Chapter 15 - Debt and Equity Capital
CHAPTER 15
Debt and Equity Capital
Review Questions
15-1
A trust indenture indenture is drawn to protect protect the position position of of bondhol bondholders ders by imposin imposing g restrictions restrictions upon the borrowing borrowing corporation. corporation. One of the the most most common common of these these restriction restrictionss is that the company company must not declare diidends that would cause the wor!ing capital to fall below a specified amount. An oerly generous diidend policy could leae the company so short of cash as to endanger the position of bondholde bondholders. rs.
15-"
#estrictions #estrictions comm commonly only imposed imposed on a borrowing borrowing company by longlong-term term creditors creditors relate to $a% diidend payments& $b% acquisition of property and equipment& $c% increases in managerial compensation and $d% acquisition of additional debt. 'uch actions are usually usua lly permitted only only if they will not reduce the current ratio and amount of wor!ing capital below specified leels& or increase the debt to equity ratio aboe a specified leel. Creation of a sin!ing fund is another common requirement designed to assure that cash will be aailable to pay the long-term debt at maturity.
15-(
)he trustee trustee protects protects the interests interests of the bondh bondhold olders ers by accounting accounting for the issuance issuance and redempt redemption ion of bond certificates& determining that proisions of the borrowing agreement are obsered by the corporation& and reporting periodically on the amount of the liability and of any related sin!ing fund. )his wor! by the trustee leaes little opportunity for either error or fraud in the issuance& sericing& or redemption of bonds.
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)he auditor auditorss should should reque request st from the trustee trustee respons responsibl iblee for the the deben debenture ture issue issue an e+act e+act description of the issue& a statement of the amount outstanding& amounts redeemed or purchased during the year& and the balance of the sin!ing fund.
15-5
)he source sourcess of inform informatio ation n for preparatio preparation n of the notes notes payable payable analy analysis sis for the the audit audit wor!ing wor!ing papers are the notes notes payable register register $if $if one is is maintained%& maintained%& or or duplicate copies of the notes notes issued. issued. ,nformation is also obtainable from the general ledger controlling account for notes payable and from the paid notes that matured during the year. ,nformation about interest e+pense& interest payable& and prepaid prepaid interest interest may be be obtained obtained from the the cash disbursemen disbursements ts ournal and the genera generall ledger.
15-1
Chapter 15 - Debt and Equity Capital
15-
)he confirmation of notes payable to financial institutions is accomplished as part of he procedure for confirming cash on deposit.
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)esting the reasonableness of the ,nterest E+pense account may disclose the e+istence of unrecorded notes payable upon which interest payments are being made.
15-0
)o satisfy themseles that all interest-bearing liabilities of the client are recorded& the auditors include questions about liabilities to financial institutions in the standard confirmation for deposits and loans at financial institutions& reiew minutes of directors meetings& analy2e the ,nterest E+pense account to detect payments applicable to unrecorded long-term debt& and reiew the sources of cash receipts and the financing of property acquisitions. A liability representation stating that all !nown liabilities hae been recorded is also obtained from the client.
15-3
4ayments of notes during the course of the e+amination may furnish eidence supplementing confirmation with payees. #enewal of notes payable may affect the balance sheet presentation of the liability.
