A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT 9 th Edition Karla M. Johnstone Audrey A. Gramling Larry E. Rittenberg CHAPTER 13 AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
LEARNING OBJECTIVES 1. Identify the significant accounts, disclosures, and relevant assertions in auditing debt obligations and stockholders equity transactions 2. Identify and assess inherent risks of material misstatement associated with debt obligations and stockholders equity transactions 3. Identify and assess fraud risks of material misstatement associated with debt obligations and stockholders equity transactions 13-2
LEARNING OBJECTIVES 4. Identify and assess control risks of material misstatement associated with debt obligations and stockholders equity transactions 5. Describe how to use preliminary analytical procedures to identify possible material misstatements associated with debt obligations and stockholders equity transactions 6. Determine appropriate responses to identified risks of material misstatement in auditing debt obligations and stockholders equity transactions 13-3
LEARNING OBJECTIVES 7. Determine appropriate tests of controls and consider the results of tests of controls in auditing debt obligations and stockholders equity transactions 8. Determine and apply sufficient appropriate substantive audit procedures in auditing debt obligations and stockholders equity transactions 13-4
LEARNING OBJECTIVES 9. Apply the frameworks for professional decision making and ethical decision making to issues involving the audit of debt obligations and stockholders equity transactions 13-5
THE AUDIT OPINION FORMULATION PROCESS 13-6
PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY ACCOUNTS Debt Obligations It was identified that Soyo group was not in compliance with three of its six debt covenants with UCB as of December 31, 2007 Audit team: Did not follow up on identified debt covenant violations Did not obtain evidence indicating whether a waiver had been granted by UCB 13-7
PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY ACCOUNTS Audit work papers did not provide any evidence that audit team considered whether these violations could impact the going concern status of Soyo Audit report for 2007 included an unqualified opinion 13-8
PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY ACCOUNTS Adjustments to Stockholders Equity Accounts: Delphi Corporation Accused of violations related to improperly accounting for an increase in warranty reserves related to warranty claims made by its former parent company Misclassification of the reserve (as a direct adjustment to retained earnings) increase resulted in materially overstating its net income for 2000 by $69 million 13-9
PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY ACCOUNTS What are the risks of material misstatement associated with debt obligations and stockholders equity accounts? (LO 2, 3, 4) What are the typical substantive procedures that auditors should perform when auditing debt obligations and stockholders equity accounts? (LO 8) How could a lack of appropriate professional skepticism by auditors lead to material misstatements related to debt obligations and stockholders equity accounts? (LO 2, 3, 5, 6, 8) 13-10
LEARNING OBJECTIVE 1 IDENTIFY THE SIGNIFICANT ACCOUNTS, DISCLOSURES, AND RELEVANT ASSERTIONS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
RELEVANT ACCOUNTS WHEN AUDITING DEBT OBLIGATIONS Bonds payable Interest expense Gains or losses on refinancing debt Notes payable Mortgages payable 13-12
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 13-13
ACTIVITIES RELATED TO DEBT OBLIGATIONS Bond issuance and amortization schedules Periodic payments and interest expense Debt covenants 13-14
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 13-15
DEBT COVENANTS Restrictions in debt agreements aimed at protecting the lender by restricting the activities of the borrower Common Restrictions Maintenance of a minimum level of retained earnings before dividends can be paid Maintenance of a minimum working-capital ratio Specification of a maximum debt-equity ratio Specific callable provisions identifying procedures for calling and retiring debt at prespecified prices and dates 13-16
RELEVANT ACCOUNTS FOR AUDITING STOCKHOLDERS EQUITY Stock accounts (common, preferred, and treasury) Additional paid-in capital Dividend accounts Retained earnings 13-17
TRANSACTIONS AFFECTING 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 13-18
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 13-19
PRESENTATION AND DISCLOSURE ASSERTION FOR STOCKHOLDERS EQUITY Requires proper description 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 13-20
EXHIBIT 13.1 - BALANCE SHEET DISCLOSURE OF STOCKHOLDERS EQUITY 13-21
PRESENTATION AND DISCLOSURE ASSERTION FOR STOCKHOLDERS EQUITY Potential dilutive effect of following should be disclosed in accordance with relevant accounting guidance Convertible debt or preferred stock Stock options Warrants 13-22
EXHIBIT 13.2 - INCOME STATEMENT DISCLOSURE OF EARNINGS PER SHARE, ASSUMING DILUTION 13-23
LEARNING OBJECTIVE 2 IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
PERFORMING RISK ASSESSMENT PROCEDURES Obtaining information about inherent risks At financial statement level and at account and assertion levels Fraud risks including feedback from audit team brainstorming sessions Strengths and weaknesses in internal control Results from preliminary analytical procedures 13-25
IDENTIFYING INHERENT RISKS - DEBT Authorization of debt OBLIGATIONS 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 calculate accurately Risk of compliance with debt covenants not being appropriately reviewed and disclosed 13-26
EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS EQUITY ACTIVITIES 13-27
EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED WITH STOCKHOLDERS EQUITY ACTIVITIES 13-28
LEARNING OBJECTIVE 3 IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
IDENTIFYING 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 13-30
IDENTIFYING FRAUD RISK FACTORS - STOCKHOLDERS EQUITY Expenses charged directly to retained earnings rather than to appropriate expense accounts Stock sales or issuances: Not authorized or recorded Violate debt covenants Stock options are: Not authorized or in accordance with terms of options granted Backdated 13-31
IDENTIFYING FRAUD RISK FACTORS - STOCKHOLDERS EQUITY Dividends are paid: In violation of restrictive covenants To wrong parties or at incorrect amounts Proceeds from stock sales are misappropriated 13-32
LEARNING OBJECTIVE 4 IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL MISSTATEMENT ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
IDENTIFYING CONTROL RISKS At entity-wide level, auditor considers: Control environment Commitment to financial accounting competencies Independence of the board of directors Other entity-wide components of internal control Risk assessment Information and communication Monitoring controls 13-34
CONTROLS - DEBT OBLIGATIONS 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 13-35
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 Top management and the board of directors review draft financial statements prior to issuance for proper disclosure of equity accounts 13-36
CONTROLS - STOCKHOLDERS EQUITY TRANSACTIONS An outside party maintains details of shares issued, repurchased, and cancelled Accountant researches and analyzes proper accounting for stock option grants Organization s legal counsel and CFO review and approve the analysis 13-37
DOCUMENTING CONTROLS Can be done in any of the following formats Control matrix Control risk assessment questionnaire Memo 13-38
LEARNING OBJECTIVE 5 DESCRIBE HOW TO USE PRELIMINARY ANALYTICAL PROCEDURES TO IDENTIFY POSSIBLE MATERIAL MISSTATEMENTS ASSOCIATED WITH DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS.
