Z003800101201740141305080572 448187

Auditing
A Risk-Based Approach To Conducting A Quality Audit

10th edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 13
AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’

EQUITY TRANSACTIONS
Copyright © 2016 South-Western/Cengage Learning

LEARNING OBJECTIVES
1. Identify the significant accounts, disclosures, and

relevant assertions in auditing debt obligations and
stockholders’equity transactions
2. Identify and assess inherent risks of material
misstatement associated with debt obligations and
3. Identify and assess fraud risks of material
13-2
LEARNING OBJECTIVES
4. Identify and assess control risks of material

5. Describe how to use planning analytical procedures
to identify possible material misstatements
associated with debt obligations and
6. Determine appropriate responses to identified risks
of material misstatement in auditing debt
obligations and stockholders’ equity transactions
13-3
LEARNING OBJECTIVES
7. Determine appropriate tests of controls and

consider the results of tests of controls in auditing
debt obligations and stockholders’equity
transactions
8. Determine and apply sufficient appropriate
substantive audit procedures in auditing debt
obligations and stockholders’equity transactions
13-4
THE AUDIT OPINION FORMULATION
PROCESS
13-5
PROFESSIONAL JUDGMENT IN CONTEXT - DEFICIENCIES
IN AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY ACCOUNTS
• Debt Obligations
• It was identified that Soyo group was not in
compliance with three of its six debt covenants with
UCB as of December 31, 2007
• Audit team:
• Did not follow up on identified debt covenant violations
• Did not obtain evidence indicating whether a waiver had
been granted by UCB
• Did not provide any evidence in the work papers that
audit team considered whether these violations could
impact the going concern status of Soyo
13-6
EQUITY ACCOUNTS
• Adjustments to Stockholders’Equity Accounts:
Delphi Corporation
• Accused of violations related to improperly accounting
for an increase in warranty reserves related to
warranty claims made by its former parent company
• Misclassification of the reserve increase (as a direct
adjustment to retained earnings) resulted in materially
overstating its net income for 2000 by $69 million
13-7
EQUITY ACCOUNTS
• What are the risks of material misstatement associated
with debt obligations and stockholders’equity
accounts? (LO 2, 3, 4)
• What are the typical substantive procedures that
auditors should perform when auditing debt
obligations and stockholders’equity accounts? (LO 8)
• How could a lack of appropriate professional
skepticism by auditors lead to material misstatements
related to debt obligations and stockholders’equity
accounts? (LO 2, 3, 5, 6, 8)
13-8
LEARNING OBJECTIVE 1
IDENTIFY THE SIGNIFICANT ACCOUNTS, DISCLOSURES,

AND RELEVANT ASSERTIONS IN AUDITING DEBT
OBLIGATIONS AND STOCKHOLDERS' EQUITY
TRANSACTIONS

RELEVANT ACCOUNTS WHEN
AUDITING DEBT OBLIGATIONS
Bonds payable
Interest expense
Gains or losses on refinancing debt
Notes payable
Mortgages payable
13-10
AUDITING DEBT OBLIGATIONS
• Objective - Determining whether all obligations are

recorded and properly classified
• Relevant assertions
• Proper valuation of premium or discount
• Valuation of gains or losses on refinancing debt
• Proper presentation and disclosure, including
important restrictions contained in the debt
obligations
13-11
ACTIVITIES RELATED TO DEBT
OBLIGATIONS
Bond issuance and amortization
schedules
Periodic payments and interest

expense
Debt covenants
13-12
BOND INDENTURE
• Contract between an issuer of bonds and the

bondholder stating:
• Time period before repayment
• Amount of interest paid
• Bond being convertible (and if so, at what price or
what ratio)
• Bond being callable
• Amount of money that is to be repaid
13-13
DEBT COVENANTS
• Restrictions in debt agreements aimed at protecting

