| Chapter PHASE II - RISK RESPONSE: AUDIT OF THE FINANCING CYCLE Expected Learning Outcomes After studying this chapter, you should be able to: 4. Enumerate and describe the steps involved in auditing the financing cycle. 2. Describe the nature and the major classes of transactions in the financing cycle. 3. Explain tl in the fin and records used. 4. Apply the risk asse audit process, i.e., transactions in the financing cycle. UV gss Searoed th canscannet lhe process of analyzing and recording transactions ancing cycle as well as the accounts, documents ssment and risk response phases of the test of controls and substantive tests ofCHAPTER 10 AUDIT OF THE FINANCING CYCLE INTRODUCTION This chapter covers the explanation of the financing cycle, the types of transactions in this cycle and the internal control environment and objectives Pertaining thereto. Consideration is then given to compliance tests of controls and substantive tests of transactions in the financing cycle. In the audit of the financing cycle, the following activities should be undertaken: 1. Identify the activities and types of transactions that occur in a company’s financing cycle; 2. Relate the internal accounting control objectives to financing activity; 3. Determine the essential features of internal control over the above- mentioned transactions; 4. Perform compliance tests of controls over these transactions; and 5. After evaluating the effectiveness of internal control, perform substantive audit procedures to determine whether financial statement assertions are materially correct on accounts affected by the financing cycle. 6. Design tests of details of account balances and analytical procedures to satisfy balance-related audit objectives Steps 1 10 5 are discussed in this chapter while Step 6 is covered in Chapters 17 and 18. NATURE OF THE FINANCING CYCLE Financing cycle includes the processes, procedures and executing and recording transactions involving bank loa and equity share capital Policies for authorizing, ns, leases, bonds payable This cycle involves the responsibilities of plannin capital. Every business must receive money to productive assets used to produce revenue. Manager funds from investors who become owners or from len thus creating owners’ equity and long-term debts, 1g the cash needs and raising finance the acquisition of of the business may obtain ders who become creditors, tll ‘Seana wth CamS:anerwa Activities Related to Financing Cycle Audit of the Financing Cycle __303 A. Debt Obligations [7. Bond Issuance; amortization of bond |” discount / premium (if any) TZ Issuance of Long-term note / mortgage B. Shareholders Equity Share Issuance Purchase / Sale of Treasury Shares iS ayable 3,_ Refinancing debt of principal 3.__ Declaration / payment of dividend 4, Periodic payments and interest 4. Gravity / exercise of share options and expense warrants 5. Transfer of net income to retained eamings. Overview of the Accounts Associated Figure 10-1 and Figure 1 record the transactions in the Financing Figure 10-1: Debt Financing Bonds Payable Notes Payable - Non-Trade / Mortgage Payable Beginning balance Issuance of new notes. Ending balance with the Financing Cycle 0-2 show the overview of the accounts: and entries to Cyele Interest Expense Interest expense Interest Payable Cash i casi : 'ssuance of | Payments cee ae new notes| of principal a ee Payments of interest expense interest ending balance ‘Seana wth CamS:aner304 Chapter 10 Figure 10-2: Equity Financing Ordinary Share Capital (1) Redemption | Beginning of stock balance Issue of stock Ending balance Cash in Bank Paid-in Capital in Excess of Dividends Retained Par-Common Payable Earnings 1) Redemption | Beginning Payment of | Beginning Dividend Beginning of stock balance dividends balance — Declared balance Issue of Dividend Net earnings stock declared Ending Ending Ending balance balance balance‘Accounts affected by the Financing Cycle The following are accounts often found in the cycle: « Notes payable © Paid-in capital in excess of par « Contracts payable © Donated capita: Mortgages payable Retained earnings «Bonds payable . ions of retained earnings «Interest expense . . Accrued interest «Dividends declared e Cash in the bank «Dividends payable ¢ Capital stock — common * Proprietorship — capital account «Capital stock — preferred © Partnership — capital account Documents and Records The pertinent documents and records used in the Expenditure Cycle (Chapter 7) are also used in the financing cycle. In addition, the following forms may also be encountered: Share Certificate. An engraved form showing the number of shares of shares owned by a shareholder in a corporation. Bond Certificate, An engraved form showing the number of bonds owned by @ bondholder. Bond Indenture. A contract stating the terms of the bond issue between the bondholder and the issuing entity. Broker's Advice. A statement from a broker specifying the details of an investing transaction. Promissory Note. A financial instrument evidencing the promise to pay a loan granted to the enterprise. ‘Seana wth CamS:aner306 Chapter 10 AUDITING THE FINANCING CYCLE PHASE | ~ RISK ASSESSMENT Basic Considerations An