Beruflich Dokumente
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CHAPTER 10
LEARNING OBJECTIVES
Review Exercises,
Checkpoints Multiple Choice Problems, and
Simulations
4. Describe common errors and frauds in the 18, 19, 20, 21 36 48(*), 49, 50(*),
accounting for capital transactions and 51, 52(*), 53(*),
investments, and design audit and 54, 55, 56, 57, 58,
investigation procedures for detecting them. 59(*), 60(*), 61
10.2 Actions by the board of directors or finance committee are usually required as authorization for notes
payable. Auditors would want to read all minutes of the board and executive committees, extracting copies
of all financial matters, including notes payable authorizations.
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Chapter 10 - Finance and Investment Cycle
10.3 To obtain relevant audit data about investment securities, auditors procedures include:
Personally examining the securities while other negotiable fund sources are sealed off or are being
examined simultaneously.
Obtaining a written statement from the clients representative that the securities were returned
intact.
Obtaining the information by confirmation from an independent party (e.g., trustee) who holds the
securities.
10.4 A controlled count of the clients investment securities consists of the audit teams gaining access to the
securities in the presence of a responsible client officer. The count is first controlled by simultaneously
counting or sealing off other negotiable funds (such as securities held as collateral) and second by the
auditors personally conducting the count. When the count is completed, the auditors should obtain a
written statement from the clients officer that the securities were returned intact.
A securities count working paper should include a record of the name of the company represented by the
certificate, the interest rate for bonds, the dividend rate for preferred stocks, the due date for bonds, the
serial numbers on the certificates, the face value of bonds, the number or face amount of bonds and stock
shares, and notes on the name of the owner shown on the face of the certificate or on the endorsements on
the back (should be the client company).
10.5 A compensating control for finance and investment cycle accounts is a control feature used when the
company does not specify a standard control procedure (such as strict separation of functional
responsibilities). In the area of finance and investment, the compensating control feature is the involvement
of two or more persons in each kind of important functional responsibility.
If involvement by multiple persons is not specified, then oversight or review can be substituted. For
example, the board of directors can authorize purchase of securities or creation of a partnership. The CFO
or CEO can carry out the transactions, have custody of certificates and agreements, manage the partnership
or the portfolio of securities, oversee the record keeping, and make the decisions about valuations and
accounting (authorizing the journal entries). These are rather normal management activities, and they
combine several responsibilities. The compensating control can exist in the form of periodic reports to the
board of directors, oversight by the investment committee of the board, and internal audit involvement in
making a periodic reconciliation of securities certificates in a portfolio with the amounts and descriptions
recorded in the accounts.
10.6 According to auditing standards (SAS 57, AU 342) specific relevant aspects of control over the production
of accounting estimates include:
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Chapter 10 - Finance and Investment Cycle
10.7 When a company has produced an estimate of an investment valuation based on a nonmonetary exchange,
an auditor can look at the companys tax return to check on consistent tax treatment.
10.8 Transactions in long-term debt, capital stock, paid-in capital, and retained earnings are usually not tested as
a matter of an internal control evaluation. These transactions are generally audited completely by reference
to authorizations, tracing them to events reflected in the accounts and related disclosures, and by vouching
to cash receipts and disbursements and other formal documentation for verification of the transaction
amounts. Subjecting these transactions to detailed audit procedures is explained by the great importance of
these transactions and their limited number.
10.9 Some of the typical assertions found in owners equity descriptions and account balances are:
No other shares (including options, warrants, and the like) have been issued and not recorded or
reflected in the accounts and disclosures.
The accounting is proper for options, warrants, and other stock issue plans, and related disclosures
are adequate.
The valuation of shares issued for noncash consideration is proper in conformity with accounting
principles.
10.10 Some of the important assertions found in the long-term liability accounts are:
Liabilities are properly classified according to their current or long-term status. The current
portion of long-term debt is properly valued and classified.
Terms, conditions, and restrictions relating to noncurrent debt are adequately disclosed.
Disclosures of maturities for the next five years and the capital and operating lease disclosures are
accurate and adequate.
All important contingencies are either accrued in the accounts or disclosed in footnotes.
