1Chapter 22 Audit of the Capital Acquisition and Repayment Cycle

Review Questions 22-1 Four examples of interest bearing liability accounts commonly found on balance sheets are: 1. 2. 3. 4. Notes payable Contracts payable Mortgages payable onds payable

!hese liabilities ha"e the follo#ing characteristics in common: 1. 2. 3. 4. $elati"ely fe# transactions affect the account balance% but each transaction is often highly material in amount. !he exclusion of a single transaction could be material in itself. !here is a legal relationship bet#een the client entity and the holder of the stoc&% bond% or similar o#nership document. !here is a direct relationship bet#een interest and di"idend accounts and debt and e'uity.

!hese liabilities differ in #hat they represent and the nature of their respecti"e liabilities. 22-2 !he characteristics of the liability accounts in the capital ac'uisition and repayment cycle that result in a different auditing approach than the approach follo#ed in the audit of accounts payable are: 1. 2. 3. 4. $elati"ely fe# transactions affect the account balance% but each transaction is often highly material in amount. !he exclusion of a single transaction could be material in itself. !here is a legal relationship bet#een the client entity and the holder of the stoc&% bond% or similar o#nership document. !here is a direct relationship bet#een interest and di"idend accounts and debt and e'uity.

22(1

22-3 )t is common to audit the balance in notes payable in con*unction #ith the audit of interest expense and interest payable because it minimi+es the "erification time and reduces the li&elihood of o"erloo&ing misstatements in the balance. ,nce the auditor is satisfied #ith the balance in notes payable and the related interest rates and due dates for each note% it is easy to test the accuracy of accrued interest. )f the interest expense for the year is also tested at the same time% the li&elihood of omitting a note from notes payable for #hich interest has been paid is minimi+ed. -hen there are a large number of notes or a large number of transactions during the year% it is usually too time consuming to completely tie out interest expense as a part of the audit of the notes payable and related accrued interest. Normally% ho#e"er% there are only a fe# notes and fe# transactions during the year. 22-4 !he most important controls the auditor should be concerned about in the audit of notes payable are: 1. 2. 3. 4. !he proper authori+ation for the issuance of ne# notes .or rene#als/ to insure that the company is not being committed to debt arrangements that are not authori+ed. Controls o"er the repayment of principal and interest to insure that the proper amounts are paid. 0roper records and procedures to insure that all amounts in all transactions are properly recorded. 0eriodic independent "erification to insure that all the controls o"er notes payable are #or&ing.

22-5 !he most important analytical procedures used to "erify notes payable is a test of interest expense. y the use of this test% auditors can unco"er misstatements in interest calculations or possible unrecorded notes payable. 22)t is more important to search for unrecorded notes payable than unrecorded notes recei"able because the omission of an asset is less li&ely to occur than the omission of a debt. 1e"eral audit procedures the auditor can use to unco"er unrecorded notes payable are: 1. 2. 3. 4. 2xamine the notes paid after year(end to determine #hether they #ere liabilities at the balance sheet date. ,btain a standard ban& confirmation that includes specific reference to the existence of notes payable from all ban&s #ith #hich the client does business. $e"ie# the ban& reconciliation for ne# notes credited directly to the ban& account by the ban&. ,btain confirmation from creditors #ho ha"e held notes from the client in the past and are not currently included in the notes payable schedule.

22(2

22- !continued" 3. 5. 4naly+e interest expense to unco"er a payment to a creditor #ho is not included on the notes payable schedule. $e"ie# the minutes of the board of directors for authori+ed but unrecorded notes.

22-# !he primary purpose of analy+ing interest expense is to unco"er a payment to a creditor #ho is not included on the notes payable schedule. !he primary considerations the auditor should &eep in mind #hen doing the analysis are: 1. 2. )s the payee for the interest payment listed in the cash disbursements *ournal also included in the notes payable list6 7as a confirmation for notes payable been recei"ed from the payee6

