Chap 16 - Audit of the Capital Acquisition and Repayment Cycle

Question 1

1. List four examples of​ interest-bearing liability accounts commonly found in balance sheets
A.
Salaries payable
B.
Notes payable
C.
Bonds payable
D.
Mortgages payable
.E.
Accounts payable
F.
Contracts payable

           2. Liabilities have the following characteristics in​ common:  A. Several low amount transactions affect these accounts. B. The exclusion of a single transaction could be material in itself. C. There is an indirect relationship between interest and dividend accounts and debt and equity. D. Liabilities involve accrual and payment of interest as well as debt. E. The relationship between the client entity and the holder of the ownership document is legal in nature. F. Relatively few transactions affect the account​ balance, but each transaction is often highly material in amount.

       3. How do they​ differ? Liabilities (1)\_\_\_\_\_\_\_    differ in what they represent and the nature of their respective liabilities.    do not all have a normal credit balance.
do not usually all bear interest.

Answer 1

1. B, C, D, F
2. B, D, E, F
3. differ in what they represent and the nature of their respective liabilities.

Question 2

Why are liability accounts included in the capital acquisition and repayment cycle audited differently from accounts​ payable?
The characteristics of the liability accounts in the capital acquisition and repayment cycle that result in a different auditing approach than the approach followed in the audit of accounts payable​ are:
1. (1)____ transactions affect the account​ balances, (2)______
2. The exclusion of a single transaction (3)_________
3. The relationship between the client entity and the holder of the ownership document (4)________in nature.
4. The liabilities involve accrual and payment of (5)___

(1): High volume of
Relatively few
(2): and each transaction is often very small (immaterial) in amount.
but each transaction is often highly material in amount.
(3): could be material in itself.
is unlikely to be material in itself.
(4): is legal
is not legal
(5): interest as well as debt.
principal as well as debt.

Answer 2

(1) : Relatively few
(2) : but each transaction is often highly material in amount.
(3) : could be material in itself.
(4) : is legal
(5) ; interest as well as debt.

Question 3

1. Four types of restrictions​ long-term creditors often put on companies when granting a loan​ are
A.
Operations restrictions.
B.
Issue of additional debt restrictions.
C.
Payment of dividends restrictions.
D.
Payment of employee salaries restrictions.
.E.
Financial ratio restrictions.
F.
Revenue restrictions.
      2. The auditor can find out about these restrictions​ by
A.
Analyzing the interest expense.
B.
Examining the loan agreement.
C.
Examining related correspondence associated with the loan.
D.
Requesting confirmation.
E.
Analyzing the notes payable account.

Answer 3

1. A, B, C, E

2. B, C, D

Question 4

With which internal controls should the auditor be most concerned in the audit of notes​ payable? Explain the importance of each.
A.
Proper records and procedures to insure that all amounts in all transactions are properly recorded.
D.
Controls over the repayment of principal and interest to insure that the proper amounts are paid.
E.
Periodic independent verification to insure that all the controls over notes payable are working.
F.
Attitudes and rationalization to insure that management does not disregard separation of duties.
G.
The proper authorization for the issuance of new notes​ (or renewals) to insure that the company is not being committed to debt arrangements that are not authorized.

Answer 4

A, D, E, G

Question 5

Which of the following controls will most likely justify a reduced assessed level of control risk for the completeness assertion for notes​ payable?
1.
Before approving disbursement of principal payments on notes​ payable, the treasurer reviews terms in the note.
2.
The accounting staff reviews the board of​ director’s meeting minutes for any indication of any transactions involving outstanding debt to make sure all borrowings are included in the general ledger.
3.
All borrowings that exceed​ $500 000 require approval from the board of directors before loan contracts can be finalized.
4.
Accounting maintains a detailed schedule of outstanding notes payable that is reconciled monthly to the general ledger.

Answer 5

2

Question 6

It is common practice to audit the balance in notes payable in conjunction with the audit of interest expense and interest payable. Explain the advantages of this approach.
It is common to audit the balance in notes payable in conjunction with the audit of interest expense and interest payable because it (1)________. Once the auditor is satisfied with the balance in notes payable and the related interest rates and due dates for each​ note, it is easy to test the (2)___. If the interest expense for the year is also tested at the same​ time, the likelihood of (3)_______.