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Chapter 10 - Finance and Investment Cycle
10.11 a. Confirmations for stockholder equity: Capital stock may be subject to confirmation when
independent registrars and transfer agents are employed. Such agents are responsible for knowing the
number of shares authorized and issued and for keeping lists of stockholders names. The basic information
about capital stock, such as number of shares, classes of stock, preferred dividend rates, conversion terms,
dividend payments, shares held in the company name, expiration dates, and terms of warrants and stock
dividends and splits, can be confirmed with the independent agents. Many of these items can be
corroborated by the auditors own inspection and reading of stock certificates, charter authorizations,
directors minutes, and registration statements. However, when there are no independent agents, most audit
evidence is gathered by vouching stock record documents (such as certificate book stubs). When
circumstances call for extended procedures, information on outstanding stock (very small, closely held
companies) may be confirmed directly with the holders.
b. Notes and bonds payable: Written confirmations are usually obtained from the independent
parties. If the notes are payable to banks, the standard bank confirmation may be used. Formal debt
instruments can be confirmed by letter to the holder or his or her agent. The confirmation requests should
include questions of amount, interest rate, due date, collateral, restrictive covenants, and other terms. To aid
in the search for unrecorded liabilities, confirmation requests should be sent to lenders with whom the
company has done business in the recent past even if no liability balance is shown at the confirmation date.
10.12 The information that can be confirmed when independent registrars and transfer agents are utilized by the
client include the items as features of interest in the answer to review question 10.9. Many of these items
can be corroborated by the auditors inspecting the reports from these agents, reading the minutes of the
directors, and reading prospectuses.
10.13 Off-balance-sheet information refers to information that relates to obligations and commitments assumed
by the clients that do not appear on the balance sheet as current or long-term liabilities. Such information
should be disclosed by the client in the footnotes to the financial statements. Therefore, the auditors must
be alert to these items and gather evidence that will allow the auditors to determine whether the footnote
disclosure is adequate. Such information includes leases, endorsements on discounted notes or others
obligations, guarantees, repurchase or remarketing agreements, commitments to purchase at fixed prices,
commitments to sell at fixed prices, legal judgment, litigation, and pending litigation.
10.14 If a company does not monitor notes payable for due dates and interest payment dates in relation to
financial statement dates, these misstatements can appear in the financial statements:
Understated interest expense and understated current liabilities resulting from failure to accrue
interest expense.
Understated current liabilities and overstated long-term debt resulting from failure to classify the
current portion of long-term debt in current liabilities.
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Chapter 10 - Finance and Investment Cycle
10.16 Some of the typical areas for concern in the investment accounts are:
Valuation of investments at cost, market, or value impairment that is other than temporary.
Impairment of goodwill.
Propriety, effectiveness, and risk disclosure of derivative securities used as a hedge of exposure to
changes in fair value (fair value hedge), variability in cash flows (cash flow hedge), or fluctuations in
foreign currency.
Determination of the fair value of derivatives and securities, including valuation models and the
reasonableness of key assumptions.
Realistic distinctions of research, feasibility, and production milestones for capitalization of software
development costs.
10.17 Securities held by trustees or brokers should be confirmed, and the confirmation request should seek the
same descriptive information as that obtained in a physical inspection by the auditor. That is, the name of
the company, number and class of shares, and any restrictions on the stock. The broker can also confirm the
market value and the trading activity in the securities for the period.
10.18 The unfortunate auditors learned that they should know about the requirements of the securities acts, they
should use experts in the area if they do not have expertise themselves, and they can ask the SEC for advice
in advance.
When suspecting violation of U.S. securities laws (SEC), an auditor should take the factual and descriptive
information to a competent attorney for review and an opinion. Auditors can advise company management
to consult with the SEC about the necessity for conforming to the law in connection with contemplated
transactions.
10.19 Auditors could discover the off-balance-sheet financing described in Case 10.2 (Off-Balance Sheet
Inventory Financing) by (1) making inquiries about large and unusual financing transactions, (2) noticing
the large sale transaction when performing analytical comparisons of monthly or seasonal sales, (3)
examining the sales contract, (4) discussing with management the business purpose of the transaction, and
(5) inquiring in secretary of state records for identification of customer company incorporators and
registered agent.
10.20 Related parties might inflate values with spurious transactions, finally putting them in financial statements
of an auditee (Go for the Gold case).
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Chapter 10 - Finance and Investment Cycle
10.21 First, it is essential that the auditors have expertise in the clients industry. When such expertise is lacking,
the auditors must secure the necessary knowledge by hiring knowledgeable personnel or a consultant with
the appropriate knowledge. Second, the auditor must take into account the historical nature of films of this
type. While management may expect one film to be as successful as recent films of a similar genre, the
auditor must take into account the full range of successful and unsuccessful films. A statistical analysis
could generate a range of values, which the auditor may use. Within this range, the auditor would likely
take a conservative estimate. This may be at odds with management who may want to take a more
aggressive approach to the revenue estimate. Third, the auditors must analyze the assumptions used by
management to reach their estimates. These assumptions may be based on overly optimistic projection of
ticket sales, DVD sales, and other merchandising agreements.