entity’s financing cycle consists of transactions pertaining to the acquisition of capital funds through borrowings from others, short-term and long-term excluding trade credit, and share capital and the subsequent redemption and reacquisition of these securities. This cycle includes the sequence of procedures for authorizing. executing and recording transactions that involve bank loans, mortgages, bonds payable and share capital. The payments of interest and dividends are also an integral part of the financing cycle. Audit risk is similar to the risk for investing cycle transactions and balances | Ordinarily, control risk is low and the auditor can also keep detection risk at a | low level. Possible errors related to financing activities include the following: * Failing to make interest accruals, or making them twice © Accruing interest in the wrong period © Maki incorrect estimates of allowances for obligations * Failing to recognize that the entity violated a debt agreement e Failing to record dividend that were declared A. PERFORMING RISK ASSESSMENT FOR DEBT OBLIGATION TRANSACTIONS. As part of performing risk assessment procedures, the auditor obtains information that is useful in assessing the risk of material misstatement. This includes information about inherent risks at the financial statement level (for example, the client's business and operational risks, financial reporting risks) and at the account and assertion levels, fraud risks including feedback from audit team brainstorming sessions, strengths and weaknesses in internal control, and results from preliminary analytical procedures, Once the risks of material misstatement have been identified, the auditor then determines how best to respond to them as part of the audit opinion formulation process. ‘Seana wth CamS:aner> Identifying Inherent Risks Audit of the Financing Cycle _307 Inherent risks related to debt obligations primarily concern the authorization of debt, receipt of funds, recording of debt transactions, and compliance with any debt covenants. For authorization, inherent risks include incurring debt that is not properly authorized or reviewed. Similarly, there are risks that new debt, debt extinguishments, or debt payment transactions are not properly: authorized. In terms of recording debt transactions, risks include interest expense not being properly recorded or accrued and debt not being classified or recorded in accordance with PFRS. Regarding debt covenant compliance issues, inherent risks relate to whether debt covenants are calculated accurately and whether compliance with debt covenants is appropriately reviewed and disclosed. Identifying Fraud Risk Factors Standards of auditing require the auditor to identify and assess the risks of material misstatement due to fraud at the financial statement level and at the assertion level. As part of brainstorming activities, the auditor should identify possible frauds that could occur such as violation of debt covenants. Other potential frauds related to debt obligations include the following: Debt obligations are not properly authorized. * Long-term or short-term debt is misclassified. | Interest expense is recorded in the wrong period, at the wrong amount, not recorded at all, or is misclassified. Entire loan payments are charged to either princip: al or interest. Identifying Control Ri auditor has obtained an understanding of the inherent and fraud rial misstatement associated with debt obligations, the auditor the controls that the client has designed and implemented to address those risks. Remember, the auditor is required, to ain an overall understanding of internal controls for both integrated au and financial statement only audits. Such understanding is normally gained by means of a walkthrough of the process. inquiry, observation, and review of the client’s documentation. The auditor considers both entity-wide controls and transaction controls at the ‘account and assertion levels. This understanding provides the auditor with a basis for making an initial control Tisk assessment. Once the risks of 1 needs to understand ‘Scand wth CamS:aner308 Chapter 10 Performing Preliminary Analytical Procedures When planning the audit, the auditor is required to perform preliminary analytical procedures, These procedures can help auditors identify areas of potential misstatements. The following are examples of typical analytical procedures related to debt obligations: Perform a trend analysis of the balances in notes payable, interest expense, and accrued interest with prior periods, considering known client activities related to debt. Estimate interest expense based on average interest rates and average debt outstanding * Calculate debt-to-equity ratios and perform a trend analysis with prior periods. ° Calculate the times interest earned ratio and perform a trend analysis with prior periods. PERFORMING RISK ASSESSMENT PROCEDURES FOR SHAREHOLDERS’ EQUITY TRANSACTIONS, Identifying Inherent Risks Inherent risks relate to shareholder's equity transactions vary across the specific activities. Figure 10-3 outlines some of the common inherent risks associated with typical shareholders’ equity activities, ‘Seana