Chapter 22

Auditing and Assurance Services, 16e (Arens/Elder/Beasley)
Chapter 22 Audit of the Capital Acquisition and Repayment Cycle
22.1 Learning Objective 22-1
1) Which of the following statements is correct regarding the capital acquisition and payment
cycle?
A) Bonds are frequently issued by companies in small amounts.
B) There are relatively few transactions and each transaction is typically highly material.
C) A primary emphasis in auditing debt is on existence.
D) Audit procedures for notes payable and interest income are often performed simultaneously.
Answer: B
Terms: Capital acquisition and payment cycle
Diff: Easy
Objective: LO 22-1
AACSB: Reflective thinking
2) The capital acquisition and repayment cycle does not include

A) payment of interest.
B) payment of dividends.
C) payment of vendor invoices.
D) acquisition of capital through interest-bearing debt.
Answer: C
Terms: Capital acquisition and payment cycle
Diff: Easy
Objective: LO 22-1
3) Which of the following statements regarding the capital acquisition and repayment cycle is
most correct?
A) A relatively few transactions affect the cycle, and most are smaller amounts.
B) A large numbers of transactions affect the cycle, and most are smaller amounts.
C) A relatively few transactions affect the cycle, and most are highly material.
D) A large number of transaction affect the cycle, and most are highly material.
Answer: C
Terms: Capital acquisition and repayment cycle
Diff: Easy
Objective: LO 22-1
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4) The primary audit objectives to focus on when auditing accounts in the capital acquisition and
repayment cycle are
A) accuracy and completeness.
B) accuracy and existence.
C) completeness and valuation.
D) accuracy and valuation.
Answer: A
Terms: Primary audit objectives focus on when auditing debt
Diff: Easy
Objective: LO 22-1
5) Performance materiality is often set at a(n) ________ level for notes payable.
A) high
B) moderate
C) low
D) unknown
Answer: C
Terms: Performance materiality for notes payable
Diff: Easy
Objective: LO 22-1
6) When auditing interest-bearing debt, the auditor should ________ verify the related interest
expense and interest payable.
A) not
B) attempt to
C) simultaneously
D) never
Answer: C
Terms: Audit of interest-bearing debt and related interest expense and interest payable
Diff: Easy
Objective: LO 22-1
7) Assessed control risk and results of substantive tests of transactions are normally unimportant
for designing tests of details of balances for which of the following accounts?
A) accounts receivable
B) inventory
C) accounts payable
D) notes payable
Answer: D
Terms: Assessed control risk; Results of substantive tests of transactions; Unimportant for
designing tests of details of balances
Diff: Moderate
Objective: LO 22-1
2
8) In the audit of the transactions and amounts in the capital acquisition and repayment cycle, the
auditor must take great care in making sure that the significant legal requirements affecting the
financial statements have been properly fulfilled and
A) any violations are reported to the SEC.
B) are adequately disclosed in the financial statements.
C) must issue a disclaimer if they haven't been fulfilled.
D) any departures from the agreements are made with management's knowledge and consent.
Answer: B
Terms: Audit of transactions and amounts in the capital acquisition and repayment cycle
Diff: Moderate
Objective: LO 22-1
9) All corporations must have