10.27 a. Incorrect Related parties can own the bonds, but their ownership must be disclosed.
b. Incorrect This is not the responsibility of external auditors.
c. Incorrect This is not a primary responsibility of external auditors.
d. Correct Among the choices available, obtaining an opinion from legal counsel is the best
response. The legality of a bond issue is important although not the only
important thing.
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Chapter 10 - Finance and Investment Cycle
10.28 a. Incorrect A company does not necessarily need to use a transfer agent.
b. Incorrect These are usually approved by directors.
c. Incorrect Stock dividends are recorded at fair market value.
d. Correct Capital stock transactions are important by definition, and the directors should
have approved all of them.
10.29 c. Correct Losses on investment should be recorded in the accounts and shown in the
financial statements. (Losses on trading securities in the income statement; loss
on available-for-sale securities in the equity section.)
10.30 a. Incorrect This is a substantive test that has little to do with controls.
b. Incorrect Prepaid expense would have to be calculated based on the payment date.
c. Incorrect This might provide evidence regarding imputed interest expense, but only if all
liabilities are recorded. Imputed interest generally requires a detailed test
considering the specific terms of the debt.
d. Correct Detect unrecorded liabilities is the best response, but remember that the
procedure might be ineffective if the interest expense on an unrecorded liability
is also unrecorded.
10.31 a. Incorrect This is somewhat true because the bank wont let the auditor in without
permission. However, (d) is more important.
b. Incorrect It is unlikely that either would be able to detect forged securities.
c. Incorrect The auditor could do this without the client.
d. Correct A client representative should be present to acknowledge return so the auditor
will not be accused of theft.
10.32 a. Correct Stock certificates should be defaced but retained so the auditors can actually see
the canceled certificate.
b. Incorrect See (a).
c. Incorrect The defaced certificates should be retained so the auditors can see that they have
not been issued.
d. Incorrect See (c).
10.34 a. Correct Capital stock transactions are important by definition, and the directors should
have approved all of them.
b. Incorrect Sales of stock should be traced to cash receipts, but not necessarily other
transactions.
c. Incorrect Purchases of treasury stock should be traced to cash disbursements, but not
sales.
d. Incorrect If shares are sold, the numbered certificates will not be available.
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Chapter 10 - Finance and Investment Cycle
10.36 a. Correct To conceal fraud related to marketable securities, collusion between those
responsible for record keeping and custody would be required. The possibility of
collusion is reduced if no direct contact between responsible parties exists.
b. Incorrect Securities must be registered in the name of the company.
c. Incorrect Custody and authorization are incompatible duties.
d. Incorrect How the trust company secures the assets has nothing to do with preventing
fraud at the company.
10.39 a. Incorrect This is not a suitable objective for analytical procedures because gains and
losses can result from unique circumstances.
b. Correct The auditor may develop expectations regarding the completeness assertion for
unrecorded investment income from stocks by using dividend records published
by standard investment advisory services to recompute dividends received.
Interest income from bond investments can be calculated from interest rates and
payment dates noted on the certificates. Income from equity-based investments
can be estimated from audited financial statements of the investees. Thus,
applying an expected rate of return to the net investment amount may be an
effective means of estimating total investment income.
c. Incorrect The auditor must evaluate managements plans for the securities.
d. Incorrect This is not a suitable objective for analytical procedures because market prices
are volatile and difficult to predict.
10.40 a. Incorrect If bonds are unrecorded, nothing will show up in bond premium or discount.
b. Incorrect This has nothing to do with completeness of bonds payable.
c. Correct The recorded interest expense should reconcile with the outstanding bonds
payable. If interest expense appears excessive relative to the recorded bonds
payable, unrecorded long-term liabilities may exist.
d. Incorrect If the payable account is incomplete, the bond will not be on the listing the
auditor uses to select confirmations.
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Chapter 10 - Finance and Investment Cycle
10.43 d. Correct Events such as the renewal of the note payable do not require adjustment of the
financial statements but may require disclosure. Accordingly, the auditor should
determine that the renewal had essentially the same terms and conditions as the
recorded debt at year-end. A significant change may affect the presentation of
notes payable such as a reclassification from short term to long term.
