CHAPTER

6
6-1.

AUDIT OF THE FINANCING AND INVESTING CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS

Investing activities include an entitys 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. 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 do in the acquisition of goods. elated!party transactions to acquire investments or property, plant, and equipment may result in improper valuation of the accounts. "ecurities may be stolen or diverted. #istorically, business entities have manipulated the accounting values at $hich assets $ere recorded by acquiring assets from a related party or selling assets to a related party. %cquiring assets at inflated values may result in draining cash from the acquiring entity. "elling assets at inflated values to related parties results in increased revenue and assets to the selling entity, and these may never be reali&ed. %ll transactions conducted $ith related parties must be examined carefully.

6-2.

6-3.

'ritical controls include separating the responsibilities for authori&ing transactions, keeping records, and having custody of the asset. (enerally, the board, or sometimes an investment committee of the board, must approve individual investments. %fter obtaining board approval, the treasurer or vice president for finance has authority to execute the purchase or sale of an investment transaction. )ue 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. ,hen 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.

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

6-4.

The substantive tests, grouped according to the assertions they test, are as follo$sExistence or occurrence: ecorded investments and investment income exist. Inspect securities on hand and trace to listing. 'onfirm securities held by others.

Completeness: %ll investments and investment income are recorded. %pply analytical procedures. Rights and obligations: Investments and investment income are o$ned by the entity. .or investments acquired during the period, examine supporting invoices and paid checks. .or dividends, interest, and disposals of investments, examine remittance advices.

aluation or allocation: Investments are valued in accordance $ith (%%/ and investments and investment income are mathematically accurate. econcile the investment listing to the subsidiary ledger and general ledger account. ecalculate interest revenue and verify dividend income by reference to published reports of dividends.

!resentation and disclosure: Investments and investment income are presented in accordance $ith (%%/. 6-5. evie$ statement presentation for compliance $ith (%%/.

.inancing activities consist of an entitys transactions to *0+ obtain long!term *capital+ funds by issuing long!term debt or capital stock1 *2+ make payments associated $ith long!term funds, such as payment of interest and dividends1 and *3+ retire long!term funds by paying off or reacquiring debt or equity obligations. 4ong!term debt includes notes, mortgages, and bonds. 'apital stock includes both common and preferred stock. 5ften these transactions are recorded in the sales and collections cycle, but they are so significant that additional controls are applied to them. The characteristics of the liability accounts that result in a different auditing approach than follo$ed in the audit of accounts payable are0+ elatively fe$ 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.

6-6.

Audit o" the #inancing and $n%esting Cycle: &ests o" Controls and Substanti%e &ests o" &ransactions

63

3+ The relationship bet$een the client entity and the holder of the o$nership document is legal in nature. 6+ The liabilities involve accrual and payment of interest as $ell as debt. 6-7. It is common to audit the balance in notes payable in conjunction $ith the audit of interest expense and interest payable because it minimi&es the verification time and reduces the likelihood of overlooking errors in the balance. 5nce the auditor is satisfied $ith 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 $hich interest has been paid is minimi&ed. ,hen there are a large number of notes or a large number of transactions during the year, it is usually too time consuming to completely tie out interest expense as a part of the audit of the notes payable and related accrued interest. 7ormally, ho$ever, there are only a fe$ notes and fe$ transactions during the year. The most important controls the auditor should be concerned about in the audit of notes payable are0+ The proper authori&ation for the issuance of ne$ notes *or rene$als+ to ensure that the company is not being committed to debt arrangements that are not authori&ed. 2+ 'ontrols over the repayment of principal and interest to ensure that no more is paid on the note than is required. 3+ /roper records and procedures to ensure that all amounts in all transactions are properly recorded. 6+ /eriodic independent verification to ensure that all the controls over notes payable are $orking. 6-9. .our types of restrictions long!term creditors often put on companies in granting them a loan are0+ 2+ 3+ 6+ .inancial ratio restrictions /ayment of dividends restrictions 5perations restrictions Issue of additional debt restrictions

6-8.