A) preferred stock.
B) capital stock.
C) paid-in capital in excess of par.
D) dividends payable.
Answer: B
Diff: Moderate
Objective: LO 22-1
10) List the four characteristics of the capital acquisition and repayment cycle that make it
unique from other cycles.
Answer: The four characteristics are:
• Relatively few transactions affect the account balances, but each transaction is often highly
material in amount.
• The exclusion or misstatement of a single transaction can be material.
• There is a legal relationship between the client entity and the holder of the stock, bond, or
similar ownership document.
• There is a direct relationship between the interest and dividends accounts and debt and equity.
Terms: Unique characteristics of capital acquisition and repayment cycle
Diff: Challenging
Objective: LO 22-1
3
11) List six accounts in the capital acquisition and repayment cycle commonly found on balance
sheets of corporations. What characteristics do these accounts have in common that distinguish
them from other accounts?
Answer: Balance sheet accounts in the capital acquisition and repayment cycle include:
• Notes payable
• Contracts payable
• Mortgages payable
• Bonds payable
• Accrued interest
• Cash in the bank
• Capital stock-common
• Capital stock-preferred
• Paid-in capital in excess of par
• Donated capital
• Retained earnings
• Appropriations of retained earnings
• Treasury stock
• Dividends declared
• Dividends payable
The unique characteristics of these accounts are:
• Relatively few transactions affect the account balances, but each transaction is often highly
material in amount.
• The exclusion of a single transaction could be material in itself.
• There is a legal relationship between the client entity and the holder of the stock, bond, or
similar ownership document.
• There is a direct relationship between the interest and dividends accounts and debt and
equity.
Terms: Accounts commonly found in capital acquisition and repayment cycle and unique
characteristics
Diff: Challenging
Objective: LO 22-1
12) One unique characteristic of the capital acquisition and repayment cycle is that relatively few
transactions affect the account balances, but each transaction is often highly material in amount.
Answer: TRUE
Terms: Characteristic of capital acquisitions and repayment cycle
Diff: Easy
Objective: LO 22-1
4
13) Auditors seldom learn about the capital acquisition and repayment cycle when gaining an
understanding of the client's business and industry.
Answer: FALSE
Diff: Easy
Objective: LO 22-1
14) When auditing the capital acquisition and repayment cycle, it is common to verify each
transaction taking place in the cycle for the entire year as a part of verifying the balance sheet
accounts.
Answer: TRUE
Terms: Auditing capital acquisition and repayment cycle; Verify transactions
Diff: Moderate
Objective: LO 22-1
15) There is an indirect relationship between the interest and dividends accounts and debt and
equity.
Answer: FALSE
Diff: Moderate
Objective: LO 22-1
1) Which of the following is not an objective of the auditor's examination of notes payable?
A) to determine whether internal controls are adequate
B) to determine whether client's financing arrangements are effective and efficient
C) to determine whether transactions regarding the principal and interest of notes are properly
authorized
D) to determine whether the liability for notes and related interest expense and accrued liabilities
are properly stated
Answer: B
Terms: Objectives of auditor's examination of notes payable
Diff: Easy
Objective: LO 22-2
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2) Responsibility for the issuance of new notes payable would normally be vested in the
A) board of directors.
B) purchasing department.
C) accounting department.
D) accounts payable department.
Answer: A
Terms: Responsibility for issuance of notes payable
Diff: Easy
Objective: LO 22-2
3) An auditor is determining whether an issuance of notes payable for cash was correctly
recorded. Her best course of action would be to
A) confirm with the bond trustee as to the amount of bonds issued.
B) confirm with the underwriter as to the appropriate market yield on the bonds.
C) trace the cash received from the proceeds to the accounting records.
D) verify that the amount was included in a footnote disclosure.
Answer: C
Terms: Audit of bonds payable
Diff: Challenging
Objective: LO 22-2
AACSB: Analytic thinking
4) The auditor's independent estimate of interest expense from notes payable uses average
interest rates and
A) average notes payable outstanding.
B) year-end notes payable outstanding.
C) only notes payable above the level of materiality.
D) only notes payable to major lenders.
Answer: A
Terms: Auditor's independent estimate of interest expense from notes payable
Diff: Easy
Objective: LO 22-2
5) The tests of details of balances procedure which requires the auditor to trace the totals of the
notes payable list to the general ledger satisfies the audit objective of
A) accuracy.
B) existence.
C) detail tie-in.
D) completeness.
Answer: C
Terms: Tests of details of balances procedures for notes payable
Diff: Easy
Objective: LO 22-2
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6) The audit objective to determine that notes payable in the schedule actually exist is verified by
the test of details of balances procedure to
A) foot the notes payable list.
B) confirm notes payable.
C) recalculate interest expense.
D) examine the balance sheet for proper disclosure of noncurrent portions.
Answer: B
Terms: Audit objective to determine notes payable actually exist
Diff: Easy
Objective: LO 22-2
7) Actual interest expense is significantly higher than the auditor's estimate. This would most
likely lead the auditor to conclude that the client has not
A) recorded all long-term interest bearing debt in the accounting records.
B) recorded all interest expense paid or accrued.
C) properly accounted for the discount of bonds payable account.
D) properly recorded interest income.
Answer: A
Terms: Substantive analytical procedures result in interest expense higher than actually recorded
Diff: Easy
Objective: LO 22-2
8) You are auditing the long-term notes payable account for a client. Which of the following
audit procedures would you most likely employ?
A) Compare interest expense recorded by the client with the notes payable account for
reasonableness.
B) Confirm bonds payable with individual bond holders.
C) Perform analytical procedures on the bond discount or premium account.
D) Examine bond documents for the presence of hybrid securities.
Answer: A
Terms: Audit of long-term bonds payable
Diff: Challenging
Objective: LO 22-2
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9) The two most important balance-related audit objectives for notes payable are
A) completeness and detail tie-in.
B) completeness and valuation.
C) accuracy and valuation.
D) accuracy and completeness.
Answer: D
Terms: Most important balance-related audit objectives for notes payable
Diff: Moderate
Objective: LO 22-2
10) Which of the following audit tests would provide evidence regarding the balance-related
audit objective of existence for an audit of notes payable?
A) Examine due dates on duplicate copies of notes.
B) Examine balance sheet for proper presentation and disclosure of notes payable.
C) Examine corporate minutes for loan approval.
D) Foot the notes payable list for notes payable and accrued interest.
Answer: C
Terms: Audit tests to provide evidence regarding the balance-related audit objective of existence
for audit of notes payable
Diff: Moderate
Objective: LO 22-2
11) Which of the following balance-related audit objectives is not applicable to the audit of notes
payable?
A) realizable value
B) detail tie-in
C) cutoff
D) classification
Answer: A
Terms: Balance-related audit objectives not related to audit of notes payable
Diff: Moderate
Objective: LO 22-2
8
12) When there are not numerous transactions involving notes payable during the year, the
