CHAPTER SIX

AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT

CYCLE

Chapter Objectives

After studying this chapter, you should be able to:

1. Identify the accounts and unique characteristics of the capital acquisition and repayment
cycle.
2. Design and perform audit tests of notes payable and related accounts and transactions.
3. Identify the primary concerns in the audit of owner’s equity transactions.
4. Design and perform tests of controls, substantive tests of transactions, and tests of details
of balances for capital stock and retained earnings.

Business corporations obtain substantial amounts of their financial resources by incurring

interest-bearing debt and by issuing capital stock. The acquisition and repayment of capital is
sometimes referred to as the financing cycle. This transaction cycle includes the sequence of
procedures for authorizing, executing, and recording transactions that involve bank loans,
mortgages, bonds payable, and capital stock as well as the payment of interest and dividends.

Characteristics of the Capital Acquisition and Repayment Cycle

Four characteristics of the capital acquisition and repayment cycle significantly influence the
audit of these accounts:

1. Relatively few transactions affect the account balances, but each transaction is often
highly material in amount- For example, bonds are infrequently issued by most
companies, but the amount of a bond issue is normally large. Because of their size, it is
common to verify each transaction taking place in the cycle for the entire year as part of
verifying the balance sheet accounts.

2. The exclusion of a single transaction could be material in itself- For example, the
omission or incorrect recording of a single debt transaction could have a material effect
 on the financial statements. Accordingly, a primary emphasis in auditing debt is on the
completeness and accuracy of debt.

3. There is a legal relationship between the client entity and the holder of the stock, bond,
and similar ownership documents- In the audit of the transactions and amounts in the
cycle, the auditor must take great care in making sure that the significant legal
requirements affecting the financial statements have been properly fulfilled and
adequately presented and disclosed in the statements.

4. There is a direct relationship between the interest and dividends accounts and debt and
equity- In the audit of interest-bearing debt, it is desirable to simultaneously verify the
related interest expense and interest payable. This holds true for owners’ equity,
dividends declared, and dividends payable.

Because of the significance and complexity of these transactions, auditors often assist clients
in planning and addressing financial reporting issues for capital transactions. Thus, auditors
frequently identify business risk issues for capital acquisition activities early in the planning
process that should be considered in the design of audit procedures for transactions and
account balances in the capital acquisition and repayment cycle.

Let’s begin by describing the accounts in the cycle, and how the unique characteristics of the
cycle impact the audit of these accounts.

Accounts in the Cycle

The accounts in a company’s capital acquisition and repayment cycle depend on the type of
business the company operates and how it is financed. For example, all corporations have
capital stock and retained earnings, but some may also have preferred stock, additional paid-
in capital, and a treasury stock. The following are accounts often found in the cycle:

 Notes payable  Accrued interest

 Contracts payable  Cash in the bank
 Mortgages payable  Capital stock-common
 Bonds payable  Capital stock-preferred
 Interest expense  Paid-in capital in excess of par
 Donated capital
 Retained earnings
 Appropriations of retained
earnings
 Treasury stock
 Dividends declared
 Dividends payable
 Proprietorship-capital account
 Partnership-capital account
The methodology for designing tests of details of balances for accounts in the capital acquisition
and repayment cycle is the same as that followed for other accounts.

In determining the tests of details of balances for notes payable, the auditor considers business
risk, tolerable misstatement, inherent risk, control risk, results of tests of controls and substantive
tests of transactions, and the results of analytical procedures. Tolerable misstatement is often set
at a low level because it is often possible to completely audit the account balance or the
transaction affecting the account balance. Inherent risk is also typically set at low level because it
is usually easy to determine the correct account value.

The audit procedures for many of the accounts in the capital acquisition and repayment cycle are
best understood by studying representative accounts that are significant parts of the cycle for a
typical business. The following sections discuss:

1. The audit of notes payable and related interest expense to illustrate interest-bearing
capital and

2. The audit of common stock, paid-in capital in excess of par, dividends, and retained
earnings.

Notes Payables

A note payable is a legal obligation to a creditor, which may be unsecured or secured by

assets. Typically, a note is issued for a period somewhere between 1 month and 1 year, but
there are also long-term notes of over a year. Notes are issued for many different purposes,
and the pledged property includes a wide variety of assets, such as securities, accounts
receivable, inventory, and fixed assets. The principal and interest payments on the notes must
be made in accordance with the terms of the loan agreement. For short-term loans, a principal
and interest payment is usually required only when the loan becomes due; but for loans over
90 days, the note usually calls for monthly or quarterly interest payments.
 The objectives of the audit of notes payable are to determine whether the following are true:

 The internal controls over notes payable are adequate.