The auditor can find out about these restrictions by examining the loan agreement and related correspondence associated $ith the loan, and by confirmation. The auditor must perform calculations and observe activities to determine $hether the client has observed the restrictions. 6-1 . The major internal control over o$ners equity are0+ /roper authori&ation of transactions 2+ /roper record keeping

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Solutions Manual to Accompany Applied Auditing, 2006 Edition 3+ %dequate segregation of duties bet$een maintaining o$ners equity records and handling cash and stock certificates 6+ The use of an independent registrar and stock transfer agent

6-11.

"ince it is important to verify that properly authori&ed dividends have been paid to o$ners 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 $ould be inadequate. "uch an audit step is useless unless the dividend list has first been verified to include all stockholders of record at the dividend record date. % 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 $ith the total amount actually paid. % random sample of canceled checks should then be compared to the independent registrars records to verify that the payments $ere actually made to valid shareholders. 0+ c 2+ d 0+ d 2+ a 0+ d 0+ a 0+ b !. $%&'()* (+ C(,-&(. 0. To assure that all note liabilities are authori&ed by proper management. 2. To assure that note transactions are recorded in full and in detail. 3. To prevent misuse of 3+ c 6+ d 3+ c 6+ d 2+ a 2+ a 2+ a 8+ c 8+ a 9+ a 3+ b 3+ a 3+ c ". $(-*,-/!. F/,!,#/!. S-!-*0*,- E&&(& 4oss of assets through payment of excess interest rates or the diversion of cash to unauthori&ed persons. Improper disclosure or errors in note payable through duplication. :isstatement of #. A%1/- $&(#*1%&* -( D*-*&0/,* E2/)-*,#* (+ 3!-*&/!. E&&(& 'heck note request forms for proper authori&ation. 6+ c

6-12. 6-13. 6-14. 6-15. 6-16. 6-17.

)etermine if master file is maintained, and reconcile detailed contents to control. )etermine if duties are

Audit o" the #inancing and $n%esting Cycle: &ests o" Controls and Substanti%e &ests o" &ransactions notes and funds earmarked for notes. liabilities and cash.

65

segregated. /erform all substantive procedures on extended basis. 'heck paid notes for cancellation. )etermine if reconciliations are periodically made, and verify reconciliation. )etermine if interest computations are internally verified. ecompute interest on a test basis.

6. To assure that notes are not paid more than once. 8. To assure that all note! related transactions agree $ith account balances. 9. To further assure that only the proper interest amount is paid and recorded. 6-18.

4oss of cash.

:isstatement of notes payable.

:isstatement of interest expense and related accrual.

"ince 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. I-*0 N(. 0. 2. S%")-!,-/4* A%1/- $&(#*1%&* 'ompare to government study depreciation table. Test all expense charges to these accounts over a certain amount. <xamine equipment listed on the books.

6-19. I,-*&,!. C(,-&(. ;se of government study depreciation tables. :ake approvals required for all expending over a certain amount. #ave construction foreman report to accounting department periodically $hether or not there have been abandonments or replacements. #ave expense records internally verified.

3.

6.

%naly&e depreciation and administrative expenses by ratio

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Solutions Manual to Accompany Applied Auditing, 2006 Edition comparison to previous years. 8. %ssign tools to individual foreman and periodically count the tools. #ave recording of property acquisitions internally verified. The deposit of all cash directly into the bank account. Take a physical count of the tools.

9.

evie$ supporting documentation on property acquisitions and compare to recorded value. *0+ 'onfirmation of bank accounts and other tests for unrecorded loans. *2+ /hysical examination of plant assets.

=.

6-2 . L/!"/./-5 -6!- #(%.1 "* U,#(4*&*1 a. 4a$suit b. >uilding used as collateral for a loan c. ;nrecorded lease d. 7ote payable e. /olicy loan f. 7ote payable g. Income taxes payable for nondeductible expenses A%1/- $&(#*1%&* -( U,#(4*& L/!"/./-5 evie$ minutes of the >oard of )irectors meetings. <xamine documents of o$nership and bank confirmations. <xamine the lease agreements. <xamine underlying records for the related loan. 'onfirmation $ith life insurance company. 5btain confirmation from bank. evie$ travel and expense reports.