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Chapter 10 - Finance and Investment Cycle
The three questions in the problem can be called environment questions. Questions specific to
management assertions are:
Existence or Occurrence
a. Are marketable securities investment transactions supported by invoices from brokers or other
documents supporting securities not obtained through brokers?
b. For investments held by the company, are CUSIP numbers recorded for each certificate and are
the CUSIP numbers periodically compared to the securities being held?
Completeness
c. Do the cash disbursements procedures contain directions for identifying and accounting for
investments in marketable securities?
d. Are subsidiary records of investments kept? Are they reconciled periodically with a control
account? Are sales proceeds analyzed to account for gains and losses?
e. Are securities recorded in the companys name or in broker accounts in the company name?
Valuation or Allocation
f. Are investments representing control over investees accounted for by the equity method?
g. Does the controller approve investment security transactions for proper calculation of interest
purchased in bond transactions, special terms of options, warrants, and other features of complicated
investment securities?
h. Does the controllers office receive notice of dividends declared in companies in which
investments are held so accounting can match the proper period? Do accountants have instructions to
accrue interest to the date of the financial statements?
i. Does the board of directors, vice president of finance, or treasurer indicate in writing the intent of
the management in connection with classifying investment securities?
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Chapter 10 - Finance and Investment Cycle
a. The objectives (specific assertions) for the audit of investment securities are to obtain evidence
regarding the:
b. The following audit procedures should be undertaken with respect to the audit evidence for
existence and cost valuation of Basss held-to-maturity investment securities:
Inspect and count securities in the companys safe and safe deposit box.
Examine brokers statements to obtain assurance that all transactions were recorded.
Examine documents in support of purchases and sales of investment securities.
Inspect the minutes of the board of directors meetings.
Obtain a client representation letter that confirms the clients representations concerning
the held-to-maturity investment securities.
Verify the calculation of interest income.
Review the propriety of the presentation and disclosure of the securities in the financial
statements.
Make certain that the client representation letter includes the proper assertions concerning
the securities portfolio.
c. The following audit procedures should be undertaken with respect to the audit evidence regarding
Basss controlling equity investment in Commercial Industrial, Inc.
Inspect and count securities in the companys safe and safe deposit box.
Examine documents in support of purchases and sales of investment securities.
Inspect the minutes of the board of directors meetings.
Review the audited financial statements of the (25 percent) investee.
Verify that the equity method of accounting was used for carrying value of the
investment in Commercial Industrial.
Obtain a client representation letter that confirms the clients representations concerning
the controlling interest.
Verify the calculation equity method income.
Review the propriety of the presentation and disclosure of the securities in the financial
statements.
Make certain that the client representation letter includes the proper assertions concerning
the controlling interest.
d. Audit procedures should be undertaken with respect to obtaining audit evidence about the
classification of held-to-maturity securities in the Bass portfolio? (Hint: Review the audit program in
Appendix 10B-3.)
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Chapter 10 - Finance and Investment Cycle
e. Suppose the held-to-maturity portfolio (excluding the investment in Commercial Industrial, Inc.)
is carried at cost in the amount of $3,450,000. Audit procedures with respect to obtaining audit
evidence about the market (fair) value of this portfolio might include:
f. Suppose the auditor determines that the held-to-maturity portfolio (excluding the investment in
Commercial Industrial, Inc.) has an aggregate market (fair) value of $2,970,000. Audit procedures
with respect to obtaining audit evidence regarding a value impairment that might be other than
temporary? (Hint: Review the audit program in Appendix 10B-3.)
Determine whether value impairments are other than temporary by considering evidence of
the following:
(a) Fair value is materially below cost.
(b) The value decline is due to specific adverse conditions.
(c) The value decline is industry or geographically specific.
(d) Management does not have both the intent and ability to hold the security long
enough for a reasonable hope of value recovery.
(e) The fair value decline has existed for a long time.
(f) A debt security has been downgraded by a rating agency.
(g) The financial condition of the issuer has deteriorated.
(h) Dividends of interest payments have been reduced or eliminated.
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Chapter 10 - Finance and Investment Cycle
a. Union Pacific would prefer accounting for the lease as an operating lease for a number of reasons:
The charge to income for interest and depreciation under capital lease is higher in early
years than rent expense charged for an operating lease.
Treating the lease as an operating lease reduces the asset base and improves return on
assets.
Treating the lease as an operating lease avoids recording the debt for a capital lease,
which results in a lower debt to equity ratio.
b. The auditor would need to review an independent estimate of the value of the building and of its
expected useful life. The auditor would also review the terms of the lease for life, renewal options,
rental rate, additional rental costs, and so on. The auditor may also want to confirm the terms of
the lease with the lessor. Finally, the auditor would test the clients calculations for the lease
treatment under SFAS 13 and obtain representation from the client that the assumptions are
appropriate.
a. Instructions to be given to the assistant regarding the examination of the securities kept in the safe
deposit box include the following:
(1) A copy of the clients inventory of the contents box should be obtained and used in
connection with the inspection of the securities. Comparing the contents of the box and
the inventory will provide assurance that all securities listed in the inventory are on hand.