wth CamS:anerwa Activities r [Sales and issuances of Equity Shares Purchase of Treasury Shares Dividend \ ‘Share Options and Warrants Audit of the Financing Cycle 309 Figure 10-3: Inherent Risks Associated with Shareholders’ Equity Inherent Risk _ organization's bylaws. Stock issuances / sales are recorded in the wrong period. Stock issued in exchange for goods / services is not properly valued. | Equity activities are not properly disclosed in accordance with | PFRS. _ __ ‘All shares repurchased is not recorded as treasury shares. Treasury share transactions are recorded in the wrong period The cost of treasury shares that is subsequently retired is not properly allocated among the appropriate accounts. Dividends may be recorded and paid before being declared. Dividends may not be properly approved before being declared. Dividends are recorded in the wrong period. Options / warrants are granted without being properly approved. Inadequate records as exercised. Options exercised or expired remain on the organization's books. Option / warrant grants are not properly valued due to inappropriate assumptions or models. Inappropriate amortization methods are used. Inaccurate period of service |S used. . to options / warrants issued but not Identifying Fraud Risk Factors Other potential frauds related to following: * Sales or issuances of equity shares are * Stales or issuances of equity share * Sales or issuance shareholders’ equity accounts include the not authorized. 5 violate debt covenants. es of equity shares are not recorded. ‘Seana wth CamS:aner Issuances / sales are not authorized in accordance with310 Chapter 10 * Share options exercised are not authorized or are not in accordance with the terms of options granted. * Share options are backdated. * Dividends are paid in violation of restrictive covenants. * Dividends are paid to wrong parties or at in incorrect amounts. . Proceeds from stock sales are misappropriated. Identifying Control Risks Once the auditor has obtained an understanding of the inherent and fraud risks of material misstatement associated with shareholders? equity transactions, the auditor needs to understand the controls that the client has designed and implemented to address those risks. Remember, the auditor is required to gain an overall understanding of internal controls for both integrated audits and financial statement only audits. Such understanding is normally gained by means of a walkthrough of the process, inquiry, observation, and review of the client’s documentation. The auditor considers both entity-wide controls and transaction controls at the account and assertion levels. This understand} ng provides the auditor with a basis for making an initial control risk assessment. Performing Preliminary Analytical Procedures When planning the audit, the auditor j analytical procedures. These procedures potential misstatements. S required to perform prelintinary can help auditors identify ateas of If preliminary analytical procedures donot relationships, the auditor would conclude that misstatement does not exist in these identify any unexpected a heightened risk of material accounts, ‘Seana wth CamS:anerAudit of the Financing Cyele 1, Obtaining Evidence About Internal Control Operating Effectiveness for Debt Obligations and Stockholders’ Equity Transactions Some effective internal control measures over financing cycle transactions that may be adopted by the client and assessed by the auditor are as follows: 1. Current liabilities (other those arising from trade credit and operating expenses) a) A system authorization on both as to original transaction resulting in a liability and as to payment of the liability should be well-defined as established. Authorization may be noted in the corporate minutes or on such appropriate documents such as purchase order, invoices, etc. b) A satisfactory system of record keeping with adequate forms and documentation should be instituted. c) There should be a plan of organization with appropriate division of duties, provision for fixing responsibility and requiring authorization and approval, periodic review of computations and entries in the records should be established and implemented. 2. Long-term liabilities Long-term obligations should be properly authorized by the board of directors or by a required majority of the shareholders. There should be proper control over issued and unissued obligations as in bonds, by an independent bond trustee or transfer agent. a) b) Redeemed bonds should be canceled, properly mutilated and retained for auditor in order to prevent the authorized issuance. d) Bond ledger should be used in which details of bonds issued, canceled and outstanding are shown. A subsidiary bondholders’ ledger should also be maintained by the issuing corporation or the bond trustee for bonds registered, as to principal and payment. be exercised over the payment of interest on ©) Proper control should ‘ long-term liabilities. Payment may be done by an independently engaged interest-paying agent. °) ‘Seanad wth CamS:anerEquity share capital a) Internal contro! measures regarding the issuan} of share certificates and proper accounting for transfer