271258981-Boynton-SM-Ch-17.doc

CHAPTER 17 AUDIT

ING THE INVESTING AND

FINANCING

CYCLE Learning Check 17-1.

Investing activities represent the purchase and sale of land, buildings, equipment, and other assets not generally held for resale. In addition, investing activities include the purchase and sale of financial instruments not intended for trading purposes (discussed in chapter 18). Financing activities include transactions and events whereby cash is obtained from or repaid to creditors (debt financing) or owners (equity financing). Financing activities would include, for example, acquiring debt, capital leases, issuing bonds, or issuing preferred or common stock. Financing activities would also include payments to retire debt, reacquiring stock (treasury stock), and the payment of dividends.

17-2. When auditing the investing and financing cycles auditors typically address the following issues: 

What assets are necessary to support the operations of the entity, and what are management’s long-range plans for growing the entity’s asset base?

Answering this question assists the auditor in developing

expectations of long-term assets needed to support operations.

Solutions Manual to Modern Auditing: Copyright 

2005, John Wiley and Sons, Inc.

17-1



What assets were acquired, or disposed of, during the period? Answering this question confirms the auditor’s expectations regarding assets needed to operate effectively.

It also assists the auditor in

developing expectations of regarding financing activities. 

How were newly acquired assets financed? Answering this question completes the audit of the investing and financing cycles.

These cycles are often audited together due to the strong connection between asset acquisition and the financing of those assets. 17-3. Investing activities are critical to a company in the hotel industry as facilities are the primary productive asset. The location and quality of hotel facilities are directly related to revenues and represent a substantial proportion of the asset side of the balance sheet. Due to the long-term nature of these assets they are usually financed with long-term mortgages. Alternatively, buildings are only necessary to house the process of computer assembly and often these facilities may be leased rather than purchased. A computer assembler may even consider an operating lease rather than a capital lease.

The core processes for the computer

assembler are marketing and purchasing and long-term assets are primarily a support function. 17-4.

a.

Audit objectives for plant assets can be summarized as follows: Specific Audit Objectives Transaction Objectives Occurrence. Recorded acquisitions of plant assets (EO1), disposals of plant assets (EO2), and repair and maintenance transactions (EO3) represent transactions that occurred during the year. Completeness. All acquisitions of plant assets (C1), and disposals of plant assets (C2), and repair and maintenance transactions (C3) that occurred during the period were recorded. Accuracy. Acquisitions of plant assets (VA1), disposals of plant assets (VA2),



17-2

and repair and maintenance transactions (VA3) are accurately valued using GAAP and correctly journalized, summarized and posted. Transactions for depreciation expense are properly valued (VA5). Cutoff. All acquisitions of plant assets (EO1 and C1), and disposals of plant assets (EO2 and C2), and repair and maintenance transactions (EO3 and C3) have been recorded in the correct accounting period. Classification. All acquisitions of plant assets (PD1), and disposals of plant assets (PD2), and repair and maintenance transactions (PD3) have been recorded in the proper accounts. Balance Objectives Existence. Recorded plant assets represent productive assets that are in use at the balance sheet date (EO4). Completeness. Plant assets balances include the effects of all applicable transactions during the period (C4). Rights and Obligations. The entity owns or has rights to all recorded plant assets at the balance sheet date (RO1). Valuation and Allocation. Plant assets balances are stated at cost (VA4), less accumulated depreciation (VA5), and are written down for material impairments (VA6). Disclosure Objectives Occurrence and Rights and Obligations.

Disclosed plant and equipment

events and transactions have occurred and pertain to the entity (PD4). Completeness. All PP&E disclosures that should have been included in the financial statements have been included (PD5). Understandability. All PP&E information is appropriately presented and information in disclosures is understandable to users (PD6). Accuracy and Valuation. PP&E information is disclosed accurately and at appropriate amounts (PD7).

b.

The audit objectives for natural resources and intangible assets would be quite similar to those for plant assets.

The natural

resource issues are almost identical and the auditor needs to consider the issues associated with depletion of assets.

With

respect to intangible assets, there are significant issues associated with the valuation of intangibles at acquisition, the amortization of intangibles, and the impairment of intangibles. Solutions Manual to Modern Auditing: Copyright 


17-3

17-5.

a.

Following are several examples of analytical procedures and how they might be used to identify potential misstatements. Ratio Fixed

Asset

Audit Significance An unexpected increase in fixed asset turnover may

Turnover

indicate the failure to record or capitalize depreciable

Total Asset Turnover

assets. An unexpected increase in total asset turnover may indicate the failure to record or capitalize depreciable assets. An unexpected increase or decrease in the depreciation

Depreciation Expense

as

a

Percent of Property, Plant

expense as a percent of depreciable assets may indicate an error in calculating depreciation.

and

Equipment Repair Expenses to

An unexpected increase in repair and maintenance

Net Sales

expense may indicate the possibility that assets that should be capitalized have been expensed.

b.