 Transactions for principal and interest involving notes payable are properly
authorized and recorded as defined by the six transaction-related audit objectives.

 The liability or notes payable and the related interest expense and accrued liability are
properly stated as defined by eight of the nine balance-related audit objectives.
(Realizable value is not applicable to liability accounts.)

Internal Controls

There are four important controls over notes payable:

1. Proper authorization for the issue of new notes: Responsibility for the issuance of new
notes should be vested in the board of directors or high-level management personnel.
Generally, two signatures of properly authorized officials are required for all loan
agreements. The amount of the loan, the interest rate, the repayment terms, and the assets
pledged are all part of the approved agreement. When notes are renewed, it is important
that they be subject to the same authorization procedures as those for the issuance of new
notes.

2. Adequate control over the repayment of principal and interest: The periodic payments of
interest and principal should be controlled as a part of the acquisition and payment cycle.
At the time the note was issued, the accounting department should have received a copy in
the same manner in which it receives vendors’ invoices and receiving reports. The accounts
payable department should automatically issue checks or electronic fund transfers for the
notes when they become due, again in the same manner in which it prepares payments for
acquisitions of goods and services. The copy of the note is the supporting documentation
for payment.

3. Proper documents and records: These include the maintenance of subsidiary records and
control over blank and paid notes by a responsible person. Paid notes should be cancelled
and retained under the custody of an authorized official.
 4. Periodic independent verification: Periodically, the detailed note records should be
reconciled with the general ledger and compared with the note holders’ records by an
employee who is not responsible for maintaining the detailed records. At the same time, an
independent person should recompute the interest expense on notes to test the accuracy and
propriety of the record keeping.

Analytical procedures

Analytical procedures are essential for notes payable because tests of details for interest expense
and accrued interest can often be eliminated when results are favorable. The following table
illustrates typical analytical procedures for notes payable and related interest accounts.

Table 5-1 Analytical Procedures for Notes Payable

Analytical Procedures Possible Misstatement

Recalculate approximate interest expense Misstatement of interest expense or

on the basis of average interest rates and accrued interest, or omission of an
overall monthly notes payable outstanding note payable

Compare individual notes outstanding with Omission or misstatement of a note

the prior year payable

Compare total balance in notes payable, Misstatement of notes payable, interest

interest expense, and accrued interest with expense or accrued interest
prior year

Tests of Details for Notes Payable and Interest

The normal starting point for the audit of notes payable is a schedule of notes payable and
accrued interest obtained from the client. The usual schedule includes detailed information of all
transactions that took place during the entire year for principal and interest, the beginning and
ending balances for notes and interest payable, the descriptive information about the notes, such
as the due date, the interest rate, and the assets pledged as collateral.
When there are numerous transactions involving notes during the year, it may not be practical to
obtain a schedule. In that situation, the auditor is likely to request that the client prepare a
schedule of only those notes with unpaid balances at the end of the year. This would show a
description of each note, its ending balance, and the interest payable at the end of the year,
including the collateral and interest rate.

The three most important balance-related audit objectives in notes payable are as follows:

1. Existing notes payable are included (completeness).

2. Notes payable in the schedule are accurately recorded (accuracy).

3. Notes payable are properly presented and disclosed (presentation and disclosure).

The first two objectives are important because a misstatement can be material if even one is
omitted or incorrect.

Table 5-2 Balance-Related Audit Objectives and Tests of Details of Balances for Notes
Payable and Interest

Balance-Related Audit Objectives Common Tests of Details of Balances Procedure

Detail tie-in: Notes payable in the Foot (add) the notes payable list for notes payable and
notes payable schedule agree with the accrued interest.
client’s notes payable register or master
Trace the totals to the general ledger.
file, and the total is added and agrees
with the general ledger. Trace the individual notes payable to the master file.

Existence: Notes payable in the Confirm notes payable (normally with a positive
schedule exist. confirmation).

Examine duplicate copy of notes for authorization.

Examine corporate minutes for loan approval.

