Auditing A RiskBased Approach To Conducting A Quality

Auditing A Risk-Based Approach To Conducting A Quality Audit 10 th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg CHAPTER 13 AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

LEARNING OBJECTIVES 1. 2. 3. Identify the significant accounts, disclosures, and relevant assertions in auditing debt obligations and stockholders’equity transactions Identify and assess inherent risks of material misstatement associated with debt obligations and stockholders’equity transactions Identify and assess fraud risks of material misstatement associated with debt obligations and stockholders’equity transactions Copyright © 2016 South-Western/Cengage Learning 13 -2

LEARNING OBJECTIVES 4. 5. 6. Identify and assess control risks of material misstatement associated with debt obligations and stockholders’equity transactions Describe how to use planning analytical procedures to identify possible material misstatements associated with debt obligations and stockholders’equity transactions Determine appropriate responses to identified risks of material misstatement in auditing debt obligations and stockholders’ equity transactions Copyright © 2016 South-Western/Cengage Learning 13 -3

LEARNING OBJECTIVES 7. 8. Determine appropriate tests of controls and consider the results of tests of controls in auditing debt obligations and stockholders’equity transactions Determine and apply sufficient appropriate substantive audit procedures in auditing debt obligations and stockholders’equity transactions Copyright © 2016 South-Western/Cengage Learning 13 -4

THE AUDIT OPINION FORMULATION PROCESS Copyright © 2016 South-Western/Cengage Learning 13 -5

LEARNING OBJECTIVE 1 IDENTIFY THE SIGNIFICANT ACCOUNTS, DISCLOSURES, AND RELEVANT ASSERTIONS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS' EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

RELEVANT ACCOUNTS WHEN AUDITING DEBT OBLIGATIONS Bonds payable Interest expense Gains or losses on refinancing debt Notes payable Mortgages payable Copyright © 2016 South-Western/Cengage Learning 13 -7

AUDITING DEBT OBLIGATIONS • Objective - Determining whether all obligations are recorded and properly classified • Relevant assertions • Proper valuation of premium or discount • Valuation of gains or losses on refinancing debt • Proper presentation and disclosure, including important restrictions contained in the debt obligations • Restrictions in debt agreements aimed at protecting the lender by restricting the activities of the borrower Copyright © 2016 South-Western/Cengage Learning 13 -8

ACTIVITIES RELATED TO DEBT OBLIGATIONS Bond issuance and amortization schedules Periodic payments and interest expense Debt covenants Copyright © 2016 South-Western/Cengage Learning 13 -9

BOND INDENTURE • Contract between an issuer of bonds and the bondholder stating: • Time period before repayment • Amount of interest paid • Bond being convertible (and if so, at what price or what ratio) • Bond being callable • Amount of money that is to be repaid Copyright © 2016 South-Western/Cengage Learning 13 -10

RELEVANT ACCOUNTS FOR AUDITING STOCKHOLDERS’EQUITY Stock accounts (common, preferred, and treasury) Additional paid-in capital Dividend accounts Retained earnings Copyright © 2016 South-Western/Cengage Learning 13 -11

ACTIVITIES RELATED TO STOCKHOLDERS’EQUITY New stock issuances Purchase of treasury stock Declaration and payment of dividends Grants of stock options and warrants Exercises and expirations of stock options and warrants Transfer of net income to retained earnings Recording of prior-period adjustments to retained earnings Copyright © 2016 South-Western/Cengage Learning 13 -12

VALUATION ASSERTION FOR STOCKHOLDERS’EQUITY • When issuing stock for noncash, difficulties arise in determining • Whether the market value of the stock issued or of the asset acquired is a better representation of value • The proper accounting for an exchange of stock to acquire another business • Stock options - Measured at the fair value of the option Copyright © 2016 South-Western/Cengage Learning 13 -13

PRESENTATION AND DISCLOSURE ASSERTION FOR STOCKHOLDERS’EQUITY • Requires proper description/disclosure of: • Each class of stock outstanding and number of shares authorized, issued, and outstanding and special rights associated with them • Stock options outstanding and convertible features • Existence of stock warrants • Any restrictions or appropriations of retained earnings • Prior-period adjustments and other comprehensive income adjustments • EPS See Exhibit 13. 1 and Exhibit 13. 2 Copyright © 2016 South-Western/Cengage Learning 13 -14