Inherent risk may be low for the existence assertion for plant assets as they are not vulnerable to theft and they are easy to observe. However, inherent risk may be moderate to high for issues of completeness associated with the recording of capital leases, the existence

of

various

capitalized

expenditures,

or

with

the

accounting estimate associated with depreciation expense. c.

The same system of internal control that governs normal day to day expenditures also applies to the acquisition of plant assets. Additional controls that might not apply to routine expenditures include the fact that due to the size and long-term implications of acquisitions of plant assets, they are normally subject to a capital budgeting process and review by the board of directors (or committee of the board).

Depreciation policies and useful lives

should be reviewed by a disclosure committee. Solutions Manual to Modern Auditing: Copyright 


17-4

17-6.

a.

In a first time audit, the auditor undertakes an investigation of the beginning balances and the ownership of major units of plant currently in service. In a recurring engagement, the auditor only has the responsibility for determining that the beginning balances agree with the adjusted balances in the preceding year's working papers.

b.

17-7.

a.

The substantive tests that apply to three or more assertions are: 

Perform analytical procedures.



Vouch plant asset additions to supporting documentation.



Vouch plant asset disposals to supporting documentation.



Review entries to repairs and maintenance expense.



Inspect plant assets.



Examine title documents and contracts.



Review provisions for depreciation

Applying analytical procedures involves the use of ratios and other analytical techniques. This test applies to all assertion categories except rights and obligations.

b.

Inspecting plant assets generally involves physical inspection of additions to plant assets and touring other plant assets while being alert to evidence of additions and disposals not included on client schedules and to conditions that bear on the proper valuation and classification of plant assets. This test also relates to all assertion categories except rights and obligations.

c.

Examining title documents and lease contracts involves the scrutiny of these documents for such information as ownership



17-5

rights and contract terms. This test relates primarily to the existence or occurrence, rights and obligations, valuation or allocation, and presentation and disclosure assertions. d.

Vouching plant asset additions involves testing from the accounting records to supporting documentation. This test provides evidence for the existence or occurrence, rights and obligations, and valuation or allocation assertions.

17-8. The procedures that may be useful to the auditor in determining whether all plant asset retirements have been recorded are: 

Analyze the miscellaneous revenue account for proceeds from sales of plant assets.



Investigate the disposition of facilities associated with discontinued product lines and operations.



Trace retirement work orders and authorizations for retirements to the accounting records.

17-9



Review insurance policies for termination or reductions of coverage.



Make inquiry of management as to retirements. a.

In reviewing depreciation entries and computations, the auditor seeks evidence on the reasonableness, consistency, and accuracy of depreciation charges. The factors pertaining to reasonableness include (a) the client's past history in estimating useful lives, (b) the remaining useful lives of existing assets, (c) the gains and losses experienced on the sale of assets, and (d) industry practices. For consistency, the auditor can obtain information about the depreciation methods used from a review of schedules and inquiry of the client. The accuracy of depreciation charges can be verified by recalculation.



17-6

b.

The auditor should evaluate whether the client has appropriately accounted for the impairment of plant assets when there has been a material change in the way an asset is used, or when there has been a material change in the business environment. The evidence to

evaluate

impairment

is

based

on

an

estimate

undiscounted future cash flows from the asset.

of

the

Based on the

criteria established in FASB 121, an auditor should consider that the value of an asset is impaired when the undiscounted future cash flows from an asset are less than the book value of the asset. 17-10. a.

The financing cycle includes transactions and events whereby cash is obtained from or repaid to creditors (debt financing) or owners (equity financing). Financing activities would include, for example, acquiring debt, capital leases, issuing bonds, or issuing preferred or common stock. Financing activities would also include payments to retire debt, reacquiring stock (treasury stock), and the payment of dividends.

b.

The financing cycle interfaces with the expenditure cycle when cash is disbursed for bond interest, the redemption of bonds, payment of cash dividends, and the purchase of treasury stock.

17-11.

The audit objectives for the financing cycle are: Specific Audit Objectives Transaction Objectives Occurrence. Recorded debt (EO1), interest cost (EO2), and equity (EO3) represent transactions that occurred during the year. Completeness. All debt (C1) and interest costs incurred (C2), and equity transactions (C3) that occurred during the period were recorded. Accuracy. Debt (VA1), interest costs (VA2), and equity transactions (VA3) transactions

are

accurately

valued


using

GAAP

and

correctly

journalized,


17-7

summarized and posted. Cutoff. All debt (EO1 and C1), interest cost (EO2 and C2), and equity transactions (EO3 and C3) have been recorded in the correct accounting period. Classification. All debt (PD1), interest cost (PD2), and equity transactions (PD3) have been recorded in the proper accounts. Balance Objectives Existence. Recorded debt (EO4) and equity (EO5) exist at the balance sheet date. Completeness. All debt (C4) and equity (C5) is recorded at the balance sheet date. Rights and Obligations. All recorded debt balances are the obligations of the entity (RO1), and equity balances represent owner’s claims on the reporting entity’s assets (RO2). Valuation and Allocation.