normal starting point for the audit of notes payable is
A) a schedule of notes payable and accrued interest prepared by the audit team.
B) a schedule of notes payable and accrued interest obtained from the client.
C) a schedule of only those notes with unpaid balances at the end of the year prepared by the
client.
D) the notes payable account in the general ledger.
Answer: B
Terms: Starting point for audit of notes payable
Diff: Moderate
Objective: LO 22-2
13) The tests of details of balances procedure which requires the auditor to examine notes paid
after year-end to determine whether they were liabilities at the balance sheet date is an attempt to
satisfy the audit objective of
A) existence.
B) completeness.
C) accuracy.
D) classification.
Answer: B
Terms: Tests of details of balances procedures to examine notes paid after year-end satisfies
audit objective
Diff: Moderate
Objective: LO 22-2
14) The audit objective that requires that existing notes payable be included in the notes payable
schedule is satisfied by performing which of the following audit procedures?
A) Confirm notes payable.
B) Trace the total of the notes payable schedule to the general ledger.
C) Review the notes payable schedule to determine whether any are related parties.
D) Review the bank reconciliation for new notes credited directly to the bank account by the
bank.
Answer: D
Terms: Audit objective that requires existing notes payable be included in notes payable
schedule
Diff: Moderate
Objective: LO 22-2
9
15) The audit objective that requires the auditor to determine that notes payable on the notes
payable schedule are properly classified can be tested by performing the procedure to
A) confirm notes payable.
B) examine corporate minutes for loan approval.
C) examine notes, minutes, and bank confirmations for restrictions.
D) review the notes to determine whether any are with related parties.
Answer: D
Terms: Audit objective that requires auditor to determine that notes payable are properly
classified
Diff: Challenging
Objective: LO 22-2
16) During the course of an audit, a CPA observes that the recorded interest expense seems to be
excessive in relation to the balance in the long-term debt account. This observation could lead
the auditor to suspect that
A) long-term debt is understated.
B) discount on bonds payable is overstated.
C) long-term debt is overstated.
D) premium on bonds payable is understated.
Answer: A
Terms: CPA observes recorded interest expense excessive in relation to balance in long-term
debt account
Diff: Challenging
Objective: LO 22-2
17) To determine if notes payable are included in the proper period, the auditor should
A) trace the cash received from the issuance to the accounting records.
B) examine duplicate copies of notes to determine whether the notes were dated on or before the
balance sheet date.
C) examine duplicate copies of notes for principal and interest rates.
D) trace the individual notes payable to the master file.
Answer: B
Terms: Balance-related audit objective to examine duplicate copies of notes payable
Diff: Challenging
Objective: LO 22-2
10
18) In the audit of notes payable, it is common to include tests of principal and interest payments
as a part of the audit of the acquisitions and payment cycle because the payments are in the cash
disbursements journal that is being sampled. It is also normal to test these transactions as part of
the capital acquisitions and repayment cycle because
A) it is not unusual for the auditor to duplicate a process, thereby gathering a larger quantity of
evidence.
B) replicating the evidence will provide the auditor with a higher level of assurance.
C) the tests done in the acquisitions and payments cycle will look only at the cash credit side so
the tests done in the capital acquisitions and repayment cycle will look at the debit side of the
transaction.
D) due to the infrequency of these transactions, in many cases no transactions involving notes
payable are included in the sample tests of acquisitions and payments.
Answer: D
Terms: Audit of notes payable tests of principal and interest payments
Diff: Challenging
Objective: LO 22-2
19) Which of the following is not an important control over notes payable?
A) There is proper authorization over the issuance of new notes payable.
B) Notes payable are issued when the business climate is favorable.
C) Adequate controls exist over repayment of interest and principal.
D) There exist proper documents and records.
Answer: B
Terms: Issuance of mortgage bonds
Diff: Moderate
Objective: LO 22-2
20) Which of the following is an accurate statement regarding the audit of the capital acquisition
and repayment schedule?
A) When internal controls over notes payable are deficient, auditors are required to confirm the
notes payable.
B) As auditors perform tests of details of balances for balance-related audit objectives, the
evidence obtained helps satisfy the notes payable presentation and disclosure requirements.
C) The normal starting point for the audit of notes payable is a list of fixed asset acquisitions.
D) The schedule of notes payable and accrued interest must be prepared regardless of the number
of transactions involved.
Answer: B
Diff: Challenging
Objective: LO 22-2
11
21) Which balance-related audit objective is important for uncovering both errors and fraud?
A) completeness
B) existence
C) accuracy
D) detail tie-in
Answer: A
Terms: Acquisition and payment cycle
Diff: Moderate
Objective: LO 22-2
22) Why are substantive analytical procedures essential for notes payable?
Answer: They are essential because tests of details for interest expense and accrued interest can
often be eliminated if the results from the analytical procedures are favorable.
Terms: Analytical procedures for notes payable
Diff: Easy
Objective: LO 22-2
23) What are the two most important balance-related audit objectives in notes payable?
Answer:
• existing notes payable are included (completeness)
• notes payable are accurately recorded (accuracy)
Terms: Balance-related audit objectives in notes payable
Diff: Moderate
Objective: LO 22-2
24) Identify three substantive analytical procedures commonly performed for notes payable.
Answer: Some possible analytical procedures for notes payable include:
• Recalculate approximate interest expense on the basis of average interest rates and overall
monthly notes payable.
• Compare individual notes outstanding with the prior years.
• Compare total balance in notes payable, interest expense, and accrued interest with prior year
balances.
Diff: Moderate
Objective: LO 22-2
12
25) The starting point for the audit of notes payable is a schedule of notes payable and accrued
interest. Discuss the information typically included in the schedule.
Answer: The usual schedule includes detailed information of all transactions that took place
during the entire year for principal and interest, the beginning and ending balances for notes and
interest payable, and descriptive information about the notes, such as the due date, the interest
rate, and the assets pledged as collateral.
Terms: Information included in notes payable schedule
Diff: Moderate
Objective: LO 22-2
26) You are employing tests of details of balances for notes payable and interest expense.
Describe below specific audit procedures you would perform for the balance-related audit
objectives of detail tie-in and existence. List at least two for each objective.
Answer: Detail tie-in: (1) foot the notes payable list for notes payable and accrued interest, (2)
trace the totals on the notes payable list to the general ledger, (3) trace the individual notes
payable to the master file.
Existence: (1) confirm notes payable, (2) examine duplicate copies for authorization, (3) examine
corporate minutes for loan approval.
Terms: Tests of details of balances for notes payable - detail tie-in and existence of balance-
related audit objectives
Diff: Moderate
Objective: LO 22-2
27) Discuss the four key controls over notes payable.