LEARNING OBJECTIVE 2 IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

INHERENT RISKS - DEBT OBLIGATIONS Authorization of debt • Incurring debt that is not properly authorized or reviewed Receipt of funds • New debt, debt extinguishments, or debt payment transactions not being properly authorized Recording of debt transactions • Interest expense not being properly recorded or accrued • Debt not being recorded in accordance with GAAP Compliance with any debt covenants • Risk of debt covenants not being calculated accurately • Risk of compliance with debt covenants not being appropriately reviewed and disclosed Copyright © 2016 South-Western/Cengage Learning 13 -16

EXHIBIT 13. 3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS’EQUITY ACTIVITIES Copyright © 2016 South-Western/Cengage Learning 13 -17

EXHIBIT 13. 3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS’EQUITY ACTIVITIES Copyright © 2016 South-Western/Cengage Learning 13 -18

LEARNING OBJECTIVE 3 IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

FRAUD RISK FACTORS - DEBT OBLIGATIONS Violations of debt covenants are not disclosed Debt obligations are not properly authorized Long-term or short-term debt is misclassified Interest expense either not recorded, misclassified, or recorded: • In the wrong period • At the wrong amount Entire loan payments are charged to either principal or interest Copyright © 2016 South-Western/Cengage Learning 13 -20

FRAUD RISK FACTORS STOCKHOLDERS’EQUITY Expenses charged directly to retained earnings Stock sales or issuances not authorized or recorded Stock sales or issuances violate debt covenants Stock options: • Not authorized or not in accordance with terms • Backdated Dividends paid in violation of restrictive covenants Dividends paid to wrong parties or at incorrect amounts Proceeds from stock sales are misappropriated Copyright © 2016 South-Western/Cengage Learning 13 -21

LEARNING OBJECTIVE 4 IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

CONTROLS - DEBT OBLIGATIONS • Disclosure policies and procedures • Board of directors approves all new debt • Debt and interest accounts are updated and reconciled to the general ledger on a monthly basis • Review of draft financial statements prior to issuance for proper disclosure of debt obligations • A debt amortization schedule is: • Prepared for each new debt obligation • Updated as appropriate • Reviewed by appropriate personnel Copyright © 2016 South-Western/Cengage Learning 13 -23

CONTROLS - STOCKHOLDERS’EQUITY TRANSACTIONS • Board of directors approves all stock transactions • CEO and CFO authorize approved stock transactions • Stockholders’equity accounts are updated and reconciled to the general ledger on a timely basis • Appropriate review of draft financial statements for proper disclosures related to equity accounts • An outside party maintains details of shares issued, repurchased, and cancelled • Accountant researches and analyzes proper accounting for stock option grants Copyright © 2016 South-Western/Cengage Learning 13 -24

LEARNING OBJECTIVE 5 DESCRIBE HOW TO USE PLANNING ANALYTICAL PROCEDURES TO IDENTIFY POSSIBLE MATERIAL MISSTATEMENTS ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

PLANNING ANALYTICAL PROCEDURES: IDENTIFY AREAS OF POTENTIAL MISSTATEMENTS • For debt obligations • Trend analysis of: • Balances in notes payable and accrued interest • Debt-to-equity ratio • Times interest earned ratio • Estimate overall interest expense based on average interest rates and average debt outstanding • For stockholders’equity accounts • Compare current year account balances with prior-year account balances Copyright © 2016 South-Western/Cengage Learning 13 -26

LEARNING OBJECTIVE 6 DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

DETERMINING APPROPRIATE AUDIT PROCEDURES • Debt accounts - Substantive procedures are typically appropriate because: • Number of transactions is relatively small • Dollar amounts involved are usually quite material • Stockholders’equity transactions - Substantive approach using only tests of details is typically appropriate • Number of equity transactions with outside parties is normally small Copyright © 2016 South-Western/Cengage Learning 13 -28

LEARNING OBJECTIVE 7 DETERMINE APPROPRIATE TESTS OF CONTROLS AND CONSIDER THE RESULTS OF TESTS OF CONTROLS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

OBTAINING EVIDENCE ABOUT INTERNAL CONTROL OPERATING EFFECTIVENESS • Involves testing both entity-wide and transaction controls • Tests of transaction controls • Inquiry of personnel performing the control • Observation of control being performed • Inspection of documentation confirming that the control has been performed • Reperformance of the control by the auditor testing the control Copyright © 2016 South-Western/Cengage Learning 13 -30

LEARNING OBJECTIVE 8 DETERMINE AND APPLY SUFFICIENT APPROPRIATE SUBSTANTIVE AUDIT PROCEDURES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’EQUITY TRANSACTIONS Copyright © 2016 South-Western/Cengage Learning