Debt (VA4), and equity (VA5) balances are properly

valued in accordance with GAAP. Disclosure Objectives Occurrence and Rights and Obligations. Debt (PD4) and equity (PD8) disclosures have occurred and pertain to the entity. Completeness. All debt (PD5) and equity (PD9) disclosures that should have been included in the financial statements have been included. Understandability. All debt (PD6) and equity (PD10) information is appropriately presented and information in disclosures is understandable to users. Accuracy and Valuation. Debt (PD7) and equity (PD 11) information is disclosed accurately and at appropriate amounts.

17-12. a.

There is considerable variation in the importance of long-term debt in financial statements. In some companies with strong free cash flows, debt is immaterial. In other companies, such as public utilities, long-term debt may be more than 50% of total equities. Stockholder’s equity is clearly material to the balance sheet. The income statement effects and the effect of dividends on the retained earnings statement is often material. Inherent risk for financing transactions is generally moderate as transactions occur infrequently.

b.

Following are several examples of analytical procedures and how they might be used to identify potential misstatements in debt financing transactions.



17-8

Ratio

Audit Significance

Free Cash Flow

Negative free cash flows indicate the need for, and approximate amount of, expected financing to prevent

Interest

Bearing

drawing down on cash or investments. Provides a reasonableness of the entity’s proportion of

Debt to Total Assets

debt

Shareholders’

experience or industry data. Provides a reasonableness of the entity’s proportion of

Equity

to

Assets Comparing

Total

that

equity

that

may

may

be

be

compared

with

compared

with

prior

prior

years’

years’

Return

experience or industry data. If a company is able to generate a higher rate of return

on Assets with the

on assets than its incremental cost of debt, this is a

Incremental Cost of

signal that an entity may use debt financing to expand

Debt

the assets and earnings of the entity.

Current Portion of

A test of the entity’s ability to service its financing

Debt and Dividends

obligations. Ratios less than 1.0 indicate potential

to Cash Flow from

liquidity problems.

Operations Times Interest

A test of the entity’s ability to generate earnings to

Earned

cover cost of debt service. Ratios less than 1.0 indicate that the entity’s earnings are insufficient to cover

Interest Expense to

financing costs. A reasonableness test of recorded interest expense that

Interest

should approximate the entity’s average cost of debt

Bearing

Debt

17-13.

Control

capital.

risk

as

also

low

as

financing

transactions

receive

considerable attention from senior management and the board of directors that carefully monitor the acquisition and retirement of debt. 17-14.

The functions that relate to financing cycle transactions include:



Authorizing bonds and capital stock



Issuing bonds and capital stock



17-9



Paying bond interest and cash dividends



Redeeming and reacquiring bonds and capital stock



Recording financing transactions

17-15.

Because of the nature and materiality most types of long-term debt

transactions, inherent risk is often moderate to high for all related account balance assertions. Based on consideration of these factors and any relevant control risk assessments, an appropriate level of detection risk is determined for each significant assertion related to long-term debt balances. Many auditors follow a primarily substantive approach to longterm debt because of the efficiency and effectiveness of using confirmations to audit a small population size.



17-10

17-16.

The substantive tests that apply to the existence or occurrence and

valuation or allocation assertions for long-term debt balances are. EO Verify accuracy of balances, schedules,

VA X

and subsidiary ledgers (perform initial procedures) Perform analytical procedures. X Vouch entries in long term debt and X

X X

related income statement accounts Review authorizations and contracts X Confirm debt with lenders and bond X

X X

trustees Recalculate interest expense

X

17-17. a.

In vouching entries to long-term debt accounts, the direction of the substantive

test

is

from

recorded

entries

to

supporting

documentation. This test pertains to the existence or occurrence, completeness, rights and obligations, and valuation or allocation assertions. b.

In confirming debt, the auditor has direct communication with lenders and bond trustees and the responses are returned directly to the auditor. This test relates to four assertions: existence or occurrence, completeness, rights and obligations, and valuation or allocation.

c.

In recalculating interest expense, the auditor re-performs the computations made by the client. This test relates primarily to valuation or allocation.

17-18.

Inherent risk for stockholders' equity balances should be low.

However, the acceptable level of detection risk for the existence or occurrence and completeness assertions for capital stock are likely to be high when the company uses a registrar and transfer agent. For the other Solutions Manual to Modern Auditing: Copyright 


17-11

assertions, detection risk may be moderate. Again, many auditors follow a primarily substantive approach to auditing shareholder’s equity because of the efficiency and effectiveness of using confirmations (registrar or transfer agent) to audit a small population size. 17-19.

The substantive tests that apply to the existence or occurrence and

completeness assertions for stockholders' equity balances are Perform analytical procedures Vouch entries to capital stock accounts Vouch entries to retained earnings Review articles of incorporation and bylaws Review authorizations and terms of stock issues Confirm shares outstanding with registrar

EO X X X X X and X

transfer agent Inspect stock certificate book Inspect certificates of shares held in treasury

17-20.

