the trustee will maintain a current list of holders and will remit interest checks to them in the same manner as dividend checks are distributed to stockholders.

Debenture bonds

are backed only by the general credit of the issuing corporation and not by liens on specific assets

Audit Documentation

-A copy of the loan agreement or the indenture relating to a bond issue should be placed in the auditors' permanent file. -Listing of restrictions from the loan agreement is used to check for compliance. -lead schedule is often not required for short-term notes payable or for long-term debt. -Documentation for controls

Audit procedure: Determine the appropriate accounting is applied to employee stock compensation plans

-Accounting at fair value at the date of issuance, normally using Black-Scholes.

Control of Capital Stock Transactions by the Board of Directors

-All changes in capital stock accounts should receive formal advance approval by the board of directors. -Authority for all dividend actions rests with the directors

Current workpapers for the auditors

-Analyses of ledger accounts for notes and bonds payable -Related accounts of interest and discount or premium

Partnership contract

-Auditor verifies distribution of net income in accordance with profit-sharing provisions -Maintenance of partners' capital accounts at prescribed levels -Drawings -Loan accounts for partners

Options Backdating

-Boards date issuance as of a prior date. -This is legal if properly disclosed and accounted for, but for many companies it was not. -Study by Erik Lie (Univ of Iowa) found that options issued immediately before a sharp increase in stock price in an "uncanny number of cases."

Presentation

-Complete description of each issue -Title -Par or stated value -Dividend rate -Conversion and call provisions -Number of shares authorized, issued and in treasury -Dividends in arrears -Shares reserved for stock options or conversions

stock transfer agents.

-Corporations with actively traded securities. - primary responsibility is maintaining detailed stockholder records (name and address of each stockholder) and carrying out transfers of stock ownership. -maintains a record of the total shares outstanding

Dividends

-Determine the dates and amounts of dividends authorized -Verify the amounts paid -Determine the amount of any preferred dividends in arrears -Review the treatment of unclaimed dividend checks -Proper accounting for cash and stock dividends

Audit Procedure: Obtain analyses of capital stock account

-For an initial audit engagement, capital stock accounts should be analyzed from the beginning of the corporation - All changes in capital stock should bear the authorization of the board of directors -prepare a list showing the number of shares of treasury stock on hand.

Review Notes Payable Paid or Renewed after the Balance Sheet Date.

-If paid before completion of audit: cash payments provide the auditors with additional evidence on the liability -auditors should scan the notes payable records for the period between the balance sheet date and the completion of the audit so that they may be aware of any unusual transactions, such as the reestablishment of an insider note

Independent Registrar and Stock Transfer Agent

-Internal control is far stronger when the services of an independent stock registrar and a stock transfer agent are utilized

Evaluate financial statement presentation and disclosure

-Long-term debt payable in the current period -Restrictions imposed by long-term debt agreements -Unamortized bond premium or discount

Confirm Debt with Payees or Appropriate Third Parties.

-Notes payable to financial institutions are confirmed as part of the confirmation of cash deposit balances. -Bond transactions usually can be confirmed directly with the trustee. -Included with standard confirmation form for cash -For others, use letter drafted on client's letterhead -Confirm dates of origin, due dates, unpaid balances of notes, interest rates, dates to which interest has been paid and collateral for notes

Audit procedures appropriate for the verification of debt include the following:

-Obtain or prepare analyses of debt accounts and related interest, premium, and discount accounts. -Examine copies of notes payable and supporting documents. -Confirm debt with payees or appropriate third parties. -Vouch borrowing and repayment transactions to supporting documents. -Perform analytical procedures to test the overall reasonableness of interest-bearing debt and interest expense. -Test the valuation of debt, computation of interest expense, interest payable, and amortization of discount or premium. -Evaluate whether debt provisions have been met. -Trace authority for issuance of debt to the corporate minutes. -Review notes payable paid or renewed after the balance sheet date. -Perform procedures to identify notes payable to related parties. -Send confirmation letters to financial institutions to obtain information about financing arrangements. -Evaluate proper financial statement presentation and disclosure of debt and related transactions.

Send confirmation letters about financing arrangements

-Separate confirmation letter to verify details of financing arrangements. -Examples: Lines of credit

Determine compliance with restrictions and preferences related to capital stock and disclosures are appropriate

-Stock options may require that stock is set aside to issue when exercised.

Audit procedure: Confirm Shares Outstanding with the Independent Registrar and Stock Transfer Agent.

-The number of shares issued and outstanding on the balance sheet date may be confirmed -Written on clients letter head, written by client BUT mailed by auditor

Audit Procedure: Test the Valuation of Debt, Computations of Interest Expense, Interest Payable, and Amortization of Discount or Premium.

-To test valuation, the auditors test the amounts of amortization of debt premiums or discounts

Internal control over dividends

-Use of an independent dividend-paying agent is to be recommended from the standpoint of internal control, as it materially reduces the possibility of fraud or error -Small corporation that does not use the services of a dividend-paying agent, the responsibility for payment of dividends is usually lodged with the treasurer and the secretary

Audit Procedure: Evaluate compliance with debt provisions

-Vouch payments to sinking fund -Maintenance of stipulated minimum levels of working capital -Examine evidence of insurance of pledged property -Compare amounts of management compensation and dividends paid to amounts allowed by agreements -If the company has not complied fully with the requirements, the auditors should inform both the client and the client's legal counsel of the violation. -May have to be reclassified as current -Violations should be disclosed in the notes

Verify authority for issuance of debt to

-corporate minutes

The trustee is charged with the protection of the

-creditors' interests and with monitoring the issuing company's compliance with the provisions of the indenture. -Also keeps records -Distributes interest and principal payments

Audit procedure: Examine Copies of Notes Payable and Supporting Documents.

