CHAPTER AUDIT OF THE FINANCING AND INVESTING CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS 6-1 Investing activities include an entity’s activities to invest in debt or equity securities of other entities and investments in property, plant, and equipment These transactions are often recorded during the expenditure cycle but are so significant that additional controls are applied to them 6-2 Kickbacks, acquisitions of goods for personal use, appropriation of assets, and processing of fictitious transactions can occur in the acquisition of property, plant, and equipment, just as they in the acquisition of goods Related-party transactions to acquire investments or property, plant, and equipment may result in improper valuation of the accounts Securities may be stolen or diverted Historically, business entities have manipulated the accounting values at which assets were recorded by acquiring assets from a related party or selling assets to a related party Acquiring assets at inflated values may result in draining cash from the acquiring entity Selling assets at inflated values to related parties results in increased revenue and assets to the selling entity, and these may never be realized All transactions conducted with related parties must be examined carefully 6-3 Critical controls include separating the responsibilities for authorizing transactions, keeping records, and having custody of the asset Generally, the board, or sometimes an investment committee of the board, must approve individual investments After obtaining board approval, the treasurer or vice president for finance has authority to execute the purchase or sale of an investment transaction Due to their large peso value and susceptibility to misappropriation, investment certificates (stocks or bonds) are often left in the custody of a broker or bank When the entity takes custody of investment certificates should be stored in a safe deposit box Typically the general ledger clerk maintains investment records unless the entity has a large volume of investment transactions 6-2 6-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition The substantive tests, grouped according to the assertions they test, are as follows: Existence or occurrence: Recorded investments and investment income exist  Inspect securities on hand and trace to listing  Confirm securities held by others Completeness: All investments and investment income are recorded  Apply analytical procedures Rights and obligations: Investments and investment income are owned by the entity  For investments acquired during the period, examine supporting invoices and paid checks For dividends, interest, and disposals of investments, examine remittance advices Valuation or allocation: Investments are valued in accordance with GAAP and investments and investment income are mathematically accurate  Reconcile the investment listing to the subsidiary ledger and general ledger account  Recalculate interest revenue and verify dividend income by reference to published reports of dividends Presentation and disclosure: Investments and investment income are presented in accordance with GAAP  Review statement presentation for compliance with GAAP 6-5 Financing activities consist of an entity’s transactions to (1) obtain long-term (capital) funds by issuing long-term debt or capital stock; (2) make payments associated with long-term funds, such as payment of interest and dividends; and (3) retire long-term funds by paying off or reacquiring debt or equity obligations Long-term debt includes notes, mortgages, and bonds Capital stock includes both common and preferred stock Often these transactions are recorded in the sales and collections cycle, but they are so significant that additional controls are applied to them 6-6 The characteristics of the liability accounts that result in a different auditing approach than followed in the audit of accounts payable are: 1) Relatively few transactions affect the account balances but each transaction is often highly material in amount 2) The exclusion of a single transaction could often be material by itself 3) The relationship between the client entity and the holder of the ownership document is legal in nature 4) The liabilities involve accrual and payment of interest as well as debt Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions 6-3 6-7 It is common to audit the balance in notes payable in conjunction with the audit of interest expense and interest payable because it minimizes the verification time and reduces the likelihood of overlooking errors in the balance Once the auditor is satisfied with the balance in notes payable the related interest rates and due dates for each note, it is easy to test the accuracy of accrued interest If the interest expense for the year is also tested at the same time, the likelihood of omitting a note from notes payable for which interest has been paid is minimized When there are a large number of notes or a large number of transactions during the year, it is usually too time consuming to completely tie out interest expense as a part of the audit of the notes payable and related accrued interest Normally, however, there are only a few notes and few transactions during the year 6-8 The most important controls the auditor should be concerned about in the audit of notes payable are: 1) The proper authorization for the issuance of new notes (or renewals) to ensure that the company is not being committed to debt arrangements that are not authorized 2) Controls over the repayment of principal and interest to ensure that no more is paid on the note than is required 3) Proper records and procedures to ensure that all amounts in all transactions