Boynton SM CH 17

CHAPTER 17
AUDIT
ING THE INVESTING AND
FINANCING
CYCLE
Learning
Check
17-1.
Investing activities represent the purchase and sale of land, buildings,

equipment, and other assets not generally held for resale. In addition,
investing activities include the purchase and sale of financial instruments
not intended for trading purposes (discussed in chapter 18). Financing
activities include transactions and events whereby cash is obtained from
or repaid to creditors (debt financing) or owners (equity financing).
Financing activities would include, for example, acquiring debt, capital
leases, issuing bonds, or issuing preferred or common stock. Financing
activities would also include payments to retire debt, reacquiring stock
(treasury stock), and the payment of dividends.
17-2. When auditing the investing and financing cycles auditors typically
address the following issues:
What assets are necessary to support the operations of the entity, and
what are managements long-range plans for growing the entitys
asset base?
Answering this question assists the auditor in developing
expectations of long-term assets needed to support operations.
Solutions Manual to Modern Auditing: Copyright
2005, John Wiley and Sons, Inc.
17-1
What assets were acquired, or disposed of, during the period?

Answering this question confirms the auditors expectations regarding
assets needed to operate effectively.
It also assists the auditor in
developing expectations of regarding financing activities.
How were newly acquired assets financed? Answering this question

completes the audit of the investing and financing cycles.
These cycles are often audited together due to the strong connection
between asset acquisition and the financing of those assets.
17-3. Investing activities are critical to a company in the hotel industry as
facilities are the primary productive asset. The location and quality of
hotel facilities are directly related to revenues and represent a substantial
proportion of the asset side of the balance sheet. Due to the long-term
nature of these assets they are usually financed with long-term
mortgages.
Alternatively, buildings are only necessary to house the process of
computer assembly and often these facilities may be leased rather than
purchased. A computer assembler may even consider an operating lease
rather than a capital lease.
The core processes for the computer
assembler are marketing and purchasing and long-term assets are

primarily a support function.
17-4.
a.
Audit objectives for plant assets can be summarized as follows:

Specific Audit Objectives
Transaction Objectives
Occurrence. Recorded acquisitions of plant assets (EO1), disposals of plant
assets (EO2), and repair and maintenance transactions (EO3) represent
transactions that occurred during the year.
Completeness. All acquisitions of plant assets (C1), and disposals of plant
assets (C2), and repair and maintenance transactions (C3) that occurred
during the period were recorded.
Accuracy. Acquisitions of plant assets (VA1), disposals of plant assets (VA2),
17-2
and repair and maintenance transactions (VA3) are accurately valued using
GAAP and correctly journalized, summarized and posted.
Transactions for depreciation expense are properly valued (VA5).
Cutoff. All acquisitions of plant assets (EO1 and C1), and disposals of plant
assets (EO2 and C2), and repair and maintenance transactions (EO3 and C3)
have been recorded in the correct accounting period.
Classification. All acquisitions of plant assets (PD1), and disposals of plant
assets (PD2), and repair and maintenance transactions (PD3) have been
recorded in the proper accounts.
Balance Objectives
Existence. Recorded plant assets represent productive assets that are in
use at the balance sheet date (EO4).
Completeness. Plant assets balances include the effects of all applicable
transactions during the period (C4).
Rights and Obligations. The entity owns or has rights to all recorded plant
assets at the balance sheet date (RO1).
Valuation and Allocation. Plant assets balances are stated at cost (VA4),
less accumulated depreciation (VA5), and are written down for material
impairments (VA6).
Disclosure Objectives
Occurrence and Rights and Obligations.
Disclosed plant and equipment
events and transactions have occurred and pertain to the entity (PD4).
Completeness. All PP&E disclosures that should have been included in the
financial statements have been included (PD5).
Understandability. All PP&E information is appropriately presented and
information in disclosures is understandable to users (PD6).
Accuracy and Valuation. PP&E information is disclosed accurately and at
appropriate amounts (PD7).
b.
The audit objectives for natural resources and intangible assets

would be quite similar to those for plant assets.
The natural
resource issues are almost identical and the auditor needs to

consider the issues associated with depletion of assets.
With
respect to intangible assets, there are significant issues associated

with the valuation of intangibles at acquisition, the amortization of
intangibles, and the impairment of intangibles.
17-3
17-5.
a.
Following are several examples of analytical procedures and how

they might be used to identify potential misstatements.
Ratio
Fixed
Asset
Audit Significance
An unexpected increase in fixed asset turnover may
Turnover
indicate the failure to record or capitalize depreciable
Total Asset Turnover
assets.
An unexpected increase in total asset turnover may
indicate the failure to record or capitalize depreciable
assets.
An unexpected increase or decrease in the depreciation
Depreciation
Expense
as
Percent of Property,
Plant
expense as a percent of depreciable assets may

indicate an error in calculating depreciation.
and
Equipment
Repair Expenses to
An unexpected increase in repair and maintenance
Net Sales
expense may indicate the possibility that assets that

should be capitalized have been expensed.
b.
Inherent risk may be low for the existence assertion for plant assets
as they are not vulnerable to theft and they are easy to observe.
However, inherent risk may be moderate to high for issues of
completeness associated with the recording of capital leases, the
existence
of
various
capitalized
expenditures,
or
with
the
accounting estimate associated with depreciation expense.

c.
The same system of internal control that governs normal day to day
expenditures also applies to the acquisition of plant assets.
Additional controls that might not apply to routine expenditures
include the fact that due to the size and long-term implications of
acquisitions of plant assets, they are normally subject to a capital
budgeting process and review by the board of directors (or
committee of the board).
Depreciation policies and useful lives
should be reviewed by a disclosure committee.