(1): increases the inherent risk associated with the notes payable.
minimizes the verification time and reduces the likelihood of overlooking misstatements in the balance.
reduces the inherent risk associated with the notes payable.
(2): accuracy of accrued interest.
guarantee associated with the notes payable.
legal relationship between the client entity and the holder of the notes payable.
(3); disclosing the incorrect fair market value is also minimized.
disclosing the wrong guarantee is minimized.
omitting a note from notes payable for which interest has been paid is minimized.

Answer 6

(1) : minimizes the verification time and reduces the likelihood of overlooking misstatements in the balance.
(2) : accuracy of accrued interest.
(3) : omitting a note from notes payable for which interest has been paid is minimized.

Question 7

Which analytical procedures are most important in verifying notes​ payable? Which types of misstatements can the auditor uncover by the use of these​ tests?
The most important analytical procedures used to verify notes payable is (1)__________
By the use of this​ test, auditors can uncover errors in (2)________.

(1): a test of the current ratio.
a test of the total debt ratio.
a test of interest expense.
sending confirmation to the debt holder.

(2): interest calculations or possible unrecorded notes payable.
the market value of the assets guaranteed.
the market value of the notes payable.

Answer 7

(1) : a test of interest expense.

(2) : interest calculations or possible unrecorded notes payable.

Question 8

Why is it more important to search for unrecorded notes payable than for unrecorded notes​ receivable? List several audit procedures the auditor can use to uncover unrecorded notes payable.

It is more important to search for unrecorded notes payable than unrecorded notes receivable because
(1)_______.

 a note payable has a larger dollar value than a note receivable.
 a note payable is more important than a note receivable.
 of the guarantee associated with the note payable.
 the omission of an asset is less likely to occur than the omission of a debt.

Answer 8

(1): the omission of an asset is less likely to occur than the omission of a debt.

Question 9

Several audit procedures the auditor can use to uncover unrecorded notes payable​ are
A.
Examine the notes paid after​ year-end to determine whether they were liabilities at the balance sheet date.
B.
Obtain direct confirmation of accounts receivable and perform alternative procedures for nonresponses.
C.
Review the minutes of the board of directors for authorized but unrecorded notes.
D.
Obtain an engagement letter from the client.
E.
Review the bank reconciliation for new notes credited directly to the bank account by the bank.
F.
Analyze interest expense to uncover a payment to a creditor who is not included on the notes payable schedule.
G.
Assess the going concern of the company.
H.
Obtain confirmation from creditors who have held notes from the client in the past and are not currently included in the notes payable schedule.
I.
Obtain a standard bank confirmation that includes specific reference to the existence of notes payable from all banks with which the client does business.

Answer 9

A, C, E, F, H, I

Question 10

What is the primary purpose of analyzing interest​ expense?
The primary purpose of analyzing interest expense is to (1)_____.

ensure proper approval of the interest expense.    ensure the proper classification of interest expense.    match the interest expense with the appropriate note payable on the notes payable schedule.    uncover a payment to a creditor who is not included on the notes payable schedule.

Answer 10

(1): uncover a payment to a creditor who is not included on the notes payable schedule.

Question 11

what primary considerations should the auditor keep in mind when doing the​ analysis?
1.___________________
2.____________________
Has a confirmation for notes payable been received from the payee?
Is the fair value of the note payable properly disclosed in the financial statement?
Is the fair value of the note payable properly disclosed in the financial statement?
Is the payee for the interest payment listed in the cash disbursements journal also included in the notes payable list?

Answer 11

1. Has a confirmation for notes payable been received from the payee?
2. Is the payee for the interest payment listed in the cash disbursements journal also included in the notes payable list?

Question 12

Distinguish between tests of controls and tests of details of balances for liability accounts in the capital acquisition and repayment cycle.
The audit of transactions for liability accounts in the capital acquisition and repayment cycle consists of tests of the control (1)________ whereas the tests of details of balances concern (2)____.

(1): over the payment of principal and interest and the issuance of new notes or other liabilities,
of the balance of the liabilities, interest payable, and interest expense,
over the cash receipt as a result of the issuance of new notes or other liabilities,
over disbursements made throughout the year,

(2): analytical procedures only.
the testing of the payment of principal and interest and the issuance of new notes or other liabilitites.
the balances of all accounts on the balance sheet.
the balance of the liabilities, interest payable, and interest expense.

