Modern Auditing:

Assurance Services and the Integrity

of Financial Reporting, 8th Edition

William C. Boynton
California Polytechnic State
University at San Luis Obispo
Raymond N. Johnson
Portland State University

Chapter 17 – Auditing the Investing and Financing Cycles

Chapter Overview
Nature of the Investing and Financing Cycles

• Overview of the Cycles

– Investing Activities

– Financing Activities

• Understanding the Entity and

Environment
Understanding the Entity and
Environment
Investing Cycle – Audit
Objectives
IInnvveessttiinngg CCyyccllee –— AAnnaally

Analytical Procedures Common Iy Used to Aud it Plant Assets

Fixed asset turnover Net sales + average fixed assets An unexpected increase in fixed asset turnover
may indicate the failure to record or capitalize
deprecial le assets.
ToaassernoverNsaes-aeraeoaasses An unexpected increase in total asset turnover
may indicate the failure to record or capitalize
deprecial le assets.
Return on total assets (Net income+(interest“(1-tax An unexpected increase in return on assets may
rate))) - average total assets indicate the failure to record or capitalize depre-
cial ie assets.
Depreciation expense Depreciation expense + average An unexpected increase or decrease in the
as a percent of property plant and equipment depreciation expense as a percent of deprecialile
property, plant and assets may indicate an error in calculating
equipment depreciation.
Repair expenses to
net sales Repair and maintenance An unexpected increase in repair and mainte-
expense nance expense may indicate the possil ility that
-netsaes assets that should have I een capitalized have
lieen expensed.
 Investing Cycle

• Inherent Risk

• Consideration of Internal Controls

• Preliminary Audit Strategies

 Substantive Tests for Plant Assets
Initial Procedures

• Analytical Procedures

• Tests of Details of Transactions

– Vouch Plant Asset Additions
– Vouch Plant Asset Disposals
– Review Entries to Repairs
and Maintenance Expense
 Substantive Tests for Plant
Assets
• Tests of Details of Balances
– Inspect Plant Assets
– Examine Title Documents and Contracts

• Tests of Details of Accounting

Estimates
– Review Provisions for Depreciation
– Impairment of Plant Assets
– Tests of Details of Presentation
and Disclosure
 Study Break

1. This cycle involves activities such

as the purchase and sale of land,
buildings, and equipment not
generally held for resale.
A. Investing Cycle
B. Financing Cycle
C. Cash Disbursements Cycle
D. Cash Receipts Cycle

A. Investing Cycle
 Study Break

2. All of the following are classes of

transactions associated with the
audit of plant assets, except:
A. Depreciation Expense
B. Disposal of Fixed Assets
C. Payroll Expense
D. Acquiring of Fixed Assets

C. Payroll Expense
 Study Break

3. While auditing the investing cycle, this

test of details of balances allows the
auditor to obtain direct personal
knowledge of the existence of the
plant assets.
A. Inspect plant assets
B. Examine title documents and contracts
C. Impairment of plant assets
D. Review provisions for depreciation

A. Inspect plant assets

Financing Cycle
Financing Cycle –Audit Objectives
FFiinnaanncciinngg CCyyccllee -–AAnnaalty
PPrroocceedduurreess
Analytical Procedures CommonIy Used to Aud it the Financing Cycle
Free Cash Flow Cash Flow from Operation less
Capital Expenditures
Interest-Bearing Del t Interest-Bearing Del t + Total
to Total Assets Assets
Shareholders' Equity Shareholders’ Equity - Total
to Total Assets Assets
Comparing Return on Is ROA > the incremental cost of
Assets with the Incre- del t?
mental Cost of Del t
ROA = (Net Income + (Interest x
(l- tax rate)))/Average Total
Assets
Return on Common (Net Income Preferred Divi-
Equity dends) - Average Common
Shareholders’ Equity
Negative free cash flows indicate the need for,
and approximate amount of, expected financing
to prevent drawing down on cash or investments.
Provides a reasonal leness of the entity's propor-
tion of del t that may lie compared with prior
years’ experience or industry data.
Provides a reasonal leness of the entity's propor-
tion of equity that may lie compared with prior
years’ experience or industry data.
If a company is alile to generate a higher rate of
return on assets than its incremental cost of
del t, this is a signal that an entity may use debt
financing to expand the assets and earnings of
the entity.
Provides a reasonal leness test of shareholder’s
equity given the company's earnings and financ-
ing structure.
 Financing Cycle

• Inherent Risk

• Consideration of Internal Control

• Common Documents and Records

Financing Cycle – Functions and Related Contr
Authorizing bonds and capital stock

• Issuing bonds and capital stock

• Paying bond interest and cash dividends

• Redeeming and reacquiring bonds and

capital stock

• Recording financing transactions

Preliminary Audit Strategies for
Long-Term Debt
 Substantive Tests of Long-Term Debt

• Initial Procedures

• Analytical Procedures

• Tests of Details of Transactions

 Substantive Tests of Long-Term Debt

• Tests of Details of Balances

– Review Authorizations and Contracts
– Confirm Debt
– Recalculate Interest Expense

• Tests of Details of Presentation and

Disclosure
 Study Break

4. This cycle involves activities such

as acquiring debt, issuing bonds,
and issuing common stock.
A. Investing Cycle
B. Financing Cycle
C. Cash Disbursements Cycle
D. Cash Receipts Cycle

B. Financing Cycle
 Study Break

5. This financing function involves

making payments to the proper
payees in according with board of
director or management
authorizations.
A. Authorizing bonds
B. Authorizing capital stock
C. Paying bond interest and cash dividends
D. Recording financing transactions

C. Paying bond interest and cash dividends

 Study Break

6. All of the following are tests of

details of balances for the
financing cycle, except:

A. Confirmation of accounts payable

B. Confirmation of long-term debt
C. Review authorization and contracts
D. Recalculate interest expense

A. Confirmation of accounts payable

Preliminary Audit Strategies for
Shareholders’ Equity
 Substantive Tests of
Stockholders’ Equity
• Initial Procedures

• Analytical Procedures

• Tests of Details of Transactions

– Vouch Entries to Paid-in
Capital Accounts
– Vouch Entries to Retained Earnings
Analytical Procedures
 Substantive Tests of
Stockholders’ Equity
Tests of Details of Balances
– Review Articles of Incorporation and Bylaws
– Review Authorization and Terms of
Stock Issues
– Confirm Shares Outstanding with Registrar
and Transfer Agent
– Inspect Stock Certificate Book
– Inspect Certificates of Shares Held
in Treasury

• Tests of Details of Presentation and

Disclosure