Completeness: Existing notes payable Examine notes paid after year end to determine
are included in the notes payable whether they were liabilities as at the balance sheet
schedule. date.

Review the bank confirmation for notes payable

details.

Review the bank reconciliation for new notes.

Obtain confirmations from prior creditors.

Analyze interest expense to identify notes.

Examine past notes for cancellation.

Review minutes of board meetings.

Accuracy: Notes payable and accrued Examine notes for principal and interest rates.
interest on the schedule are accurate.
Confirm notes payable, interest rates, and last date
interest paid to holders of notes.

Recalculate accrued interest.

Classification: Notes payable in the Examine due dates of notes to allocate liability among
schedule are properly classified. current or long-term.

Review notes to determine whether any are related-

party notes or accounts payable.

Cut-off: Notes payable are included in Examine notes to determine whether notes were dated
the proper period. on or before the balance sheet date.

Rights and obligations: The company Examine notes to determine whether the company has
has an obligation to pay the notes obligations for payment.
payable.

Presentation and disclosure: Notes Examine notes, minutes, and confirmation for
payable, interest expense, and accrued
 interest are properly presented and restrictions.
disclosed.
Examine balance sheet for proper disclosure of non-
current portions, related parties, and restrictions
resulting from notes payable.

Owners’ Equity

Sources and Nature of Owners’ Equity

Most of this section is concerned with the audit of stockholders’ equity accounts of corporate
clients; the audit of owners’ equity in partnerships and sole proprietorships is discussed briefly
near the end of the chapter.

Owners’ equity for corporate clients consists of capital stock accounts (preferred and common)
and retained earnings. Balances in the capital accounts change when the corporation issues or
repurchases stock. The account balances are not affected by transfer of ownership of shares from
one shareholder to another. Retained earnings are normally increased by earnings and decreased
by dividend payments. Additionally, a few journal entries (e.g., prior period adjustments) may
directly affect retained earnings. Transactions in the owners’ equity accounts are generally few in
number, but material in amount. Often no change will occur during the year in the capital stock
accounts, and perhaps only one or two entries will be made to the retained earnings account.

The objectives of the audit of owners’ equity are to determine whether the following are true:

 The internal control over capital stock and related dividends are adequate.

 Owners’ equity transactions are recorded properly, as defined by the six transaction-
related audit objectives.

 Owners’ equity balances are properly presented and disclosed, as defined by the balance-
related audit objectives for owners’ equity accounts (rights/obligations and realizable
value are not applicable).

Internal Control for Owners’ Equity

Several important internal controls are of concern to the independent auditor in owners’ equity:
proper authorization of transactions by board of directors and corporate officers, proper record
keeping, adequate segregation of duties between maintaining owners’ equity records and
handling cash and stock certificates, and the use of an independent registrar and stock transfer
agent.

1. Proper Authorization of Transactions

Because each owner’s equity transaction is typically material, many of these transactions must be
approved by the board of directors. The following types of owners’ equity transactions usually
require specific authorization:

a. Issuance of Capital Stock- the authorization includes the type of the equity to issue
(such as preferred or common stock), number of shares to issue, par value of the
stock, privileged conditions for any stock other than common, and date of the issue.
b. Repurchase of Capital Stock- the repurchase of common or preferred shares, the
timing of the repurchase, and the amount to pay for the shares should all be approved
by the board of directors.
c. Declaration of dividends- the board of directors should authorize the form of the
dividends (such as cash or stock), the amount of the dividend per share, and the
record and payment dates of the dividends.

2. Proper Record Keeping and Segregation of Duties

When a company maintains its own records of stock transactions and outstanding stock, the
internal controls must be adequate to ensure that:

 the actual owners of the stock are recognized in the corporate records,

 the correct amount of dividends is paid to shareholders as of record date,

 the potential for employee fraud is minimized.

The most important procedures for preventing misstatements in owners’ equity are:

1. well defined policies for preparing stock certificates and recording capital stock
transactions and
 2. independent internal verification of information in the records

A control over capital stock used by most companies is the maintenance of stock certificate
books and a shareholders’ capital stock master file. A capital stock certificate record captures
the issuance and repurchase of capital stock for the life of the corporation. The record for a
capital stock transaction includes such information as the certificate number, the number of
shares issued, the name of the person to whom it was issued, and the issue date. When shares are
repurchased, the capital stock certificate book should include the cancelled certificates and the
date of their cancellation. A shareholders’ capital stock master file is the record of the
outstanding shares at any given time. The master file acts a check on the accuracy of the capital
stock certificate record and the common stock balance in the general ledger. It is also used as the
basis for the payment of dividends.