(The validity of the inventory will be determined by examination of the transactions
pertaining to investments.) The copy of the inventory, after being checked, should be
added to the audit documentation as evidence of work performed.
(2) The banks record of persons entering the deposit box should be examined to determine
that only authorized persons have had access to the box and that there was no entry to the
box between December 31 and January 11. Entry to the box between those dates may be
an indication that a security was returned to safekeeping after being borrowed at
year-end. The security may have been borrowed and used as collateral to obtain cash to
cover a shortage at December 31.
(3) The assistant should be instructed to insist that the treasurer be present while the
securities are being examined. The treasurers presence will deter any future claim that, if
a security is missing at a later date, the assistant took it.
(a) The name of the registered owner (Demot Corp.) appearing on each security
other than bearer bonds should be noted.
(b) The dates stamped on stock certificates giving the dates that the certificates were
prepared should be noted and subsequently compared with cash disbursements.
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Chapter 10 - Finance and Investment Cycle
(c) The name of the corporation issuing the security and the class of the security
(Class A, Par Value, 1st Preferred, etc.) should be noted for assurance that a
lower priced security (perhaps somewhat similar in corporate name or a
different security of the issuing corporation) has not been substituted for a
higher priced security.
(d) The face value of bonds and the number of shares represented by each stock
certificate should be compared with the inventory to determine that the entire
amount of the corporations holdings of each security is on hand.
(e) The serial numbers of the securities should be compared with those on the
inventory and, for those securities carried over from the prior year, compared
with the serial numbers of securities listed in the prior-year audit documentation.
A change in serial numbers that cannot be properly explained may be an
indication of manipulation of the securities.
(f) The certificate should be read to ascertain that interest rates and payment dates
for bonds and the dividend rates and payment dates, if given, for preferred
stocks. This information may be used later in the verification of investment
income.
(g) Bonds should be examined to determine maturity dates. Maturity dates are
needed for checking the computation of the amortization of bond premiums or
discounts.
(h) Coupon bonds should be inspected to determine that no past due interest
coupons are unclipped and all future interest coupons are attached.
(i) The assistant should be alert for any obvious alterations to securities or forged
certificates.
(j) The assistant should also examine the reverse side of the certificates to
determine whether they have been endorsed for transfer. The presence of an
endorsement may be an indication that the security had been converted
temporarily for some use, perhaps fraudulent, in the past.
(k) Any worthless securities on hand should also be examined and compared with
the clients inventory and with prior audit documentation. Any missing
securities should be noted for subsequent follow-up to determine that the client
had received the funds derived from the sale or redemption of securities deemed
worthless in error.
b. The treasurers entry into the safe deposit box on January 4 violated the auditors control over
liquid assets that must be counted simultaneously or kept under control until counted to avoid the
substitution of a counted asset for an uncounted asset in an attempt to conceal a shortage. The
auditor would probably apply the following additional procedures:
(1) Reconcile bank balances at both year-end and at the count date.
(2) Obtain a bank confirmation as of the count date.
(3) Examine cash entries between year-end and the count date for any unusual entries.
(4) Examine all investment transactions taking place between the balance-sheet date and the
count date to verify the amount of the investments at the balance-sheet date.
(5) If the client keeps a large fund of cash on hand, make a surprise count of the cash fund.
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Chapter 10 - Finance and Investment Cycle
(6) Review the transactions since year-end relating to any other assets, such as mortgages
owned, to determine whether any substitutions have been made.
(7) Visit the Chamber of Commerce and take a look at the photograph.
e. (best) Verify that transfers from the trading portfolio to the held-to-maturity
investment portfolio have been properly recorded.
10.52 Intangibles
1. a. Machinery 17,000
Patents 17,000
b. Inspect the patent document and vouch to the work orders for machinery improvement.
Recalculate amortization of patent.
b. Vouch transaction to the documentation to support the receipt of revenue. Vouch cash to
deposit in bank account.
To record the 60% loss caused by the explosion in the prior year. Correction of an accounting
error of the prior year. Write-off of damage due to flood.
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Chapter 10 - Finance and Investment Cycle
b. Vouch to insurance documents for claims. Review local news for evidence of explosion and/or
flood.
b. Recalculate amortization.