22-$ !he tests of controls and substanti"e tests of transactions for liability accounts in the capital ac'uisition and repayment cycle consists of tests of the control and substanti"e tests o"er the payment of principal and interest and the issuance of ne# notes or other liabilities% #hereas the tests of details of balances concern the balance of the liabilities% interest payable% and interest expense. 4 uni'ue aspect of the capital ac'uisition and repayment cycle is that auditors normally "erify the transactions and balances in the account at the same time% as described in the solution to $e"ie# 8uestion 22(3. 22-% Four types of restrictions long(term creditors often put on companies in granting them a loan are: 1. 2. 3. 4. Financial ratio restrictions 0ayment of di"idends restrictions ,perations restrictions )ssue of additional debt restrictions

!he auditor can find out about these restrictions by examining the loan agreement and related correspondence associated #ith the loan% and by confirmation. !he auditor must perform calculations and obser"e acti"ities to determine #hether the client has obser"ed the restrictions. 22-1& !he primary ob*ecti"es in the audit of o#ners9 e'uity accounts are to determine #hether: 1. !he internal controls o"er capital stoc& and related di"idends are ade'uate.

22(3

22-1& !continued" 2. ,#ners9 e'uity transactions are recorded properly% as defined by the follo#ing six transaction(related audit ob*ecti"es: 3. ,ccurrence Completeness 4ccuracy 0osting and summari+ation Classification !iming

,#ners9 e'uity balances in the financial statements satisfy the follo#ing balance(related audit ob*ecti"es: :etail tie(in 2xistence Completeness 4ccuracy Classification Cutoff

4.

,#ners9 e'uity balances are properly presented and disclosed to satisfy the follo#ing presentation and disclosure(related audit ob*ecti"es: ,ccurrence and $ights and ,bligations Completeness 4ccuracy and ;aluation Classification and <nderstandability

22-11 4lthough the corporate charter and byla#s are legal documents% their legal nature is not being *udged by the auditor. !hey are being used only to reference transactions being tested by the auditor and pro"ide insight into some of the &ey control features of the company. !he auditor should consult an attorney if the information the auditor needs from the documents is not clear or if a legal interpretation is needed. 22-12 !he ma*or internal controls o"er o#ners9 e'uity are: 1. 2. 3. 4. 0roper authori+ation of transactions 0roper record &eeping 4de'uate segregation of duties bet#een maintaining o#ners9 e'uity records and handling cash and stoc& certificates !he use of an independent registrar and stoc& transfer agent

22(4

22-13 !he audit of o#ners9 e'uity for a closely held corporation differs from that for a publicly held corporation in that the amount of time spent in "erifying o#ners9 e'uity in a closely held corporation is usually minimal because of the relati"ely fe# transactions for capital stoc& accounts that occur during the year. For publicly held corporations% the audit of o#ners9 e'uity is more complex due to the existence of a larger number of shareholders and fre'uent changes in the indi"iduals holding stoc&. !he audits are not significantly different in regard to #hether the transactions in the e'uity accounts are properly authori+ed and recorded and #hether the amounts in the accounts are properly classified% described% and stated in accordance #ith generally accepted accounting principles. 22-14 !he duties of a stoc& registrar are to ma&e sure that stoc& is issued by a corporation in accordance #ith the capital authori+ation of the board of directors% to sign all ne#ly issued stoc& certificates% and to ma&e sure old certificates are recei"ed and cancelled before a replacement certificate is issued #hen there is a change in the o#nership of the stoc&. !he duties of a transfer agent are to maintain the stoc&holder records% and in some cases% disburse cash di"idends to shareholders. !he use of the ser"ices of a stoc& registrar impro"es the effecti"eness of the client9s internal controls by pre"enting the improper issuance of stoc& certificates. 4long similar lines% the use of the ser"ices of an independent transfer agent impro"es the control o"er the stoc& records by putting them in the hands of an independent organi+ation. 22-15 !he number of shares outstanding% the correct "aluation of capital stoc& transactions% and par "alue can all be confirmed #ith a transfer agent. !he balance can then be easily recalculated from this information. 22-1 1ince it is important to "erify that properly authori+ed di"idends ha"e been paid to o#ners of stoc& as of the di"idend record date% a comparison of a random sample of cancelled di"idend chec&s to a di"idend list prepared by management #ould be inade'uate. 1uch an audit step is useless unless the di"idend list has first been "erified to include all stoc&holders of record at the di"idend record date. 4 better test is to determine the total number of shares outstanding at the di"idend date from the stoc& registrar and recompute the total di"idends that should ha"e been paid for comparison #ith the total amount actually paid. 4 random sample of cancelled chec&s should then be compared to the independent registrar9s records to "erify that the payments #ere actually made to "alid shareholders. 22-1# )f a transfer agent disburses di"idends for a client% the total di"idends declared can be "erified by tracing the amount to a cash disbursement entry to the agent and also confirming the amount. !here should ordinarily be no need to test indi"idual di"idend disbursement transactions if a stoc& transfer agent is used.

