Financing and Investing Cycle Activities

 Investment Transactions

 Property, Plant, and Equipment Transactions

 Debt and Equity Transactions

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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Accounting for Investment Transactions
 Purchases and sales of investments typically
require the board of director’s authorization.

 A broker’s advice form usually specifies the

details of investment transactions and
accompanies the receipt of interest or dividends.

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
2
 Key Accounts, Documents, and Files for
Investment Transactions
Accounts Documents
 Marketable Securities Bond certificate An engraved document showing
the number of bonds the investor owns
 Investments in Stock
Broker’s advice A statement the securities broker
 Investments in Bonds prepares giving the details of an investment
 Interest Revenue transaction in bonds or stocks
Stock certificate An engraved document showing
 Dividend Revenue the number of stock shares the investor owns
 Gains (Losses) on Journals and Ledgers
Sales of Securities Investments subsidiary ledger A listing of
investments and securities owned

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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Accounting for Property, Plant, and
Equipment Transactions
 Special requisition forms are usually required
because of the large value of PP&E purchases.
 Typically subsidiary ledgers for PP&E are
utilized.
 Dispositions may require an asset retirement
order, a form used to authorize and document the
disposal of these assets.

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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 Accounting for Debt and Equity
Transactions
 The issuance of debt or equity securities must be
authorized by the board of directors.
 Bond and stock certificates are issued for cash, and a
broker’s advice or other cash remittance form
provides the details to record the proceeds of the
issue.
 Stock and bond certificate books and stockholder and
bondholder subsidiary ledgers are maintained either
by the company or by a registrar and transfer agent.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
5
 Key Accounts, Documents, and Files for
Debt and Equity Transactions
Accounts Documents*
 Common Stock Bond indenture (debt agreement) A contract stating
 Preferred Stock the terms of a bond issue between the issuing entity
 Bonds Payable and the bondholder
 Paid-in-Capital Securities contract A formal written contract
stipulating the terms of the issuance of securities
 Treasury Stock
 Premium (Discount)
Journals and Ledgers
on Bonds Payable Shareholders’ ledger A listing of shareholders and
 Dividends
shares owned
 Dividends Payable
Stock certificate book A record of all issued stock
certificates. It includes stubs indicating the number
 Interest Expense
of shares issued and outstanding
* Documents for investments are not repeated for debt and equity transactions
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
6
Assessing Control Risk for the Financing
and Investing Cycle
 In many organizations, financing and investing transactions
occur infrequently and involve large amounts.
 Auditors often assess control risk at or near the maximum
level and apply substantive tests to each transaction and
related balance.
 When there is a high volume of these transactions, auditors
may develop specific tests of controls for these transactions.
 Most significant financing and investing cycle accounts are
usually: investments; intangible assets; property, plant and
equipment (PP&E); long-term debt; and stockholder equity.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
7
 Common Substantive Audit Tests for
Investments
Common Audit
Tests Technique Type of Test Assertions
Perform security Physical Test of balances Existence
counts examination Rights and
obligations
Confirm securities Confirmation Test of balances Existence
Rights and
obligations
Test valuation and Vouching Test of balances Valuation
classificatiion Confirmation
Perform analytical Analytical Analytical All
procedures procedures
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
8
 SAS No. 81, Auditing Investments
SAS No. 81 requires the auditor to perform one or more of the
following procedures to obtain evidence about the existence,
ownership, and completeness assertions for securities in the
custody of outside parties
 Physical inspection of the securities at the third-party location
 Confirmation with the issuer of the securities
 Confirmation with the custodian
 Confirmation of unsettled transactions with the broker-dealer
 Confirmation with the counterparty
 Reading executed partnership or similar agreements
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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 FASB No. 115 Classifications of
Investments
Classification Valuation Method
Held-to-maturity securities -- Amortized Cost
debt securities the entity
intends to hold until their
maturity date
Fair Value -- unrealized gains and
Trading securities -- debt and
losses included in earnings
equity securities bought and
held with the intent to sell in
the near term
Available-for-sale securities -- Fair Value -- unrealized gains and
debt and equity securities not losses reported in a separate
classified as either held-to- section of stockholders’ equity
maturity or trading and excluded from earnings
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
10
 Testing Classifications of Investments
The major criterion for selecting the appropriate classification
and corresponding valuation method is management’s intent
regarding the purpose for buying and holding securities.
 Examine entity’s actual investment activities in categories to
support management’s intentions.
 Examine written records of investment strategies, minutes of
the board, or minutes of the investment committee, etc.
 Consider the entity’s financial wherewithal to adhere to
investment intentions.
 Obtain written representations from management confirming
that the investments are properly classified. Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
11
 Valuation Tests
 Examine evidence of the cost of securities based upon
broker’s advices, canceled checks, etc. Recalculate the
amortization of the discount or premium.
 Determine market values from published security
prices at year end, direct confirmation with brokers or
appraisers, and/or testing client valuation models.
 Ownership of 20% or more implies equity method.
 Verify that the fair value is above the amortized cost
and pursue the unusual situations where amortized cost
exceeds fair value. Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
12
 Effects of Control Risk on Substantive
Tests for Investments
 When investment portfolios are small and do not
involve much activity, auditors usually assess control
risk at or near the maximum level and obtain most of
the evidential matter from substantive tests.
 For large portfolios, the auditor may perform tests of
controls to support a lower assessed level of control
risk for these assertions.
 Substantive tests should be related to the assessed level
of control risk. Low risk can support reduced tests.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
13
 Intangible Assets
 Legal documents are usually available to support
intangible assets.
 Valuation is generally cost less amortization.
 Amortization is over the intangible’s life, but not to
exceed forty years.
 Goodwill is obtained when a client purchases
another company in an arm’s length transaction.
Records of goodwill are usually kept in the
permanent file.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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Property, Plant, and Equipment (PP&E)
 Initially recorded at cost.
 Capitalize additions (etc.) are capitalized when
they increase the useful life of the asset or
improve its operation.
 Ordinary repairs and maintenance are expensed.
 Matching principle requires depreciation to charge
current operations with the costs of the PP&E.