Answer 12

(1) : over the payment of principal and interest and the issuance of new notes or other liabilities,
(2) : the balance of the liabilities, interest payable, and interest expense.

Question 13

Identify the presentation and​ disclosure-related audit​ objective(s) for each audit procedure.
Audit procedure
1.
The schedule of notes payable in the footnotes includes all notes outstanding.
2.
The footnote identifies which notes are due to related parties.
3.
The total of notes payable in the footnotes agrees with the total of notes payable on the balance sheet.
4.
The footnote listing of notes payable includes only those obligations that are the responsibility of the company.
5.
The footnote clearly describes the assets that are collateral for the note obligations.
Disclosure-related audit objective(s)
Completeness
Classification and understandability
Accuracy and valuation
Occurrence and rights and obligations

Answer 13

1. Completeness
2. Classification and understandability
3. Accuracy and valuation
4. Occurrence and rights and obligations
5. Classification and understandability

Question 14

Evangeline Ltd. took out a​ 20-year mortgage for​ $2 600 000 on June​ 15, 2018​, and pledged its only manufacturing building and the land on which the building stands as collateral. Each month a payment of​ $20 000 was paid to the mortgagor. You are in charge of the​ current-year audit for​ Evangeline, which has a balance sheet date of December​ 31, 2018. The client has been audited previously by your public accounting​ firm, but this is the first time Evangeline Ltd. has had a mortgage.

1. Explain why it is desirable to prepare a working paper for the permanent file for the mortgage.
   It is desirable to prepare a working paper for the permanent file for the mortgage so that (1)______

   substantive tests will not be necessary.
   test of details will not be necessary.
   the appropriate information concerning the mortgage will be conveniently available for future years' audits.
   the fair value of the mortgage is easily accessible.  What type of information should be included in the working​ paper? A. Amortization schedule of principal and interest B. Date of purchase C. All the provisions of the mortgage D. Market interest rate at the date of the purchase E. Amortization schedule of the premium or discount amount F. Calculation for the premium or discount amount G. List of items pledged as collateral H. Purchase price    2. Explain why the audits of mortgage​ payable, interest​ expense, and interest payable should all be done together. A. These accounts are related and the results of testing each account have a bearing on the other accounts. The likelihood of an error in the​ client's records is found faster and more effectively when done together. B. Several tests of controls are performed on the mortgage​ payable, interest​ expense, and interest payable accounts. C. The mortgage​ payable, interest​ expense, and interest payable accounts have low inherent risk. D. The likelihood of material errors for mortgage​ payable, interest​ expense, and interest payable is low.    3. List the audit procedures that should ordinarily be performed to verify the issue of the​ mortgage, the balance in the mortgage and interest payable accounts on December​ 31, 2018​, and the balance in interest expense for the year 2018.   A. Confirm the mortgage​ amount, terms, and collateral with the lending institution. B. Recompute the dividends paid during the year. C. Test the​ client's calculations of unamortized bond discount or​ premium, accrued​ interest, and bonds payable. D. Test interest expense for reasonableness. E. Recompute interest payable at the balance sheet date and reconcile interest expense to the decrease in principal and the payments made. F. Determine if the mortgage was properly authorized. G. Obtain the mortgage agreement and schedule the pertinent provisions in the permanent file. H. Examine copies of notes due to related party for proper authorization.

Answer 14

1. (1): the appropriate information concerning the mortgage will be conveniently available for future years’ audits.
   A, B, C, G, H
2. A
3. A, D, E, F, G

Question 15

The ending general ledger balance of​ $186 000 in notes payable for Sisam Manufacturing Inc. is made up of 20 notes to eight different payees. The notes vary in duration anywhere from 30 days to two years and in amounts from​ $1000 to​ $10 000. In some​ cases, the notes were issued for cash​ loans; in other​ cases, the notes were issued directly to vendors for the purchase of inventory or equipment. The use of relatively​ short-term financing is necessary because all existing properties are pledged for mortgages.​ Nevertheless, there is still a serious cash shortage.
Recordkeeping procedures for notes payable are not​ good, considering the large number of loan transactions. There is neither a notes payable master file nor an independent verification of ending​ balances; however, the notes payable records are maintained by a secretary who does not have access to cash.
The audit has been done by the same public accounting firm for several years. In the current​ year, the following procedures were performed to verify notes​ payable:

1. What should be the emphasis in the audit of notes payable in this​ situation? Explain.
   The emphasis in the audit of notes payable in this situation should be in determining whether (1)_____. The four audit procedures listed (2)_________satisfy this emphasis.