Answer: The four key controls over notes payable are:
• Proper authorization for the issue of new notes. Responsibility for the issuance of new notes
should be vested in the board of directors or high-level management personnel, with signatures
of multiple properly authorized officials required for all loan agreements.
• Adequate controls over the repayment of principal and interest. At the time notes are issued,
the accounting department should receive a copy in the same manner in which it receives
vendors' invoices and receiving reports. The accounts payable department should automatically
issue checks for the notes when they become due, in the same manner in which it prepares
checks for acquisitions of goods and services.
• Proper documents and records. These include the maintenance of subsidiary records and
control over blank and paid notes by an authorized person. Paid notes should be cancelled and
retained under the custody of an authorized official.
• Periodic independent verification. The detailed note records should be reconciled
periodically with the general ledger and compared with the note holders' records by an employee
who is not responsible for maintaining the detailed records. At the same time, an independent
person should recompute interest expense on notes to test the accuracy of the record keeping.
Terms: Key controls
Diff: Challenging
Objective: LO 22-2
13
28) Discuss the overall objectives of the audit of notes payable.
Answer: The overall objectives of the audit of notes payable are to determine whether:
• The internal controls over notes payable are adequate.
• Transactions for principal and interest involving notes payable are properly authorized and
recorded in accordance with the six transaction-related audit objectives.
• The liability for notes payable and the related interest expense and accrued liability are
properly stated as defined by seven of the eight balance-related audit objectives (realizable value
is excluded).
• Disclosures related to notes payable and the related interest expense satisfy the four
presentation and disclosure audit objectives.
Terms: Objectives of audit of notes payable
Diff: Challenging
Objective: LO 22-2
29) Notes payable are generally for a period of sixty days or less.
Answer: FALSE
Terms: Notes payable time
Diff: Easy
Objective: LO 22-2
30) When performing substantive analytical procedures for notes payable, if actual interest
expense is materially larger than the auditor's expectation, one possible cause would be interest
payments on unrecorded notes payable.
Answer: TRUE
Diff: Moderate
Objective: LO 22-2
31) The balance-related audit objective realizable value is not applicable when auditing notes
payable.
Answer: TRUE
Terms: Auditing notes payable and balance-related audit objective realizable value
Diff: Moderate
Objective: LO 22-2
14
32) The three most important balance-related audit objectives for notes payable are existence,
realizable value, and accuracy.
Answer: FALSE
Terms: Balance-related audit objectives for notes payable; Existence, realizable value and
accuracy
Diff: Moderate
Objective: LO 22-2
33) The audit procedure "Foot the notes payable list and trace the totals to the general ledger" is
performed when verifying the accuracy objective for notes payable.
Answer: FALSE
Terms: Verifying accuracy objective for notes payable audit procedure
Diff: Moderate
Objective: LO 22-2
34) The audit procedure "Review the notes to determine whether any are related party notes or
accounts payable" is performed when verifying the classification objective for notes payable.
Answer: TRUE
Terms: Audit procedure to verify classification objective for notes payable
Diff: Moderate
Objective: LO 22-2
35) If loans require significant restrictions on the activities of the company, they must be
disclosed in the footnotes.
Answer: TRUE
Terms: Notes payable and disclosure requirements
Diff: Moderate
Objective: LO 22-2
1) Which of the following would generally not need to be approved by the board of directors?
A) issuing capital stock
B) repurchasing capital stock
C) declaration of a dividend
D) payment of a dividend
Answer: D
Terms: Not need approval by board of directors
Diff: Moderate
Objective: LO 22-3
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2) Which of the following owners' equity transactions usually require specific authorization from
a company's board of directors?
A)
Repurchase of common Issuance of common
stock stock Declaration of dividends
Yes Yes Yes
B)
Yes Yes No
C)
No Yes No
D)
No No Yes
Answer: A
Terms: Owners' equity transactions that require specific authorization
Diff: Moderate
Objective: LO 22-3
3) When a company maintains its own records of stock transactions and outstanding stock,
internal controls must be adequate to ensure that
A) actual owners are recorded in the bylaws.
B) the correct amount of dividends is paid to stockholders owning the stock on the dividend
record date.
C) the correct amount of dividends is paid to stockholders owning the stock on the declaration
date.
D) actual owners are recorded in the minutes.
Answer: B
Terms: Internal controls to maintain records of stock transactions and outstanding stock
Diff: Moderate
Objective: LO 22-3
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4) The amount of time spent verifying owners' equity is frequently minimal for closely held
corporations because
A) these companies are so small that it is not necessary to audit the capital section.
B) the few owners all have access to the books so the auditor spends more time on accounts like
liabilities, which affect outsiders.
C) there are few if any transactions during the year for the capital stock accounts, except for
earnings and dividends.
D) there is no public interest in these companies.
Answer: C
Terms: Time spent verifying owners' equity for closely held corporations
Diff: Moderate
Objective: LO 22-3
5) Which of the following types of owners' equity transactions would require authorization by
the board of directors?