and registration of shares should be established. One of these measures is the appointment of share and transfer agent or an independent re jy prenumbered by the printer and and issuing the certificates be b) Share centificates should be serial that the authority for signin designated by the board of directors. corresponding records of the ing the name and address of ¢) As individual certificates are issuet certificates should be prepared conta the shareholders and the number of I d) Canceled certificates should be mutilated and any necessary documentary stamps should be attached to the canceled certificates, e) Entries for share issuances and transfers should be made by a person who does not have authority to sign and issue certificates. Il. Obtaining Substantive Evidence in Auditing Debt Obligations and Shareholders’ Equity Transactions The audits of debt obligation and shareholder's equity transactions typically involve only substantive procedures. Debt obligation accounts are tested with both substantive analytical procedures and tests of details. In contrast, only tests of details are typically used to audit shareholders’ equity accounts. Further, the transactions in the shareholders’ equity accounts are typically tested 100% because they are usually so few, and yet they are highly material. Substantive Tests of Detail : Debt Obligations Transactions Typical substantive procedures include: Reading new loan agreements Determining what changes, if any, have been made to prior loan agreements Confirming with relevant outside parties the significant factors and transactions that have occurred ‘Seana wth CamS:anerAudit of the Financing Cycle 313 As a starting point for these procedures, the auditor will have the client provide a schedule of debt obligations and interest. The client should also have a bond premium / discount amortization schedule that the auditor can review in assessing whether bonds are appropriately valued and disclosed in the financial statements. For additions to debt, the auditor traces the proceeds into the cash receipts records and-the bank statement. The auditor might also examine the debt instrument and obtain assurance regarding board approval of the debt through review of board meeting minutes. For debt reductions. the auditor examines payments through the cash disbursements records, ssibly including canceled checks. Also, for notes or mortgages that have been paid in full, the auditor should examine the canceled notes Debt and Bond Covenants The auditor should obtain an understanding of the procedures the client uses to determine whether they are in compliance with their debt covenants. The auditor should then independently determine if the client is in compliance. Substantive Tests of Details = Shareholders’ Equity Transactions a. Asa starting point for testing capital stock and equity transactions, the auditor should review a copy of the client’s article of incorporation. This document provides relevant information with respect to each class of stock. The auditor can agree that information to the disclosures included in the client’s financial statements. The auditor will also prepare, or ask the client to prepare, an analysis of all capital stock transactions. The auditor will inspect documentation related to the client’s record keeping of capital stock and contributed capital. This documentation may be maintained by the client or held by a ‘ransfer agent. Review of this documentation provides the auditor with evidence related to the existence and completeness of capital. c. To obtain evidence related to the valuation of capital stock, the auditor should review the minutes of the board of directors meetings and examine the stock records books (or confirm with the registrar and transfer agent) to determine issuance and repurchase of capital stock. stock, the auditor will examine in the number of shares since the ht include obtaining confirmation the transaction through the cash d. For those clients with treasury documentation supporting changes | prior year. This documentation migl from the stock transfer agent and tracing receipts or cash disbursements journal. ‘Seana wth CamS:aner314 Chapter 10 e. Dividends ; 1. The auditor examines the minutes of the board of directors meetings, for authorization of the dividends per share amount and the dividend record date. 2. The auditor will also want to obtain evidence as to whether the Payment was made to the stockholders who owned the stock as of the dividend record date. The auditor can trace the payee’s name on the canceled check to the dividend records to make sure the payee Was to have received the dividend. 3. The auditor also needs to be aware of restrictions related to dividend Payments and determine that the restrictions are adequately disclosed in the financial statements. Retained earnings — The auditor typically examines all transactions recorded in the retained earnings account during the audit period. The common entries include net income or loss. These amounts would be tested through substantive audit procedures related to revenues and expenses. The other common entry includes dividends. additional entries, the auditor examines documentation su; the entries should be included, For example, if there is correction of an error from a prior period, the auditor determines that the correction is made in accordance with relevant accounting standards, If there are pporting that ‘Seana wth CamS:anerque I. 6. 