the lender by restricting the activities of the borrower
• Common Restrictions
• Maintenance of a minimum level of retained earnings
before dividends can be paid
• Maintenance of a minimum working-capital ratio
• Specification of a maximum debt-equity ratio
• Specific callable provisions identifying procedures for
calling and retiring debt at prespecified prices and dates
13-14
RELEVANT ACCOUNTS FOR AUDITING
STOCKHOLDERS’ EQUITY
Stock accounts (common, preferred,
and treasury)
Additional paid-in capital
Dividend accounts
Retained earnings
13-15
ACTIVITIES RELATED TO
STOCKHOLDERS’EQUITY
New stock issuances
Purchase of treasury stock
Declaration and payment of dividends
Grants of stock options and warrants
Exercises and expirations of stock options and warrants
Transfer of net income to retained earnings
Recording of prior-period adjustments to retained earnings
13-16
VALUATION ASSERTION FOR
• When issuing stock for noncash, difficulties arise in
determining
• Whether the market value of the stock issued or of the
asset acquired is a better representation of value
• The proper accounting for an exchange of stock to
acquire another business
• Stock options - Measured at the fair value of the
option
13-17
PRESENTATION AND DISCLOSURE
ASSERTION FOR STOCKHOLDERS’EQUITY
• Requires proper description/disclosure of:
• Each class of stock outstanding and number of shares
authorized, issued, and outstanding and special rights
associated with them
• Stock options outstanding and convertible features
• Existence of stock warrants
• Any restrictions or appropriations of retained earnings
• Prior-period adjustments and other comprehensive
income adjustments
• EPS See Exhibit 13.1 and Exhibit 13.2
13-18
IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL

MISSTATEMENT ASSOCIATED WITH DEBT
OBLIGATIONS AND STOCKHOLDERS’ EQUITY
TRANSACTIONS

PERFORMING RISK ASSESSMENT
PROCEDURES
• Obtaining information about inherent risks
• At financial statement level and at account and
assertion levels
• Fraud risks including feedback from audit team
brainstorming sessions
• Strengths and weaknesses in internal control
• Results from planning analytical procedures
13-20
INHERENT RISKS - DEBT OBLIGATIONS
Authorization of debt
•Incurring debt that is not properly authorized or reviewed
Receipt of funds
•New debt, debt extinguishments, or debt payment
transactions not being properly authorized
Recording of debt transactions

•Interest expense not being properly recorded or accrued
•Debt not being recorded in accordance with GAAP
Compliance with any debt covenants

•Risk of debt covenants not being calculated accurately
•Risk of compliance with debt covenants not being
appropriately reviewed and disclosed
13-21
EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED
WITH STOCKHOLDERS’EQUITY ACTIVITIES
13-22
EXHIBIT 13.3 - INHERENT RISKS ASSOCIATED
WITH STOCKHOLDERS’EQUITY ACTIVITIES
13-23
IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL

OBLIGATIONS AND STOCKHOLDERS’EQUITY
TRANSACTIONS

FRAUD RISK FACTORS - DEBT
OBLIGATIONS
Violations of debt covenants are not disclosed
Debt obligations are not properly authorized
Long-term or short-term debt is misclassified
Interest expense either not recorded, misclassified, or

recorded:
•In the wrong period
•At the wrong amount
Entire loan payments are charged to either principal or
interest
13-25
FRAUD RISK FACTORS -
Expenses charged directly to retained earnings
Stock sales or issuances not authorized or recorded
Stock sales or issuances violate debt covenants
Stock options:
• Not authorized or not in accordance with terms

• Backdated
Dividends paid in violation of restrictive covenants
Dividends paid to wrong parties or at incorrect amounts
Proceeds from stock sales are misappropriated
13-26
IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL

OBLIGATIONS AND STOCKHOLDERS’ EQUITY
TRANSACTIONS

CONTROLS - DEBT OBLIGATIONS
• Disclosure policies and procedures

• Board of directors approves all new debt
• Debt and interest accounts are updated and reconciled
to the general ledger on a monthly basis
• Review of draft financial statements prior to issuance
for proper disclosure of debt obligations
• A debt amortization schedule is:
• Prepared for each new debt obligation
• Updated as appropriate
• Reviewed by appropriate personnel
13-28
CONTROLS - STOCKHOLDERS’EQUITY
TRANSACTIONS
• Board of directors approves all stock transactions
• CEO and CFO authorize approved stock transactions
• Stockholders’equity accounts are updated and
reconciled to the general ledger on a timely basis
• Appropriate review of draft financial statements for
proper disclosures related to equity accounts
• An outside party maintains details of shares issued,
repurchased, and cancelled
• Accountant researches and analyzes proper
accounting for stock option grants
13-29
DOCUMENTING CONTROLS
• Can be done in any of the following formats

• Control matrix
• Control risk assessment questionnaire
• Memo
13-30
DESCRIBE HOW TO USE PLANNING ANALYTICAL PROCEDURES

TO IDENTIFY POSSIBLE MATERIAL MISSTATEMENTS ASSOCIATED
WITH DEBT OBLIGATIONS AND STOCKHOLDERS’ EQUITY
TRANSACTIONS

PLANNING ANALYTICAL PROCEDURES:
IDENTIFY AREAS OF POTENTIAL MISSTATEMENTS
• For debt obligations
• Trend analysis of:
• Balances in notes payable and accrued interest
• Debt-to-equity ratio
• Times interest earned ratio
• Estimate overall interest expense based on average
interest rates and average debt outstanding
• For stockholders’equity accounts
• Compare current year account balances with prior-
year account balances
13-32
DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED

RISKS OF MATERIAL MISSTATEMENT IN AUDITING DEBT
OBLIGATIONS AND STOCKHOLDERS’EQUITY
TRANSACTIONS

DETERMINING APPROPRIATE AUDIT
PROCEDURES
• Debt accounts - Substantive procedures are typically
appropriate because:
• Number of transactions is relatively small
• Dollar amounts involved are usually quite material
• Stockholders’equity transactions - Substantive
approach using only tests of details is typically
appropriate
• Number of equity transactions with outside parties is
normally small
13-34
DETERMINE APPROPRIATE TESTS OF CONTROLS AND

CONSIDER THE RESULTS OF TESTS OF CONTROLS IN
AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’
EQUITY TRANSACTIONS

OBTAINING EVIDENCE ABOUT INTERNAL
CONTROL OPERATING EFFECTIVENESS
• Involves testing both entity-wide and transaction
controls
• Tests of transaction controls
• Inquiry of personnel performing the control
• Observation of control being performed
• Inspection of documentation confirming that the
control has been performed
• Reperformance of the control by the auditor testing
the control
13-36
DETERMINE AND APPLY SUFFICIENT APPROPRIATE

SUBSTANTIVE AUDIT PROCEDURES IN AUDITING
DEBT OBLIGATIONS AND STOCKHOLDERS’EQUITY
TRANSACTIONS

SUBSTANTIVE ANALYTICAL
PROCEDURES - DEBT OBLIGATIONS
• Involves developing an independent expectation of
interest expense
• Expectation based on:
• Average debt outstanding
• Average interest rates
• Use data disaggregated by type of debt
• Test of controls may not need to be performed
• Information used to perform analytical procedure is
typically confirmed with an independent outside party
13-38
SUBSTANTIVE TESTS OF DETAILS - DEBT
OBLIGATIONS
Reading new loan agreements
Determining any changes that have

been made to prior loan agreements
Confirming with relevant outside

parties the significant factors and
transactions that have occurred
13-39
EXHIBIT 13.6 - RELEVANT MANAGEMENT ASSERTIONS
AND SUBSTANTIVE PROCEDURES FOR DEBT OBLIGATIONS
13-40
SUBSTANTIVE TESTS OF DETAILS - DEBT
AND BOND COVENANTS
• Auditor should:
• Obtain an understanding of the procedures the client
uses to determine whether they are in compliance
with their debt covenants
• Independently determine if the client is in compliance
• If not in compliance, auditor should assess the effects of
the violation
13-41
SUBSTANTIVE TESTS OF DETAILS -
STOCKHOLDERS’EQUITY TRANSACTIONS
• Reviewing a copy of client’s articles of incorporation
• Preparing, or asking client to prepare, an analysis of all
capital stock transactions
• Inspecting documentation related to client’s record
keeping of capital stock and contributed capital
maintained by the client or held by a transfer agent
• Transfer agent: An organization used by a client to:
• Maintain records of investors and account balances and
transactions
• Cancel and issue certificates and process investor mailings
13-42
• Obtaining evidence related to the valuation of capital
stock
• Reviewing the minutes of the board of directors
meetings
• Examining the stock records books
• Obtaining evidence for all capital stock transactions
• Tracing proceeds to cash receipts journal and reviewing
documentation
13-43
• For stock issued in a nonmonetary transaction
• Determining that client has properly recorded issuance in
accordance with GAAP
• For clients with treasury stock
• Examining documentation supporting changes in
number of shares since prior year
13-44
DIVIDENDS
• Examine minutes of board of directors meetings for
authorization of dividend per share amount and
dividend record date
• For clients maintaining their own records and paying
the dividends
• Auditor need to recalculate the amount of the
dividends and agree that amount to the cash
disbursements journal
• For client using a transfer agent:
• Trace the payment to a cash disbursement made by
the client to the agent 13-45
RETAINED EARNINGS
• Examine transactions recorded in retained earnings
account during audit period
• Common entries include net income or loss
• These amounts tested through substantive audit
procedures related to revenues and expenses
• Other common entry includes dividends
• Auditor should review documentation for any
additional entries
13-46
AUDITING IN PRACTICE - DEFICIENCIES IN SUBSTANTIVE
PROCEDURES RELATED TO EQUITY TRANSACTIONS:
INSIGHTS FROM THE PCAOB
• Auditors failed to:

• Evaluate whether clients had appropriately determined
the fair values assigned to equity-based transactions and
to test reasonableness of fair values
• Evaluate adequacy of disclosure of equity transactions
and determine whether the equity transactions were
recorded in the proper period
• Address and evaluate the substance, business purpose,
or significant terms of the equity arrangements
• Consider the accounting principles potentially applicable
to the equity transactions
13-47
FRAUD-RELATED SUBSTANTIVE
PROCEDURES FOR DEBT OBLIGATIONS
Search public records to identify debt obligations
Vouch and trace loan proceeds and debt payments
Send confirmations to lenders and creditors, and

confirmation of compliance with any debt covenants
Require original supporting documents
Agree detail of debt terms to authorization in minutes

of board meetings
13-48
FRAUD-RELATED SUBSTANTIVE PROCEDURES
FOR STOCKHOLDERS’EQUITY ACCOUNTS
Confirm terms of equity arrangements and shares held directly

with shareholders
Confirm with shareholders regarding any side agreements
Employ an appropriate level of professional skepticism and

carefully analyze transactions
Confirm relevant information with the transfer agent
Account for and vouch all proceeds from stock issues
13-49
DOCUMENTING SUBSTANTIVE
PROCEDURES - FOR DEBT OBLIGATIONS
• Copies of the debt agreements
• Identification of specific items tested
• Schedule of debt obligations and interest
• A summary of the calculations supporting
compliance with debt covenants
• Confirmations or documentation of alternative
procedures performed
13-50
DOCUMENTING SUBSTANTIVE PROCEDURES -
FOR STOCKHOLDERS’EQUITY TRANSACTIONS
• Client’s articles of incorporation

• A summary of changes in equity accounts
• Verification of authorization with respect to any
changes in capitalization or declaration of dividends
• Confirmations with transfer agent or shareholders
13-51

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Auditing

A Risk-Based Approach To Conducting A Quality Audit

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

AUDITING DEBT OBLIGATIONS AND STOCKHOLDERS’

Copyright © 2016 South-Western/Cengage Learning

1. Identify the significant accounts, disclosures, and

4. Identify and assess control risks of material

7. Determine appropriate tests of controls and

IDENTIFY THE SIGNIFICANT ACCOUNTS, DISCLOSURES,

Copyright © 2016 South-Western/Cengage Learning

Gains or losses on refinancing debt

• Objective - Determining whether all obligations are

Periodic payments and interest

• Contract between an issuer of bonds and the

• Restrictions in debt agreements aimed at protecting

Additional paid-in capital

Purchase of treasury stock

Declaration and payment of dividends

Grants of stock options and warrants

Exercises and expirations of stock options and warrants

Transfer of net income to retained earnings

Recording of prior-period adjustments to retained earnings

IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL

Copyright © 2016 South-Western/Cengage Learning

Recording of debt transactions

Compliance with any debt covenants

IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL

Copyright © 2016 South-Western/Cengage Learning

Debt obligations are not properly authorized

Long-term or short-term debt is misclassified

Interest expense either not recorded, misclassified, or

Stock sales or issuances not authorized or recorded

Stock sales or issuances violate debt covenants

• Not authorized or not in accordance with terms

Dividends paid in violation of restrictive covenants

Dividends paid to wrong parties or at incorrect amounts

Proceeds from stock sales are misappropriated

IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL

Copyright © 2016 South-Western/Cengage Learning

• Disclosure policies and procedures

• Can be done in any of the following formats

DESCRIBE HOW TO USE PLANNING ANALYTICAL PROCEDURES

Copyright © 2016 South-Western/Cengage Learning

DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED

Copyright © 2016 South-Western/Cengage Learning

DETERMINE APPROPRIATE TESTS OF CONTROLS AND

Copyright © 2016 South-Western/Cengage Learning

DETERMINE AND APPLY SUFFICIENT APPROPRIATE

Copyright © 2016 South-Western/Cengage Learning

Reading new loan agreements

Determining any changes that have

Confirming with relevant outside

• Auditors failed to:

Vouch and trace loan proceeds and debt payments

Send confirmations to lenders and creditors, and

Require original supporting documents

Agree detail of debt terms to authorization in minutes

Confirm terms of equity arrangements and shares held directly

Confirm with shareholders regarding any side agreements

Employ an appropriate level of professional skepticism and

Confirm relevant information with the transfer agent

Account for and vouch all proceeds from stock issues

• Client’s articles of incorporation