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
15
 Common Substantive Audit Tests for
Property, Plant, and Equipment (Slide 1 of 2)
Common Audit
Tests Technique Type of Test Assertions
Analyze additions Vouching Test of Existence
and deletions Tracing transactions Valuation
Test of balances Rights and
Obligations
Search for Vouching Test of Completeness
unrecorded Inquiry transactions
retirements Observation
and inquiry
Analyze repairs Vouching Test of Existence or
and maintenance transactions occurrence
Presentation
and disclosure
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
16
 Common Substantive Audit Tests for
Property, Plant, and Equipment (Slide 2 of 2)
Common Audit
Tests Technique Type of Test Assertions
Test and support Reperformance Test of balances Valuation
depreciation
Perform analytical Analytical Analytical All
procedures procedure
Search for liens Inquiry Observation and Presentation
and mortgages Inspection inquiry and disclosure
Test of balances Rights and
obligations
Examine lease Inspection Test of balances All
agreements
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
17
 Effect of Control Risk on Substantive
Tests for Property, Plant, and Equipment
 PP&E often involves only a few assets of relatively
high value.
 Even if controls are strong, the time to test these
controls might exceed the time necessary to perform
substantive tests.
 Auditors often assess control risk at or near the
maximum level and then use substantive tests to obtain
evidence about the assertions for PP&E.
 If volume of PP&E transactions is high, tests of
controls may be more efficient. Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
18
 Common Substantive Audit Tests
for Long-Term Debt
Common Audit
Tests Technique Type of Test Assertions
Obtain confirmations Confirmation Test of balances Existence
Rights and
obligations
Completeness
Vouch additions and Vouching Test of Existence
deletions transactions Rights and
obligations
Perform analytical Analytical Analytical All
procedures procedures
Review debt agreement Inspection Test of balances Presentation and
provisions disclosure Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
19
 Review Debt Agreements
 Because long-term debt frequently has restrictive
covenants, the auditor should review all debt
agreements.
 Violations of debt agreements should be investigated
and discussed with the client.
 Client should attempt to obtain a waiver from the
lender.
– If waiver is not obtained the debt may have to be recorded
as short-term.
– Going concern problems become an issue.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
20
 Stockholder Equity
 The primary stockholder equity accounts include
common and preferred stock, contributed capital, and
retained earnings.
 The client’s articles of incorporation (included in the
auditor’s permanent files) provide the details of the
possible stock classes that the client can offer.
– Rights and preferences
– Number of authorized shares
– Par values
– Any restrictions associated with the stock class Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
21
 Stock and Contributed Capital
 Auditor is concerned with the total stock issued and its
contributed capital.
– Transfers among shareholders are not generally important.
– Stock ownership by individuals is not confirmed.
 Limited transactions in this area generally allows the
auditor to examine all transactions in the account.
– Trace approvals of new stock issues to minutes.
 Examine stock records or seek confirmation from
outside agents who maintain the records.
 Support all treasury stock transactions and existence. Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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 Retained Earnings
 Primary entries in retained earnings are income and
dividends.
 Dividends declared should be tested.
– Trace authorization to minutes of the Board of Directors
– Note dividend per share, date of record, and date of payment
– Recalculate dividend charge
– Support payment of dividends to shareholders
 Income is tested through other phases of the audit.

Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
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 Operations
 Direct substantive audit tests of revenue and expense
accounts for most audit engagements are usually limited.
– Double-entry bookkeeping links operation and balance sheet
accounts, thus many tests have been performed.
– Tests of control structure may result in a low level of assessed
control risk that will permit limited substantive audit testing.
– Testing of balance sheet accounts forces differences to be in income
statement, thus limited direct tests of revenue and expenses are
necessary.
 Analytical procedures are most common substantive tests.
Chapter 18
Understanding Internal Control, Assessing Control Risk, and
Performing Substantive Tests: The Financing and Investing Cycle
24