A) issuance of capital stock
B) repurchase of capital stock
C) declaration of dividends
D) all of the above
Answer: D
Terms: Owners' equity transaction requiring authorization by board of directors
Diff: Moderate
Objective: LO 22-3
6) The record of the issuance and repurchase of capital stock for the life of the corporation is
maintained in the
A) shareholders' capital stock master file.
B) capital stock certificate record.
C) schedule of stock owners.
D) corporate directory.
Answer: B
Terms: Record of issuance and repurchase of capital stock
Diff: Moderate
Objective: LO 22-3
17
7) The record of the outstanding shares at any given time is maintained in the
A) corporate directory.
B) stock certificate books.
C) schedule of stock owners.
D) shareholders' capital stock master file.
Answer: D
Terms: Record of outstanding shares
Diff: Moderate
Objective: LO 22-3
8) When a dividend is declared by the board of directors, the source for determining who should
receive dividend checks is the
A) shareholders' capital stock master file.
B) stock certificate books.
C) common stock account in the general ledger.
D) corporate directory.
Answer: A
Terms: Source for determining who should receive dividend checks
Diff: Moderate
Objective: LO 22-3
9) The authorization of an issuance of capital stock normally includes all but which of the
following?
A) type of stock to be issued
B) number of shares to be issued
C) date shares are to be issued
D) amount of dividend to be paid on shares issued
Answer: D
Terms: Authorization of issuance of capital stock includes
Diff: Moderate
Objective: LO 22-3
10) Any company with stock listed on a securities exchange is required to engage a(n)
A) equity analyst.
B) stock transfer agent.
C) independent registrar.
D) equity placement specialist.
Answer: C
Terms: Company with stock listed on securities exchange required to engage
Diff: Moderate
Objective: LO 22-3
18
11) All of the following are owners' equity accounts except for
A) common stock.
B) paid-in-capital in excess of par.
C) sales.
D) retained earnings.
Answer: C
Terms: Owners' equity accounts
Diff: Easy
Objective: LO 22-3
12) When a company maintains its own records of stock transactions and capital stock
outstanding, its internal controls must be adequate to accomplish three objectives. List them
below.
Answer:
1. Actual owners of the stock are recognized in the corporate records.
2. The correct amount of dividends is paid to stockholders owning the stock as of the dividend
record date.
3. The potential for misappropriation of assets is minimized.
Terms: Internal controls and objectives when records maintained of stock transactions and
capital stock outstanding
Diff: Easy
Objective: LO 22-3
13) What is the difference between an independent registrar and a stock transfer agent?
Answer: Companies whose shares are listed on a securities exchange are required to enlist the
services of an independent registrar as a control to prevent the improper issue of stock
certificates. The registrar is responsible for making sure that stock is issued by a corporation in
accordance with the capital stock provisions in the corporate charter and the authorization by the
board of directors. When there is a change in the ownership of the stock, the registrar is
responsible for signing all newly issued stock certificates and making sure that old certificates
are received and cancelled before a replacement certificate is issued.
A stock transfer agent maintains stockholder records, including those documenting transfers of
stock ownership. The employment of a transfer agent helps strengthen control over the stock
records by putting the records in the hands of an independent organization and helps reduce the
cost of record keeping by using a specialist. Many companies also have the transfer agent
disburse cash dividends to shareholders, further improving internal control.
Terms: Independent registrar and stock transfer agent differences
Diff: Easy
Objective: LO 22-3
19
14) What are two important internal control procedures that companies should implement to
prevent misstatements in owners' equity when a company maintains its own records of stock
transactions and outstanding stock?
Answer: Control procedures should include:
1. well-defined policies for preparing stock certificates and recording capital stock transactions
2. proper assignment of personnel
3. adequate record-keeping procedures
4. independent internal verification of information in the records.
Terms: Procedures to prevent misstatements in owners' equity
Diff: Moderate
Objective: LO 22-3
15) Discuss the internal controls related to owners' equity that are of concern to the auditor.
Answer:
• Proper authorization of transactions. Material transactions should be approved by the board
of directors, including issuance of capital stock, repurchase of capital stock, and declaration of
dividends.
• Proper recordkeeping and segregation of duties. This should include well-defined policies
for preparing stock certificates and recording capital stock transactions, and independent internal
verification of information in the records. Internal controls should be adequate to ensure that
actual owners of the stock are recognized in the corporate records, the correct amount of
dividends paid to the stockholders owning stock as of the record date, and the potential for
misappropriations of assets is minimized. Many companies use a capital stock certificate book
and a shareholders' capital stock master file to improve control over capital stock transactions.
• Independent registrar and stock transfer agent. An independent registrar acts as a control to
prevent the improper issuance of stock certificates. A stock transfer agent acts as a control over
the stock records.
Terms: Internal controls related to owners' equity
Diff: Challenging
Objective: LO 22-3
20
16) Match six of the terms (a-i) used in the capital acquisitions and repayment cycle with the
descriptions provided below (1-6):
a. capital acquisition and repayment cycle