17-4
17-6.
a.
In a first time audit, the auditor undertakes an investigation of the

beginning balances and the ownership of major units of plant
currently in service. In a recurring engagement, the auditor only
has the responsibility for determining that the beginning balances
agree with the adjusted balances in the preceding year's working
papers.
b.
17-7.
a.
The substantive tests that apply to three or more assertions are:
Perform analytical procedures.
Vouch plant asset additions to supporting documentation.
Vouch plant asset disposals to supporting documentation.
Review entries to repairs and maintenance expense.
Inspect plant assets.
Examine title documents and contracts.
Review provisions for depreciation
Applying analytical procedures involves the use of ratios and other

analytical techniques. This test applies to all assertion categories
except rights and obligations.
b.
Inspecting plant assets generally involves physical inspection of

additions to plant assets and touring other plant assets while being
alert to evidence of additions and disposals not included on client
schedules and to conditions that bear on the proper valuation and
classification of plant assets. This test also relates to all assertion
categories except rights and obligations.
c.
Examining title documents and lease contracts involves the

scrutiny of these documents for such information as ownership
17-5
rights and contract terms. This test relates primarily to the

existence or occurrence, rights and obligations, valuation or
allocation, and presentation and disclosure assertions.
d.
Vouching plant asset additions involves testing from the accounting

records to supporting documentation. This test provides evidence
for the existence or occurrence, rights and obligations, and
valuation or allocation assertions.
17-8. The procedures that may be useful to the auditor in determining whether
all plant asset retirements have been recorded are:
Analyze the miscellaneous revenue account for proceeds from sales of

plant assets.
Investigate the disposition of facilities associated with discontinued

product lines and operations.
Trace retirement work orders and authorizations for retirements to the

accounting records.
17-9
Review insurance policies for termination or reductions of coverage.
Make inquiry of management as to retirements.

a.
In reviewing depreciation entries and computations, the auditor

seeks evidence on the reasonableness, consistency, and accuracy
of depreciation charges. The factors pertaining to reasonableness
include (a) the client's past history in estimating useful lives, (b)
the remaining useful lives of existing assets, (c) the gains and
losses experienced on the sale of assets, and (d) industry practices.
For consistency, the auditor can obtain information about the
depreciation methods used from a review of schedules and inquiry
of the client. The accuracy of depreciation charges can be verified
by recalculation.
17-6
b.
The auditor should evaluate whether the client has appropriately

accounted for the impairment of plant assets when there has been
a material change in the way an asset is used, or when there has
been a material change in the business environment. The evidence
to
evaluate
impairment
is
based
on
an
estimate
undiscounted future cash flows from the asset.
of
the
Based on the
criteria established in FASB 121, an auditor should consider that the

value of an asset is impaired when the undiscounted future cash
flows from an asset are less than the book value of the asset.
17-10. a.
The financing cycle includes transactions and events whereby cash

is obtained from or repaid to creditors (debt financing) or owners
(equity financing). Financing activities would include, for example,
acquiring debt, capital leases, issuing bonds, or issuing preferred or
common stock. Financing activities would also include payments to
retire debt, reacquiring stock (treasury stock), and the payment of
dividends.
b.
The financing cycle interfaces with the expenditure cycle when

cash is disbursed for bond interest, the redemption of bonds,
payment of cash dividends, and the purchase of treasury stock.
17-11.
The audit objectives for the financing cycle are:

Specific Audit Objectives
Transaction Objectives
Occurrence. Recorded debt (EO1), interest cost (EO2), and equity (EO3) represent
transactions that occurred during the year.
Completeness.
All debt (C1) and interest costs incurred (C2), and equity
transactions (C3) that occurred during the period were recorded.
Accuracy.
Debt (VA1), interest costs (VA2), and equity transactions (VA3)
transactions
are
accurately
valued
using
GAAP
and
correctly
journalized,
17-7
summarized and posted.

Cutoff. All debt (EO1 and C1), interest cost (EO2 and C2), and equity transactions
(EO3 and C3) have been recorded in the correct accounting period.
Classification. All debt (PD1), interest cost (PD2), and equity transactions (PD3)
have been recorded in the proper accounts.
Balance Objectives
Existence. Recorded debt (EO4) and equity (EO5) exist at the balance sheet date.
Completeness. All debt (C4) and equity (C5) is recorded at the balance sheet date.
Rights and Obligations. All recorded debt balances are the obligations of the entity
(RO1), and equity balances represent owners claims on the reporting entitys
assets (RO2).
Valuation and Allocation.
Debt (VA4), and equity (VA5) balances are properly
valued in accordance with GAAP.