22(3

22-1$ !he ma*or emphasis in auditing the retained earnings account should be on the recorded changes that ha"e ta&en place during the year% such as net earnings for the year% di"idends declared% prior period ad*ustments% extraordinary items charged or credited directly to retained earnings% or setting up or elimination of appropriations. 2xcept for di"idends declared% the other items should be "erified during other parts of the engagement. !his is especially true of the net earnings for the year. !herefore% the audit of retained earnings primarily consists of an analysis of the changes in retained earnings and the "erification of the authori+ation and accuracy of the underlying transactions. 22-1% For auditing o#ners9 e'uity and calculating earnings per share% it is crucial to "erify that the number of shares used in each is accurate. 2arnings are "erified as an integral part of the entire audit and should re'uire no additional "erification as a part of o#ners9 e'uity. !he most important auditing considerations in "erifying the earnings per share figure are the accounting principles prescribed by 1F41 12= and the descriptions of the "arious classes of stoc& in the corporate charter and minutes of the board of directors. 'ultiple Choice Questions (rom C)A *+aminations a. a. .2/ .4/ b. b. .2/ .3/ c. c. .2/ .1/

22-2& 22-21

,iscussion Questions and )ro-lems 22-22

a. )/R)01* 0( C023R04 1. !o insure that all note liabilities are actual liabilities of the company. 2. !o insure that note transactions are recorded in full and in detail. -. )03*235A4 (52A2C5A4 13A3*'*23 '5113A3*'*23 >oss of assets through payment of excess interest rates or the di"ersion of cash to unauthori+ed persons. )mproper disclosure or misstatements in notes payable through duplication. c. A/,53 )R0C*,/R* 30 ,*3*R'52* *6513*2C* 0( 'A3*R5A4 '5113A3*'*23 2xamine note re'uest forms for proper authori+ation and discuss terms of note #ith appropriate management personnel. $econcile detailed contents of master file or other records to control account.

22(5

22-22 !continued"
a. )/R)01* 0( C023R04 3. !o insure that all note(related transactions agree #ith account balances. 4. !o pre"ent misuse of notes and funds earmar&ed for notes. -. )03*235A4 (52A2C5A4 13A3*'*23 '5113A3*'*23 Misstatement of notes payable. c. A/,53 )R0C*,/R* 30 ,*3*R'52* *6513*2C* 0( 'A3*R5A4 '5113A3*'*23 $econcile master file #ith outstanding notes payable.

Misstatement of liabilities and cash.

0erform all substanti"e procedures on extended basis. !race from paid notes file to cash receipts to determine that the appropriate amount of cash #as recei"ed #hen the note #as issued. 2xamine outstanding notes and paid notes for similarities and the potential for reusing the notes. $ecompute interest on a test basis.

3. !o insure that notes are not paid more than once. 5. !o insure that only the proper interest amount is paid and recorded.

>oss of cash.

Misstatement of interest expense and related accrual.

22-23

a.
)/R)01* !o determine the nature of restrictions on client as a means of "erifying #hether the restrictions ha"e been met and to insure they are ade'uately disclosed. !o insure that the bonds are not sub*ect to unnecessary early retirement by bondholders and that proper disclosures are made. !o determine if the account balances are reasonable as related to each other and to examine for unreasonable changes in the account balances. !o determine if the calculations are correct and accounts are accurate. !o obtain independent confirmation of bond indebtedness and collateral.

A/,53 )R0C*,/R* 1

4 3

22(?

