Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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CHAPTER 15
AUDITING THE FINANCING/INVESTING PROCESS: LONG-
TERM LIABILITIES, STOCKHOLDERS’
EQUITY, AND INCOME STATEMENT ACCOUNTS
Answers to Review Questions
15-1 A substantive audit strategy is normally followed when auditing the long-term debt and
capital accounts because, although the number of transactions is smaller, each transaction
is usually material. Thus, it is normally more cost-effective to conduct substantive tests
15-2 The most important assertions to the auditor for long-term debt are occurrence,
authorization, completeness, valuation, and classification. The documents that normally
15-3 The auditor can estimate interest expense by multiplying the twelve monthly balances for
long-term debt by the average interest rate. The reasonableness of interest expense can
then be assessed by comparing this estimate to the interest expense amount recorded in
the general ledger. If the two amounts are not materially different, the auditor can
conclude that interest expense is fairly stated. If the estimated amount of interest expense
15-4 Confirmation of long-term debt provides evidence for the existence, completeness, and
valuation assertions.
15-5 The registrar is responsible for ensuring that all stock issued is in compliance with the
corporate charter and for maintaining control totals for total shares outstanding. The
15-6 When the entity does not use a registrar or transfer agent and a sufficient number of
personnel are available, the following segregation of duties should be maintained:
• The individuals responsible for issuing, transferring, and canceling stock certificates
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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should not have any accounting responsibilities.
15-7 The two most common disclosures for stockholders’ equity are (1) the number of shares
authorized, issued, and outstanding for each class of stock and (2) restrictions on retained
earnings and dividends. These disclosures are necessary so that stockholders can
determine what share of the company they own and whether there are any restrictions on
the declaration of dividends.
Other disclosures for stockholders’ equity include:
• Call privileges, prices, and dates for preferred stock.
15-8 When the entity uses an independent dividend-disbursing agent, the auditor can confirm
the amount disbursed to the agent by the entity. This amount is agreed with the amount
authorized by the board of directors. The auditor can recompute the dividend amount by
multiplying the number of shares outstanding on the record date by the amount of the per
appropriations or changes in existing appropriations should be traced to the contractual
agreement that required the appropriation. Last, the auditor must make sure that all
necessary disclosures related to retained earnings are made in the footnotes.
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
15-9 Three substantive analytical procedures that the auditor might use in auditing the income
statement include:
• Use the prior years’ trends in quarterly dollar amounts for each significant revenue and
expense account (e.g., disaggregate revenue by product or location) to develop an
multiplying the commission rates times eligible sales).
15-10 The auditor conducts a detailed analysis and vouches the transactions in legal expense,
travel and entertainment, and other income/expense accounts because these are accounts
that are not directly affected by an accounting process, accounts which contain sensitive
information or unusual transactions, or accounts for which detailed information is needed
for the tax return or other schedules included with the financial statements.
Answers to Multiple-Choice Questions
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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15-22 To test the reasonableness of the amount of reported interest expense, the auditor could
multiply (6%/12) by each of the monthly balances for long-term debt and add them
together to estimate interest expense for the year. This estimate equals $4,575, which is
15-23 The working paper contains the following deficiencies:
• The subject of the working paper is not properly indicated in the title.
• There is no indication of any follow-up on the identified error in the accrued
interest payable computation.
• There is no indication as to whether the confirmation exception was resolved.
• The working paper does not support the overall conclusions expressed.
• The tick mark “R” is used but not explained in the tick mark legend.
• There is no indication that the working paper was prepared by entity personnel.
15-24 The substantive audit procedures that Lee should apply in examining the common stock
and treasury stock accounts of Wu, Inc., are as follows:
• Review the corporate charter to verify details of the common stock such as authorized
shares, par value, etc.
by inspecting the minutes of board of directors’ meetings.
• Verify capital-stock issuances by examining supporting documentation and tracing
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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entries into the records.
• Verify treasury-stock transactions by examining supporting documentation and tracing
entries into the records.
• Examine all certificates canceled during the year.
• 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.
Solution to Discussion Case
15-25 a. There are a number of audit procedures that Johnson can conduct in order to determine
if the entity is in violation of the debt agreement. Note that the possible violation of
the debt covenants may have occurred during the subsequent events period. The
entity’s year-end was June 30, and the suspected violation occurred on August 31, the
date the restrictions became effective. Possible audit procedures are as follows:
• Test the covenant restrictions at August 31. However, since the entity does not
a waiver or modification.