15-1 )he auditors do not udge the legality of a bond issue6 they do& howeer& need to study the bond indenture carefully so that they can determine the information to be presented in the balance sheet and the notes to the financial statements. )his study is also necessary so that they can determine that standard procedures for authori2ation hae been followed and that the company is complying with any restrictie coenants pertaining to wor!ing capital& diidends& etc. 15-11 )he (-year bonds payable issued by 7ansfield Corporation should be classified as a current liability when the time remaining to maturity is no more than one year or the operating cycle $whicheer is longer%. )his change in classification from long term to current should be made only if the bonds are to be paid from current assets. ,f 7ansfield has arranged to refinance the maturing bonds on a long-term basis& there will be no use of current assets to pay the bonds and they will continue to be shown as a long-term liability. 15-1" 8o& the points coered do not constitute a sufficient erification of long-term liabilities. Other matters include consideration of internal control& the e+tent of compliance with restrictions imposed by financing agreements& computation of interest e+pense and accrued interest payable& identification of pledged assets& and determination of proper balance sheet presentation of longterm liabilities and related data. 15-1( )ransactions affecting owners equity accounts are generally few in number but substantial in amount6 the audit time required for this part of the e+amination is relatiely small. Detailed reiew of indiidual transactions is therefore appropriate6 the tests of controls that are so important for assets and current liabilities are much less applicable to owners equity. 15-1* )he most important single internal control procedure relating to capital stoc! transactions consists of utili2ing the serices of an independent registrar and stoc! transfer agent. )his action eliminates the problem of handling stoc! certificates and the danger of oerissuance. 15-15 )he primary responsibility of an independent registrar is to aoid oerissuance of stoc!. )his entails the countersigning of each certificate issued and the maintenance of records of certificates issued and canceled.
15-"
Chapter 15 - Debt and Equity Capital
15-1 )he auditors erify the general ledger account for capital stoc! by obtaining or preparing a list of outstanding shares from the open stubs in the stoc! certificate boo!. )his list is also reconciled with the stoc!holder ledger that shows accounts with indiidual stoc!holders. 15-1/ 'toc! certificates are serially numbered by the printer and may be deliered to the corporation in the form of a bound boo! with serially numbered stubs attached. As each certificate is issued& the date& name of holder& and number of shares are filled in on both the certificate and the stub. A list of outstanding shares may be prepared at any time from the open stubs. )he purpose of the stoc! certificate boo! is to preent the oerissuance of stoc! and to maintain control oer capital stoc! transactions. 15-10 )he wor! done by the auditors in the e+amination of Capital 'toc! accounts during an initial audit includes the analysis of these accounts for the entire period since the organi2ation of the corporation& as well as obtaining copies of the articles of incorporation& bylaws& and minutes of meetings of directors and stoc!holders. ,n subsequent audits& this wor! is merely brought up to date by adding an analysis of the eents of the current period. 15-13 )he list of stoc!holders would usually be prepared from the stoc!holder ledger. )his subsidiary ledger is maintained in terms of numbers of shares& rather than in dollars. ,t contains a separate account with each stoc!holder& showing the shares acquired& shares disposed of& and running balance of shares owned. Each entry is also referenced by certificate number. 15-" 9hen assets other than cash are receied for capital stoc!& the alues assigned such assets should be formally stated by resolution of the board of directors. )he par alue of the shares issued for the assets is not an indication of the alue receied. ,f the alues set by the board appear unreasonable& in relation to the mar!et alue of the stoc! or the appraised alue of the assets& the auditors are obligated to inestigate further& and to question whether aluation of the assets is in accordance with generally accepted accounting principles. 15-"1 'ince the )reasury 'toc! account was not encountered by the auditors during their first audit of the corporate client& we may assume that the company acquired treasury shares during the year by purchase& donation from shareholders& in e+change for cancellation of a receiable& or some similar manner. )o determine ust how these shares were acquired and whether they are properly stated at the amount of :(&& the auditors should begin by analy2ing the )reasury 'toc! account. )he treasury stoc! certificates should be inspected and tied in with the account analysis. ,n erifying the entries to the account& the auditors should refer to minutes of directors meetings for authori2ation to acquire the treasury shares and the price authori2ed. )he auditors should also erify the payments made by reference to paid chec!s and stoc!bro!ers adice of purchase& if aailable. ;inally& the auditors should determine in the light of applicable state statutes whether the acquisition of treasury shares was permissible& and whether retained earnings should be restricted by the cost of the shares.
15-(
Chapter 15 - Debt and Equity Capital
15-""
usiness e+penses may hae been paid from personal funds without crediting the proprietorship accounts& and personal e+penses may hae been paid from business funds and recorded by charges to e+pense rather than to the drawings account.