Disclosure Objectives
Occurrence and Rights and Obligations. Debt (PD4) and equity (PD8) disclosures
have occurred and pertain to the entity.
Completeness. All debt (PD5) and equity (PD9) disclosures that should have been
included in the financial statements have been included.
Understandability. All debt (PD6) and equity (PD10) information is appropriately
presented and information in disclosures is understandable to users.
Accuracy and Valuation. Debt (PD7) and equity (PD 11) information is disclosed
accurately and at appropriate amounts.
17-12. a.
There is considerable variation in the importance of long-term debt

in financial statements. In some companies with strong free cash
flows, debt is immaterial. In other companies, such as public
utilities, long-term debt may be more than 50% of total equities.
Stockholders equity is clearly material to the balance sheet. The
income statement effects and the effect of dividends on the
retained earnings statement is often material. Inherent risk for
financing transactions is generally moderate as transactions occur
infrequently.
b.
Following are several examples of analytical procedures and how

they might be used to identify potential misstatements in debt
financing transactions.
17-8
Ratio
Audit Significance
Free Cash Flow
Negative free cash flows indicate the need for, and

approximate amount of, expected financing to prevent
Interest
Bearing
drawing down on cash or investments.

Provides a reasonableness of the entitys proportion of
Debt to Total Assets
debt
Shareholders
experience or industry data.

Equity
to
Assets
Comparing
Total
that
equity
that
may
may
be
be
compared
with
compared
with
prior
prior
years
years
Return

If a company is able to generate a higher rate of return
on Assets with the
on assets than its incremental cost of debt, this is a
Incremental Cost of
signal that an entity may use debt financing to expand
Debt
the assets and earnings of the entity.
Current Portion of
A test of the entitys ability to service its financing
Debt and Dividends
obligations. Ratios less than 1.0 indicate potential
to Cash Flow from
liquidity problems.
Operations
Times
Interest
A test of the entitys ability to generate earnings to
Earned
cover cost of debt service. Ratios less than 1.0 indicate

that the entitys earnings are insufficient to cover
Interest Expense to
financing costs.
A reasonableness test of recorded interest expense that
Interest
should approximate the entitys average cost of debt
Bearing
Debt
17-13.
Control
capital.
risk
as
also
low
as
financing
transactions
receive
considerable attention from senior management and the board of

directors that carefully monitor the acquisition and retirement of debt.
17-14.
The functions that relate to financing cycle transactions include:
Authorizing bonds and capital stock
Issuing bonds and capital stock
17-9
Paying bond interest and cash dividends
Redeeming and reacquiring bonds and capital stock
Recording financing transactions
17-15.
Because of the nature and materiality most types of long-term debt
transactions, inherent risk is often moderate to high for all related

account balance assertions. Based on consideration of these factors and
any relevant control risk assessments, an appropriate level of detection
risk is determined for each significant assertion related to long-term debt
balances. Many auditors follow a primarily substantive approach to longterm debt because of the efficiency and effectiveness of using
confirmations to audit a small population size.
17-10
17-16.
The substantive tests that apply to the existence or occurrence and
valuation or allocation assertions for long-term debt balances are.

EO
Verify accuracy of balances, schedules,
VA
X
and subsidiary ledgers (perform initial

procedures)
Perform analytical procedures.
X
Vouch entries in long term debt and X
X
X
related income statement accounts

Review authorizations and contracts
X
Confirm debt with lenders and bond X
X
X
trustees
Recalculate interest expense
17-17. a.
In vouching entries to long-term debt accounts, the direction of the

substantive
test
is
from
recorded
entries
to
supporting
documentation. This test pertains to the existence or occurrence,

completeness, rights and obligations, and valuation or allocation
assertions.
b.
In confirming debt, the auditor has direct communication with

lenders and bond trustees and the responses are returned directly
to the auditor. This test relates to four assertions: existence or
occurrence, completeness, rights and obligations, and valuation or
allocation.
c.
In recalculating interest expense, the auditor re-performs the

computations made by the client. This test relates primarily to
valuation or allocation.
17-18.
Inherent risk for stockholders' equity balances should be low.
However, the acceptable level of detection risk for the existence or

occurrence and completeness assertions for capital stock are likely to be
high when the company uses a registrar and transfer agent. For the other
17-11
assertions, detection risk may be moderate. Again, many auditors follow

a primarily substantive approach to auditing shareholders equity
because of the efficiency and effectiveness of using confirmations
(registrar or transfer agent) to audit a small population size.
17-19.
The substantive tests that apply to the existence or occurrence and
completeness assertions for stockholders' equity balances are

Perform analytical procedures
Vouch entries to capital stock accounts
Vouch entries to retained earnings
Review articles of incorporation and bylaws
Review authorizations and terms of stock issues
Confirm shares outstanding with registrar
EO
X
X
X
X
X
and X
transfer agent
Inspect stock certificate book
Inspect certificates of shares held in treasury
17-20.
X
X
C
X
X
X
X
Following a several examples of analytical procedures and how
they might be used to identify potential misstatements in shareholders

equity transactions.
Ratio
Audit Significance
Return on common
Provides a measure of the rate of return generated on
stockholders equity
the common shareholders investment. Auditors should

understand the competitiveness factors that allow a
Equity
to
total
company to obtain unusually high returns.

liability and equity
equity
Dividend

Auditors would normally expect low dividend payout
payout
rate
that
may
be
compared
with
prior
years
rates for high growth companies that need reinvested

earnings to fund investments in working capital and
Earnings per share
long-term assets.
Earnings per share is useful for comparisons with price
17-12
Ratio
Audit Significance
per share.
This ratio can be compared with industry
Sustainable growth
price earnings ratios for reasonableness.