b. capital stock certificate book
c. closely held corporation
d. independent registrar
e. note payable
f. publicly held corporation
g. stock transfer agent
h. schedule of notes payable and accrued interest
i. stock maintenance agent
________ 1. an outside person engaged by a corporation to make sure that its stock is issued in
accordance with capital stock provisions in the corporate charter and authorizations by the board
of directors
________ 2. the normal starting point for the audit of notes payable; includes detailed
information of all transactions related to notes payable that took place during the year
________ 3. a record of the issuance and repurchase of capital stock for the life of the
corporation
________ 4. an outside person engaged by a corporation to maintain the stockholder records, and
often to disburse cash dividends
________ 5. an entity that is required to engage an independent registrar
________ 6. the cycle that concerns the acquisition of capital resources through interest-bearing
debt and owners' equity and repayment of the capital
Answer:
1. d
2. h
3. b
4. g
5. f
6. a
Terms: Capital acquisition and payment cycle; Capital stock certificate book; Independent
registrar; Publicly held corporation; Stock transfer agent; Schedule of notes payable and accrued
interest
Diff: Moderate
Objective: LO 22-3
21
17) The Securities and Exchange Commission requires companies listed on exchanges to employ
stock transfer agents.
Answer: FALSE
Terms: Securities and Exchange Commission; Stock transfer agents
Diff: Easy
Objective: LO 22-3
18) Public companies whose stock is listed on a stock exchange must employ an independent
registrar.
Answer: TRUE
Terms: Public companies with stock listed on stock exchange; Independent registrar
Diff: Easy
Objective: LO 22-3
19) The shareholders' capital stock master file is used as the basis for the payment of dividends
and also acts as a check on the accuracy of the common stock balance in the general ledger.
Answer: TRUE
Terms: Shareholders' capital master file use
Diff: Easy
Objective: LO 22-3
20) Independent registrars commonly disburse cash dividends to shareholders.