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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b. ASC Topic 470, “Debt” provides guidance for situations in which a violation
of a debt covenant has occurred at the balance sheet date. This standard basically
states that callable debt shall be classified as a current liability unless (1) the creditor
has waived or subsequently lost the right to demand payment for more than a year or
In this case, the most appropriate solution is for Johnson to determine if Mother Earth
violated the covenants on August 31. If so and if the entity can obtain a waiver, the
debt should continue to be classified as noncurrent because no violation existed at the
balance sheet date and the waiver after the balance sheet date cures the problem. If
Johnson determined that a violation had occurred at August 31, at a minimum the
status of the debt should be disclosed in the footnotes.
Solution to Internet Assignment
15-26 Much of the information needed to complete this assignment is located on
www.sec.gov. Specifically, the following link:
http://www.sec.gov/news/press/2010/2010-93.htm
Also search “Diebold” at Stanford Law School’s Security Class Action Clearinghouse
at securities.stanford.edu .
a) Diebold is an Ohio based corporation traded on the New York Stock Exchange. It
manufactures and sells ATMs, electronic voting machines, and bank security systems.
Between 2002 and 2005, Diebold engaged in fraudulent accounting practices to
inflate earnings. These accounting practices included the improper use of ‘bill-and-
hold’ accounting, manipulating reserves and accruals, and improperly delaying and
goods be on a bill-and-hold basis. Importantly, the customer must also have a
substantial business purpose for doing so. However, many of Diebold’s orders failed
to meet these criteria.
Diebold was also able to inflate earnings by failing to properly accrue for
known liabilities. In various years, for example, Diebold had under accrued for the
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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company’s Long-Term Incentive Plan (an employee benefit plan to reward company
performance), North American sales commission (commission to sales personnel),
and its team incentive accrual (incentive pay to service personnel). The effect of
reserve, without: any legitimate accounting analysis, to fill shortfalls in operating
results.” Throughout 2004, Diebold released parts of the reserve to meet “analyst
earnings consensus for the first two quarters and revised analyst earnings consensus
in the third quarter.”
Finally, in 2003 and in subsequent years, Diebold improperly capitalized certain
account was overstated.” CAP 250 was an installation accounting system, which
accrued for the cost of installation. Similar to Division 35, the account was
overstated and Diebold management failed to reconcile the known error. In addition
to this, Diebold improperly capitalized technology costs that should have been
expensed. According to the SEC Complaint, “In certain quarters when Diebold’s
earnings were short of forecast, Diebold management made top-level entries to
fraudulently capitalize additional expenses to the Oracle project. These improper
“additions,” which often were round numbers such as $1 million, had the effect of
materially reducing reported expenses, and thus increasing reported earnings.”
The SEC Complaint stated that, “Diebold’s improper, and in many instances
fraudulent, accounting practices misstated the company’s reported pre-tax earnings by
at least $127 million. To correct the recent misstatements, on
September 30, 2008, Diebold restated its financial statements for the years 2003
through 2006, and the first quarter of 2007, in its Form 10-K for 2007.”
b) To identify the misstatements in the earlier years of the fraud, the auditors should
have done a better job maintaining their professional skepticism and exercising good
judgment. Diebold was consistently reporting earnings that were right at analysts’
earnings expectations. Had the auditors exhibited more professional skepticism, they
Chapter 15 – Auditing the Financing/Investing Process: Long-Term Liabilities, Stockholders’ Equity, and Income
Statement Accounts
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regarding management’s assertions of the account balance. These assertions include
existence, accuracy, and valuation. A thorough examination could have aided the
have been performed to compare the company’s current accruals to prior years as
well as to industry averages. When irregularities are identified, the auditors should
have inquired of management and gained a thorough understand of why the
irregularities existed.
Finally, the auditors could have scanned closing journal entries in high-risk accounts,
c) On June 2, 2010, as a result of the SEC’s and other legal actions, Diebold and three
former financial executives of the company were charged with “engaging in a
fraudulent accounting scheme to inflate the company’s earnings.” Under a