Provides an estimate of rate of sales growth that can be
rate
obtained without changing the entitys profitability or

financing structure. The auditor should expect changes
in the financing structure when sales grow significantly
faster than the sustainable growth rate.
17-21.
Various value-added services that the auditor might offer to a client
related to the investing and financing cycles include:
Benchmarking the return generated by investing activities against

competitors.
Independent review of strategic plans for investing activities.
Explanation of the advantages and disadvantages of bank financing,

mortgage financing, lease financing, financing that may be available
from insurance companies or other entities, or various classes of
preferred stock.
Many investments are accomplished through merger or acquisition. A

CPA firm may provide expertise in guiding a company through a
merger or acquisition. This service would include identifying possible
acquisitions candidates, helping an entity evaluate the potential
benefits and risks associated with an acquisitions, as well as how to
structure the acquisition.
Comprehensive
Questions
(Estimated time - 25 minutes)
17-13
17-22.
The key internal controls related to Grant's property, equipment
and related transactions that Harris may consider in assessing control

risk include the following:
Advance approval in accordance with management's criteria is

required for property and equipment transactions.
Approval authority for transactions above an established dollar

value is required at a higher level, such as the board of directors.
Property and equipment transactions are adequately documented.
There are written policies covering capitalizing expenditures,

classifying leases, and determining estimated useful lives, salvage
values, and methods of depreciation and amortization.
There are written policies covering retirement procedures that

include serially numbered retirement work orders, stating reasons
for retirement and bearing appropriate approvals.
There are adequate policies and procedures to determine whether

property and equipment are received and properly recorded such
as a system that matches purchase orders, receiving reports and
vendors' invoices.
There are adequate procedures to determine whether dispositions

of property and equipment are properly accounted for and
proceeds, if any, are received in accordance with management's
authorization.
A property and equipment subsidiary ledger is maintained showing

additions,
retirements,
and
depreciation,
and
the
ledger
is
periodically reconciled.
Property and equipment is physically inspected and reconciled at

reasonable intervals with independently maintained property and
equipment records.
An annual budget is prepared and monitored to forecast and control

acquisitions and retirements of property and equipment.
17-14
Reporting procedures assure prompt identification and analysis of

variances between authorized expenditures and actual costs.
Property and equipment is protected by adequate safeguards.
Property
and
equipment
is
insured
in
accordance
with
management's authorization.
Documents evidencing title and property rights are periodically

compared with the detailed property records.
The entity employs internal auditors to test whether the internal

control structure policies and procedures are operating effectively.
17-15
17-23. a.
The following matrix identifies the substantive tests pertaining to

property, plant and equipment and the audit objectives pertaining
to each.
Category
Substantive Test
Specific
Initial
1) Obtain and understanding of the entity and its environment and
Audit
Objectives
Procedure
determine:
a) The significance of plant assets, and changes in plant assets, to
All
the entity.
b) Key economic drivers that influence the entitys acquisition of
plant assets.
c)
Industry standards for the extent to which the entity is capital

intensive and the impact of plant assets on earnings.
d) Understand the degree to which the company has used variable

interest entities and operating leases to finance assets.
VA4
2) Perform initial procedures on plant assets balances and records that

will be subjected to further testing.
EO1, EO4
a) Trace beginning balance for plant assets and accumulated

depreciation to prior years working papers.
b) Review activity in general ledger accounts plant assets and
depreciation expense and investigate entries that appear
unusual in amount or source.
c)
VA4
Obtain client-prepared schedules of plant asset additions,

retirements and depreciation expense, and determine that they
accurately represent the underlying accounting records from
VA4
which they were prepared by:

i)
Footing and crossfooting the schedules and reconciling the

totals with increases or decreases in the related general
ledger balances during the period.
ii)
Analytical
Procedure
s
Testing agreement of items on schedules with entries in
related general ledger accounts.

3) Perform analytical procedures:
All
a) Develop an expectation for plant assets using knowledge of the

industry and the entitys business activity
b) Calculate ratios:
i)
Fixed asset turnover
ii)
Depreciation expense as a percent of sales
iii) Repair and maintenance expense as a percent of sales

iv) Rate of return on assets
17-16
Category
Substantive Test
Specific
Audit
Objectives
c)
Analyze ratio results relative to expectations based on prior
years, industry data, budgeted amounts, or other data.

4) Vouch plant asset additions to supporting documentation.
EO1,
Details of
5) Vouch plant asset disposals to supporting documentation.
VA4
Transactio
6) Vouch a sample of entries to repairs and maintenance expense.
EO2,
ns
7) Vouch the recording of new capital lease and operating leases to
VA4
Tests
of
underlying contracts.
EO3,
VA1,
PD1,
EO4,
VA2,
PD2,
EO4,
VA3,
PD3,
EO4,
VA4
EO1, C1, VA1, PD1
Tests
of
8) Inspect plant asset.
Details of
a) Inspect plant asset additions.
EO4
Balances
b) Tour other plant assets and be alert to evidence of additions
EO4, C1, C2, C4
and disposals not included on clients schedules and to

conditions that bear on the proper valuation and classification
of the plant assets.
Tests
of
RO1
9) Examine title documents and contracts

10) Evaluate the fair presentation of depreciation
expense
by
Details of
evaluating the appropriateness of useful lives and estimated
Accountin
salvage values.
VA6
11) Determine if any significant events have resulted in an impairment
Estimates
Tests
of
of the value of plant assets.