X X

C X

X X X

Following a several examples of analytical procedures and how

they might be used to identify potential misstatements in shareholder’s equity transactions. Ratio

Audit Significance

Return on common

Provides a measure of the rate of return generated on

stockholders’ equity

the common shareholders’ investment. Auditors should understand the competitiveness factors that allow a

Equity

to

total

company to obtain unusually high returns. Provides a reasonableness of the entity’s proportion of

liability and equity

equity

Dividend

experience or industry data. Auditors would normally expect low dividend payout

payout

rate

that

may

be

compared

with

prior

years’

rates for high growth companies that need reinvested earnings to fund investments in working capital and

Earnings per share

long-term assets. Earnings per share is useful for comparisons with price



17-12

Ratio

Audit Significance per share.

This ratio can be compared with industry

Sustainable growth

price earnings ratios for reasonableness. Provides an estimate of rate of sales growth that can be

rate

obtained without changing the entity’s profitability or financing structure. The auditor should expect changes in the financing structure when sales grow significantly faster than the sustainable growth rate.

17-21.

Various value-added services that the auditor might offer to a client

related to the investing and financing cycles include: 

Benchmarking the return generated by investing activities against competitors.



Independent review of strategic plans for investing activities.



Explanation of the advantages and disadvantages of bank financing, mortgage financing, lease financing, financing that may be available from insurance companies or other entities, or various classes of preferred stock.



Many investments are accomplished through merger or acquisition. A CPA firm may provide expertise in guiding a company through a merger or acquisition. This service would include identifying possible acquisitions candidates, helping an entity evaluate the potential benefits and risks associated with an acquisitions, as well as how to structure the acquisition.

Comprehensive Questions (Estimated time - 25 minutes)



17-13

17-22.

The key internal controls related to Grant's property, equipment

and related transactions that Harris may consider in assessing control risk include the following: 

Advance approval in accordance with management's criteria is required for property and equipment transactions.



Approval authority for transactions above an established dollar value is required at a higher level, such as the board of directors.



Property and equipment transactions are adequately documented.



There are written policies covering capitalizing expenditures, classifying leases, and determining estimated useful lives, salvage values, and methods of depreciation and amortization.



There are written policies covering retirement procedures that include serially numbered retirement work orders, stating reasons for retirement and bearing appropriate approvals.



There are adequate policies and procedures to determine whether property and equipment are received and properly recorded such as a system that matches purchase orders, receiving reports and vendors' invoices.



There are adequate procedures to determine whether dispositions of property and equipment are properly accounted for and proceeds, if any, are received in accordance with management's authorization.



A property and equipment subsidiary ledger is maintained showing additions,

retirements,

and

depreciation,

and

the

ledger

is

periodically reconciled. 

Property and equipment is physically inspected and reconciled at reasonable intervals with independently maintained property and equipment records.



An annual budget is prepared and monitored to forecast and control acquisitions and retirements of property and equipment.



17-14



Reporting procedures assure prompt identification and analysis of variances between authorized expenditures and actual costs.



Property and equipment is protected by adequate safeguards.



Property

and

equipment

is

insured

in

accordance

with

management's authorization. 

Documents evidencing title and property rights are periodically compared with the detailed property records.



The entity employs internal auditors to test whether the internal control structure policies and procedures are operating effectively.



17-15

17-23. a.

The following matrix identifies the substantive tests pertaining to property, plant and equipment and the audit objectives pertaining to each.

Category

Substantive Test

Specific

Initial

1) Obtain and understanding of the entity and its environment and

Audit

Objectives Procedure

determine:

s

a) The significance of plant assets, and changes in plant assets, to

All

the entity. b) Key economic drivers that influence the entity’s acquisition of plant assets. c)

Industry standards for the extent to which the entity is capital intensive and the impact of plant assets on earnings.

d) Understand the degree to which the company has used variable interest entities and operating leases to finance assets.

VA4

2) Perform initial procedures on plant assets balances and records that will be subjected to further testing.

EO1, EO4

a) Trace beginning balance for plant assets and accumulated depreciation to prior year’s working papers. b) Review activity in general ledger accounts plant assets and depreciation expense and investigate entries that appear unusual in amount or source. c)

VA4

Obtain client-prepared schedules of plant asset additions, retirements and depreciation expense, and determine that they accurately represent the underlying accounting records from

VA4

which they were prepared by: i)

Footing and crossfooting the schedules and reconciling the totals with increases or decreases in the related general ledger balances during the period.

ii) Analytical Procedure s

Testing agreement of items on schedules with entries in

related general ledger accounts. 3) Perform analytical procedures:

All

a) Develop an expectation for plant assets using knowledge of the industry and the entity’s business activity b) Calculate ratios: i)

Fixed asset turnover

ii)

Depreciation expense as a percent of sales

iii) Repair and maintenance expense as a percent of sales iv) Rate of return on assets



17-16

Category

Substantive Test

Specific

Audit

Objectives c)

Analyze ratio results relative to expectations based on prior

years, industry data, budgeted amounts, or other data. 4) Vouch plant asset additions to supporting documentation.