SUBSTANTIVE ANALYTICAL PROCEDURES - DEBT OBLIGATIONS • Involves developing an independent expectation of interest expense • Expectation based on: • Average debt outstanding • Average interest rates • Use data disaggregated by type of debt • Test of controls may not need to be performed • Information used to perform analytical procedure is typically confirmed with an independent outside party Copyright © 2016 South-Western/Cengage Learning 13 -32

SUBSTANTIVE TESTS OF DETAILS DEBT OBLIGATIONS Reading new loan agreements Determining any changes that have been made to prior loan agreements Confirming with relevant outside parties the significant factors and transactions that have occurred Copyright © 2016 South-Western/Cengage Learning 13 -33

SUBSTANTIVE TESTS OF DETAILS DEBT AND BOND COVENANTS • Auditor should: • Obtain an understanding of the procedures the client uses to determine whether they are in compliance with their debt covenants • Independently determine if the client is in compliance • If not in compliance, auditor should assess the effects of the violation Copyright © 2016 South-Western/Cengage Learning 13 -34

SUBSTANTIVE TESTS OF DETAILS STOCKHOLDERS’EQUITY TRANSACTIONS • Reviewing a copy of client’s articles of incorporation • Preparing, or asking client to prepare, an analysis of all capital stock transactions • Inspecting documentation related to client’s record keeping of capital stock and contributed capital maintained by the client or held by a transfer agent • Transfer agent: An organization used by a client to: • Maintain records of investors and account balances and transactions • Cancel and issue certificates and process investor mailings Copyright © 2016 South-Western/Cengage Learning 13 -35

SUBSTANTIVE TESTS OF DETAILS STOCKHOLDERS’EQUITY TRANSACTIONS • Obtain evidence related to valuation of capital stock • Review minutes of the board of directors meetings • Examine stock records books • Obtain evidence for all capital stock transactions • Trace proceeds to cash receipts journal • For stock issued in a nonmonetary transaction • Determine that client has properly recorded issuance in accordance with GAAP • For clients with treasury stock • Examine supporting documentation Copyright © 2016 South-Western/Cengage Learning 13 -36

SUBSTANTIVE TESTS OF DETAILS DIVIDENDS • Examine minutes of board of directors meetings for authorization of dividend per share amount and dividend record date • For clients maintaining their own records and paying the dividends • Auditor need to recalculate the amount of the dividends and agree that amount to the cash disbursements journal • For client using a transfer agent: • Trace the payment to a cash disbursement made by the client to the agent Copyright © 2016 South-Western/Cengage Learning 13 -37

SUBSTANTIVE TESTS OF DETAILS RETAINED EARNINGS • Examine transactions recorded in retained earnings account during audit period • Common entries include net income or loss • These amounts tested through substantive audit procedures related to revenues and expenses • Other common entry includes dividends • Auditor should review documentation for any additional entries Copyright © 2016 South-Western/Cengage Learning 13 -38

FRAUD-RELATED SUBSTANTIVE PROCEDURES FOR DEBT OBLIGATIONS Search public records to identify debt obligations Vouch and trace loan proceeds and debt payments Send confirmations to lenders and creditors, and confirmation of compliance with any debt covenants Require original supporting documents Agree detail of debt terms to authorization in minutes of board meetings Copyright © 2016 South-Western/Cengage Learning 13 -39

FRAUD-RELATED SUBSTANTIVE PROCEDURES FOR STOCKHOLDERS’EQUITY ACCOUNTS Confirm terms of equity arrangements and shares held directly with shareholders Confirm with shareholders regarding any side agreements Employ an appropriate level of professional skepticism and carefully analyze transactions Confirm relevant information with the transfer agent Account for and vouch all proceeds from stock issues Copyright © 2016 South-Western/Cengage Learning 13 -40

DOCUMENTING SUBSTANTIVE PROCEDURES - FOR DEBT OBLIGATIONS • Copies of the debt agreements • Identification of specific items tested • Schedule of debt obligations and interest • A summary of the calculations supporting compliance with debt covenants • Confirmations or documentation of alternative procedures performed Copyright © 2016 South-Western/Cengage Learning 13 -41

DOCUMENTING SUBSTANTIVE PROCEDURES FOR STOCKHOLDERS’EQUITY TRANSACTIONS • Client’s articles of incorporation • A summary of changes in equity accounts • Verification of authorization with respect to any changes in capitalization or declaration of dividends • Confirmations with transfer agent or shareholders Copyright © 2016 South-Western/Cengage Learning 13 -42