22-23 !continued" b. !he auditor should be alert for the follo#ing pro"isions in the bond indenture agreement: 1. 2. 3. 4. 3. c. $estrictions on payment of di"idends Con"ertibility pro"isions 0ro"isions for repayment $estrictions on additional borro#ing $e'uired maintenance of specified financial ratios

!he auditor can determine #hether the abo"e pro"isions ha"e been met by the follo#ing procedures: 1. 2. 3. 4. 3. 4udit of payments of di"idends :etermine if the appropriate stoc& authori+ations are ade'uate :etermine if sin&ing fund is ade'uate 1earch for other liabilities Calculate ratios and compare to agreement

d.

!he auditor should "erify the unamorti+ed bond discount or premium on a bond that #as in force at the beginning of the year by recalculation. !his is done by di"iding the premium or discount by the number of total months the bonds #ill be outstanding and multiplying by the number of months remaining. For bonds issued in the current year% the bond premium or discount must first be "erified. !he monthly premium or discount is then calculated and multiplied by the number of months still outstanding. !he follo#ing information should be re'uested from the bondholder in the confirmation of bonds payable: 1. 2. 3. 4. 3. 5. ?. 4mount of bond Maturity date )nterest rate 0ayment dates 0ayment amounts 4ssets pledged as security $estrictions on client acti"ities

e.

22-24

a.

!he auditing necessary for notes payable and related interest accounts in these circumstances #ould be minimal. 4side from chec&ing interest calculations and postings to the proper accounts as a matter of audit routine% the only ma*or audit procedure #ould be to confirm the amount and pro"isions of the note #ith the ban&.

22(=

22-24 !continued" b. )f Fox #as unprofitable% had a need for additional financing% and had deficient internal controls% it #ould be necessary to search for unrecorded notes. !his could be done by obtaining standard ban& confirmations #ith specific reference to the existence of notes payable% re"ie#ing the ban& statements and reconciliations for ne# notes credited directly to the ban& account by the ban&% and analy+ing interest expense to unco"er a payment to a creditor #ho is not included on the notes payable schedule. !he emphasis in the "erification of notes payable in this situation should be in determining #hether all existing notes are included in the client9s records. !he four audit procedures listed do not satisfy this emphasis.

22-25

a.

b.
A/,53 )R0C*,/R* 1 2 3 4 )/R)01* !o determine if the notes payable list reconciles to the general ledger. !o determine if the notes payable on the list are correctly recorded and disclosed. !o "erify that all recorded notes payable are properly recorded and disclosed. !o insure that interest expense is properly recorded on the boo&s.

c.

0rocedure 2 is not necessary in light of procedure 3. !hey both perform the same function and the confirmation is from an independent source. !he sample si+es for the procedures are probably appropriate% considering the deficiencies in record &eeping procedures. )n addition to the procedures mentioned% the follo#ing ones are essential because there must be a search for unrecorded notes: 1. 4naly+e interest expense and send a confirmation for notes payable to all payees not recei"ing a confirmation for notes. 2. Confirm the balance in notes payable to payees included in last year9s notes payable list but not confirmed in the current year. 3. 2xamine notes paid after year(end to determine #hether they #ere liabilities at the balance sheet date. 22(@

d.

22-25 !continued" 4. ,btain a standard ban& confirmation that includes a specific reference to notes payable from all ban&s #ith #hich the client does business. 3. $e"ie# the minutes of the board of directors. 22-2 )n each case% any actual failure to comply #ould ha"e to be reported in a footnote to the statements in "ie# of the possible serious conse'uences of ad"ancing the maturity date of the loan. !he indi"idual audit steps that should be ta&en are as follo#s: a. Calculate the #or&ing capital ratio at the beginning of and through the pre"ious fiscal year. )f it is under 2 to 1% determine compensation of officers for compliance #ith the limitation. 2xamine the client9s copies of insurance policies or certificates of insurance for compliance #ith the co"enant% preparing a schedule of boo& "alue% appraised or estimated "alue% and co"erage for the report. Confirm policies held #ith trustee. 2xamine "ouchers supporting tax payments on all property co"ered by the indenture. y reference to the local tax la#s and the "ouchers% determine that all taxes ha"e been paid before the penalty(free period expired. )f the "ouchers in any case are inade'uate% confirm #ith the trustee #ho holds the tax receipts. ;ouch the payments to the sin&ing fund. Confirm bond purchases and sin&ing fund balance #ith trustee. ,bser"e e"idence of destruction of bonds for bonds cancelled. $eport the fund as an asset% preferably gi"ing the composition as to cash and bonds held ali"e% if any. )t is desirable to prepare an audit schedule for the permanent file for the mortgage so that the appropriate information concerning the mortgage #ill be con"eniently a"ailable for future years9 audits. !his information should include all the pro"isions of the mortgage as #ell as the purchase price% date of purchase% and a list of items pledged as collateral. )t may also contain an amorti+ation schedule of principal and interest .especially if the auditor has access to a computer program for preparation of such a schedule/. !he audit of mortgage payable% interest expense% and interest payable should all be done together since these accounts are related and the results of testing each account ha"e a bearing on the other accounts. !he li&elihood of misstatement in the client9s records is determined faster and more effecti"ely by doing them together.