PRELIMINARY ANALYTICAL PROCEDURES Help identify areas of potential misstatements For debt obligations Trend analysis of: Balances in notes payable Interest expense Accrued interest with prior periods Estimate interest expense based on average interest rates and average debt outstanding 13-40
PRELIMINARY ANALYTICAL PROCEDURES Calculate debt-to-equity ratios and perform a trend analysis with prior periods Calculate the times interest earned ratio and perform a trend analysis with prior periods For stockholders equity accounts Compare current year account balances with prioryear account balances 13-41
LEARNING OBJECTIVE 6 DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
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 13-43
LEARNING OBJECTIVE 7 DETERMINE APPROPRIATE TESTS OF CONTROLS AND CONSIDER THE RESULTS OF TESTS OF CONTROLS IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
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 13-45
LEARNING OBJECTIVE 8 DETERMINE AND APPLY SUFFICIENT APPROPRIATE SUBSTANTIVE AUDIT PROCEDURES IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS EQUITY TRANSACTIONS
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 If test of controls are not performed Information used to perform analytical procedure is confirmed with an independent outside party 13-47
EXHIBIT 13.4 - PANEL A: SUBSTANTIVE ANALYTICAL PROCEDURES APPROACH TO OBTAINING AUDIT EVIDENCE FOR COMPLETENESS OF INTEREST EXPENSE 13-48
EXHIBIT 13.4 - PANEL B: SUBSTANTIVE ANALYTICAL PROCEDURES AND TESTS OF DETAILS APPROACH TO OBTAINING AUDIT EVIDENCE FOR COMPLETENESS OF INTEREST EXPENSE 13-49
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 13-50
EXHIBIT 13.5 - RELEVANT MANAGEMENT ASSERTIONS AND SUBSTANTIVE PROCEDURES FOR DEBT OBLIGATIONS 13-51
SUBSTANIVE PROCEDURES - DEBT AND Auditor should: BOND COVENANTS Obtain an understanding of the procedures the client uses to determine whether they are in compliance with their debt covenants Then independently determine if the client is in compliance If not in compliance, auditor should assess the effects of the violation 13-52
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 13-53
SUBSTANTIVE TESTS OF DETAILS - STOCKHOLDERS EQUITY TRANSACTIONS Obtaining evidence related to the valuation of capital stock Reviewing the minutes of the board of directors meetings Examining the stock records books Obtaining evidence for all capital stock transactions Tracing proceeds to cash receipts journal and reviewing documentation 13-54
SUBSTANTIVE TESTS OF DETAILS - STOCKHOLDERS EQUITY TRANSACTIONS For stock issued in a nonmonetary transaction Determining that client has properly recorded issuance in accordance with GAAP For clients with treasury stock Examining documentation supporting changes in number of shares since prior year 13-55
AUDITING IN PRACTICE - DEFICIENCIES IN SUBSTANTIVE PROCEDURES RELATED TO EQUITY TRANSACTIONS: INSIGHTS FROM THE PCAOB Auditors failed to: Evaluate whether clients had appropriately determined the fair values assigned to equity-based transactions Test reasonableness of fair values Evaluate adequacy of disclosure of equity transactions in the notes to the financial statements Determine whether the equity transactions were recorded in the proper period 13-56
AUDITING IN PRACTICE - DEFICIENCIES IN SUBSTANTIVE PROCEDURES RELATED TO EQUITY TRANSACTIONS: INSIGHTS FROM THE PCAOB Address and evaluate the substance, business purpose, or significant terms of the equity arrangements Consider the accounting principles potentially applicable to the equity transactions 13-57
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 13-58
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 13-59
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 13-60
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 with the transfer agent information on issued stock Account for and vouch all proceeds from stock issues 13-61
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 13-62
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 13-63