15-*
Chapter 15 - Debt and Equity Capital
Questions Requiring Analysis
15-"/ 'ince the auditors will already hae in their wor!ing papers from prior years audits the terms and requirements of the mortgage note& their wor! in the current e+amination will consist of determining that there has been no change in the principal amount of the notes& that interest payments hae been made in accordance with the terms of the note& and that any requirements as to insurance or other such matters hae been obsered. )he balance payable of the note will be established by direct confirmation with the mortgagee. )he propriety of the interest payments can be tested by independent computation of the interest charges. Any restrictions imposed by the borrowing agreement as to insurance& diidends& other borrowing& or e+penditures for property and equipment will be recorded in the audit wor!ing papers. )he inestigation of these points will& of course& depend upon the precise nature of the restrictions imposed. 15-"0 )he e+istence of a 2ero balance at year-end does not preclude the need for an audit of the 8otes 4ayable to Officers account. 'uch an account reflects related party transactions. ,t is important that the independent auditors ascertain that the 2ero balance resulted from a bona fide repayment of the officers notes& rather than from a temporary ?window-dressing? repayment with the loan being reestablished subsequent to the balance sheet date. )he auditors are also concerned with proper authori2ation and recording of transactions occurring during the year. 15-"3
$a% Armadas default on the note maturing 'eptember ( must be disclosed in notes to the financial statements for the year ended August (1. )his default could affect Armadas status as a going concern& and is a subsequent eent requiring disclosure. $b%
15-(
Een if the default is properly disclosed& the auditors may be unable to issue a standard unqualified opinion on the financial statements. )he financial statements hae been prepared under the assumption that Armada is a going concern. ,f this assumption has become of questionable alidity& the auditors may hae to add e+planatory language to their report about Armadas ability to remain a going concern. $a% @es& the auditors should act upon the information obtained from the telephone call. )he auditors should not engage in eaesdropping& but there is no suggestion of such action in this instance. Auditors certainly are not supposed to close their ears or eyes to the happenings about them during the course of an e+amination. On the contrary& they should be alert to recogni2e significant eidence in any form. )he auditors should immediately inform the president of their interest in accommodation endorsements or any other form of contingent liability.
$b%
)he contingent liability for the accommodation endorsement should be disclosed in a note to the une ( balance sheet. )he note should indicate that the contingent liability was ended during uly by payment by the ma!er at maturity. )he purpose of the disclosure is to ma!e readers of the statement aware that Columbia Corporation has in the past incurred contingent liabilities by accommodation endorsement of notes. )he reader is thus warned of the possibility of such situations arising again& although no such specific suggestion should be made in the note to the financial statements. ,nclusion of the note may also hae the incidental effect of impressing upon the client the importance of contingent liabilities in a statement of financial position.
15-5
Chapter 15 - Debt and Equity Capital
$c%
)he contingent liability might hae been detected by the following auditing proceduresB $1%
$"%
$(% $*%
15-(1
Obtain a liability representation from the client. ,nsistence upon a written statement by officers concerning any loss contingencies of which they hae !nowledge is probably the most effectie way of detecting such items. #eiew the minutes of directors meetings. 4rior approal of such endorsements should be obtained from the board before an officer endorses a note of another company. )he bylaws may prohibit such lending of the companys credit. 'end a confirmation to the clients financial institution specifically confirming the details of any contingent liabilities. #equest the attorneys of the client to adise the auditors directly of any contingent liability of which the attorneys hae !nowledge. ,t is possible that the client may hae discussed with the attorneys the ris! inoled in accommodation endorsements.
$a% Despite the fact that the options hae a higher option price than the stoc!s current price& they may well hae alue. Call options with option prices that are higher than the related stoc! prices are traded on option mar!ets eery day. 7anagement should hae a business aluation e+pert $specialist% alue the options to determine the appropriate amount of compensation cost to be recogni2ed.
