Chapter 6

Audit of the Capital and Repayment Cycle

•Owners’ equity of corporate clients consists of capital stock accounts
(preferred and common) and retained earrings. Balances in the capital
stock accounts change when the corporation issues or repurchases stock.
•The accounts balances are not affected by transfers of ownership of
shares from one shareholder to another.
•Retained earnings are normally increased by earnings and decreased
by dividends payments.
•Additionally, a few journal entries (e.g. prior period adjustments) may
directly affect retained earnings.
•Transactions in the owners’ equity accounts are generally few

in number, but material in amounts.

•No change may occur during the year in the capital stock

accounts, and perhaps only one or two entries will be made to

the retained earnings accounts.

The auditors’ objectives of auditing owners’ equity
1. Consider internal control over owners’ equity
2. Determine the existence of recorded owners’ equity
3. Establish the completeness of recorded owners ‘equity.
4. Determine that the valuation of owners’ equity is in accordance
with generally accepted accounting principles.
5. Establish the clerical accuracy of schedules of owners’ equity
6. Determine that the presentation and disclosure of owners’ equity
are appropriate.
In conjunction with the audit of owners’ equity accounts, the auditor
will also obtain evidence about the related accounts of dividends
payables and capital stock discounts and premiums.
•Evidence is also gathered regarding the proper cutoff of cash receipts
and disbursements relating to the equity accounts.
Internal control over owner’s Equity- There are three principal
elements of strong internal control over capital stock and dividends.
These are:
1) The proper authorization of transactions by the board of directors
and corporate officers
2) The segregation of duties in handling these transactions ( preferably
the use of independent agents for stock registration and transfer and
for dividend payments)
3) The maintenance of adequate records
Audit program for capital stock
•The following procedures are required in many engagements for the
verification of capital stock.
1. Obtain an understanding of internal control over capital stock
transactions
2. Examine articles of incorporation, bylaws, and minutes for provisions
in relation to capital stock. ( To determine existence, completeness,
and obligations)
3. Obtain or prepare analyses of the capital stock accounts. ( To
establish clerical accuracy)
4. Accounts for all proceeds from stock issues. ( To establish existence,
completeness and obligations and valuation )
5. Confirm shares outstanding with the independent register and stock
transfer agent.( To establish existence, completeness and obligations
6. For a corporation acting as its own stock register and transfer agent,
reconcile the stockholders records with the general ledger. ( To
determine existence, completeness, and obligation)
7. Determine compliance with stock option plans and with other
restrictions and preferences pertaining to capital stock.( To establish
presentations and disclosure)
•Capital stock transactions are usually few in number; consequently,
the auditors usually, substantiate all transactions rather than obtaining
evidences to reduce their assessment of control risk.
Audit of retained earning and dividends
•The audit work of retained earnings and dividends includes two major

steps. These are:

1) The review of retained earnings and any appropriation of

retained earnings- the auditors should review the changes in retained

earning during the year.

Credits to retained earning accounts ordinarily represent amounts of

net income transferred from the income summary account.