(1): all existing notes are included in the client’s records.
all notes included in the client’s records exist.
the interest rates on the notes is above or below the market interest rate.
(2): do
do not

2. State the purpose of each of the four audit procedures listed.
   Audit procedure
   a.
   Obtain a list of notes payable from the​ client, foot the notes payable balances on the​ list, and trace the total to the general ledger.
   b.
   Examine duplicate copies of notes for all outstanding notes included on the listing. Compare the name of the​ lender, amount, and due date on the duplicate copy with the list.
   c.
   Obtain a confirmation from lenders for all listed notes payable. The confirmation should include the due date of the​ loan, the​ amount, and interest payable at the balance sheet date.
   d.
   Recompute accrued interest on the list for all notes. The information for determining the correct accrued interest is to be obtained from the duplicate copy of the note. Foot the accrued interest amounts and trace the balance to the general ledger.
   Purpose
   To determine if the notes payable list reconciles to the general ledger.
   To verify that all recorded notes payable are properly recorded and disclosed.
   To determine if the notes payable on the list are correctly recorded and disclosed.
   To ensure that interest expense is properly recorded on the books.
3. Evaluate whether each of the four audit procedures was necessary. Evaluate the sample size for each procedure.
   (1) ______is not necessary in light of procedure c.  
   (2) ________________. The sample sizes for the procedures are (3)________ considering the deficiencies in record keeping procedures.

(1): Procedure a
Procedure b
Procedure d
(2): The recalculation procedure is not as important as the confirmation procedure.
They both perform the same function and the confirmation is from an independent source.
Tracing the amount to the general ledger is not as important as the confirmation procedure.
(3): not appropriate,
probably appropriate,

4. List other audit procedures that should be performed in the audit of notes payable in these circumstances.
   A.
   Analyze interest expense and send a confirmation for notes payable to all payees not receiving a confirmation for notes.
   B.
   Examine duplicate copies of notes for principal and interest rates.
   C.
   Obtain a standard bank confirmation that includes a specific reference to notes payable from all banks with which the client does business.
   D.
   Examine copies of notes due to related parties for proper authorization.
   E.
   Confirm the balance in notes payable to payees included in last​ year’s notes payable list but not confirmed in the current year.
   F.
   Examine notes paid after​ year-end to determine whether they were liabilities at the balance sheet date.
   G.
   Recompute the dividends paid during the year.
   H.
   Review the minutes of the board of directors.

Answer 15

1. (1): all existing notes are included in the client’s records.
   (2) : do not
2. a. To determine if the notes payable list reconciles to the general ledger.
   b. To determine if the notes payable on the list are correctly recorded and disclosed.
   c. To verify that all recorded notes payable are properly recorded and disclosed.
   d. To ensure that interest expense is properly recorded on the books.
3. (1): Procedure 2
   (2) : They both perform the same function and the confirmation is from an independent source.
   (3) : probably appropriate,
4. A, C, E, F, H

Question 16

What are the primary objectives in the audit of​ owners’ equity​ accounts?
C.
The internal controls over share capital and related dividends are adequate.
D.
​Owners’ equity transactions are recorded​ properly, as defined by the six​ transaction-related audit objectives.
E.
Financial ratio restrictions are properly disclosed.
F.
​Owners’ equity balances are properly presented and disclosed to satisfy the management disclosure requirements.
G.
​Owners’ equity balances are properly presented and disclosed to satisfy the​ disclosure-related audit objectives.
H.
​Owners’ equity balances are properly​ recorded, as defined by the eight​ balance-related audit objectives.