b.

c.

d.

22-2#

a.

b.

22(1A

22-2# !continued" c. !he audit procedures that should ordinarily be performed to "erify the issue of the mortgage% the balance in the mortgage and interest payable% and the balance in the interest expense accounts are: 1. 2. 3. 4. 3. d. :etermine if the mortgage #as properly authori+ed. ,btain the mortgage agreement and schedule the pertinent pro"isions in the permanent file% including the face amount% payments% interest rate% restrictions% and collateral. Confirm the mortgage amount% terms% and collateral #ith the lending institution. $ecompute interest payable at the balance sheet date and reconcile interest expense to the decrease in principal and the payments made. !est interest expense for reasonableness.

Benerally accepted accounting principles re'uire disclosures related to long(term debt. !he terms of the debt agreement are to be disclosed% including interest rates% maturity dates% fi"e(year payment information% assets pledged as collateral% among other items. 1ignificant restrictions on the acti"ities of the company% such as maintaining cash or other compensating balances or restricting the amount of di"idends that can be paid% should be disclosed. !hus% auditors obtain copies of long(term debt agreements to determine that the clientCs disclosures are complete and accurate.

22(11

22-2$
a. )/R)01* 0( C023R04 1. !o insure that records are properly maintained. 2. !o insure that records are properly maintained. 3. !o insure that the general ledger reflects the balance of supporting records. 4. !o insure that the di"idends declared are paid to the proper indi"iduals. 3. !o insure that stoc& is issued and retired only at the discretion of the board. 5. !o insure that all shares issued or retired are properly authori+ed. -. )03*235A4 (52A2C5A4 13A3*'*23 '5113A3*'*23 Misstatement of o#ners9 e'uity and the disbursement of di"idends and capital to the #rong people. Misstatement of o#ners9 e'uity and earnings per share. Misstatement of o#ners9 e'uity and earnings per share. c. A/,53 )R0C*,/R*1 30 ,*3*R'52* *6513*2C* 0( 'A3*R5A4 '5113A3*'*23 :etermine if company uses ser"ices of an independent registrar% or transfer agent. Confirm details of e'uity accounts #ith them. 4ccount for all unissued certificates and account for all cancelled certificates and their mutilation. !race postings from master file and stoc& certificates into general ledger. $econcile master file to general ledger. ,btain confirmation of paid di"idends from independent transfer agent.

Misstatement of di"idends declared on balance sheet or payment to the #rong people% #hich could result in a liability. )llegal payments of cash and issue of shares.

2xamine cancelled shares and ne#ly issued ones to ma&e sure they are included in the board of directors minutes. ;erify authenticity of all changes in o#ners9 e'uity account.

Misstatement of di"idends declared on balance sheet or payment to the #rong people% #hich could result in a liability.