$"%
$5% $% $/%
$b% $1% Obtain a copy of the stoc! option plan for the auditors permanent file and become thoroughly familiar with its proisions. )race the approal of the plan to minutes of directors and stoc!holders meetings. $(% 4repare a wor!ing paper for the permanent file showing the number of shares authori2ed by the plan& and the number granted& e+ercised& and e+pired each year. Design the wor!ing paper so that data can be added each year. $*%
15-
Chapter 15 - Debt and Equity Capital
Obe!tive Questions
15-("
7ultiple Choice $a% $(% )he client will not receie proceeds related to redemption of its interest bearing debtit will pay off the debt. $b%
$1% Auditors will test the relationship between interest payments and recorded long term liabilities. 9hen interest payments seem too high& it may be due to the e+istence of unrecorded liabilities. Also& the process of performing procedures to determine who interest is paid to may reeal unrecorded debt.
$c%
$"% 9hen debt proisions are iolated& long term debt often becomes immediately payable& and therefore& a current liability.
$d%
$"% A registrar and transfer agent !eep information on the shares issued& outstanding& and the owners of that stoc!.
$e%
$"% ,t is not customary to confirm stoc!holdings by direct communication with indiidual stoc!holders. ;or an actiely traded stoc!& contacting indiidual stoc!holders would be ery costly and not li!ely to produce a satisfactory proportion of replies.
$f%
$1% )he auditors should trace treasury stoc! purchase transactions to the certificates on hand. ,f the certificates are not on hand& they should be confirmed directly with the custodian. )he articles of incorporation& answer $"%& will not proide information on the details of specific stoc! issuances and treasury stoc! transactions. )here is no interest on the treasury stoc!& and accordingly& answer $(% doesnt relate directly to treasury stoc!. ;inally& it is far more li!ely that the oerall board of directors& not the audit committee& will approe treasury stoc! transactions. )herefore& answer $*% is not correct.
$g%
$1% )ransactions in the owners equity accounts are ery few in comparison with the olume of entries in the other three groups. Consequently& the audit time required for owners equity is usually much smaller than for reenue& assets& or liabilities.
$h%
$(% )he bond trustee will be able to proide information on both the sin!ing fund transactions and the year-end balance.
$i%
$"% )he auditors e+amination of long-term debt always includes an e+amination of copies of debt agreements to ensure the client is not in iolation of the coenants of these agreements. Answer $1% describes a procedure that is not performed. Answers $(% and $*% describe procedures that may be performed but they pertain more directly to other accounts.
15-/
Chapter 15 - Debt and Equity Capital
$%
$1% Capital stoc! transactions should all be approed by the clients board of directors. Answer $"% is incorrect because there will be no cash receipt for stoc! repurchase transactions. Answers $c% and $d% are incorrect because cash disbursements will not be recorded and numbered stoc! certificates will not be on hand after stoc! sales.
$!%
$(% An audit obectie for owners equity is to determine that presentation and disclosure is appropriate. Answer $1% is incorrect because owners equity does not include long-term debt. Answer $"% is incorrect because common stoc! should not be alued at current mar!et alue. Answer $*% is incorrect because the term equity accounting rule aluationsF is of uncertain meaning.
$l%
$1% A common difficulty for a sole proprietorship is segregating personal and business assets and personal net worth. ;or e+ample& credit cards and cash accounts may be used for both personal and business use& thus complicating the accounting process.
$m%
$*% Answer $*% is correct because companies frequently require that direct borrowings on notes payable be authori2ed by the board of directors6 accordingly& auditors will determine whether proper policy has been followed.
$n%
$*% Answer $*% is correct because the primary responsibility of the stoc! registrar is to preent any oer issuance of stoc!& and thereby erify that the stoc! is issued properly.
$o%
$1% Canceled stoc! certificates should be defaced and attached to corresponding stubs as is done with oided chec!s. )he obectie of the control is to preent reissuance.
