Chapter 15

Auditing the
Financing/Investing
Process: Long-Term
Liabilities,
Stockholders′ Equity,
and Income
Statement Accounts

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 LO# 1

Auditing Long-Term Debt

The auditor must be assured that the amounts shown
on the balance sheet for the various types of long-term
debt are not materially misstated. This assurance
extends to the recognition of interest expense. For the
vast majority of entities, it is more efficient to follow a
strategy of conducting substantive testing.

15-2
 LO# 1

Inherent Risk Assessment –

Long-Term Debt
The inherent risk for notes and bonds would
normally be assessed as low to moderate because
the volume of transactions are low, the accounting
is not complex, and the client often receives third-
party statements or amortization tables.

However, the amounts are usually large and the

financial markets have developed sophisticated
instruments that have characteristics of both debt
and equity. The inherent risk associated with these
instruments is normally high.

15-3
 LO# 2

Control Risk Assessment –

Long-Term Debt
When a substantive strategy is followed, the
auditor still needs a sufficient understanding
of the entity’s internal control system over debt.

15-4
 LO# 3

Assertions and Related

Control Activities
Occurrence and Authorization
Completeness
Valuation
Disclosure - Classification

15-5
 LO# 4

Substantive Procedures
of Long-Term Debt
Assertions Substantive Tests of Transactions
Occurrence Examine copies of new note or bond agreements. Examine board of
directors' minutes for approval of new lending agreements.

Trace large cash receipts and payments to source documents and the
general ledger. Review interest expense for payments to debt holders not
Completeness listed on the debt analysis schedule. Review notes paid or renewed after
the balance sheet date to determine if there are unrecorded liabilities at
year-end. Evaluate lease contracts to determine if leases are properly
accounted for as an operating or capital lease.
Examine board minutes for evidence of proper authorization of notes or
Authorization
bonds.
Accuracy Test a sample of receipts and payments.
Review debt activity for a few days before and after year-end to determine
Cutoff
if the transactions are included in the proper period.
Examine the due dates on notes or bonds for proper classification
Classification
between current and long-term debt.

15-6
 LO# 4

Substantive Procedures
of Long-Term Debt

15-7
 LO# 5

Auditing Stockholders’ Equity

The following three types of transactions are
of importance to the auditor:
1. Issuance of stock including transactions such as
sale of stock for cash; the exchange of stock for
assets, services, or convertible debt; and
issuance of stock for stock splits.
2. Repurchase of stock including both the
reacquisition of stock and retirement of stock.
3. Payment of dividends including cash and stock
dividends.
15-8
 LO# 6

Control Risk Assessment –

Stockholders’ Equity
A substantive strategy is often used to audit
stockholders’ equity because the number of
transactions is usually small. The auditor must still
understand the types of controls that are in place to
prevent the misstatement of equity transactions.
Large, publicly traded companies use an
independent registrar, transfer agent, and
dividend-disbursing agent to process and
record equity transaction. Relevant information
about equity transactions may be confirmed
with those parties.
15-9
 LO# 7

Assertions and Related

Control Activities
Occurrence Accuracy
Verify that stock and Verify that stock and
dividend transactions dividend transactions
comply with have been properly
corporate charter. posted and
summarized in the
accounting records.

Authorization Valuation
Verify that stock and Verify that stock and
dividend transactions dividend transactions
have been properly have been properly
approved. valued.
15-10
 LO# 8

Segregation of Duties
When possible, the following duties should be
segregated:
1. The individuals responsible for issuing, transferring, and
canceling stock certificates should not have any
accounting responsibilities.
2. The individual responsible for maintaining the detailed
stockholders’ records should be independent of the
maintenance of the general ledger control accounts.
3. The individual responsible for maintaining the detailed
stockholders’ records should not also process cash
receipts or disbursements.
4. Appropriate segregation of duties should be established
among the preparation, recording, signing, and mailing of
dividend checks.

15-11
 LO# 9

Auditing Capital-Stock Accounts

Occurrence and Completeness

Valuation
Completeness of Disclosure

15-12
 LO# 10

Auditing Dividends
All dividends declared and paid will be audited
because of concerns of violations of corporate
bylaws or debt covenants.

When an independent When an independent agent is

dividend-disbursing not used, the auditor can
agent is used, the auditor recomputed the amount of the
can confirm the amount dividend authorized by the
disbursed with the agent. board of directors and trace the
This amount is agreed amount to cash disbursements
with the amount or dividends payable.
authorized by the board
of directors.

15-13
 LO# 11

Auditing Retained Earnings

Under normal circumstances, retained earnings are

affected by the current year’s income or loss and the
dividends declared and or paid.
The major exceptions are the existence of prior period
adjustments, correction of errors, stock retirements,
and changes in appropriations of retained earnings.

15-14
 LO# 12

Auditing Income Statement

Accounts
The audit of revenue and expense accounts
depends on the extent of work conducted on the
entity’s control system and balance sheet accounts.
Substantive procedures on selected income
statement accounts include:
o The results of testing controls for the various business
processes.
o The results of the detailed tests of balance sheet accounts
and the related income statement accounts.
o Performance of substantive analytical procedures on income
statement accounts.
o Detailed tests of selected income statement accounts.
15-15
End of Chapter 15

15-16