22(12

22-2%
a. )/R)01* 0( A/,53 )R0C*,/R*1 1. !o determine #hat type of stoc& may be issued% under #hat circumstances% and its description. 2. !o determine the propriety of changes in the accounts and to "erify their accuracy. 3. !o determine if there #ere any shares issued or retired during year% or if any certificates are missing. 4. !o determine if all retired stoc& has been cancelled. 3. !o determine if any stoc& issues% retirements% or di"idends #ere authori+ed. 5. !o "erify that earnings per share has been correctly computed. ?. !o determine that di"idends are legal and disclosure in the financial statements is proper. -. '5113A3*'*231 37A3 'A8 9* /2C0:*R*, <nauthori+ed outstanding stoc& or improper description of stoc&. !he issuance or retirement of stoc& #ithout proper authori+ation% improper "aluation% or incorrect di"idend calculations. <nrecorded or unauthori+ed transactions% or transactions not handled in a legal manner. 1ame as 4. <nauthori+ed or omitted e'uity transactions. )ncorrect earnings per share computation. )llegal payments of di"idends and improper disclosure of the information in the financial statements.

22-3& !he proposal for the limitation of procedure is not *ustified by the stated facts. 4lthough the transfer agent and the registrar &no# the number of shares issued% they do not necessarily &no# the number of shares outstanding. Furthermore% the audit of capital stoc& includes more than determining the number of shares outstanding. For example% the auditor must determine #hat authori+ations exist for the issuance of shares% #hat assets #ere recei"ed in payment of shares% ho# the transactions #ere recorded% and #hat subscription contracts ha"e been entered into. Confirmation from the registrar could not help in determining these things. )n addition to confirmation from the registrar% the audit of capital stoc& might include the follo#ing procedures% the purposes of #hich are briefly indicated: 1. 2. 2xamine the corporation charterDto determine the number of shares authori+ed and the special pro"isions for each class of stoc& if more than one class is authori+ed. 2xamine minutes of stoc&holders9 and directors9 meetingsDto determine authori+ation for appointments of the registrar and the transfer agentE to determine authori+ation for the issuance or reac'uisi( tion of shares.

22(13

22-3& !continued" 3. 4. 3. 5. ?. =. @. 2xamine pro"isions regarding capital stoc& in the corporation la# of the state of incorporationFto determine any special pro"isions% such as those for the issuance of no par stoc&. 4naly+e 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. !race the consideration recei"ed for capital stoc& into the recordsF to determine #hat consideration has been recei"ed and ho# it has been recorded. 2xamine and schedule treasury stoc& and re"ie# entries for treasury stoc&Fto determine the existence of treasury stoc& as authori+ed and to determine that a proper record has been made. $e"ie# registrar9s in"oices and cash disbursementsFto determine that original issue taxes ha"e been paid. Compare di"idends #ith stoc& outstanding at di"idend datesFto determine that di"idends ha"e been properly paid and also to substantiate the stoc& outstanding. $e"ie# subscription and option contracts% etc.Fto determine the facts in regard to subscriptions and options and to determine that these facts ha"e been properly recorded and that they are ade'uately disclosed. !he audit program for the audit of 0ate Corporation9s capital stoc& account #ould include the follo#ing procedures: 1. 2xamine the articles of incorporation% the byla#s% and the minutes of the board of directors from the inception of the corporation to determine the pro"isions or decisions regarding the capital stoc&% such as classes of stoc&% par "alue or stated "alue% authori+ed number of shares% authori+ation for the sale of ne# issues or additional sales of unissued stoc&% declarations of stoc& splits and di"idends in the form of cash or stoc&% and granting of stoc& options or stoc& rights. :etermine that the accounting records are in accordance #ith these pro"isions or decisions and that appropriate disclosure is made by footnote if necessary. 2xtract pertinent data for the auditor9s permanent file. 2xamine the stoc& certificate stub boo& and determine #hether the total of the open stubs agrees #ith the Capital 1toc& account in the general ledger. 2xamine cancelled stoc& certificates% #hich are generally attached to the corresponding stub. )nformation on the stubs regarding the number of shares% date% etc. for both outstanding and cancelled stoc& certificates should be compared #ith the Capital 1toc& account. 4ll certificate numbers should be accounted for and% if the C04 deems it necessary% confirmation of the 22(14

22-31

a.

2.