EO1,

Details of

5) Vouch plant asset disposals to supporting documentation.

VA4

Transactio

6) Vouch a sample of entries to repairs and maintenance expense.

EO2,

ns

7) Vouch the recording of new capital lease and operating leases to

VA4

Tests

of

underlying contracts.

EO3,

VA1,

PD1,

EO4,

VA2,

PD2,

EO4,

VA3,

PD3,

EO4,

VA4 EO1, C1, VA1, PD1 Tests

of

8) Inspect plant asset.

Details of

a) Inspect plant asset additions.

EO4

Balances

b) Tour other plant assets and be alert to evidence of additions

EO4, C1, C2, C4

and disposals not included on client’s schedules and to conditions that bear on the proper valuation and classification of the plant assets. Tests

of

RO1

9) Examine title documents and contracts 10) Evaluate the fair presentation of depreciation

expense

by

Details of

evaluating the appropriateness of useful lives and estimated

Accountin

salvage values.

VA6

g

11) Determine if any significant events have resulted in an impairment

Estimates Tests of

of the value of plant assets. 12) Compare statement presentation with GAAP.

Details of

a) Determine that plant assets and related expenses, gains, and

Presentati

losses are properly identified and classified in the financial

on

statements.

and

Disclosure

VA5

PD4, PD7 PD4, PD7

b) Determine the appropriateness of disclosures related to the cost, book value, depreciation methods, and useful lives of major classes of plant assets, the pledging of plant assets as

PD5

collateral and the terms of lease contracts. c)

Evaluate the completeness of presentation and disclosures for receivables in drafts of financial statements to determine

PD6

conformity to GAAP by reference to disclosure checklist. d) Read

disclosures

and

independently

evaluate

their

understandability.

b.

Is Adjustment

Item

Audit Reasons Why Audit Adjustment or Reclassification is Required or Not Required

or



17-17

No.

Reclassification Required?

1.

Yes or No Yes

Commissions paid to real estate agents are costs directly related to the acquisition of the property and should be included in the land cost. Costs of removing, relocating, or reconstructing property of others to acquire possession are costs that are directly attributable to conditioning the property for use and should be included in land costs. An adjustment is required for these items so that total land costs can properly be included in Property, Plant

2.

No

& Equipment. No adjustment is required because clearing costs are costs that are directly attributable to conditioning the property for use and should be included in land costs

3.

Yes

which are part of Property, Plant & Equipment. Since clearing costs are costs of the land, amounts realized from the sale of materials recovered, such as timber and gravel, should be a reduction of the cost of the land and should not be recorded as other

4.

Yes

income. All costs relating to the purchase of machinery and equipment should be capitalized. For purchased items such costs would include invoice price, freight costs, and unloading charges. Royalty payments, however, should not be included in the cost of the machinery. Such payments should be charged to expenses as they accrue. The machinery costs, other than royalty payments, should be included in Property, Plant & Equipment.



17-18

17-24.

(Estimated time - 20 minutes)

Substantive tests that Pierce should use in examining Mayfair's mobile construction equipment and related depreciation would include the following: 

Determine that the equipment account is properly footed.



Determine that the subsidiary accounts agree with controlling accounts.



Obtain, or prepare, an analysis of changes in the account during the year.



Determine that beginning-of-year balances agree with the prior year's ending balances.



Inspect documents in support of additions during the year.



Inspect documents in support of retirements during the year.



Analyze repairs and maintenance for possible reclassifications.



Determine the propriety of accounting for equipment not in current use.



Test the accuracy of equipment and accounting records by o Selecting items from the accounting records and verifying their physical existence. o Selecting items of equipment and locating them in the accounting records. o Evaluate the reasonableness of estimated lives and methods of depreciation used. o Test the calculation of depreciation expense and accumulated depreciation balance. o Apply analytical procedures such as comparing depreciation expense to balance sheet accounts for proper relationship and comparing the current year's depreciation expense with prior year's depreciation expense.



17-19

o Evaluate the financial statement presentation and disclosures for conformity with generally accepted accounting principles. o Review insurance coverage. (Note: Other possible tests in the chapter may also be used.) 17-25.

(Estimated time - 25 minutes) a. Substantive Test 1.

Vouch

entries

2.

of

Financial

Assertion to Existence

retained earnings board

b.

or

Statement c.

Type

of

Evidence occurrence, Documentary

to rights and obligations, and

director valuation or allocation

minutes. Vouch entries in long- All

except

presentation Documentary

term debt accounts to and disclosure board 3.

of

minutes Vouch

director

to

cash Existence

or

occurrence, Mathematical

disbursements journal valuation or allocation and recalculate bond 4.

interest Vouch

5.

brokers advice valuation or allocation Inspect entries in cash Existence or occurrence, Documentary

entries

to Existence

disbursements journal

6.