3. Independent Registrar and Stock Transfer Agent

- Employed to prevent the improper issue of share certificates and to maintain shareholder
records.

- Ensures that stock is issued by a corporation in accordance with the capital stock
provisions in the articles of incorporation.

- A stock transfer agent tends to be used by large corporations for the purpose of
maintaining the stockholder records, including those documenting transfers of stock
ownership.

- Smaller organizations may use their lawyer or maintain the stock register themselves.

Audit of Capital Stock and Paid-In Capital

There are four main concerns in auditing capital stock and paid-in capital in excess of par:

1. Completeness: existing capital stock transactions are recorded.

2. Occurrence and accuracy: recorded capital stock transactions exist and are accurately
recorded.

3. Accuracy: capital stock is accurately recorded.

 4. Presentation and disclosure: capital stock is properly presented and disclosed.

Completeness: if a registrar or transfer is used the auditor can easily confirm the nature of
transactions and their valuation. Review the minutes of the board of directors to uncover
issuances and repurchases, especially near the balance sheet date. For a small client review of
records held by the lawyer or client is enough.

Occurrence and accurate recording (transactions): regardless of the controls in existence, it is

normal practice to all capital stock transactions because of their materiality and permanence in
the records. Existence can ordinarily be tested by examining the minutes of the board of directors
meetings for proper authorization. Cash received can be confirmed with the transfer agent and
traced to cash receipts. Valuation of stock dividends or stock used to purchase assets is more
difficult.

Accuracy (of ending balance): verified based upon number of shares outstanding at the balance
sheet date. A confirmation from the transfer agent is the simplest way to obtain this information.
After the auditor is satisfied that the number of shares outstanding is correct, the recorded par
value in the capital account can be verified by multiplying the number of shares by the par value
of the stock.

Presentation and disclosure: the most important sources of information for determining proper
presentation and disclosure are the articles of incorporation, the minutes of board of directors
meetings, and the auditor’s analysis of capital stock transactions. The auditor need to ensure that
each class of stock is properly described, such as the number of shares issued and outstanding
and any special rights of an individual class. The proper presentation and disclosure of stock
options, stock warrants, and convertible securities can be verified by examining legal documents.

Audit of Dividends

The primary emphasis in the audit of dividends is on the transactions rather than on the ending
balance. The exception is when there are dividends payable.

The following are the most important objectives, including those concerning dividends payable:

1. Recorded dividends exist (existence).

 2. Existing dividends are recorded (completeness).

3. Dividends are accurately recorded (accuracy).

4. Dividends as paid to stockholders exist (existence).

5. Dividends payable are recorded (completeness).

6. Dividends payable are accurately recorded (accuracy).

Existence of recorded dividends can be checked by examining the minutes of board of directors
meetings for authorization of the amount of the dividend per share and the dividend date. 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.

The accuracy of a dividend declaration can be audited by recomputing the amount on the basis of
the dividend per share and the number of shares outstanding. If the client uses a transfer agent to
disburse dividends, the total can be traced to a cash disbursement entry to the agent and also
confirmed.

When a client keeps its own dividend records and pays the dividends itself, the auditor can verify
the total amount of the dividend by recalculation and reference to cash disbursed. In addition, it
is necessary to verify whether the payment was made to the stockholders who owned the stock as
of the dividend record date.

Audit of Retained Earnings

For most companies, the only transactions involving retained are net earnings for the year and
dividends declared. But there may also be corrections of prior-period earnings, prior- period
adjustments charged or credited directly to retained earnings and the setting up or elimination of
appropriations of retained earnings.

The starting point for the audit of retained earnings is an analysis of retained earnings for the
entire year. The audit of the credit to retained earnings for net income for the year or the debit for
a loss is accomplished by simply tracing the entry in retained earnings to the net earnings figure
on the income statement.
An important consideration in auditing debits and credits to retained earnings other than net
earnings and dividends is determining whether the transactions should have been included. After
the auditor is satisfied that the recorded transactions are appropriately classified as retained
earnings transactions, the next step is to decide whether they are accurately recorded.