Answer 16

C, D, G, H

Question 17

Evaluate the following​ statements: “The corporate charter and the bylaws of a company are legal​ documents; therefore, they should not be examined by the auditors. If the auditor wants information about these​ documents, a lawyer should be​ consulted.”
A.
Although the corporate charter and bylaws are legal​ documents, their legal nature is not being judged by the auditor. They are being used only to reference transactions being tested by the auditor and provide insight into some of the key control features of the company. The auditor should consult a lawyer if the information the auditor needs from the documents is not clear or if a legal interpretation is needed.
B.
Since these are legal​ documents, the auditor​ doesn’t have the legal right to review the corporate charter and bylaws. Even though their legal nature is not being judged by the​ auditor, a lawyer should be contacted if the auditor wants this information or if a legal interpretation is needed.
C.
The auditor should have access to all legal documents without question because the auditor needs to disclose any issues in the financial statements. The auditor should not have to consult a lawyer for any​ reason; it is part of the audit scope.
D.
All of the above

Answer 17

A

Question 18

What are the major internal controls over​ owners’ equity?
A.
The use of an independent registrar and share transfer agent
D.
Dividends payable are recorded.
E.
Capital share is properly presented and disclosed.
F.
Adequate segregation of duties between maintaining​ owners’ equity records and handling cash and share certificates
G.
Proper authorization of transactions
H.
Proper record keeping

Answer 18

A, F, G, H

Question 19

Describe the duties of a share registrar and a transfer agent. How does the use of their services affect the​ client’s internal​ controls?

1.
Share registrar
2.
Transfer agent
a. 
The duties are to maintain the shareholder​ records, and in some​ cases, disburse cash dividends to shareholders.
b.
The duties are to make sure that shares are issued by a corporation in accordance with the capital authorization of the board of​ directors, to sign all newly issued share​ certificates, and to make sure old certificates are received and cancelled before a replacement certificate is issued when there is a change in the ownership of the share.

   2. The use of the services of a share registrar improves the effectiveness of the​ client's internal controls by (1)\_\_\_\_\_\_\_. Along similar​ lines, the use of the services of an independent transfer agent improves the control over the (2)\_\_\_\_.

(1): preventing the improper issuance of share certificates.
ensuring that dividends are paid when due.
improving the control over the share records by putting them in the hands of an independent organization.

(2): covenants’ calculations.
shares by preventing the improprer issuance of share certificates.
share records by putting them in the hands of an independent organization.

Answer 19

1-b, 2-a

(1) : preventing the improper issuance of share certificates.
(2) : share records by putting them in the hands of an independent organization.

Question 20

What kinds of information can be confirmed with a transfer​ agent?
A.
The number of shares outstanding
B.
The correct valuation of share capital transactions
E.
A schedule of notes receivable from shareholders
F.
The par value of the share

Answer 20

A, B, F

Question 21

Evaluate the following​ statement: “The most important audit procedure to verify dividends for the year is a comparison of a random sample of cancelled dividend cheques with a dividend list that has been prepared by management as of the dividend record​ date.”
A.
Because it is important to verify that properly authorized dividends have been paid to owners of shares as of the dividend record​ date, a comparison of a random sample of cancelled dividend cheques to a dividend list prepared by management would be inadequate. Such an audit step is useless unless the dividend list has first been verified to include all shareholders of record at the dividend record date.
B.
The better test is to determine the total number of shares outstanding at the dividend date from the share registrar and recompute the total dividends that should have been paid for comparison with the total amount actually paid. A random sample of payments should then be compared to the independent​ registrar’s records to verify that the payments were actually made to valid shareholders.
C.
The only test is to send out confirmations to all of the shareholders of record at the dividend record date and verify the amount of the dividend paid. This is time consuming but necessary.
D.
A and C only
E.
A and B only
F.
None of the above