Debit to Retained earnings accounts ordinarily includes entries for net

losses, cash and stock dividends, and for the creations or enlargement
• Appropriation of retained earnings requires specific
authorization by the board of directors.
2) The review of dividend procedures for both
cash and stock dividends- - in the verification of cash
dividends, the auditors usually, will perform the following
steps
a)Determine the dates and amounts of dividends
authorized.
b)Verify the amounts paid.
c)Determine the amount of any preferred divided
is arrears.
d)Review the treatment of unclaimed dividend
• The auditors’ analysis of divided declarations may reveal the
existence of cash dividends declared but not paid.
• These dividends must be shown as liabilities in the balances sheet.
• The auditors also may review the procedures for handling unclaimed
dividends and ascertain that these items are recognized as liabilities.
•The amount of any accumulated divided in arrears on preferred stock
should be computed.
•In the verification of dividend there is additional responsibility of
determining that the proper amounts have been transferred from
retained earnings to capital stock and paid-in-capital accounts for both
large and small stock dividends.
•Presentations- the presentations of capital stock in the balance sheet
include a complete description of each issue. Information to be
disclosed includes the title of each issue; par or stated value; dividend
rate, in any; dividend preference; conversion and call provisions;
number of shares authorized, issued and in treasure; dividends in
arrears if any ; and shares reserved for stock options or for
conversions.
•Treasury stock preferably is shown in the stockholders’ equity
section, at cost, as a deduction from the combined total of paid-in
capital and retained earnings.
•Changes in retained earning during the year may be shown
in a separate statement or combined with the income
statement.
•One of the most significant points to consider in determining
the presentation of retained earnings in the balance sheet is the
existence of any restriction on the use of this retained income.
•Disclosure-In evaluating client disclosure, the auditor must
be aware that changes in retained earning during the year may
be shown in a separate statement or combined with the income
statement.
•A combined statement of income and retained earnings often is
presented.
•In this form of presentation, the amount of retained earnings at
the beginning of the year is added to the net income figure,
dividends declared are subtracted from the subtotal, and the
final figure represents the new balances of retained earning.
•Existence of any restriction on the use of retained that might be
resulted form the agreements with banks, bondholders, and other
creditors commonly impose limitations on the payment of
dividends etc must be fully disclosed in the note to the financial
statements.
Audit of Debt
•Business corporations obtain substantial amounts of their
financial resources by incurring interest-bearing debt and
by issuing capital stock.
•The acquisitions and repayment of capital is sometimes
referred to as the financing cycle.
•This transaction cycle includes the sequence of procedures for
authorizing, executing, and recording transactions that
involve bank loans, mortgages, bonds payables, and capital
stock as well as the payments of interests and dividends.
Audit of Interest Bearing Debt
Long term debt usually is substantial in amount and often
extends over a longer time period. Debenture, secured bond,
and notes payable (sometimes secured by mortgages or trust
deeds) are the principal types of long-term debt.
Debentures are backed only by the general credit of the issuing
corporation and not by liens on specific assets. Since in most
respects, debenture has the characteristics of other corporate
bonds, we shall use the term bonds to include both debentures
and secured bonds payable.
• The formal document creating bond indebtedness is called
the indenture or trust indenture. When creditors supply
capital on a long-term basis, they often insist upon placing
certain restrictions on the borrowing company.
•For example, the indenture often includes a restrictive
covenant that prohibits the company from declaring dividends
unless the amount of working capital is maintained above a
specific amount.
• The acquisitions of plant and equipment, or the increasing
of material salaries, may be permitted only if the current
ratio is maintained at a specified level and if net income
reaches a designed amount.
• Another device for protecting the long-term creditors is the
requirement of a sinking fund or redemption fund to be held
by a trustee.
• If these restrictions are violated, the indenture may provide
that the entire debt is due on demand.
The auditors’ objectives in the audit of interest-bearing debt are to:
1. Consider internal control over interest-bearing debt
2. Determine the existence of recorded interest-bearing debt
3. Establish the completeness of recorded interest –bearing debt.
4. Determine that the client has obligations to pay the recorded
interest-bearing debt.
5. Establish the clerical accuracy of schedules of interest-bearing debt.
6. Determine that the valuation of interest-bearing debt is in
accordance with generally accepted accounting principles.
7. Determine that the presentation and disclosure of interest-bearing
debt are appropriate, including disclosures of the major provisions of
loan agreements.
•In conjunction with the audit of interest-bearing debt, the auditors will
also obtain evidence about interest expense, interest payables and bond
discount and premium.
•Many of the principles related to accounts payable also apply to audit of
interest-bearing debt. As in the case of accounts payable the
understatement of debt is a major potential audit problem.
•Related to disclosure of interest-bearing debt, the auditors must
determine whether the company has met requirements and restrictions
imposed upon it by debt agreements.
•Audit program for interest-bearing debt- The audit program does not
provide for the usual distinction between tests of controls and
substantive testing. This is because; individual transactions will
generally be examined for all large debt agreements. To document the
internal structure, the auditors will usually prepare a written description
as well as an internal control questionnaire. Questions included in a
typical questionnaire are the following.
- Are all amounts of new interest-bearing debt authorized by
appropriate management?
- Is an independent trustee used for all bond issues?
- Does a company official monitor compliance with debt provisions?
- Other relevant questions
•Because, transactions are few in number, but large in dollar amounts,
the auditors are generally able to substantiate the individual transactions.
•Therefore, testing of controls occurs through what actually amounts to
dual-purpose transactions testing.
•The objective of major substantive testing procedures of interest
bearing debt transactions and balances are given in the following
table.
 Substantive Tests Primary Audit
objectives to be
addressed

 Obtain analysis of interest-bearing debt and Clerical accuracy

related accounts
 Examine copies of notes payable and supporting Completeness
Documents Existence and
obligations
 Confirm interest-bearing debt with payees or
appropriate third parties
 Vouch borrowing and repayments transactions to
supporting documents.

 Perform analytical procedures to test the overall Completeness,

reasonableness of interest-bearing debt and Existence and
valuations
interest expense.
 Test the computation of interest expense, interest
payable, and authorization of discount and
premium
 Evaluate whether debt provisions have been met
 Trace authority for issuance of debt to corporate minutes.
 Review notes payable paid or renewed after the balance sheet date.
 Perform procedures to identify notes to related parties.
 Send confirmation letters to financial institutions to obtain
information about financing arrangements.
 Evaluate proper financial statement presentation and disclosure of
interest-bearing debt and related transactions.
End !