CHAPTER

AUDIT OF THE FINANCING AND INVESTING

CYCLE: TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS

6-1.

Investing activities include an entitys activities to invest in debt or equity

securities of other entities and investments in property, plant, and equipment.
These transactions are often recorded during the expenditure cycle but are so
significant that additional controls are applied to them.

6-2.

Kickbacks, acquisitions of goods for personal use, appropriation of assets, and

processing of fictitious transactions can occur in the acquisition of property, plant,
and equipment, just as they do in the acquisition of goods. Related-party
transactions to acquire investments or property, plant, and equipment may result
in improper valuation of the accounts. Securities may be stolen or diverted.
Historically, business entities have manipulated the accounting values at which
assets were recorded by acquiring assets from a related party or selling assets to a
related party. Acquiring assets at inflated values may result in draining cash from
the acquiring entity. Selling assets at inflated values to related parties results in
increased revenue and assets to the selling entity, and these may never be realized.
All transactions conducted with related parties must be examined carefully.

6-3.

Critical controls include separating the responsibilities for authorizing

transactions, keeping records, and having custody of the asset.
Generally, the board, or sometimes an investment committee of the board, must
approve individual investments. After obtaining board approval, the treasurer or
vice president for finance has authority to execute the purchase or sale of an
investment transaction.
Due to their large peso value and susceptibility to misappropriation, investment
certificates (stocks or bonds) are often left in the custody of a broker or bank.
When the entity takes custody of investment certificates should be stored in a safe
deposit box.
Typically the general ledger clerk maintains investment records unless the entity
has a large volume of investment transactions.

6-2
6-4.

Solutions Manual to Accompany Applied Auditing, 2006 Edition

The substantive tests, grouped according to the assertions they test, are as follows:
Existence or occurrence: Recorded investments and investment income exist.

Inspect securities on hand and trace to listing.

Confirm securities held by others.

Completeness: All investments and investment income are recorded.

Apply analytical procedures.

Rights and obligations: Investments and investment income are owned by the
entity.

For investments acquired during the period, examine supporting invoices and
paid checks. For dividends, interest, and disposals of investments, examine
remittance advices.

Valuation or allocation: Investments are valued in accordance with GAAP and

investments and investment income are mathematically accurate.

Reconcile the investment listing to the subsidiary ledger and general ledger
account.

Recalculate interest revenue and verify dividend income by reference to

published reports of dividends.

Presentation and disclosure: Investments and investment income are presented in

accordance with GAAP.

Review statement presentation for compliance with GAAP.

6-5.

Financing activities consist of an entitys transactions to (1) obtain long-term

(capital) funds by issuing long-term debt or capital stock; (2) make payments
associated with long-term funds, such as payment of interest and dividends; and
(3) retire long-term funds by paying off or reacquiring debt or equity obligations.
Long-term debt includes notes, mortgages, and bonds. Capital stock includes both
common and preferred stock. Often these transactions are recorded in the sales
and collections cycle, but they are so significant that additional controls are
applied to them.

6-6.

The characteristics of the liability accounts that result in a different auditing

approach than followed in the audit of accounts payable are:
1) Relatively few transactions affect the account balances but each transaction
is often highly material in amount.
2) The exclusion of a single transaction could often be material by itself.
3) The relationship between the client entity and the holder of the ownership
document is legal in nature.
4) The liabilities involve accrual and payment of interest as well as debt.

Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions

6-3

6-7.

It is common to audit the balance in notes payable in conjunction with the audit of
interest expense and interest payable because it minimizes the verification time
and reduces the likelihood of overlooking errors in the balance. Once the auditor
is satisfied with the balance in notes payable the related interest rates and due
dates for each note, it is easy to test the accuracy of accrued interest. If the
interest expense for the year is also tested at the same time, the likelihood of
omitting a note from notes payable for which interest has been paid is minimized.
When 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,
however, there are only a few notes and few transactions during the year.

6-8.

The most important controls the auditor should be concerned about in the audit of
notes payable are:
1) The proper authorization for the issuance of new notes (or renewals) to ensure
that the company is not being committed to debt arrangements that are not
authorized.
2) Controls over the repayment of principal and interest to ensure that no more is
paid on the note than is required.
3) Proper records and procedures to ensure that all amounts in all transactions
are properly recorded.
4) Periodic independent verification to ensure that all the controls over notes
payable are working.

6-9.