22-31 !continued" number of certificates printed should be obtained from the printer. 4 test chec& should be made to determine that the proper amounts of original issue and capital stoc& transfer taxes ha"e been affixed to the stubs and the cancelled certificates. !he stoc&holders sho#n in the stoc& certificate stub boo& should be compared #ith the stoc&holders9 master file if one is maintained. 3. 4naly+e the Capital 1toc& account from the corporation9s inception and "erify all entries. !race all transactions in"ol"ing the transfer of cash either to the cash receipts or the cash disbursements records. )f property other than cash #as recei"ed in exchange for capital stoc&% trace the recording of the property to the proper asset account and consider the reasonableness of the "aluation placed on the property. !ransactions sho#ing the sale of stoc& at a discount or premium should be traced to the Capital Contributed in 2xcess of 0ar ;alue account. )f capital stoc& has been sold at a discount% consideration should be gi"en to the possible "iolation of state la#s and the client9s attention should be directed to the matter. 1hould the analysis of the Capital 1toc& account disclose that the corporation has engaged in treasury stoc& transactions% determine that the increase or decrease in net assets resulting from these transactions has not been placed in the $etained 2arnings account. !he audit procedures to be applied to the audit of the Capital Contributed in 2xcess of 0ar ;alue account are usually applied at the same time that the Capital 1toc& account is being audited because the t#o accounts are interrelated. !he accounts should be analy+ed and the entries "erified #hen the related entries in the Capital 1toc& account are "erified. )f an entry is not related to Capital 1toc& account entries% as in the case of a #rite(off of a deficit as the result of a 'uasi reorgani+ation% authori+ation for the entry and the supporting material should be examined. !he follo#ing audit procedures #ould be applied to the $etained 2arnings account: i. 4naly+e the account from its inception. Consider the "alidity of the amounts representing income or loss that #ere closed from the 0rofit and >oss account. 4mounts representing appraisal increments or #riting up of assets should be considered for reasonableness% and the increase should be reported separately from retained earnings in the stoc&holders9 e'uity section of the balance sheet. 22(13

4.

22-31 !continued" ii. 4ny extraordinary gains or losses carried directly to the $etained 2arnings account should be in"estigated and their treatment re"ie#ed in relation to generally accepted accounting principles. 2ntries recording the appropriation of retained earnings or the return of such appropriations should be re"ie#ed for reasonableness% and authori+ation for the entries should be traced to the proper authority. 1imilarly% actions of the board of directors that affected retained earnings should be traced to the account analysis. Conditions such as loan co"enants or contingent liabilities that #ere unco"ered during the audit that might re'uire or ma&e desirable the placing of restrictions on retained earnings should be re"ie#ed for proper disclosure in the financial statements. 2ntries recording cash or stoc& di"idends should be traced to the minutes of the board of directors for authori+ation and traced to the Cash account or the Capital 1toc& account. 4 separate computation should be made by the C04 of the total amount of di"idends paid based upon his or her schedules of outstanding stoc& as an o"erall test of the existence of the distributions. )f stoc& di"idends ha"e been distributed% the amount remo"ed from retained earnings should be re"ie#ed for compliance #ith generally accepted accounting principles.

iii.

i".

".

b.

)n conducting his or her audit% the C04 "erifies retained earnings as he or she does other items on the balance sheet for se"eral reasons. 4 principal reason is that the "erification is an assurance or double chec& that no important item #as o"erloo&ed in the audit of the accounts that #ere the contra or balancing part of the entry recorded in retained earnings. 4n example of an important item that may be o"erloo&ed #ould be a balance sheet account that #as closed during the year under audit and the account remo"ed from the general ledger current file. 4nother reason is that% though the entry in the contra account may ha"e been examined% the auditor may ha"e o"erloo&ed that the balancing part of the entry #as to retained earnings% a treatment that may ha"e been contrary to generally accepted accounting principlesE his or her audit of retained earnings #ould bring this noncompliance to his or her attention. 1till another reason for "erifying the retained earnings account is to determine #hether any portion of the balance in the account may be sub*ect to restriction by state la# or other authority. 1ince the account is the basis for the payment of di"idends% it is

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important to determine that the balance is composed of income reali+ed from transactions free from any restrictions.