To correct the accounting error of last year of improperly capitalizing an expense item
b. Review goodwill account. Vouch to original calculation of goodwill to ensure all expenses in
the account are capital expenses.
6. a. Equipment 8,500
Accounts Receivable Nontrade 2,500
Leasehold Improvements 11,000
To record equipment in the proper account and to record a receivable for the real estate taxes
To record current amortization and correct the error of failure to record amortization of
leasehold improvements on a straight-line, 10-year basis. No adjustment to depreciation of
equipment because it was acquired in December.
b. Vouch transaction to purchase order for equipment and work orders for leasehold
improvements. Recalculate amortizations.
b. Vouch transaction to original expenses for proper amounts. Review Retained earnings for
propriety of other items.
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Chapter 10 - Finance and Investment Cycle
b. To ensure that if the collateral is damages the company will be reimbursed and can
pay off the loan. The borrower is required to keep insurance coverage on the
plant/equipment or inventory in order to safeguard against the catastrophic loss of
collateral.
c. Confirm insurance with the insurance company; review insurance policy at client.
b. To protect the lenders from loses incurred by the loss of a key employee. This
insures the life of the indispensable owner or manager without whom the company
could not continue. The lender usually gets an assignment of the policy.
c. Confirm insurance with the insurance company; review insurance policy at client
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Chapter 10 - Finance and Investment Cycle
c. Review financial information; review financial reports of guarantor (if any); confirm
with lender the receipt of financial information.
The borrower is required to maintain a certain level in key financial ratios such as:
b. Financial ratios provide an analysis of the financial condition of the borrower and
help the lender determine the likelihood of repayment. In addition, the borrower
might be prevented from doing certain things via loan covenants.
c. Review ratios; vouch numbers used in ratio calculations to the source information
b. Guarantees the continuing existence of your borrower and will impede the
deterioration of financial condition due to merger with an unknown entity.
c. Compare organizational charts with prior years; review minutes of the board of
directors meetings; review local news sources.
b. Ensures that the company does not take on excessive debt affecting the quality of the
original loan.
b. In situations in which the net worth is being eroded by the extraction of capital in the
form of dividends or stockholders withdrawal, the lender might find it necessary to
restrict the amount of money that can be taken out of the company. In subchapter-S
corporations, it is not uncommon to limit withdrawals to the owners tax liability.
D. It is important for an auditor to ensure that the client is in compliance with debt covenents because if
the client is in violation of the debt covenants the lender may be able to call the debt (i.e. ask for
immediate payment). Such a demand for cash, if the amount is large, may create a going concern
issue for the client.
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Chapter 10 - Finance and Investment Cycle
a. The procedures you should employ in examining the Broadwall 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.
Recompute interest expense and interest payable.
Review minutes of meetings of the board of directors for proper authorization.
Verify payments made during the year and transactions after the year-end.
Read the notes to the financial statements regarding the loan agreements and evaluate the
adequacy of disclosure and compliance with restrictions.
Obtain a management representation letter.
b. Broadwalls financial statements should disclose the following information concerning the loans
from its president:
In each case any actual failure to comply would need to be reported in a footnote to the statements in view
of the possible serious consequences of advancing the maturity date of the loan. The individual audit steps
follow:
1. Check balance sheets at beginning and through the previous fiscal year for working capital ratio. If
under 2:1, check compensation of officers for compliance with limitation.
2. Examine clients copies of insurance policies or certificates of insurance for compliance with the
covenant, preparing schedule of book value, appraised or estimated actual value, and coverage for
report. Confirm policies held with trustee.
3. Examine vouchers supporting tax payments on all property covered by the indenture. By reference
to the local tax laws and the vouchers, determine that all taxes have been paid before the
penalty-free period expired. If vouchers in any case are inadequate, confirm with trustee who
holds the tax receipts.
Existence
(a) Verify authorized shares with (a) Inspect the certificates held as
reference to corporate charter. treasury stock.
(b) Confirm outstanding shares with
owners.
(c) Count outstanding shares as shown in
the stock record book stubs.
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Chapter 10 - Finance and Investment Cycle
Completeness
Valuation
(g) Vouch amount of paid-in capital to (b) Vouch amounts recorded for
cash receipts. purchase to cash disbursements and
amounts received on resale to cash
receipts. Recalculate gain (loss)
and trace to retained earnings or
other capital account.
GAAP disclosure
(h) Read the financial statements and (c) Read the financial statements,
footnotes to determine whether all particularly the schedule of capital
numbers of shares, terms, and changes and the footnotes to
descriptions are accurate. determine whether the treasury
stock amounts (including gains and
losses) are properly classified and
described.