12) Compare statement presentation with GAAP.
Details of
a) Determine that plant assets and related expenses, gains, and
Presentati
losses are properly identified and classified in the financial
on
statements.
and
Disclosure
VA5
PD4, PD7
PD4, PD7
b) Determine the appropriateness of disclosures related to the

cost, book value, depreciation methods, and useful lives of
major classes of plant assets, the pledging of plant assets as
PD5
collateral and the terms of lease contracts.

c)
Evaluate the completeness of presentation and disclosures for

receivables in drafts of financial statements to determine
PD6
conformity to GAAP by reference to disclosure checklist.

d) Read
disclosures
and
independently
evaluate
their
understandability.
b.
Is
Adjustment
Item
Audit Reasons Why Audit Adjustment or Reclassification

is Required or Not Required
or
17-17
No.
Reclassification
Required?
1.
Yes or No
Yes
Commissions paid to real estate agents are costs

directly related to the acquisition of the property and
should be included in the land cost. Costs of
removing, relocating, or reconstructing property of
others to acquire possession are costs that are
directly attributable to conditioning the property for
use and should be included in land costs. An
adjustment is required for these items so that total
land costs can properly be included in Property, Plant
2.
No
& Equipment.
No adjustment is required because clearing costs are
costs that are directly attributable to conditioning the
property for use and should be included in land costs
3.
Yes
which are part of Property, Plant & Equipment.

Since clearing costs are costs of the land, amounts
realized from the sale of materials recovered, such as
timber and gravel, should be a reduction of the cost
of the land and should not be recorded as other
4.
Yes
income.
All costs relating to the purchase of machinery and
equipment should be capitalized. For purchased items
such costs would include invoice price, freight costs,
and unloading charges. Royalty payments, however,
should not be included in the cost of the machinery.
Such payments should be charged to expenses as
they accrue. The machinery costs, other than royalty
payments, should be included in Property, Plant &
Equipment.
17-18
17-24.
Substantive tests that Pierce should use in examining Mayfair's mobile

construction equipment and related depreciation would include the
following:
Determine that the equipment account is properly footed.
Determine that the subsidiary accounts agree with controlling

accounts.
Obtain, or prepare, an analysis of changes in the account during the

year.
Determine that beginning-of-year balances agree with the prior year's

ending balances.
Inspect documents in support of additions during the year.
Inspect documents in support of retirements during the year.
Analyze repairs and maintenance for possible reclassifications.
Determine the propriety of accounting for equipment not in current

use.
Test the accuracy of equipment and accounting records by

o Selecting items from the accounting records and verifying their
physical existence.
o Selecting items of equipment and locating them in the
accounting records.
o Evaluate the reasonableness of estimated lives and methods of
depreciation used.
o Test the calculation of depreciation expense and accumulated
depreciation balance.
o Apply analytical procedures such as comparing depreciation
expense to balance sheet accounts for proper relationship and
comparing the current year's depreciation expense with prior
year's depreciation expense.
17-19
o Evaluate the financial statement presentation and disclosures

for conformity with generally accepted accounting principles.
o Review insurance coverage.
(Note: Other possible tests in the chapter may also be used.)
17-25.

a. Substantive Test
1.
Vouch
entries
2.
of
Financial
Assertion
to Existence
retained earnings
board
b.
or
Statement c.
Type
of
Evidence
occurrence, Documentary
to rights and obligations, and
director valuation or allocation
minutes.
Vouch entries in long- All
except
presentation Documentary
term debt accounts to and disclosure

board
3.
of
minutes
Vouch
director
to
cash Existence
or
occurrence, Mathematical
disbursements journal valuation or allocation

and recalculate bond
4.
interest
Vouch
5.
brokers advice
valuation or allocation
Inspect entries in cash Existence or occurrence, Documentary
entries
to Existence
disbursements journal
6.
Vouch
to
board
or
valuation or allocation
of Existence
or
occurrence, Documentary,
director authorization, valuation or allocation

and
confirmation
consider
confirming
with
transfer agent.
17-20
a. Substantive Test
b.
Financial
7.
Recalculate
Assertion
Valuation or allocation
8.
interest expense
Inspect
cash All
except
Statement c.
consider
confirmation
and
confirming
9.
with bond trustee.

Vouch to board
of Presentation and disclosure
10.
directors minutes
Vouch to board
of Existence
or
director minutes and valuation
or
and
Evidence
Mathematical
supporting
documentation
review
Documentary
allocation,
authorizations rights and obligations, and
terms
of
stock presentation and disclosures
issues
17-26.
a.

The substantive tests that Andrews should employ in examining the
loans are as follows:
Obtain an understanding of the business purpose of the loans

made by the president.
Confirm the loans, including terms, by direct communication.
Re-compute (or verify) interest expense and interest payable.
Re-compute the long-term and short-term portions of the debt.
Review minutes of meetings of the board of directors for proper

authorization.
of
presentation Documentary,
disbursements journal and disclosure

entry,
Type
Verify payments made during the year and transactions after the
year end.
17-21
Read
(notes
to)
the
financial
statements
and
the
loan
agreements, and evaluate the adequacy of disclosure and

compliance with restrictions.
b.
Obtain a management representation letter.
Broadwall's financial statements should disclose the following

information concerning the loans from its president:
The nature of the related-party relationship
The dollar amounts of the loans
Amounts due to the president and, if not otherwise apparent,

the terms and manner of settlement.
17-27.
The substantive tests that Jones should apply in examining the common
stock and treasury stock accounts are as follows:
Review the corporate charter to verify details of the common stock such
as authorized shares, par value, etc.
Obtain or prepare an analysis of changes in common stock and

treasury stock accounts.
Compare opening balances with prior year's working papers.
Foot the total shares outstanding in the stockholders' ledger and stock
certificate book.
Determine authorization for common stock issuance and treasury

stock transactions by inspecting the minutes of the board of directors'
meetings.
Verify capital stock issuance by examining supporting documentation

and tracing entries into the records.
Verify
treasury
stock
transactions
by
examining
supporting
documentation and tracing entries into the records.