Vouch

to

board

or

occurrence, Documentary

valuation or allocation

of Existence

or

occurrence, Documentary,

director authorization, valuation or allocation and

confirmation

consider

confirming

with

transfer agent. Solutions Manual to Modern Auditing: Copyright 


17-20

a. Substantive Test

b.

Financial

7.

Recalculate

Assertion Valuation or allocation

8.

interest expense Inspect cash All

except

Statement c.

consider

confirmation

and

confirming

9.

with bond trustee. Vouch to board

of Presentation and disclosure

10.

directors minutes Vouch to board

of Existence

or

director minutes and valuation

or

and

Evidence Mathematical

supporting

documentation

review

Documentary

occurrence, Documentary allocation,

authorizations rights and obligations, and

terms

of

stock presentation and disclosures

issues 17-26. a.

(Estimated time - 25 minutes) The substantive tests that Andrews should employ in examining the loans are as follows: 

Obtain an understanding of the business purpose of the loans made by the president.



Confirm the loans, including terms, by direct communication.



Re-compute (or verify) interest expense and interest payable.



Re-compute the long-term and short-term portions of the debt.



Review minutes of meetings of the board of directors for proper authorization.



of

presentation Documentary,

disbursements journal and disclosure entry,

Type

Verify payments made during the year and transactions after the year end.



17-21



Read

(notes

to)

the

financial

statements

and

the

loan

agreements, and evaluate the adequacy of disclosure and compliance with restrictions.  b.

Obtain a management representation letter.

Broadwall's financial statements should disclose the following information concerning the loans from its president: 

The nature of the related-party relationship



The dollar amounts of the loans



Amounts due to the president and, if not otherwise apparent, the terms and manner of settlement.

17-27.


The substantive tests that Jones should apply in examining the common stock and treasury stock accounts are as follows: 

Review the corporate charter to verify details of the common stock such as authorized shares, par value, etc.



Obtain or prepare an analysis of changes in common stock and treasury stock accounts.



Compare opening balances with prior year's working papers.



Foot the total shares outstanding in the stockholders' ledger and stock certificate book.



Determine authorization for common stock issuance and treasury stock transactions by inspecting the minutes of the board of directors' meetings.



Verify capital stock issuance by examining supporting documentation and tracing entries into the records.



Verify

treasury

stock

transactions

by

examining

supporting

documentation and tracing entries into the records. Solutions Manual to Modern Auditing: Copyright 


17-22



Examine all certificates canceled during the year.



Inspect all treasury stock certificates owned by the client.



Reconcile the details of the individual certificates in the stock certificate book with the individual shareholders' accounts in the stockholders' ledger.



Compare the total in the stockholders' ledger and the stock certificate book to the balance sheet presentation.



Re-compute the weighted average number of shares outstanding.



Compare the financial statement presentation and disclosure with generally accepted accounting principles.



Determine the existence of and proper accounting for common stock and treasury stock transactions occurring since year-end.



Obtain written representations concerning common and treasury stock in the client representation letter.

17-28.


The proposal for the limitation of procedure is not justified by the stated facts. Although the transfer agent and the registrar know the number of shares issued, they do not necessarily know the number of shares outstanding. Furthermore,

the

audit

of

capital

stock

includes

more

than

determining the number of shares outstanding. For example, the auditor must determine what authorizations exist for the issuance of shares, what assets were received in payment of shares, how the transactions were recorded, and what subscription contracts have been entered into. Confirmation from the registrar could not help in determining these things. In addition to confirmation from the registrar, the audit of capital stock might include the following procedures for which the purposes are briefly indicated:



17-23



Examine the corporation charter to determine the number of shares authorized and the special provisions relating to each class of stock if more than one class is authorized.



Examine

minutes

of

stockholders'

and

directors'

meetings

to

determine authorization for appointments of the registrar and the transfer agent, and to determine authorization for the issuance or reacquisition of shares. 

Examine provisions relating to capital stock in the corporation law of the state of incorporation to determine any special provisions such as, for example, those relating to the issuance of no-par stock.



Analyze the capital stock accounts to obtain an orderly picture of stock transactions for use as a guide to other auditing procedures and as a permanent record.



Trace the consideration received for capital stock into the records to determine what consideration has been received and how it has been recorded.



Examine and schedule treasury stock and review entries for treasury stock to determine the existence of treasury stock, as authorized, and to determine that a proper record has been made.



Review registrar's invoices and cash disbursements to determine that original issue taxes have been paid.



Compare dividends with stock outstanding at dividend dates to determine that dividends have been properly paid and also to substantiate the stock outstanding.



Review subscription and option contracts, etc., to determine the facts in regard to subscriptions and options and to determine that these facts have been properly recorded and that they are adequately disclosed.