Answer: FALSE
Terms: Independent registrars
Diff: Easy
Objective: LO 22-3
21) Few large companies employ stock transfer agents, but small companies commonly do so.
Answer: FALSE
Terms: Stock transfer agents
Diff: Moderate
Objective: LO 22-3
22) Most closely held corporations have numerous transactions during the year for capital stock
accounts.
Answer: FALSE
Terms: Closely held company
Diff: Moderate
Objective: LO 22-3
22
23) A shareholders' capital stock master file is a record of the issuance and repurchase of capital
stock over the life of the corporation.
Answer: FALSE
Terms: Shareholders' capital stock master file
Diff: Moderate
Objective: LO 22-3
24) The board of directors must authorize the amount of the dividend per share and the dates of
record and payment of the dividend.
Answer: TRUE
Terms: Board of directors and dividends
Diff: Moderate
Objective: LO 22-3
1)
23
A) whether the transactions should have been included in retained earnings.
B) whether the transactions have been accurately recorded.
C) whether the transactions are classified correctly in the footnotes.
D) whether the transactions existed as of the balance sheet date.
Answer: A
Terms: Audit of retained earnings
Diff: Moderate
Objective: LO 22-4
2) Which of the following is an important source of information for determining whether the
presentation and disclosure-related objectives for capital stock activities are satisfied?
A) the corporate charter
B) the minutes of board of directors meetings
C) the auditor's analysis of capital stock transactions
D) all of the above
Answer: D
Terms: Capital stock is properly presented and disclosed
Diff: Moderate
Objective: LO 22-4
24
3) Which of the following audit objectives is least important in the audit of capital stock and
paid-in-capital in excess of par?
A) completeness
B) accuracy
C) rights and obligations
D) presentation and disclosure
Answer: C
Terms: Audit objective least important in audit of capital stock and paid-in capital
Diff: Moderate
Objective: LO 22-4
4) The primary concern in determining whether retained earnings is correctly disclosed on the
balance sheet is
A) correct calculation of the net income or loss for the year.
B) correct calculation of dividend payments for the year.
C) whether prior-period adjustments have been made correctly.
D) whether there are any restrictions on the payment of dividends.
Answer: D
Terms: Primary concern in determining correct disclosure of retained earnings
Diff: Moderate
Objective: LO 22-4
5) When verifying if capital stock is accurately recorded,