17-22
Examine all certificates canceled during the year.
Inspect all treasury stock certificates owned by the client.
Reconcile the details of the individual certificates in the stock

certificate book with the individual shareholders' accounts in the
stockholders' ledger.
Compare the total in the stockholders' ledger and the stock certificate
book to the balance sheet presentation.
Re-compute the weighted average number of shares outstanding.
Compare the financial statement presentation and disclosure with

generally accepted accounting principles.
Determine the existence of and proper accounting for common stock

and treasury stock transactions occurring since year-end.
Obtain written representations concerning common and treasury stock

in the client representation letter.
17-28.
The proposal for the limitation of procedure is not justified by the stated
facts. Although the transfer agent and the registrar know the number of
shares issued, they do not necessarily know the number of shares outstanding.
Furthermore,
the
audit
of
capital
stock
includes
more
than
determining the number of shares outstanding. For example, the auditor

must determine what authorizations exist for the issuance of shares,
what assets were received in payment of shares, how the transactions
were recorded, and what subscription contracts have been entered into.
Confirmation from the registrar could not help in determining these
things. In addition to confirmation from the registrar, the audit of capital
stock might include the following procedures for which the purposes are
briefly indicated:
17-23
Examine the corporation charter to determine the number of shares

authorized and the special provisions relating to each class of stock if
more than one class is authorized.
Examine
minutes
of
stockholders'
and
directors'
meetings
to
determine authorization for appointments of the registrar and the

transfer agent, and to determine authorization for the issuance or
reacquisition of shares.
Examine provisions relating to capital stock in the corporation law of the

state of incorporation to determine any special provisions such as, for
example, those relating to the issuance of no-par stock.
Analyze the capital stock accounts to obtain an orderly picture of stock

transactions for use as a guide to other auditing procedures and as a
permanent record.
Trace the consideration received for capital stock into the records to
determine what consideration has been received and how it has been
recorded.
Examine and schedule treasury stock and review entries for treasury
stock to determine the existence of treasury stock, as authorized, and
to determine that a proper record has been made.
Review registrar's invoices and cash disbursements to determine that

original issue taxes have been paid.
Compare dividends with stock outstanding at dividend dates to

determine that dividends have been properly paid and also to
substantiate the stock outstanding.
Review subscription and option contracts, etc., to determine the facts in

regard to subscriptions and options and to determine that these facts
have been properly recorded and that they are adequately disclosed.
Case
17-24
s
17-29.
a.
(Estimated Time 40 minutes)

The economic substance of the patent is the right to produce and
sell a particular drug if the drug becomes marketable. The primary
issues associated with the recording of the patent is the fair market
value of the redeemable preferred stock. If 9% is a market interest
rate and no discount or premium is appropriate, then the book
value of the patent is appropriately recognized at $10 million. The
auditor also will need to consider the appropriate amortization
period.
At this point in time the appropriate amortization period
might be 16 years. In the future, the auditor needs be sensitive to

impairment in the value of the patent.
b.
Audit procedures performed in 20x0 to audit the patent would include:

Procedure
Assertion
Obtain and understanding of the business and industry and
All assertions
determine:
a) The significance of plant assets, and changes in plant
assets, to the entity.
b) Key
economic
drivers
that
influence
the
entitys
acquisition of plant assets.

c)
Industry standards for the extent to which the entity is

capital intensive and the impact of plant assets on
earnings.
Vouch the acquisition of the patent to supporting documentation
Existence
and contracts supporting the transaction and title.
occurrence,
and
and
rights
obligations,
valuation
or
Evaluate the fair presentation of amortization expense by
allocation
Valuation
or
evaluating the appropriateness of useful life.
allocation
Determine the appropriateness of disclosures related to the cost,
Presentation
book value, amortization methods, and useful life of patent.
disclosure
and
17-25
c.
The economic substance of the redeemable preferred stock is debt.
The
security has a fixed rate of return stated as a percentage of the par value
of the security and it has a fixed redemption date. Corporate holders of
the redeemable preferred stock will enjoy a dividend received deduction
for tax purposes.
The company has not appropriately classified the
security as the redeemable preferred stock is debt in economic substance

and should be reported as the last item in debt, prior to shareholders
equity.
d.
Audit procedures performed in 20x0 to audit preferred stock would

include:
Procedure
Obtain and understanding of the business and industry and
Assertion
All assertions
determine:
a) The significance of sources of financing to the entity.
b) Key economic drivers that influence the entitys need for
financing and choice of financing.
c) Industry
standards
regarding
the
type
of
financing
commonly used within the industry.