15. . Given typical inherent Audit of the Financing Cycle 308 REVIEW QUE! TIONS AND EXERCISES estos ctivities and explain their Identify the transactions involved in finanein relationship to other cycles. nce in notes: pay It is common pract to audit and the se and interest pay conjunction with the audit of interest exp Explain the advantages of this approach Which internal controls should the auditor be most concerned about in the audit of notes payable? Explain the importance of each List four types of restrictions long-term creditors often put on companies when granting them a loan. How can the auditor find out about each of these restrictions? What are the major internal controls over owners’ equity? Evaluate the following statement: “The most important audit procedure to verify dividends for the year is a comparison of a random sample of canceled dividend checks with a dividend list that has been prepared by management as of the dividend record date.” What are the relevant accounts related to debt obligations? What are the relevant accounts and related to shareholders’ equity transactions? Identify common transactions affecting shareholders’ equity accounts. Identify common inherent risks associated with debt obligations. . Identify fraud risks associated with debt obligations. Identify fraud risks associated with shareholders’ equity accounts. and fraud risks related to material misstatement of debt obligations, identify controls that an auditor would expect a client to have implemented. Given typical inherent an shareholders’ equity accounts, expect a client to have implemented. cedures related to debt obligations? d fraud risks related to material misstatement of identify controls that an auditor would What are typical preliminary pro ‘Scan wthCamS:aner316 apter 10 Multiple Choice Questions _ —— ing cycle is the proper with debt and equity id best meet this 1g and finane ing Js woul e investin’ transactions deal wing control One control objective of thi authorization of company instruments. Which of the folloy objective? a. Separating responsibility for cu recording the transactions b. Maintaining written company directors to review major funding oF c. Using an underwriter in all cases o} instrument d. Requiring two signatures or amount stody of funds from responsibility for policies that require the board of repayment proposals fnew issue of debt or equity n all organization checks of a material During the year under audit, a company has completed a private placement of substantial amount of bonds. Which of the following is the most important step in the auditor's program for the examination of bonds payable? a. Confirming the amount issued with the bond trustee. b. Tracing the cash received from the issue to the accounting records. c. Examining the bond records maintained by the transfer agent. d, Recomputing the annual interest cost and the effective yield. Several years ago, Conway Inc., secured a conventional real estate mortgage loan. Which of the following audit procedures would be /east likely to be performed by an auditor examining the mortgage balance? a. Examine the current years’ canceled checks. b. Review the mortgage amortization schedule. c. Inspect public records of lien balances. d, Recomputed mortgage interest expense. ee the following can be used by organizations for obtaining a. Notes b. Mortgages c. Bonds d, All of the above ‘Seana wth CamS:anerae Which of the following ace ica i : 5. adit of debt obligations? ‘ounts would not typically be included in the a. Interest income b. Interest expense c. Bonds payable d. Notes payable Audit of the Financing Cycle _317 6. Inherent risks related to debt obligations primarily include which of the following? a. Debt is not properly authorized b. Interest expense is not properly accrued c. Debt covenants are not properly disclosed d. All of the above are inherent risks related to debt obligations 7. Which of the following is not an inherent risk typically associated with the existence of dividends? a. Dividends are recorded before being declared b. Dividends are not properly amortized c. Dividends have not been approved before being declared d. Dividends are recorded in the wrong period 8. Which of the following would an auditor typically not perform as part of gaining an understanding of the client’s controls related to debt obligations? a. Review the client’s documentation of controls b. Recalculate interest expense c. Inquire of management about the process of reviewing compliance with debt covenants d. Review policies related to approval required for new debt 9. Which of the following is a control the auditor would expect a client to have related to shareholders” equity transactions? a. A policy requiring approval by the board of directors for all stock transactions b. Reconciliatiun of equity accounts to the general ledger c. CFO and CEO authorization of all stock transaction