Auditing, 12e (Arens)
Chapter 18 Audit of the Capital Acquisition and Repayment Cycle
18.1 Describe the four key characteristics of the capital acquisition and repayment cycle and the
risks of fraud or error in the cycle
1) The normal audit approach for the audit of bonds issued is to
A) examine transactions that occurred near the year end date only.
B) verify each transaction taking place in the cycle for the entire year.
C) select a statistical sample of transactions throughout the year.
D) rely upon controls rather than conducting substantive tests.
2) The exclusion of a single transaction of the capital acquisition and repayment cycle could be
material in itself. This means that the following audit assertion is a major audit concern
A) completeness.
B) existence.
C) accuracy.
D) rights and obligations.
3) In the audit of the transactions and amounts in the capital acquisitions and repayments cycle,
the auditor must ensure that significant legal requirements affecting the financial statements have
been properly fulfilled and
A) any violations are reported to the relevant provincial securities commissions.
B) any departures from the agreements are made with management’s knowledge and consent.
C) are adequately disclosed in the financial statements.
D) must issue a disclaimer if they haven’t been fulfilled.
4) There is a direct relationship between the interest and dividend accounts and debt and equity.
This means that in the audit of interest-bearing debt, it is desirable to simultaneously verify
A) the related dividends declared and dividends payable.
B) the related interest expense and interest payable.
C) contracts and commitments that are long-term.
D) details provided in the Board of Directors’ minutes.
5) A note payable is
A) a long-term account payable.
B) a legal obligation to a creditor secured by assets.
C) an unsecured legal obligation to a creditor.
D) a legal obligation to a creditor which may be unsecured or secured by assets.
6) Notes payable are easy for companies to correctly value and include in the financial
statements. This means that with respect to notes payable, inherent risk is
A) low.
B) medium.
C) high.
D) not assessed.
7) Control risk for notes payable is usually assessed as low. This occurs because internal controls
are normally good for notes payable and
A) creditors would complain if the notes are not paid.
B) interest expense can easily be distinguished from bank service charges.
C) there are a small number of large transactions or this type of transaction.
D) inclusion in the accounts payable listing helps track the notes.
8) When setting the objectives for auditing notes, the auditor should consider inherent risks
associated with
A) recording errors.
B) uncollectible notes.
C) duplicated notes.
D) management bias.
9) Responsibility for the issuance of new notes should be vested in the
A) board of directors.
B) accounting department.
C) accounts payable department.
D) purchasing department.
10) Proper authorization for the issuance of notes payable requires that
A) whenever notes are renewed (refinanced), they should be subject to the same authorization
procedures as those used when they were first issued.
B) responsibility for authorizing notes should lie with the manager who will receive the benefits
of the loan.
C) responsibility for authorization should lie with the treasurer’s function, since the treasurer’s
department will receive the cash generated.
D) responsibility for authorization should lie with the manager who must generate the revenue to
repay the loan.
11) Notes payable which have been repaid in full should be
A) destroyed so that they will not be paid again inadvertently.
B) cancelled and destroyed.
C) cancelled and returned to the creditor.
D) cancelled and retained by an authorized company official.
12) Which of the following internal controls over notes payable address risks associated with the
accuracy, allocation and completeness audit assertions?
A) renewals or new notes should be approved by the Board of Directors (as evidenced in the
minutes) or by senior management
B) authorized employees should perform independent recalculations of interest and
reconciliation of the notes payable balance to the general ledger
C) subsidiary records should be maintained for each note, and there should be control over blank
and paid notes
D) paid notes should be cancelled and retained under the custody of an authorized official
13) Tests of details for notes payable interest expense and accrued interest can frequently be
eliminated when
A) tests of controls are conducted over authorization and recording procedures.
B) notes are issued by a person independent of the accounting department.
C) the notes payable schedule indicates that all notes have been repaid.
D) results of analytical review are favourable.
14) If actual interest expense is materially larger than the auditor’s independent estimate, one
possible cause could be
A) interest payments on unrecorded notes payable.
B) omitted payments of interest (i.e. underpayments).
C) interest payments recorded at the wrong lower interest rate.
D) notes payable that were set up incorrectly as short term notes.
15) Comparison of the total balance in notes payable, interest expense and accrued interest with
these accounts in the prior year could detect what type of possible misstatement?