A) the ending balance in the account does not need to verified.
B) the number of shares outstanding at the balance sheet date is verified by examining the
corporate minutes.
C) the recorded par value can be determined by multiplying the number of shares by the market
price of the stock.
D) a confirmation from the transfer agent is the simplest way to verify the number of shares
outstanding at the balance sheet date.
Answer: D
Terms: Confirmation to auditor from capital stock registrar and/or transfer agent
Diff: Moderate
Objective: LO 22-4
25
6) What type of audit test will auditors use when testing to see if the amounts of capital stock
transactions are accurately recorded?
A)
Tests of details of Substantive tests of
balances transactions Tests of controls
No Yes Yes
B)
Yes No Yes
C)
No Yes No
D)
Yes No No
Answer: D
Terms: Capital stock transactions accurately recorded
Diff: Moderate
Objective: LO 22-4
7)
26
A) The emphasis is on the ending balance in the dividends account.
B) When auditors verify that the dividends are paid to stockholders that exist, they are concerned
with the completeness objective.
C) If the client uses a transfer agent to disburse dividends, the total can be traced to a cash
disbursement entry to the agent and also confirmed.
D) All of the above are correct statements.
Answer: C
Terms: Audit of dividends
Diff: Moderate
Objective: LO 22-4
27
8) When conducting the audit of stockholders' equity, it is normal practice to verify all capital
stock transactions
A) only when the client is small.
B) that are in excess of a material amount.
C) if there aren't very many during the year.
D) regardless of the controls in existence, because of their materiality and permanence in the
records.
Answer: D
Terms: Audit of stockholders' equity and verification of capital stock transactions
Diff: Challenging
Objective: LO 22-4
9) If a company employs a capital stock registrar and/or transfer agent, the registrar or agent, or
both, should be requested to confirm directly to the auditor the number of shares of each class of
stock
A) surrendered and canceled during the year.
B) authorized at the balance sheet date.
C) issued and outstanding at the balance sheet date.
D) sold at a price above par during the year.
Answer: C
Terms: Confirmation to auditor from capital stock registrar and/or transfer agent
Diff: Moderate
Objective: LO 22-4
28
10) State the four most important audit objectives for capital stock and describe how the auditor
typically verifies each of the four objectives.
Answer: The four most important audit objectives for capital stock are:
• Existing capital stock transactions are recorded (completeness). Confirm with the registrar
or transfer agent whether any capital stock transactions occurred.
• Recorded capital stock transactions occurred and are accurately recorded (occurrence and
accuracy). Existence can be tested by examining the minutes of the board of directors' meetings
for proper authorization. Accuracy can be tested by confirming the amount with the transfer
agent and tracing the amount of the recorded capital stock transactions to the cash receipts
journal.
• Capital stock is accurately recorded (accuracy). The ending balance in the capital stock
account is verified by first determining, via confirmation from the transfer agent, the number of
shares outstanding at the balance sheet date. The recorded par value in the capital account can be
verified by multiplying the number of shares outstanding by the par value of the stock.
• Capital stock is properly presented and disclosed (presentation and disclosure). Using the
corporate charter, the minutes of board of directors' meeting and the auditor's analysis of capital
stock transactions, the auditor should determine that there is a proper description of each class of
stock. The proper presentation and disclosure of stock options, stock warrants, and convertible
securities should also be verified by examining legal documents or other evidence of the
provisions of these agreements.
Terms: Important audit objectives for capital stock and how they are verified
Diff: Challenging
Objective: LO 22-4
11) Auditing capital stock transactions as part of a merger is challenging because judgment is
often involved.
Answer: TRUE
Terms: Audit of capital stock
Diff: Easy
Objective: LO 22-4
12) A prior period adjustment may result in a debit or credit to a company's retained earnings
account.
Answer: TRUE
Terms: Prior period adjustment and retained earnings
Diff: Easy
Objective: LO 22-4
29
13) Any restrictions on the payment of dividends must be disclosed in the footnotes to the
financial statements.
Answer: TRUE
Terms: Restrictions on payment of dividends disclosed in footnotes
Diff: Easy
Objective: LO 22-4
14) The accuracy of a dividend declaration can be audited by recalculating the amount on the
basis of the dividend per share times the number of shares outstanding.
Answer: TRUE
Terms: Accuracy of dividend declaration audit procedure
Diff: Moderate
Objective: LO 22-4
15) For most companies, the only transactions involving retained earnings are net earnings for
the year and dividends declared.
Answer: TRUE
Terms: Transactions involving retained earnings
Diff: Moderate
Objective: LO 22-4
16) Examining the minutes of the board of directors' meetings for proper authorization ordinarily
tests the existence objective for capital stock transactions.
Answer: FALSE
Terms: Test existence objective for capital stock transactions; Examine minutes of board of
directors' meetings
Diff: Moderate
Objective: LO 22-4
17) Examining the minutes of the board of directors' meetings for proper authorization ordinarily
tests the occurrence objective for capital stock transactions.
Answer: TRUE
Terms: Test occurrence objective for capital stock transactions; Examine minutes of board of
directors' meetings
Diff: Moderate
Objective: LO 22-4
30
18) The emphasis in the audit of dividends is on the ending balance rather than the transactions.
Answer: FALSE
Terms: Emphasis in audit of dividends
Diff: Moderate
Objective: LO 22-4
31

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Auditing and Assurance Services, 16e (Arens/Elder/Beasley)

Chapter 22 Audit of the Capital Acquisition and Repayment Cycle

22.1 Learning Objective 22-1

2) The capital acquisition and repayment cycle does not include

9) All corporations must have

The unique characteristics of these accounts are:

22.2 Learning Objective 22-2

27) Discuss the four key controls over notes payable.

22.3 Learning Objective 22-3

a. capital acquisition and repayment cycle

________ 5. an entity that is required to engage an independent registrar

20) Independent registrars commonly disburse cash dividends to shareholders.

22.4 Learning Objective 22-4

5) When verifying if capital stock is accurately recorded,

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