Case Solutions Manual to Modern Auditing: Copyright 


17-24

s 17-29. a.

(Estimated Time – 40 minutes) The economic substance of the patent is the right to produce and sell a particular drug if the drug becomes marketable. The primary issues associated with the recording of the patent is the fair market value of the redeemable preferred stock. If 9% is a market interest rate and no discount or premium is appropriate, then the book value of the patent is appropriately recognized at $10 million. The auditor also will need to consider the appropriate amortization period.

At this point in time the appropriate amortization period

might be 16 years. In the future, the auditor needs be sensitive to impairment in the value of the patent. b.

Audit procedures performed in 20x0 to audit the patent would include: Procedure

Assertion

Obtain and understanding of the business and industry and

All assertions

determine: a) The significance of plant assets, and changes in plant assets, to the entity. b) Key

economic

drivers

that

influence

the

entity’s

acquisition of plant assets. c)

Industry standards for the extent to which the entity is capital intensive and the impact of plant assets on

earnings. Vouch the acquisition of the patent to supporting documentation

Existence

and contracts supporting the transaction and title.

occurrence, and

and rights

obligations,

valuation

or

Evaluate the fair presentation of amortization expense by

allocation Valuation

or

evaluating the appropriateness of useful life.

allocation

Determine the appropriateness of disclosures related to the cost,

Presentation

book value, amortization methods, and useful life of patent.

disclosure



and

17-25

c.

The economic substance of the redeemable preferred stock is debt.

The

security has a fixed rate of return stated as a percentage of the par value of the security and it has a fixed redemption date. Corporate holders of the redeemable preferred stock will enjoy a dividend received deduction for tax purposes.

The company has not appropriately classified the

security as the redeemable preferred stock is debt in economic substance and should be reported as the last item in debt, prior to shareholder’s equity. d.

Audit procedures performed in 20x0 to audit preferred stock would include: Procedure Obtain and understanding of the business and industry and

Assertion All assertions

determine: a) The significance of sources of financing to the entity. b) Key economic drivers that influence the entity’s need for financing and choice of financing. c) Industry

standards

regarding

the

type

of

financing

commonly used within the industry. Review authorization by the board of directors and contracts

Existence

support the transaction.

occurrence,

Confirm terms of contract with the holder of the redeemable

and obligations All assertions

preferred stock. Recalculate interest expense

Valuation

and

Compare statement presentation with GAAP.

allocation Presentation

and

a) Determine

that

long-term

debt

balances

are

properly

and right

disclosure

identified and classified in the financial statements. b) Determine the appropriateness of disclosures concerning all terms, covenants, and retirement provisions pertaining to long term debt. c) Evaluate the completeness of presentation and disclosures for receivables in drafts of financial statements to determine



17-26

Procedure conformity to GAAP by reference to disclosure checklist. d) Read

disclosures

and

independently

evaluate

Assertion their

understandability.

Professional Simulation Audit Procedure s FARS Situatio

Audit Report

Research

n The following table explains the auditing procedures that should be performed associated with the legend identified as a) through h). Legend a) b) c)

Audit Procedure Foot Crossfoot Traced beginning balance to prior year’s working papers and the

d)

general ledger. Vouched additions

e)

invoices, title reports, etc. Vouched disposals to supporting documentation, e.g., bill of sale and

f)

cash receipts Vouched reclassification to supporting documents, title reports and

g)

underlying appraisals, showing the underlying value of the building. Recalculated depreciation expense and evaluated the reasonableness

h)

of depreciation methods, useful lives, and salvage values. Vouched historical cost of disposal to underlying asset schedule with

to

supporting

documentation,

e.g.,

vendors

net book values. FARS Solutions Manual to Modern Auditing: Copyright 


17-27

Research Audit

Audit Report

Situatio

Procedure

n

s

The following quotes are from Statement of Financial Accounting Standards No. 13, Accounting for Leases.

Paragraphs 6 and 7 provide the basis for

determining if the lease is a capital lease or an operating lease. 6.

For purposes of applying the accounting and reporting standards of this Statement, leases are classified as follows: a.

Classifications from the standpoint of the lessee: i.

Capital leases. Leases that meet one or more of the criteria

in paragraph 7. ii. 7.

Operating leases. All other leases.

The criteria for classifying leases set forth in this paragraph and in paragraph 8 derive from the concept set forth in paragraph 60. If at its inception (as defined in paragraph 5(b)) a lease meets one or more of the following four criteria, the lease shall be classified as a capital lease by the lessee. Otherwise, it shall be classified as an operating lease. (See Appendix C for an illustration of the application of these criteria.) a.

The lease transfers ownership of the property to the lessee by the end of the lease term (as defined in paragraph 5(f)).

b.

The lease contains a bargain purchase option (as defined in paragraph 5(d)).

c.

The lease term (as defined in paragraph 5(f)) is equal to 75 percent or more of the estimated economic life of the leased property (as defined in paragraph 5(g)). However, if the beginning of the lease



17-28

term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. d.