$p%
$1% Answer $1% is correct because the presentation and disclosure assertion deals with whether particular components of the financial statementssuch as loan agreement coenantsare properly classified& described& and disclosed. )he other assertions are less directly related.
$q%
$1% Answer $1% is correct because the board of directors will& in general& authori2e changes in stoc!holders equity.
15-0
Chapter 15 - Debt and Equity Capital
15-(( $a%
$%
'toc! registrar.
$b%
$/%
'toc! transfer agent.
$c%
$(%
'in!ing fund.
$d%
$0%
)reasury stoc!.
$e%
$3%
)rust indenture.
Proble"s
15-(* 'O=G),O8B Case Company $Estimated timeB "5 minutes% $1%
#eiew balance sheets at beginning and through the fiscal year for the wor!ing capital ratio. ,f under " to 1& study compensation of officers for compliance with limitation.
$"%
E+amine clients copies of insurance policies or certificates of insurance for compliance with the coenant. 4repare a schedule that compares undepreciated cost& appraised& or estimated actual alue to coerage. Confirm policies held with trustee.
$(%
E+amine ouchers supporting ta+ payments on all property coered by the indenture. >y reference to the local ta+ laws and the ouchers& determine that all ta+es hae been paid before the penalty-free period e+pired. ,f ouchers in any case are inadequate& confirm with the trustee who holds the ta+ receipts.
$*%
15-(5 'O=G),O8B 7idwest 4roducts& ,nc. $Estimated timeB " minutes% $a%
)he procedures to be employed in e+amining the loans are as followsB $1% $"% $(% $*% $5% $% $/% $0%
Obtain an understanding of the business purpose of the loans made by the president. Confirm the loans& including terms& by direct communication. #ecompute $or test the reasonableness of% interest e+pense and interest payable. #ecompute the long-term and short-term portions of the debt. #eiew minutes of meetings of the board of directors for proper authori2ation.
15-3
Chapter 15 - Debt and Equity Capital
$b%
)he financial statements of 7idwest 4roducts& ,nc.& should disclose the following information concerning the loans from the presidentB $1% $"% $(%
)he nature of the related-party relationship )he dollar amounts of the loans Amounts due the president and& if not otherwise apparent& the terms and manner of settlement
15-( 'O=G),O8B Hriffin Equipment Company $Estimated timeB * minutes% $a%
An audit conducted while the note was outstanding should hae disclosed the understatement of liabilities through the procedure of confirming outstanding notes payable with the holders. ,f a duplicate copy of the note was on file& comparisons of this document with the ledger account may hae reealed a discrepancy.
$b%
An audit subsequent to payment of the note might hae disclosed the fraud byB $1% discoery that the balance of the accounts payable control account was :"& less than the accounts payable subsidiary ledger& or $"% comparison of endors monthly statements with entries in the clients accounts.
$c%
)he basic wea!ness in internal control in Hriffin Equipment Company is the concentration of all accounting and financial matters in the hands of one employee. Iop!ins has custody of cash& is in charge of accounting records and is solely responsible for all phases of many transactions. Gnder this organi2ational setup& no single control procedure or group of procedures can oercome the basic wea!ness. Cash handling and record!eeping must be segregated if internal control is to be adequate. )wo or more employees must participate in eery transaction. >arton should accept the necessity of ta!ing an actie part in financial management of the business. )wo specific suggestions are also appropriate. 9hen notes or chec!s are prepared by an employee for the signature of an e+ecutie& the e+ecutie should mail the note or chec! after signing it6 under no circumstances should these instruments be returned to the employee who prepared them. 'econdly& >arton should arrange for regular audits by a firm of independent C4As and should also as! the public accountants to ma!e a study of the companys financial and accounting operations with a iew to outlining satisfactory internal control. ,nitially& >arton may feel that he cannot afford such serices6 but& actually& he cannot afford to be without them.