are properly recorded 4) Periodic independent verification to ensure that all the controls over notes payable are working 6-9 Four types of restrictions long-term creditors often put on companies in granting them a loan are: 1) 2) 3) 4) Financial ratio restrictions Payment of dividends restrictions Operations restrictions Issue of additional debt restrictions The auditor can find out about these restrictions by examining the loan agreement and related correspondence associated with the loan, and by confirmation The auditor must perform calculations and observe activities to determine whether the client has observed the restrictions 6-10 The major internal control over owners’ equity are: 1) Proper authorization of transactions 2) Proper record keeping 3) Adequate segregation of duties between maintaining owners’ equity records and handling cash and stock certificates 4) The use of an independent registrar and stock transfer agent 6-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition 6-11 Since it is important to verify that properly authorized dividends have been paid to owners of stock as of the dividend record date, a comparison of a random sample of canceled dividend checks to a dividend list prepared by management would be inadequate Such an audit step is useless unless the dividend list has first been verified to include all stockholders of record at the dividend record date A better test is to determine the total number of shares outstanding at the dividend date from the stock registrar and recompute the total dividends that should have been paid for comparison with the total amount actually paid A random sample of canceled checks should then be compared to the independent registrar’s records to verify that the payments were actually made to valid shareholders 6-12 1) c 2) d 3) c 4) d 5) c 6-13 1) d 2) a 3) c 4) d 5) a 6) a 6-14 1) d 2) a 3) b 6-15 1) a 2) a 3) a 6-16 1) b 2) a 3) c 4) c 6-17 a b Purpose of Control Potential Financial Statement Error c Audit Procedure to Determine Existence of Material Error To assure that all note liabilities are authorized by proper management Loss of assets through payment of excess interest rates or the diversion of cash to unauthorized persons Check note request forms for proper authorization To assure that note transactions are recorded in full and in detail Improper disclosure or errors in note payable through duplication Determine if master file is maintained, and reconcile detailed contents to control To prevent misuse of notes and funds earmarked for notes Misstatement of liabilities and cash Determine if duties are segregated Perform all substantive procedures on extended basis Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions 6-18 6-5 To assure that notes are not paid more than once Loss of cash Check paid notes for cancellation To assure that all noterelated transactions agree with account balances Misstatement of notes payable Determine if reconciliations are periodically made, and verify reconciliation To further assure that only the proper interest amount is paid and recorded Misstatement of interest expense and related accrual Determine if interest computations are internally verified Recompute interest on a test basis Since the source of the debits in the asset account is the purchase journal (or similar record), the current period acquisitions of property, plant and equipment have already been partially verified as part of the acquisition and payment cycle The disposal of assets, depreciation and accumulated depreciation are not tested as a part of the acquisition and payment cycle 6-19 Item No Internal Control Substantive Audit Procedure Use of government study depreciation tables Compare to government study depreciation table Make approvals required for all expending over a certain amount Test all expense charges to these accounts over a certain amount Have construction foreman report to accounting department periodically whether or not there have been abandonments or replacements Examine equipment listed on the books Have expense records internally verified Analyze depreciation and administrative expenses by ratio comparison to previous years Assign tools to individual foreman and periodically count the tools Take a physical count of the tools 6-6 Solutions Manual to Accompany Applied Auditing, 2006 Edition Have recording of property acquisitions internally verified Review supporting documentation on property acquisitions and compare to recorded value The deposit of all cash directly into the bank account (1) Confirmation of bank accounts and other tests for unrecorded loans (2) Physical examination of plant assets 6-20 Liability that could be Uncovered Audit Procedure to Uncover Liability a Lawsuit Review minutes of the Board of Directors’ meetings b Building used as collateral for a loan Examine documents of ownership and bank confirmations c Unrecorded lease Examine the lease agreements d Note payable Examine underlying records for the related loan e Policy loan Confirmation with life insurance company f Note payable Obtain confirmation from bank g Income taxes payable for nondeductible expenses Review travel and expense reports  ... expenses by ratio comparison to previous years Assign tools to individual foreman and periodically count the tools Take a physical count of the tools 6-6 Solutions Manual to Accompany Applied Auditing, ... certificates 4) The use of an independent registrar and stock transfer agent 6-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition 6-11 Since it is important to verify that properly authorized...6-2 6-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition The substantive tests, grouped according to the assertions