-examine the client's copies of notes payable and supporting documents such as mortgages and trust deeds. -Make sure the client has copies of original documents Trust deed = A formal document which outlines the terms of a trust agreeme

Audit Procedure: Perform Analytical Procedures to Test the Overall Reasonableness of Interest-Bearing Debt and Interest Expense

-examine the relationship between recorded interest expense and the average principal amount of debt outstanding during the year -use these procedures as a test of the completeness of recorded interest-bearing debt.

Internal control over bearer (Coupon bonds)

-the trustee upon receipt of this check will make payment for coupons presented, cancel the coupons, and file them numerically -second count of the coupons is made at a later date; the coupons then are destroyed and a cremation certificate is delivered to the issuing company -DOESN'T maintain a list of holders since they are transferable through the mere act of delivery

Audit Procedure: Vouch borrowing and repayment transactions

-vouch the cash recorded as received from the issuance of notes, bonds, or mortgages to the validated copy of the bank deposit slip -installment payments should be verified by reference to the repayment schedule set forth in the note or mortgage copy in the client's possession. -comparison of canceled notes payable with the debit entries in the Notes Payable account provides further assurance that notes indicated as paid during the year have, in fact, been retired. -inspection of these notes should include a comparison of the maturity date of the note with the date of cash disbursement. -Trace disposition of any collateral used to secure canceled notes

Internal Control over Debt

1.)Effective internal control over debt begins with the authorization to incur the debt. -The bylaws of a corporation usually require that the board of directors approve borrowing -Treasurer will prepare a report on proposed finanacing 2.)Use of an Independent Trustee EX: A bank 3.)Interest Payments on Bonds and Notes Payable -Usually controled through an independant trustee

Stock certificate book

A book (similar to a check book) with renumbered stock certificates. These certificates are issued to investors with the custodian of the book recording the number of shares, the owner's name, the date of issue, and other identification information. -Basically used only by small companies that are not publicly traded. -When outstanding shares are transferred from one holder to another, the old certificate is surrendered to the company. -designated officer cancels the old certificate by perforating and attaching it to the corresponding stub in the certificate book.

sinking fund

A reserve account in which the issuer of a bond periodically retires some part of the bond principal prior to maturity so that enough capital will be accumulated by the maturity date to pay off the bond.

Where an independent stock transfer agent is not employed and the corporation issues its own stocks and maintains stock records, canceled stock certificates should:

Be defaced to prevent reissuance and attached to their corresponding stubs.

Sole proprietorship

Capital accounts -Net income -Withdrawals -Capital investments and additions traced to the cash and asset records -Ensure segregation of personal transactions from business

An auditor most likely would inspect loan agreements under which an entity's inventories are pledged to support management's financial statement assertion of:

Completeness

The auditors can best verify a client's bond sinking fund transactions and year-end balance by:

Confirmation with the bond trustee.

Sources of owner's equity

Corporate accounts Capital stock accounts -Preferred and common Retained earnings -Prior period adjustments -Transactions generally few in number but material in amount

In the first audit of a client, the auditors will analyze the

Ledger accounts for - Bonds Payable, - Bond Issue Costs, and -Bond Discount (or Bond Premium) This will be placed in the permanent file and used in further audits.

An auditor usually obtains evidence of stockholders' equity transactions by reviewing the entity's:

Minutes of board of directors meetings.

Time of Examination—Debt

Most auditors prefer to wait until the end of the year before analyzing these accounts. -Test for unrecorded liabilities cannot usually be done before the balance sheet date -Evaluation of compliance with debt provisions -Tests of interest expense -Investigation of notes paid after year-end -Audit of this doesn't take long because of the small number of transactions

Trust indenture.

The formal document creating bond indebtedness is called the indenture. - certain restrictions on the borrowing company EX: use of a sinking fund

Audit procedure: For a Corporation Acting as Its Own Stock Registrar and Transfer Agent,

These procedures include (a) accounting for stock certificate numbers, (b) examining canceled certificates, and (c) reconciling the stockholders ledger and stock certificate book with the general ledger.

Individual transactions will generally be examined for

all large debt agreements

The primary responsibility of the stock registrar is to

avoid any overissuance of stock - the registrar must make certain that the issuance of stock is properly controlled.

In conjunction with the audit of owners' equity accounts, the auditors will also obtain evidence about the related accounts of

dividends payable and capital stock discounts and premiums.

Lack of compliance with the provisions of a debt agreement usually makes the debt involved

entirely due and payable on demand.

Assertions that relate to procedures for auditing debt:

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Stockholders Ledger

provides a separate record for each stockholder, thus making it possible to determine at a glance the total number of shares owned by any one person. This record may be used in compiling the list of dividend checks or for any other communication with shareholders.

In the review of treasury stock transactions, the auditors should

refer to permanent file copies of the minutes of directors' meetings to determine: (a) that the acquisition or reissuance of treasury stock was authorized by directors and (b) that the price paid or received was in accordance with prices specified by the board.