approved by the board of directors. . d. The auditor would typically expect all of the above controls to be in place ‘Seana wth CamS:aner38 Chapter 10 - — 10. Which of the following statements is true regarding preliminary analytical procedures for debt obligations ‘and shareholders’ equity transactions? , a. Because there are typically only a few shareholders’ transactions, the auditor is not required to perform pr analytical procedures for shareholders’ equity accounts , b. Trend analysis would not typically be performed for debt obligations c. The long-term debt to equity ratio could be considered by the auditor as part of the preliminary analytical procedures d. All of the above statements are true Exercises Exercise 1 Items | through 6 are questions typically found in a standard intemal control questionnaire used by auditors to obtain an understanding of internal control structure for notes payable. In using the questionnaire for a particular client, a "yes" response indicates a possible internal control, whereas a "no" indicates a potential weakness. 1) Are liabilities for notes payable incurred only after written authorization by a proper company official? 2) Isanotes payable master file maintained? 3) Is the individual who maintains the notes payable master file someone other than the person who approves the issue of new notes or handles cash? 4) Are paid notes canceled and retained in the company files? 5) Is a periodic reconciliation made of the notes payable master file with the actual notes outstanding by an individual who does not maintain the master file? 6) Are interest expense and accrued interest recomputed periodically by an individual who does not record interest transactions? Required: a. For each of the preceding questions, state the purpose of the control. b. For each of the preceding questions, identify the type of financial tement error that could occur if the control were not in effect. c. For each of the potential errors in part 4, list an audit procedure that can be used to determine whether a material error exists. ‘Seana wth CamS:aner_Auit of the Financit Exercise 2 The auditor should review the bond indenture at the time a bond is issued and anytime subsequent changes are made to it. d. Exer The following covenants are extracted provides that failure to comply with it advances the due date of the loan to the date is 20 years hence). Identify the audit step: reporting requirements necessary following s a Briefly identify the information the auditor would expect to obtain from ‘a bond indenture. List at least five specific pieces of information that would be relevant to the conduct of the audit, the potential Because auditors are especially concerned with of the understatement of liabilities, should they confirm the existence liability with individual bondholders? State your rationale. in how the amount of the ‘A company issued bonds at a discount. Explai Id determine whether the discount is computed and how the auditor cou amount is properly amortized each year. Explain how the auditor could verify that semiannual interest payments are made on the bond each year. P20 million loan that is due on September 30 of next year. Itis the company's intent to refinance the bond before it is due, but it is waiting for the best time to issue new debt. Because its intent is to issue the bond next year, the company believes that the existing $20 million bond need not be classified as a current liability. What evidence should the auditor gather to determine the appropriate classification of the bond? ‘The company has a 15-year, 3 from a bond indenture. The indenture 5 terms in any respect automatically date of noncompliance (the maturity s that should be taken or in connection with each one of the enarios: endeavor to maintain a working capital ratio in any fiscal year following a failure to shall restrict compensation of the The debtor company shall of 2 to | at all times, and, maintain the said ratio, the company CEO and exccutive officers to a total of no more than P500,000. Executive officers for this purpose shall include the chairman of the board of directors, president, all vice presidents, the secretary, and the treasurer ‘Scand wth Comsat320 b. Chapter 10 at is security for thi The debtor company shall insure all property that ‘el nsueanee chee against loss by fire to the entent of 100% of its value. Policies securing this Protection shall be filed with the trustee. The debtor company shall pay all taxes legally assessed against the Property that serves as security for this debt within the time provided by faw for payment without penalty and shall receipted tax bills or equally acceptable evidence of payment of the same with the trustee. A sinking fund shall be deposited with the trustee by semiannual Payments of P300.000. from which the trustee shall, at her discretion, Purchase bonds of this issue. Note: The Substantive Tests of Details o Balances of the Principal Accounts affected by the Financing Cycle are covered in. Chapter 1] ~ Audit of Cash Balances Chapter 17 — Audit of Non-Trade Payables and Other Long-Term Liabilities Chapter 18 ~ Audit of Owners? Equity a nc ‘Seanad wth CamS:aner