A) Misstatement of interest expense or accrued interest, or omission of a note payable
B) Omission or misstatement of a note payable
C) Misclassification of a note payable as long term rather than current
D) Misstatement of notes payable, interest expense or accrued interest
16) During the course of an audit, a public accountant observes that the recorded interest expense
seems to be excessive in relation to the balance in the long-term debt account. This observation
could lead the auditor to suspect that
A) long-term debt is understated.
B) discount on bonds payable is overstated.
C) long-term debt is overstated.
D) premium on bonds payable is understated.
17) Recalculation of an approximate interest expense using the basis of average interests rates
and overall monthly notes payable could detect what type of possible misstatement?
A) Misstatement of interest expense or accrued interest, or omission of a note payable
B) Omission or misstatement of a note payable
C) Misclassification of a note payable as long term rather than current
D) Misclassification of notes payable, interest expense or accrued interest
18) Comparison of individual notes payable outstanding with the prior year could detect what
type of possible misstatement?
A) Misstatement of interest expense or accrued interest, or omission of a note payable
B) Omission or misstatement of a note payable
C) Misclassification of a note payable as long term rather than current
D) Misstatement of notes payable, interest expense or accrued interest
19) The normal starting point for the audit of notes payable is
A) a discussion with management of any new notes payable for the year.
B) a schedule of notes payable and accrued interest obtained from the client.
C) the assessment of materiality.
D) the minutes of the board of directors.
20) The most important balance-related and presentation and disclosure-related audit objectives
for notes payable are
A) accuracy, existence, completeness.
B) existence, completeness, valuation.
C) accuracy, completeness, understandability.
D) accuracy, completeness, valuation.
21) Two of the audit objectives for notes payable are important because a misstatement could be
material even if one note is omitted or incorrect. Which assertions are they?
A) completeness and valuation
B) existence and completeness
C) accuracy and existence
D) completeness and accuracy
22) Presentation and disclosure are important because acceptable financial reporting frameworks
require that footnotes adequately describe the terms of notes payable outstanding and the assets
pledged as collateral for the loans. Which assertion does this relate to?
A) valuation
B) existence
C) completeness
D) understandability
23) One of the reasons that the auditor reads debt agreements is to discover whether there are any
restrictions on the company, such as restrictions on the payment of dividends. It is important for
the auditor to identify such restrictions as
A) corroborative evidence can then be obtained from management.
B) the auditor can make sure that management is adhering to the restrictions.
C) the auditor can include the restrictions in the management representation letter.
D) they must be disclosed in the footnotes of the financial statements.
24) The audit objective to determine that notes payable in the schedule exist is verified by the
tests of balances procedure to
A) foot the notes payable list.
B) confirm notes payable.
C) recalculate interest expense.
D) examine the balance sheet for proper disclosure of noncurrent portions.
25) The tests of details of balances procedure which requires the auditor to examine corporate
minutes for loan approval would satisfy the audit objective of
A) classification.
B) existence.
C) completeness.
D) accuracy.
26) The tests of details of balances procedure which requires the auditor to examine notes paid
after year-end to determine whether they were liabilities at the balance sheet date is an attempt to
satisfy the audit objective of
A) existence.
B) completeness.
C) accuracy.
D) classification.
27) The audit objective to determine that existing notes payable are included in the notes payable
schedule (completeness) is accomplished by the following test of balances procedure.
A) Examine balance sheet for disclosure details.
B) Recalculate accrued interest.
C) Review the bank reconciliation for new notes credited directly to the bank account by the
bank.
D) Examine duplicate copies of notes for principal and interest rates.
28) The audit objective requiring that existing notes payable are included in the notes payable
schedule (completeness) is satisfied by performing the following audit procedure.
A) Recalculate accrued interest.
B) Examine duplicate copies of notes for details.
C) Review the notes payable schedule to determine whether any are related parties.
D) Obtain confirmations from creditors who have held notes from the client in the past and are
not currently included in the notes payable schedule.
29) Which of the following audit procedures assists the auditor with testing for completeness?
A) Analyze interest expense to uncover a payment to a creditor who is not included in the notes
payable schedule
B) examine note to determine whether the company has obligations for payment
C) examine duplicate copies of notes to determine whether notes were dated on or before the
balance sheet date
D) examine the dates on duplicate copies of notes to determine whether all or part of the notes
are a non-current liability
30) The tests of details of balances procedure which requires the auditor to trace the totals of the
notes payable list to the general ledger satisfies the objective of
A) existence.
