Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 13
True/False Questions
13-2 T
13-4 T
13-6 T
13-8 T
13-10 F
13-12 T
13-14 T
13-16 T
Multiple-Choice Questions
13-18 A
13-20 B
13-22 D
13-24 D
13-26 E
13-28 B
13-30 A
13-32 B
13-2
Review and Short Case Questions
13-33
Relevant accounts when auditing debt obligations include:
• Bonds payable
• Interest expense
• Gains or losses on refinancing debt
• Notes payable
• Mortgages payable
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Relevant accounts when auditing stockholders’ equity activities include:
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Common transactions affecting stockholders’ equity include:
• New stock issuance
13-36
13-3
amount of capital in excess of par value, accumulated other comprehensive income/(loss),
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Inherent risks related to debt obligations primarily concern the authorization of debt, receipt of
funds, recording debt transactions, and compliance with any debt covenants. For authorization,
inherent risks include incurring debt that is not properly authorized or reviewed. Similarly, there
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Inherent Risks Associated with Stockholders’ Equity Activities
Stock Sales and Issuances
Assertion
Inherent Risk
Existence
Issuances/sales not authorized in
accordance with organization’s bylaws.
Proceeds are not received.
Purchase of Treasury Stock
Assertion
Inherent Risk
Completeness
All stock repurchased is not recorded as
treasury stock.
13-4
Treasury stock transactions are recorded in
the wrong period.
Dividends
Assertion
Inherent Risk
Existence
Dividends may not be properly approved
before being declared.
Dividends are recorded in the wrong
period.
Dividends may be recorded and paid before
being declared.
Stock Options and Warrants
Assertion
Inherent Risk
Existence
Options/warrants are granted without being
properly approved.
Inadequate records as to options/warrants
issued but not exercised.
Rights/Obligations
Options exercised or expired remain on the
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• Debt covenants violations are not properly disclosed.
• Debt obligations are not properly authorized.
13-40
13-5
• Stock sales or issuances violate debt covenants.
• Stocks sales or issuances are not recorded.
13-41
Given the typical inherent and fraud risks described above, the auditor would expect an
organization to have the following controls in place:
13-42
Given the typical inherent and fraud risks described above, the auditor would expect an
organization to have the following controls in place:
• The board of directors approves all stock transactions (including options and warrants).
• The CEO and CFO authorize all stock transactions (including options and warrants)
approved by the board of directors.
13-43
The following are examples of typical planning analytical procedures related to debt obligations:
13-6
• Calculate the debt-to-equity ratios and perform a trend analysis with prior periods.
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13-45
13-46
When auditing stockholders’ equity transactions, the auditor commonly uses a substantive
13-47
Audit Program for Stockholders’ Equity
1. Examine articles of incorporation, the bylaws, and minutes of the board of directors from
inception to determine the provisions or decisions relating to the capital accounts. (Necessary
3. Schedule all entries to the accounts since inception. Vouch (examine documentation)
4. Examine retained earnings from inception:
13-7
• Schedule all entries into the account noting all that come from other than the annual closing
13-48
If the auditor wants to rely on controls for the financial statement audit, the auditor would test the
13-49
When auditing debt obligations, the primary substantive analytical procedure would involve the
auditor developing an independent expectation of interest expense. This expectation would be
based on average debt outstanding and average interest rates. When performing this analytic as a
13-50
Relevant Management Assertions and Substantive Procedures for Debt Obligations
Management Assertion
Substantive Procedure
Completeness: Recorded debt obligations
include all debt obligations.
1. Perform substantive analytical procedures.
2. Confirm debt obligations.
Completeness: All interest expense is
recorded.
1. Perform substantive analytical procedures to
analyze interest expense and recalculate accrued
interest
of current and noncurrent portions, related parties,
and restrictions resulting from debt
4. Read all disclosures for appropriateness,
consistency, and clarity.
Presentation/disclosure: Debt obligations
are properly classified in the balance sheet
between current and noncurrent liabilities,
1. Review debt agreements for the restrictive
covenants and consider their effect on disclosures
in the financial statements.
3-51
An identified concern is with balance sheet classification of outstanding debt amounts. When
presenting a classified balance sheet, organizations must determine whether outstanding debt
13-52
The auditor examines the minutes of the board of directors meetings for authorization of the
dividend per share amount and the dividend record date. For those clients who maintain their
own records and pay the dividends, the auditor recalculates the amount of the dividends and
agrees that amount to the cash disbursements journal. If a client uses a transfer agent, the auditor
traces the payment to a cash disbursement made by the client to the agent. The auditor may also
confirm the amount with the agent.
13-9
13-53
The auditor will typically examine all transactions recorded in the retained earnings account
during the audit period. The common entries include net income or loss. These amounts would
be tested through substantive audit procedures related to revenues and expenses. The other
13-54
A number of important items should be documented when performing substantive procedures for
debt obligations and stockholders’ equity activities. For debt obligations, the auditor’s
documentation should include:
• Copies of the debt agreements
• Identification of the specific items tested
13-55
A bond indenture provides important information regarding the bonds including the time period
before repayment, amount of interest paid, if the bond is convertible (and if so, at what price or
what ratio), if the bond is callable, and the amount of money that is to be repaid. The bond may
also have other terms or covenants that have been agreed to. If a company violates any of the
13–10
13-56
The retained earnings account should be audited because these audit procedures help to provide
reasonable assurance that:
• No important items were overlooked in the examination of the account,
• The account is handled in accordance with GAAP, for example, only prior period
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A 5% stock dividend should be accounted for as a debit to retained earnings for the fair market
value of the dividend and credited to capital stock and capital in excess of par. The auditor
should be sure the board of directors authorized the dividend through review of the board
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A spreadsheet could be developed to project the amortization of a bond discount or premium
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a. Information that could be obtained from reading a bond indenture would include:
• Face value of bond
• Stated interest rate
• Maturity date
o working capital ratio
o other financial statistics required
b. It is usually not necessary for auditors to confirm the existence of the liability with
individual bondholders. Most bond transactions are handled by an independent bond trustee. The
confirmation could go to the bond trustee. The auditor can verify that the organization received
c. A bond discount arises when a bond is sold to the public at less than its face value
(effective (market) interest rate is greater than the stated interest rate.) The amount of the
discount is established by comparing the net proceeds available from the bond offering with the
stated interest rate. The net proceeds can be used to compute the effective interest rate.
d. The auditor could vouch the payments made to the bond trustee.
e. The bond is due next period and therefore the initial persuasive evidence is that the bond
ought to be recorded as a current liability. The auditor would examine legal documentation, for
13-60
Any failure of the organization to comply with the covenants should be reported in a note to the