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22-32

a.
*6)*C3*, C7A2;* 52 9A4A2C* 2&&# 30 2&&$ )ncrease

ACC0/23 Cash

*6)4A2A3502 (0R *6)*C3*, C7A2;* 52 9A4A2C* -hile much of the proceeds #ere used to reduce debt and purchase hard#are and soft#are% unused proceeds #ere deposited in company ban& accounts. !he process of becoming publicly held #ould li&ely ha"e minimal impact on accounts recei"able% unless the "olume of business on the 2(4nti'ues -eb site significantly gro#s as a result of going public. ecause stoc& proceeds #ere used to purchase hard#are and soft#are% the balance in property% plant% and e'uipment #ould be expected to increase. 4ssuming the purchase of hard#are and soft#are is made on account% the balance in accounts payable #ould be expected to increase. ecause stoc& proceeds #ere used to payoff loans% the balance in long(term debt #ould be expected to decrease. :espite using stoc& proceeds to ac'uire original shares from company founders% the issuance of stoc& through the process of going public #ould result in a significant increase in the common stoc& account. :espite using stoc& proceeds to ac'uire original shares from company founders% the issuance of stoc& through the process of going public #ould result in a significant increase in the additional paid in capital account% assuming the stoc& #as issued at a price abo"e par "alue. !he transactions associated #ith going public #ould not affect the retained earnings account. !he ac'uisition of the original shares from the company founders #ould be treated as a purchase of treasury stoc&% thereby increasing the account balance. !he transactions associated #ith going public #ould not directly affect the di"idends account. )f the company pays di"idends% the account #ould increase because of the increase in the number of shares outstanding.

4ccounts $ecei"able

>ittle Change

0roperty% 0lant% and 2'uipment 4ccounts 0ayable >ong(!erm :ebt Common 1toc&

)ncrease

)ncrease

:ecrease

)ncrease

4dditional 0aid in Capital

)ncrease

$etained 2arnings !reasury 1toc&

No Change )ncrease

:i"idends

No Change

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22-32 !continued"
*6)*C3*, C7A2;* 52 9A4A2C* 2&&# 30 2&&$ >ittle Change

ACC0/23 $e"enues

*6)4A2A3502 (0R *6)*C3*, C7A2;* 52 9A4A2C* !he process of becoming publicly held #ould li&ely ha"e minimal impact on re"enues for the current year% unless the "olume of business on the 2(4nti'ues -eb site significantly gro#s as a result.

b.

-hile the decline in stoc& mar&et price to G1@ share is not fa"orable ne#s for 2(4nti'ues% that decline #ould ha"e no impact on the common stoc&% additional paid(in capital% or retained earnings accounts since the company did not engage in any stoc& related transactions during 2AA@. $ather% the decline in mar&et "alue impacts 2(4nti'ues in"estors. !he decline in stoc& price #ould li&ely increase the auditorCs assessment of business ris& and audit ris&. !he decline is li&ely to place significant pressure on management to generate fa"orable financial results in order to boost stoc& prices to earlier highs. !hat pressure may create a strong enough incenti"e for management to engage in acti"ities that may lead to an increased li&elihood of material misstatements in the financial statements due to fraud.

c.

5nternet )ro-lem 1olution< 1toc= *+chan>e Requirements 22-1 Many companies aspire to go public and ha"e their shares traded on exchanges such as the Ne# Hor& 1toc& 2xchange .NH12/ and N41:48. -hile there are numerous legal re'uirements to sell shares of stoc& to the public .see the 1ecurities and 2xchange Commission #ebsite Ihttp:JJ###.sec.go"K/% the NH12 has different re'uirements that focus on financial performance and health. ;isit the NH12 Ihttp:JJ###.nyse.comJK and N41:48 Ihttp:JJ###.nasda'.comJK #ebsites and find out the listing re'uirements for <.1. companies. Answer< !he listing re'uirements of the ma*or <1 exchanges ha"e changed in recent years. 4ccordingly% refer to the exchangesC #ebsites .i.e.% NH12 Ihttp:JJ###.nyse.comJK and N41:48 Ihttp:JJ###.nasda'.comJK/ prior to e"aluating student responses to this assignment. Note: !he NH12 ac'uired the 4merican 1toc& 2xchange .4M2L/ and 4M2L #as phased out in Manuary 2AA@.
.2ote: )nternet problems address current issues using )nternet sources. ecause )nternet sites are sub*ect to change% )nternet problems and solutions may change. Current information on )nternet problems is a"ailable at ###.pearsonhighered.comJarens./

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