B) completeness.
C) accuracy.
D) rights and obligations.
31) Caroline is performing the audit of the capital acquisition and repayment cycle. She is
currently auditing the payments of interest made during the year. The proper documentation that
Caroline should use as supporting evidence of the payment is
A) a copy of the note.
B) a bank reconciliation.
C) documentation of her inquiries with management.
D) the notes payable sub-ledger.
32) The audit objective to determine that notes payable and accrued interest on the notes payable
schedule are accurate is accomplished by which of the following test of balances procedure?
A) Examine duplicate copies of notes for principal and interest rates.
B) Review the minutes of the board of directors for authorized but unrecorded notes.
C) Trace the total of the notes payable schedule to the general ledger.
D) Review the notes to determine whether any are with related parties or should be accounts
payable.
33) The test of details of balances procedure which requires the auditor to recalculate accrued
interest will satisfy the audit objective of
A) existence.
B) completeness.
C) classification.
D) accuracy
34) A common test of details of balances procedure for notes payable is “examine duplicate
copies of notes to determine whether notes were dated on or before the balance sheet date.”
Which audit assertion is this test of detail associated with?
A) allocation (accuracy)
B) allocation (cut-off)
C) existence
D) completeness
35) The audit objective which requires the auditor to determine that notes payable on the notes
payable schedule are properly classified can be tested with the following procedure.
A) Review the notes to determine whether any are with related parties.
B) Confirm notes payable.
C) Examine corporate minutes for loan approval.
D) Examine notes, minutes, and bank confirmations for restrictions.
36) The audit procedure that requires the auditor to examine notes, minutes, and bank
confirmations for restrictions is performed to satisfy the audit objective of
A) existence.
B) completeness.
C) accuracy.
D) presentation and disclosure.
37) Discuss the four characteristics of the capital acquisition and repayment cycle that make it
unique from other cycles.
38) Discuss the overall objectives of the audit of notes payable.
39) Discuss the three key controls over notes payable.
40) Identify three analytical procedures commonly performed for notes payable.
41) State the specific balance-related audit objectives applicable to notes payable and interest
and, for each objective, identify one common test of details of balances.
42) Describe the risks of error and fraud in the debt or equity accounts.
18.2 Describe the difference in equity between public and closely held corporations
1) The amount of time spent verifying owners’ equity is frequently minimal for closely-held
corporations because
A) these companies are so small that it is not necessary to audit the capital section.
B) the few owners all have access to the books so the auditor spends more time on accounts like
liabilities, which affect outsiders.
C) there are few if any transactions during the year for the capital stock accounts, except for
earnings and dividends.
D) there is no public interest in these companies.
2) For publicly held corporations, the verification of owners’ equity is more complex due to the
A) fact that there are many more equity accounts to audit.
B) larger numbers of shareholders and frequent changes in the individuals holding the shares.
C) problem of having to confirm shares held with many more different individuals.
D) need to consider that audit risk will be lower, and different shareholders have different points
of view with respect to materiality.
3) As part of the audit, the auditor may examine authorization procedures with respect to the
repurchase or redemption of capital stock. In particular, for a public company the auditor would
verify that which of the following details have been authorized?
A) general ledger accounts affected, dividends included, amount to be paid
B) type of stock, timing, amount to be paid
C) individuals from whom repurchase will be permitted, maximum amount
D) type of stock, amount to be paid, effect upon bond sinking funds
4) Kumar is the internal auditor of Tarragon Inc. Kumar wants to put procedures in place in
order to prevent misstatements in owners’ equity and ensure proper record keeping. Kumar
suggested that management implements well-defined policies for preparing stock certificates and
recording capital stock transaction. What else should Kumar recommend?
A) Independent internal verification of information in the records
B) Having all journal entries in the equity account reviewed by the controller
C) Perform a monthly reconciliation of shareholder’s equity
D) Reconcile the dividend payments with the bank statement
5) Most large corporations employ the services of a stock transfer agent for the purpose of
A) maintaining the shareholder records.
B) recording share capital in the accounts.
C) issuing the shares for the company.
D) ensuring that stock issuances are complying with federal and provincial laws.
6) It is normal practice to verify all capital stock transactions
A) that are in excess of a material amount.
B) if there aren’t very many during the year.
C) regardless of the controls in existence, because of their materiality and permanence in the
records.
D) only when the client is small.