Review authorization by the board of directors and contracts
Existence
support the transaction.
occurrence,
Confirm terms of contract with the holder of the redeemable
and obligations
All assertions
preferred stock.
Recalculate interest expense
Valuation
and
Compare statement presentation with GAAP.
allocation
Presentation
and
a) Determine
that
long-term
debt
balances
are
properly
and
right
disclosure
identified and classified in the financial statements.

b) Determine the appropriateness of disclosures concerning all
terms, covenants, and retirement provisions pertaining to
long term debt.
c) Evaluate the completeness of presentation and disclosures for
receivables in drafts of financial statements to determine
17-26
Procedure
conformity to GAAP by reference to disclosure checklist.
d) Read
disclosures
and
independently
evaluate
Assertion
their
understandability.
Professional Simulation
Audit
Procedure
s
FARS
Situatio
Audit Report
Research
n
The following table explains the auditing procedures that should be performed
associated with the legend identified as a) through h).
Legend
a)
b)
c)
Audit Procedure
Foot
Crossfoot
Traced beginning balance to prior years working papers and the
d)
general ledger.
Vouched additions
e)
invoices, title reports, etc.

Vouched disposals to supporting documentation, e.g., bill of sale and
f)
cash receipts
Vouched reclassification to supporting documents, title reports and
g)
underlying appraisals, showing the underlying value of the building.

Recalculated depreciation expense and evaluated the reasonableness
h)
of depreciation methods, useful lives, and salvage values.

Vouched historical cost of disposal to underlying asset schedule with
to
supporting
documentation,
e.g.,
vendors
net book values.

FARS
17-27
Research
Audit
Audit Report
Situatio
Procedure
The following quotes are from Statement of Financial Accounting Standards No.
13, Accounting for Leases.
Paragraphs 6 and 7 provide the basis for
determining if the lease is a capital lease or an operating lease.

6.
For purposes of applying the accounting and reporting standards of this

Statement, leases are classified as follows:
a.
Classifications from the standpoint of the lessee:

i.
Capital leases. Leases that meet one or more of the criteria
in paragraph 7.
ii.
7.
Operating leases. All other leases.
The criteria for classifying leases set forth in this paragraph and in
paragraph 8 derive from the concept set forth in paragraph 60. If at its
inception (as defined in paragraph 5(b)) a lease meets one or more of the
following four criteria, the lease shall be classified as a capital lease by
the lessee. Otherwise, it shall be classified as an operating lease. (See
Appendix C for an illustration of the application of these criteria.)
a.
The lease transfers ownership of the property to the lessee by the

end of the lease term (as defined in paragraph 5(f)).
b.
The lease contains a bargain purchase option (as defined in

paragraph 5(d)).
c.
The lease term (as defined in paragraph 5(f)) is equal to 75 percent

or more of the estimated economic life of the leased property (as
defined in paragraph 5(g)). However, if the beginning of the lease
17-28
term falls within the last 25 percent of the total estimated

economic life of the leased property, including earlier years of use,
this criterion shall not be used for purposes of classifying the lease.
d.
The present value at the beginning of the lease term of the

minimum lease payments (as defined in paragraph 5(j)), excluding
that portion of the payments representing executory costs such as
insurance, maintenance, and taxes to be paid by the lessor,
including any profit thereon, equals or exceeds 90 percent of the
excess of the fair value of the leased property (as defined in
paragraph 5(c)) to the lessor at the inception of the lease over any
related investment tax credit retained by the lessor and expected
to be realized by him. However, if the beginning of the lease term
falls within the last 25 percent of the total estimated economic life
of the leased property, including earlier years of use, this criterion
shall not be used for purposes of classifying the lease.
A lessor
shall compute the present value of the minimum lease payments

using the interest rate implicit in the lease (as defined in paragraph
5(k)). A lessee shall compute the present value of the minimum
lease payments using his incremental borrowing rate (as defined in
paragraph 5(1)), unless (i) it is practicable for him to learn the
implicit rate computed by the lessor and (ii) the implicit rate
computed by the lessor is less than the lessee's incremental
borrowing rate. If both of those conditions are met, the lessee shall
use the implicit rate.
The lease described in the simulation meets all the criteria to be classified as
an operating lease.
Also relevant to the evaluation of this lease is FIN 46. Shailer Enterprises is a
variable interest entity that should be consolidated ANUs financial statements.
FIN 46 indicates that an enterprise that consolidates a variable interest entity is
17-29
the primary beneficiary of the variable interest entity. The primary beneficiary
of a variable interest entity is the party that absorbs a majority of the entity's
expected losses, receives a majority of its expected residual returns, or both, as
a result of holding variable interests, which are the ownership, contractual, or
other pecuniary interests in an entity. The ability to make decisions is not a
variable interest, but it is an indication that the decision maker should carefully
consider whether it holds sufficient variable interests to be the primary
beneficiary. An enterprise with a variable interest in a variable interest entity
must consider variable interests of related parties and de facto agents as its
own in determining whether it is the primary beneficiary of the entity. ANU is it
primary beneficiary that absorbs the majority of any losses to the bank or
Shailer Enterprises and received the expected returns if the value of the
property increases. The appropriate paragraphs of FIN 46 follow.
Shailer enterprises meets the following conditions of a variable interest entity
based on paragraph 2 to the summary of FIN 46.
2.
The equity investors lack one or more of the following essential

characteristics of a controlling financial interest:
a.
The direct or indirect ability to make decisions about the entity's

activities through voting rights or similar rights
b.
The obligation to absorb the expected losses of the entity if they

occur, which makes it possible for the entity to finance its activities
c.
The right to receive the expected residual returns of the entity if

they occur, which is the compensation for the risk of absorbing the
expected losses.
Paragraph 16 of FIN 46 defines a primary beneficiary.