Four types of restrictions long-term creditors often put on companies in granting

them a loan are:
1)
2)
3)
4)

Financial ratio restrictions

Payment of dividends restrictions
Operations restrictions
Issue of additional debt restrictions

The auditor can find out about these restrictions by examining the loan agreement
and related correspondence associated with the loan, and by confirmation. The
auditor must perform calculations and observe activities to determine whether the
client has observed the restrictions.
6-10.

The major internal control over owners equity are:

1) Proper authorization of transactions
2) Proper record keeping
3) Adequate segregation of duties between maintaining owners equity records
and handling cash and stock certificates
4) The use of an independent registrar and stock transfer agent

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

6-11.

Since it is important to verify that properly authorized dividends have been paid to
owners of stock as of the dividend record date, a comparison of a random sample
of canceled dividend checks to a dividend list prepared by management would be
inadequate. Such an audit step is useless unless the dividend list has first been
verified to include all stockholders of record at the dividend record date. A better
test is to determine the total number of shares outstanding at the dividend date
from the stock registrar and recompute the total dividends that should have been
paid for comparison with the total amount actually paid. A random sample of
canceled checks should then be compared to the independent registrars records to
verify that the payments were actually made to valid shareholders.

6-12.

1) c
2) d

3) c
4) d

5) c

6-13.

1) d
2) a

3) c
4) d

5) a
6) a

6-14.

1) d

2) a

3) b

6-15.

1) a

2) a

3) a

6-16.

1) b

2) a

3) c

4) c

6-17.
a.

b.

Purpose of
Control

Potential Financial
Statement Error

c.
Audit Procedure to
Determine Existence
of Material Error

1. To assure that all note

liabilities are
authorized by proper
management.

Loss of assets through

payment of excess
interest rates or the
diversion of cash to
unauthorized persons.

Check note request forms

for proper authorization.

2. To assure that note

transactions are
recorded in full and in
detail.

Improper disclosure or
errors in note payable
through duplication.

Determine if master file

is maintained, and
reconcile detailed
contents to control.

3. To prevent misuse of
notes and funds
earmarked for notes.

Misstatement of
liabilities and cash.

Determine if duties are

segregated. Perform all
substantive procedures on
extended basis.

Audit of the Financing and Investing Cycle: Tests of Controls and Substantive Tests of Transactions

6-18.

6-5

4. To assure that notes

are not paid more than
once.

Loss of cash.

Check paid notes for

cancellation.

5. To assure that all noterelated transactions

agree with account
balances.

Misstatement of notes
payable.

Determine if
reconciliations are
periodically made, and
verify reconciliation.

6. To further assure that

only the proper
interest amount is paid
and recorded.

Misstatement of interest
expense and related
accrual.

Determine if interest
computations are
internally verified.
Recompute interest on a
test basis.

Since the source of the debits in the asset account is the purchase journal (or
similar record), the current period acquisitions of property, plant and equipment
have already been partially verified as part of the acquisition and payment cycle.
The disposal of assets, depreciation and accumulated depreciation are not tested as
a part of the acquisition and payment cycle.

6-19.
Item
No.

Internal Control

Substantive
Audit Procedure

1.

Use of government study

depreciation tables.

Compare to government study

depreciation table.

2.

Make approvals required for all

expending over a certain
amount.

Test all expense charges to these

accounts over a certain amount.

3.

Have construction foreman

report to accounting department
periodically whether or not
there have been abandonments
or replacements.

Examine equipment listed on the

books.

4.

Have expense records

internally verified.

Analyze depreciation and

administrative expenses by ratio
comparison to previous years.

5.

Assign tools to individual

foreman and periodically count
the tools.

Take a physical count of the tools.

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Solutions Manual to Accompany Applied Auditing, 2006 Edition

6.

Have recording of property

acquisitions internally verified.

Review supporting documentation on

property acquisitions and compare to
recorded value.

7.

The deposit of all cash directly

into the bank account.

(1) Confirmation of bank accounts and

other tests for unrecorded loans.
(2) Physical examination of plant
assets.

6-20.
Liability that could
be Uncovered

Audit Procedure to
Uncover Liability

a. Lawsuit

Review minutes of the Board of

Directors meetings.

b. Building used as collateral for a

loan

Examine documents of ownership and

bank confirmations.

c. Unrecorded lease

Examine the lease agreements.

d. Note payable

Examine underlying records for the

related loan.

e. Policy loan

Confirmation with life insurance

company.

f. Note payable

Obtain confirmation from bank.

g. Income taxes payable for

nondeductible expenses

Review travel and expense reports.