The present value at the beginning of the lease term of the minimum lease payments (as defined in paragraph 5(j)), excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property (as defined in paragraph 5(c)) to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by him. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

A lessor

shall compute the present value of the minimum lease payments using the interest rate implicit in the lease (as defined in paragraph 5(k)). A lessee shall compute the present value of the minimum lease payments using his incremental borrowing rate (as defined in paragraph 5(1)), unless (i) it is practicable for him to learn the implicit rate computed by the lessor and (ii) the implicit rate computed by the lessor is less than the lessee's incremental borrowing rate. If both of those conditions are met, the lessee shall use the implicit rate. The lease described in the simulation meets all the criteria to be classified as an operating lease. Also relevant to the evaluation of this lease is FIN 46. Shailer Enterprises is a variable interest entity that should be consolidated ANU’s financial statements. FIN 46 indicates that an enterprise that consolidates a variable interest entity is Solutions Manual to Modern Auditing: Copyright 


17-29

the primary beneficiary of the variable interest entity. The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity's expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary interests in an entity. The ability to make decisions is not a variable interest, but it is an indication that the decision maker should carefully consider whether it holds sufficient variable interests to be the primary beneficiary. An enterprise with a variable interest in a variable interest entity must consider variable interests of related parties and de facto agents as its own in determining whether it is the primary beneficiary of the entity. ANU is it primary beneficiary that absorbs the majority of any losses to the bank or Shailer Enterprises and received the expected returns if the value of the property increases. The appropriate paragraphs of FIN 46 follow. Shailer enterprises meets the following conditions of a variable interest entity based on paragraph 2 to the summary of FIN 46. 2.

The equity investors lack one or more of the following essential characteristics of a controlling financial interest: a.

The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

b.

The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities

c.

The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.

Paragraph 16 of FIN 46 defines a primary beneficiary. 16.

For purposes of determining whether it is the primary beneficiary of a variable interest entity, an enterprise with a variable interest shall treat



17-30

variable interests in that same entity held by its related parties as its own interests.

For purposes of this Interpretation, the term related parties

includes those parties identified in FASB Statement No. 57, Related Party Disclosures, and certain other parties that are acting as de facto agents of the variable interest holder.

The following are considered to be de

facto agents of an enterprise: a.

A party that cannot finance its operations without subordinated financial support from the enterprise, for example, another variable interest entity of which the enterprise is the primary beneficiary

b.

A party that received its interests as a contribution or loan from the enterprise

c.

An officer, employee, or member of the governing board of the enterprise

d.

A party that has (1) an agreement that it cannot sell, transfer, or encumber its interests in the entity without the prior approval of the enterprise or (2) a close business relationship like the relationship between a professional service provider and one of its significant clients.

Further, paragraph 14 of FIN 46 explains why the primary beneficiary should consolidate the variable interest entity in the financial statements. 14.

An enterprise shall consolidate a variable interest entity if that enterprise has a variable interest (or combination of variable interests) that will absorb a majority of the entity's expected losses if they occur, receive a majority of the entity's expected residual returns if they occur, or both. An enterprise shall consider the rights and obligations conveyed by its variable interests and the relationship of its variable interests with variable interests held by other parties to determine whether its variable interests will absorb a majority of a variable interest entity's expected



17-31

losses, receive a majority of the entity's expected residual returns, or both. A direct or indirect ability to make decisions that significantly affect the results of the activities of a variable interest entity is a strong indication that an enterprise has one or both of the characteristics that would require consolidation of the variable interest entity.

If one

enterprise will absorb a majority of a variable interest entity's expected losses and another enterprise will receive a majority of that entity's expected residual returns, the enterprise absorbing a majority of the losses shall consolidate the variable interest entity.

The economic substance of this lease arrangement is that Shailer Enterprises is dependent upon ANU to obtain the loan, and ANU enjoys the benefits if the value of the real estate increases and suffers the loss (through the contingent rent payment) if the value of the real estate decreases. As a result, ANU should consolidate the financial statements of Shailer Enterprises as part of its own financial statements.



17-32

Audit Report Audit

FARS

Situatio

Procedure

Research

n

s

INDEPENDENT AUDITOR’S REPORT To the Board of Directors of Alpha Net Universal We have audited the balance sheets of Alpha Net Universal as of December 31, 20x7 and 20x6, and the related statements of income, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The Company has failed to consolidate the financial statements of Shailer Enterprises, a variable interest entity, that, in our opinion, should be consolidated in order to conform with generally accepted accounting principles.

If these financial statements

had been consolidated, property would be increased by $10 Million, long-term debt by $9 Million, and Shareholder’s equity would be increased by $1 million. In our opinion, except for the effects of not consolidating the financial statements of Shailer Enterprises as discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Alpha



17-33

Net Universal as of December 31, 20x7 and 20x6 and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.

Signature Date



17-34

271258981-Boynton-SM-Ch-17.doc

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