16.
For purposes of determining whether it is the primary beneficiary of a

variable interest entity, an enterprise with a variable interest shall treat
17-30
variable interests in that same entity held by its related parties as its own
interests.
For purposes of this Interpretation, the term related parties
includes those parties identified in FASB Statement No. 57, Related Party
Disclosures, and certain other parties that are acting as de facto agents
of the variable interest holder.
The following are considered to be de
facto agents of an enterprise:

a.
A party that cannot finance its operations without subordinated

financial support from the enterprise, for example, another variable
interest entity of which the enterprise is the primary beneficiary
b.
A party that received its interests as a contribution or loan from the

enterprise
c.
An officer, employee, or member of the governing board of the

enterprise
d.
A party that has (1) an agreement that it cannot sell, transfer, or

encumber its interests in the entity without the prior approval of
the enterprise or (2) a close business relationship like the
relationship between a professional service provider and one of its
significant clients.
Further, paragraph 14 of FIN 46 explains why the primary beneficiary should

consolidate the variable interest entity in the financial statements.
14.
An enterprise shall consolidate a variable interest entity if that enterprise

has a variable interest (or combination of variable interests) that will
absorb a majority of the entity's expected losses if they occur, receive a
majority of the entity's expected residual returns if they occur, or both.
An enterprise shall consider the rights and obligations conveyed by its
variable interests and the relationship of its variable interests with
variable interests held by other parties to determine whether its variable
interests will absorb a majority of a variable interest entity's expected
17-31
losses, receive a majority of the entity's expected residual returns, or

both. A direct or indirect ability to make decisions that significantly affect
the results of the activities of a variable interest entity is a strong
indication that an enterprise has one or both of the characteristics that
would require consolidation of the variable interest entity.
If one
enterprise will absorb a majority of a variable interest entity's expected

losses and another enterprise will receive a majority of that entity's
expected residual returns, the enterprise absorbing a majority of the
losses shall consolidate the variable interest entity.
The economic substance of this lease arrangement is that Shailer Enterprises is

dependent upon ANU to obtain the loan, and ANU enjoys the benefits if the
value of the real estate increases and suffers the loss (through the contingent
rent payment) if the value of the real estate decreases. As a result, ANU should
consolidate the financial statements of Shailer Enterprises as part of its own
financial statements.
17-32
Audit Report
Audit
FARS
Situatio
Procedure
Research
INDEPENDENT AUDITORS REPORT

To the Board of Directors of Alpha Net Universal
We have audited the balance sheets of Alpha Net Universal as of December 31, 20x7
and 20x6, and the related statements of income, stockholders equity and cash flows
for the years then ended. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in
the United States. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
The Company has failed to consolidate the financial statements of Shailer Enterprises,
a variable interest entity, that, in our opinion, should be consolidated in order to
conform with generally accepted accounting principles.
If these financial statements
had been consolidated, property would be increased by $10 Million, long-term debt by
$9 Million, and Shareholders equity would be increased by $1 million.
In our opinion, except for the effects of not consolidating the financial statements of
Shailer Enterprises as discussed in the preceding paragraph, the financial statements
referred to above present fairly, in all material respects, the financial position of Alpha
17-33
Net Universal as of December 31, 20x7 and 20x6 and the results of their operations
and their cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States.
Signature
Date
17-34

Boynton SM CH 17

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CHAPTER 17

ING THE INVESTING AND

Investing activities represent the purchase and sale of land, buildings,

Answering this question assists the auditor in developing

expectations of long-term assets needed to support operations.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

What assets were acquired, or disposed of, during the period?

It also assists the auditor in

developing expectations of regarding financing activities.

How were newly acquired assets financed? Answering this question

The core processes for the computer

assembler are marketing and purchasing and long-term assets are

Audit objectives for plant assets can be summarized as follows:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Disclosed plant and equipment

The audit objectives for natural resources and intangible assets

resource issues are almost identical and the auditor needs to

respect to intangible assets, there are significant issues associated

2005, John Wiley and Sons, Inc.

Following are several examples of analytical procedures and how

indicate the failure to record or capitalize depreciable

Total Asset Turnover

expense as a percent of depreciable assets may

An unexpected increase in repair and maintenance

expense may indicate the possibility that assets that

accounting estimate associated with depreciation expense.

Depreciation policies and useful lives

should be reviewed by a disclosure committee.

2005, John Wiley and Sons, Inc.

In a first time audit, the auditor undertakes an investigation of the

The substantive tests that apply to three or more assertions are:

Perform analytical procedures.

Vouch plant asset additions to supporting documentation.

Vouch plant asset disposals to supporting documentation.

Review entries to repairs and maintenance expense.

Inspect plant assets.

Examine title documents and contracts.

Review provisions for depreciation

Applying analytical procedures involves the use of ratios and other

Inspecting plant assets generally involves physical inspection of

Examining title documents and lease contracts involves the

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

rights and contract terms. This test relates primarily to the

Vouching plant asset additions involves testing from the accounting

Analyze the miscellaneous revenue account for proceeds from sales of

Investigate the disposition of facilities associated with discontinued

Trace retirement work orders and authorizations for retirements to the

Review insurance policies for termination or reductions of coverage.

Make inquiry of management as to retirements.

In reviewing depreciation entries and computations, the auditor

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

The auditor should evaluate whether the client has appropriately

undiscounted future cash flows from the asset.

criteria established in FASB 121, an auditor should consider that the

The financing cycle includes transactions and events whereby cash

The financing cycle interfaces with the expenditure cycle when

The audit objectives for the financing cycle are:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.