7) If a company employs a capital stock registrar and/or transfer agent, the registrar or agent, or
both, should be requested to confirm directly to the auditor the number of shares of each class of
stock
A) surrendered and cancelled during the year.
B) authorized at the balance sheet date.
C) issued and outstanding at the balance sheet date.
D) authorized, issued, and outstanding during the year.
8) The emphasis in the audit of dividends is on
A) ending equity balance.
B) transactions.
C) opening dividends payable balance.
D) confirming the number of shares outstanding.
9) Usually dividends are audited
A) using block sampling.
B) on a 100% basis.
C) using variables sampling.
D) using attributes sampling.
10) When the auditor examines the minutes of board of directors’ meetings for the amount of the
dividend per share and the dividend date, the auditor is checking for
A) completeness.
B) valuation.
C) understandability.
D) existence.
11) When the auditor examines the board of directors’ minutes for dividends declared, the auditor
should be alert to the possibility of unrecorded dividends declared, particularly shortly before the
balance sheet date. Which audit assertion does this address?
A) valuation
B) existence
C) completeness
D) understandability
12) An audit procedure that is part of the audit of notes payable is the review of the permanent
audit working paper files to determine if there are restrictions on the payment of dividends in
bond indenture agreements or preferred share provisions. Which presentation and disclosure
audit assertion is this associated with?
A) valuation
B) completeness
C) existence
D) classification
13) The transfer agent confirmed to the auditor that the company had 2,500,000 shares
outstanding at December 31, 2010. To have assurance over the accuracy of the dividend
payable, the auditor would multiply 2,500,000 by the
A) dividend per share declared.
B) dividend per share paid during the year.
C) dividend per share as per the articles of incorporation, even if it was not declared during the
year.
D) average dividend for the industry.
14) The auditor recomputed the dividend declaration amount by multiplying the declared
dividend per share by the number of shares outstanding. Which audit assertion is this associated
with?
A) completeness
B) accuracy
C) valuation
D) existence
15) The auditor has reconciled the dividend payment amounts disbursed according to the cash
disbursements journal to the dividend declared. Which audit assertions is this test associated
with?
A) valuation and existence
B) accuracy and valuation
C) accuracy and completeness
D) valuation and understandability
16) When a dividend is declared by the Board, the source for determining who should receive
dividend cheques is the
A) shareholders’ capital stock register or master file.
B) stock certificate books.
C) common stock account in the general ledger.
D) corporate directory.
17) As part of the audit of dividends, the auditor would verify whether the payment was made to
the shareholders who owned the stock at the dividend record date. Which of the following audit
tests assists with this objective?
A) examine the minutes of board of directors’ meetings for the amount of the dividend per share
and the dividend date
B) review the permanent audit working paper file to determine if there are restrictions on the
payment of dividends
C) recomputed the amount of dividends declared by multiplying the dividend amount per share
by the number of shares outstanding
D) select a sample of recorded dividend payments and trace the payee’s name on the cancelled
cheque to the dividend records
18) A primary concern in determining whether retained earnings is correctly disclosed on the
balance sheet is
A) correct calculation of the net income or loss for the year.
B) correct calculation of dividend payments for the year.
C) whether adjustments to retained earnings have been made correctly.
D) whether there are any restrictions on the payment of dividends.
19) Explain why the auditor’s verification of owners’ equity is more complex for publicly-held
corporations than closely-held corporations.
20) Describe the three objectives of the auditor’s examination of owners’ equity.
21) First Global is a public company. You are currently performing the audit of the owner’s
equity section and you have been asked to write a short memo about the control weaknesses you
have identified and the potential risk attached to each weakness.
First Global is a public company since March of the current year as it underwent an IPO during
the year. The corporation has been implementing various controls with regards to keeping
records of the company, but it is still a growing company, and Sasha, the equity accountant, has
been having a tough time learning all the new regulations, keeping the records up to date and
ensuring that the dividend payments are made on time.
First Global issued 2 classes of shares in the IPO. Class A shares with 10 votes were issued to
the Truman family so they could retain control and Class B shares with 1 vote each were issued
to the general public. When you reviewed the accounting records, you noticed that they
contained only one account for capital stocks.
22) Discuss the internal controls related to owners’ equity that are of concern to the auditor.
23) State the four audit concerns for capital stock and describe how the auditor typically verifies
each of these areas.
24) Describe the audit procedures and related audit assertions for the audit of dividends.