Answer 21

E

Question 22

What should be the major emphasis in auditing the retained earnings​ account? Explain your answer.
B.
The major emphasis in auditing the retained earnings account should be on the recorded changes that have taken place during the​ year, such as net earnings for the​ year, distributions, prior period​ adjustments, extraordinary items charged or credited directly to retained​ earnings, or the setting up or elimination of appropriations. Except for prior period​ adjustments, the other items should be verified during other parts of the engagement. This is especially true of the dividends declared.​ Therefore, the audit of retained earnings primarily consists of an analysis of the changes in retained earnings and the verification of the authorization and accuracy of the underlying transactions.
C.
The major emphasis in auditing the retained earnings account should be on the recorded changes that have taken place during the​ year, such as net earnings for the​ year, dividends​ declared, prior period​ adjustments, extraordinary items charged or credited directly to retained​ earnings, or the setting up or elimination of appropriations. Except for dividends​ declared, the other items should be verified during other parts of the engagement. This is especially true of the net earnings for the year.​ Therefore, the audit of retained earnings primarily consists of an analysis of the changes in retained earnings and the verification of the authorization and accuracy of the underlying transactions.
D.
The major emphasis in auditing the retained earnings account should be on the recorded changes that have taken place during the​ year, such as interest​ income, dividends​ declared, prior period​ adjustments, extraordinary items charged or credited directly to retained​ earnings, or the setting up or elimination of appropriations. Except for extraordinary​ items, the other items should be verified during other parts of the engagement. This is especially true of the dividends declared.​ Therefore, the audit of retained earnings primarily consists of an analysis of the changes in retained earnings and the verification of the authorization and accuracy of the underlying transactions.

Answer 22

C

Question 23

Explain the relationship between the audit of​ owners’ equity and the calculations of earnings per share. What are the main auditing considerations in verifying the​ earnings-per-share figure?
A.
For auditing​ owners’ equity and calculating​ earnings-per-share, it is crucial to verify that the number of shares used in each is accurate.​ Additionally, earnings must be verified at this time as it is also a crucial part of the audit of​ owners’ equity​ (and of the​ earnings-per-share calculations). The auditor should consider relevant accounting standards to verify that the​ earnings-per-share figure conforms to those standards.
B.
For auditing​ owners’ equity and calculating​ earnings-per-share, it is crucial to verify that the number of shares used in each is accurate. Earnings are verified as an integral part of the entire audit and should require no additional verification as a part of​ owners’ equity. The auditor should consider relevant accounting standards to verify the​ earnings-per-share figure and the disclosures of descriptions of the various classes of shares in the articles of incorporation and minutes of the board of directors.
C.
For auditing​ owners’ equity and calculating​ earnings-per-share, it is crucial to verify that earnings is accurate. The number of shares used is verified as an integral part of the entire audit and should require no additional verification as a part of​ owners’ equity. The auditor should consider relevant accounting standards to verify the disclosures of descriptions of the various classes of shares in the articles of incorporation and minutes of the board of directors.
D.
None of the above are correct.

Answer 23

B

Question 24

Explain how the audit of dividends declared and paid is affected if a transfer agent disburses dividends for a client. What audit procedures are necessary to verify dividends paid when a transfer agent is​ used?
If a transfer agent disburses dividends for a​ client, the total dividends declared can be verified by (1)______ and also (2)____. There should ordinarily be no need to (3)_______ if a share transfer agent is used.

(1): sending a confirmation to the shareholders of the company
tracing the amount to a cash disbursement entry to the agent
tracing the amount to the general ledger cash account of the company
(2): confirming the amount with the agent.
reviewing the bank statement of the company.
reviewing the statement sent to the shareholders.
(3): audit the financial statements disclosure related to the dividends
review the board of directors minutes
test individual dividend disbursement transactions

Answer 24

(1) : tracing the amount to a cash disbursement entry to the agent
(2) : confirming the amount with the agent.
(3) ; test individual dividend disbursement transactions

Question 25

During an audit of a publicly held​ company, the auditor should obtain written confirmation regarding debenture transactions from the
1.
​client's lawyer.
2.
internal auditors.
3.
debenture holders.
4.
trustee.

Answer 25

4

Question 26

An auditor usually obtains evidence of​ shareholders' equity transactions by reviewing the​ entity's
1.
transfer​ agent's records.
2.
cancelled share certificates.
3.
minutes of board of directors meetings.
4.
treasury share certificates book.

Answer 26

3

Question 27

Which of the following audit procedures would be most relevant when examining the completeness​ transaction-related audit objective for capital​ shares?
1.
The auditor examines minutes of the board of​ directors’ meetings to identify any actions involving the issuance of capital shares.
2.
The auditor vouches entries in the​ client’s capital shares records to board minutes.
3.
The auditor traces entries of new share issuances to the cash receipts journal.
4.
Confirmations of new shares issuances are sent to the​ client’s share transfer agent.

Answer 27

1