(i) Vouch stock option and profit-sharing
plan disclosures to contracts and plan
documents.
a. (1) The audit plan for the examination of Pate Corporations Capital Stock account would
include the following procedures:
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Chapter 10 - Finance and Investment Cycle
(b) (Existence and completeness audit assertions.) Examine the stock certificate
stub book and determine whether the total of the open stubs agrees with the
Capital Stock account in the general ledger. Examine canceled stock certificates
that are generally attached to the corresponding stub. Information on the stubs
regarding the number of shares, date, and so on for both outstanding and
canceled stock certificates should be compared with the Capital Stock account.
All certificate numbers should be accounted for.
(c) (Valuation assertion.) Analyze the Capital Stock account from the corporations
inception and audit all entries. Trace all transactions involving the transfer of
cash either to the cash receipts or the cash disbursements records. If property
other than cash was received in exchange for capital stock, trace the recording of
the property in the proper asset account and consider the reasonableness of the
valuation placed on the property. If the analysis of the Capital Stock account
discloses that the corporation has engaged in treasury stock transactions,
determine that the increases or decreases in net assets resulting from these
transactions have not been placed in the Retained Earnings account.
(2) The audit procedures to be applied to the examination of the Capital Contributed in
Excess of Par Value account are usually applied at the same time that the Capital Stock
account is being examined because the two accounts are interrelated. The account should
be analyzed and the entries audited when the related entries in the Capital Stock account
are audited.
(3) The following audit procedures would be applied to the Retained Earnings account:
(a) (Valuation assertion.) Analyze the account from its inception. Consider the
validity of the amounts representing income or loss that were closed from the
Profit and Loss account.
(b) (Valuation assertion.) Any charges or credits made directly to the Retained
Earnings account should be investigated and their treatment reviewed in relation
to generally accepted accounting principles.
(c) (Presentation and disclosure assertion.) Actions of the board of directors that
affected retained earnings should be traced to the account analysis.
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Chapter 10 - Finance and Investment Cycle
b. In conducting the audit, the auditors audit retained earnings as they do other items on the balance
sheet for several reasons. A principal reason is that this part of the audit is an assurance or double
check that no important item was overlooked in the examination of the accounts that were the
contra or balancing part of the entry recorded in Retained Earnings. An example of an important
item that may be overlooked would be a balance sheet account that was closed during the year
under audit and the ledger card for the account removed from the general ledger current file.
Another reason is that, although the entry in the contra account may have been examined, the
auditors may have overlooked that the balancing part of the entry was to Retained Earnings, a
treatment that may have been contrary to generally accepted accounting principles; their
examination of retained earnings would bring this noncompliance to their attention.
(1) Conflicts of interest. Students should recognize the apparent existence of non-arms-
length transactions in the transfer prices of products to Hardy Hardware from Hardy
Products. However, whether the prices are not equivalent to market prices is not certain.
Hardy Hardware may outperform the rest of the industry for other reasons, and Hardy
Products net of 1 percent on sales may be characteristic of its business (although the 1
percent is extremely low). The brothers have no apparent conflict between themselves.
Any conflict would have to be perceived as being between the brothers and the public
shareholders.
(2) The criterion presumption for using the equity method is a 20 percent stock ownership,
and Hardy Hardwares ownership amounts to only 15 percent. However, other
controlling influences are at work, namely, James Hardys effective control of Hardy
Hardware (20 percent) and his consequent ability to dictate the voting of the 15 percent
interest in Hardy Products.
b. Some might say that this interrelationship of investments constitutes a significant controlling
influence that, although not vested entirely in the investor corporation (Hardy Hardware), certainly
operates to the benefit of Hardy Hardware. Whether to insist on the equity method in this case
represents a difficult decision as the former auditor apparently found out.
c. The auditor should seek to compare the transfer prices to market-determined prices for the same or
similar goods. The possibility exists that Hardy Products is charging break-even prices to that
Hardy Hardware can show better operating results.
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Chapter 10 - Finance and Investment Cycle
d. Adequate disclosure in this case is not an easy issue. Certain SEC rules require disclosure of
transactions with controlling persons. Hardy Hardware will certainly have to observe SEC
regulations in statements filed with the Commission, and the auditor might protect herself or
himself as well as serve the public shareholders by insisting on similar disclosures in the annual
report. The related-party transaction disclosures specified in FASB statements and auditing
standards would be appropriate.
