Audit of the Capital

Acquisition and
Repayment Cycle

Chapter 20

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 1

 Learning Objective 1

Identify the accounts and the

unique characteristics of the
capital acquisition and
repayment cycle.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 2

 Characteristics of the Capital
Acquisition and Repayment Cycle
1. Relatively few transactions affect the
account balances, but each one is
often highly material in amount.

2. The exclusion of a single transaction

could be material in itself.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 3

 Characteristics of the Capital
Acquisition and Repayment Cycle
3. A legal relationship exists between the
client entity and the holder of the stock,
bond, or similar ownership document.

4. A direct relationship exists between the

interest and dividends accounts and
debt and equity.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 4

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 5
 Accounts in the Cycle
 Notes payable
 Contracts payable
 Mortgages payable
 Bonds payable
 Interest expense
 Accrued interest
 Appropriations of retained earnings
 Treasury stock
 Dividends declared

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 6

 Accounts in the Cycle
 Cash in the bank
 Capital stock – common
 Capital stock – preferred
 Paid-in capital in excess of par
 Donated capital
 Retained earnings
 Dividends payable
 Proprietorship – capital account
 Partnership – capital account

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 7

 Methodology for Designing Tests
of Balances for Notes Payable
Identify client
business risks Phase I
affecting notes payable
Set tolerable misstatement
and assess inherent Phase I
risk for notes payable
Assess control
risk for Phase I
notes payable
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 8
 Methodology for Designing Tests
of Balances for Notes Payable
Design and perform
tests of controls and
substantive tests of
Phase II
transactions for
capital acquisition and
repayment cycle

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 9

 Methodology for Designing Tests
of Balances for Notes Payable

Design and perform

analytical procedures Phase III
for notes payable

Design tests of Audit procedures

details of notes Sample size
payable to satisfy Phase III
balance-related Items to select
audit objectives Timing
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 10
 Learning Objective 2

Design and perform audit tests

of notes payable and related
accounts and transactions.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 11

 Notes Payable
 A note payable is a legal obligation to a creditor

 It may be unsecured or secured by assets

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 12

 Notes Payable
Objectives of the audit of notes payable:
 Internal controls over notes payable are adequate
 Transactions for principal and interest are properly
authorized and recorded
 The liability for notes payable and the related
interest expense and accrued liability are
properly stated

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 13

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 14
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 15
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 16
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 17
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 18
 Internal Controls
1. Proper authorization for the issue of
new notes.
2. Adequate controls over the repayment
of principal and interest.
3. Proper documents and records.
4. Periodic independent verification.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 19

 Tests of Controls and Substantive
Tests of Transactions
Tests of notes payable transactions
involve the issue of notes and the
repayment of principal and interest.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 20

 Analytical Procedures for
Notes Payable
Analytical procedure Possible misstatement
Recalculate approximate Misstatement of interest
interest expense on the expense and accrued
basis of average interest interest, or omission
rates and overall monthly of an outstanding
notes payable note payable

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 21

 Analytical Procedures for
Notes Payable
Analytical procedure Possible misstatement
Compare individual notes Omission or
outstanding with those misstatement of
of the prior year a note payable

Compare total balance in Misstatement of interest

notes payable, interest expense and accrued
expense, and accrued interest or notes
interest with prior-year payable
balances
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 22
 Major Balance-related Audit
Objectives in Notes Payable
1. Completeness:
Existing notes payable are included.
2. Accuracy:
Notes payable in the schedule are
accurately recorded.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 23

 Types of Audit Tests for Capital
Acquisition and Repayment Cycle
Cash in Bank Notes Payable
Payments of principal
Audited by
TOC and STOT
Ending
Issue of new notes balance
Audited by
TOC and STOT Audited by
Payments AP and TDB
of interest Interest Payable
Audited by
TOC, STOT,
and AP TOC + STOT + AP + TDB
= Sufficient appropriate evidence
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 24
 Types of Audit Tests for
Notes Payable
Interest Payable Interest Expense
Interest expense

Ending Audited by Ending

balance TOC, STOT, balance
and AP
Audited by Audited
AP and TDB by AP

TOC + STOT + AP + TDB

= Sufficient appropriate evidence

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 25

 Learning Objective 3

Identify the primary concerns

in the audit of owners’ equity
transactions.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 26

 Owners’ Equity
 Publicly held corporation

 Closely held corporation

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 27

 Owners’ Equity and Dividend
Accounts
Cash in Bank

Capital Stock – Paid-in Capital in Excess

Common of Par – Common
Redemption Beginning Redemption Beginning
of stock balance of stock balance

Issue of Issue of
stock stock

Ending Ending
balance balance

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 28

 Owners’ Equity and Dividend
Accounts
Cash in Bank

Dividends Payable Retained Earnings

Beginning Beginning
balance balance
Payment of
dividends Dividends Dividends Net
declared declared earnings

Ending Ending
balance balance

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 29

 Internal Controls
 Proper authorization of transactions

 Proper record keeping and segregation of duties

 Independent registrar and stock transfer agent

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 30

 Learning Objective 4

Design and perform tests of

controls, substantive tests of
transactions, and tests of details
of balances for capital stock and
retained earnings.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 31

 Audit of Capital Stock and
Paid-in Capital
1. Completeness:
Existing capital stock transactions
are recorded.
2. Occurrence and accuracy:
Recorded capital stock transactions
exist and are accurately recorded.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 32

 Audit of Capital Stock and
Paid-in Capital
3. Accuracy:
Capital stock is accurately recorded.

4. Presentation and disclosure:

Capital stock is properly presented and
disclosed.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 33

 Audit of Dividends
1. Occurrence:
Recorded dividends occurred.

2. Completeness:
Existing dividends are recorded.

3. Accuracy:
Dividends are accurately recorded.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 34

 Audit of Dividends
4. Occurrence:
Dividends are paid to stockholders
that exist.
5. Completeness:
Dividends payable are recorded.

6. Accuracy:
Dividends payable are accurately recorded.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 35

 Audit of Retained Earnings
Transactions involving retained earnings:
 Net earnings for the year
 Dividends declared

There may be corrections to:

 Prior-period earnings
 Prior-period adjustments
 Appropriations of retained earnings

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 36

 Types of Audit Tests
Capital Stock and Paid-in Cash in
Capital in excess of Par Bank
Issue of stock
Redemption of stock
Both audited by TOC and STOT

Ending Audited by
balance TDB
TOC + STOT + AP + TDB
= Sufficient appropriate evidence

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 37

 Types of Audit Tests
Cash in Dividends
Bank Payable
Payment of dividends
Audited by
TOC and STOT
Ending
balance

Audited by
TDB
TOC + STOT + AP + TDB
= Sufficient appropriate evidence

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 38

 Types of Audit Tests
Dividends Retained
Payable Earnings
Dividends declared Net earnings
Audited by
Audited by TOC, STOT,
TOC and STOT AP, and TDB
Ending Ending
balance balance
Audited by Audited by
TDB TDB
TOC + STOT + AP + TDB
= Sufficient appropriate evidence

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 39

 End of Chapter 20

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 22 - 40