15-1
Chapter 15 - Debt and Equity Capital
15-(/ 'O=G),O8B 7icrodent& ,nc. $Estimated timeB "5 minutes% )he proposal for the limitation of procedures is not ustified by the stated facts. Although the transfer agent and the registrar !now the number of shares issued& the transfer agent does not necessarily !now the number of shares outstanding. ;urthermore& the audit of capital stoc! includes more than determining the number of shares outstanding. ;or e+ample& the auditors must determine what authori2ations e+ist for the issuance of shares& what assets were receied in payment of shares& how the transactions were recorded& and what subscription contracts hae been entered into. Confirmation from the registrar and the transfer agent could not help in determining these matters. ,n addition to confirmation from the registrar and the transfer agent& the audit of capital stoc! might include the following procedures for which the purposes are briefly indicatedB $1%
E+amine the articles of incorporation--to determine the number of shares authori2ed and the special proisions relating to each class of stoc! if more than one class is authori2ed.
$"%
E+amine minutes of stoc!holders and directors meetings--to determine authori2ation for appointments of the registrar and the transfer agent and to determine authori2ation for the issuance or reacquisition of shares.
$(%
E+amine proisions relating to capital stoc! in the corporation law of the state of incorporation--to determine any special proisions such as those relating to the issuance of no-par stoc!.
$*%
Analy2e the capital stoc! accounts--to obtain an orderly picture of stoc! transactions for use as a guide to other auditing procedures and as a permanent record.
$5%
)race the consideration receied for capital stoc! into the records--to determine what consideration has been receied and how it has been recorded.
$%
,nspect treasury stoc! certificates and reiew entries for treasury stoc!--to determine the e+istence of treasury stoc!& and to determine that a proper record has been made.
$/%
Compare diidends with stoc! outstanding at diidend dates--to determine that diidends hae been properly paid and also to substantiate the stoc! outstanding.
$0%
#eiew subscription and option contracts& etc.--to determine the facts in regard to subscriptions and options and to determine that these facts hae been properly recorded and that they are adequately disclosed.
15-11
Chapter 15 - Debt and Equity Capital
15-(0 'O=G),O8B 4hoeni+ Corp. $Estimated timeB (5 minutes% $a% 4IOE8,J CO#4. 4roposed Adusting ournal Entries April (& "J1 $1% 4aid-ln Capital in E+cess of 'tated
("&
$"% 4roision for ,ncome )a+esK 1/& ,ncome )a+es 4ayable )o increase income ta+ proision for effect of AE 1B 55M + :("& N :1/&
"&5 1/&(5 1"& 15
1/&
K'ince client has closed accounts& the client should debit or credit #etained Earnings rather than the e+pense account named. $(% #etained Earnings (5&5 Capital 'toc! 5& 4aid-ln Capital in E+cess of 'tated e ,ssued
(0& */&5
)o correct *L"0LJ1 entry for declaration of stoc! diidend. Diidend should hae been recorded as :05&5 $:3 + 35 sharesKK%& rather than :5&. Capital 'toc! should not hae been credited since shares had not been issued. Of the :05&5& :*/&5 $:5 stated alue + 35 shares% is a stoc! diidend to be distributed and :(0& is additional paid-in capital.
KKOn *L"0LJ1& 3&5 shares were outstanding $1& shares issued& less 5 shares held in treasury%. )reasury stoc! does not receie stoc! diidend. )hus& diidend N 35 shares $1M + 3&5 shares%.
15-1"
Chapter 15 - Debt and Equity Capital
$b%
4IOE8,J CO#4. 4artial >alance 'heet April (& "J1 Capital stoc!& no par alue& 1& shares authori2ed& stated alue :5 per shareB ,ssued--1& shares& of which 5 shares are in treasury )o be issued as stoc! diidend--35 shares 4aid-in capital in e+cess of stated alue #etained earnings $:*&& representing cost of treasury stoc!& unaailable for diidends%
=ess cost of treasury stoc!
15-1(
: 5& */&5 : 5*/&5 "50&5 /"0&3 :1&5(*&3 *& :1&*3*&3