Audit Approach
Objective: Obtain evidence of the valuation of assets given in exchange for stock and notes to find the
proper valuation of recorded goodwill.
Control: Control rests with the management and accounting estimates of the value of the assets given in
exchange. Estimates of this type should be made with faithfulness to the underlying nature of the assets and
their proper valuation.
Tests of Controls: Auditors should determine the extent of management involvement in major investment
and disposal transactions. Studying the minutes of the board and internal correspondence can help
contribute this information. All other procedures bear directly on the substantive valuation evidence.
Audit of balance: Because the Amron stock asset valuation was based on the transfer of the ammunition
business assets to the new corporation, the underlying composition and book value of the assets should be
determined in detail. This work should reveal that the Amrons stock carrying value included the deferred
cost amount of $7 million. The hard part is discerning that the business purpose of the transactions is to get
out of the sporting ammunition manufacturing business. If the auditors concentrate on the flow of the
transaction and dont get the big picture, they might miss the event of discontinuance.
The Big Industrial-Gulwest transaction appears to be clear. Gulwest received stock and a note with total
value of $5.4 million. Piercing the veil of the intervening corporate creation transactions and transfers,
Gulwest gave assets that were on its original books at $12.4 million.
Discovery Summary
The evidence of value received and cost given indicated a loss of $7 million. Auditors may need to be
perceptive and a bit clever to identify it directly with the discontinued line of business, or even to call it
discontinued. Nevertheless, they were able to identify the amount as a loss and force its recognition in
the Gulwest income statement. The spurious goodwill was removed from the Gulwest balance sheet.
Audit Approach
Objective: Obtain evidence to determine the proper valuation of asset exchanges involving noncash
property.
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Chapter 10 - Finance and Investment Cycle
Audit of balances: Upon knowing the date of the transaction purchasing the airplane from Wing and the
number of Wing shares transferred, the auditors can look up the quoted market price in newspapers or other
library sources for market price history. Finding the market price should determine the proper amount to
record for the airplane.
Auditors should have a list of all subsidiary companies and should be able to recognize the Mexican
subsidiary as a related party. With this relationship, the amount of the transaction price is suspect.
However, efforts can be made to obtain new and used airplane prices to determine whether the $3,750,000
price to the Mexican subsidiary bore any relation to observable airplane valuations.
If the value were $3,750,000, the gain exists in the transaction with the subsidiary, subject to elimination
in consolidation. This gain, if any, should not be offset against the loss from the exchange with Wing.
Discovery Summary
The auditors were astute. They found that the market value of the Wing stock was $2,520,000 and insisted
that the airplane be valued at $3 million instead of $3,750,000, thus making the loss on the exchange of
Wing stock $750,000 larger. They also made sure that the subsequent gain on the sale to the Mexican
subsidiary was eliminated in consolidation, awaiting any future profit confirmation by a sale to an outside
party.
AUDIT APPROACH
Objective: To obtain evidence that trades recorded are valid and authorized (existence or occurrence
assertion).
Leeson should have had a clear reporting line to a person of authority. Due to a reorganization,
the two groups that might have had responsibility each thought he was reporting to the other one.
Long and short positions should always be balanced. Leeson could be unbalanced during the day
but was supposed to be balanced at the end of each day.
Trading limits should have been strictly enforced. Because Leeson appeared to be profitable,
trades of amounts over his limits were overlooked.
The Credit Control department should have approved loans to clients, which Leeson used to
hide losses.
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Chapter 10 - Finance and Investment Cycle
Reconciliations of funds remitted to trades made should have been completed and balanced daily.
Audit of balances: The auditors should confirm the large balances in the loans to clients account. They
should also examine the details of account 88888 for authorization of transactions.
Discovery Summary
In January 1995, The Singapore International Monetary Exchange (SIMEX) queried Baring on the size of
their positions on the exchange. SIMEX specifically questioned irregularities in the margining of account
88888. Baring responded in a letter assuring SIMEX of the adequacy of funds to support the positions and
made it clear that the entire assets of Baring Group were available to meet its financial obligations to
SIMEX. Also in January 1995, Coopers & Lybrand, Singapore discovered a discrepancy of 7.7 billion
between SIMEX and Baring accounts. Within a few days, six different versions of how the receivable had
arisen were circulated among Baring senior management. On February 23, Leeson went missing. The
liabilities he left behind totaled $1.3 billionmore than the entire capital and reserves of Baring. He was
arrested in March in a German airport. On December 2, a Singapore court sentenced him to six and a half
years. I dont think of myself as a criminal, Leeson said before his trial.
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