Review Questions: (Chapter 10: Audit of Financing Activities)

1. Identify the transactions involved in financing activities and explain their relationship to other
cycles.
Answer: Transactions under financing activities are consisted with debt obligations and
shareholders’ equity. Under Debt Obligation, activities includes issuance of bonds and
amortization of bond discount or premium if circumstances occurred, issuance of Long-term
note or mortgage payable, refinancing debt and periodic payments of interest. Under
Shareholders’ Equity, activities includes issuance of shares, purchase or sale of treasury shares,
declaration or payment of dividend, exercised of share options and warrants and transfer of net
income to retained earnings. Entity’s financing cycles consist of transactions pertaining to the
acquisition of capital funds, such as but not limited to, borrowings from others either short-term
or long-term borrowings excluding trade credit and share capital and subsequent redemption
and reacquisition of this shares. Also includes payment of interest and dividends; and
procedures for authorizing, executing and recording transactions that involves bank loans,
mortgages, bonds payable and share capital. Some transactions under financing activities also
falls under Expenditure cycle, such as but not limited to, if an entity paid interest, it will affect
both financing and expenditure cycle because it will increase expense account in relation with
the long-term liability and decrease an asset account which is Cash. Payment of interest expense
in relation with long-term liability falls under financing activity and the cash payment for this
falls under expenditure cycle, cash disbursement transaction in particular. Related documents
and records used in Expenditure Cycles was also used under Financing Cycle such as cash
disbursement transaction file/journal if long-term asset was purchased in cash and accounts
payable master file/subsidiary ledger if long-term asset was purchased on account. Also
documents and records used in Investing Cycle was also used in Financing Cycle such as Share
Certificate, Bond Certificate, Bond Indenture, Broker’s Advice and Promissory Note.

2. 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.
Answer: In all circumstances, auditing the balance of notes payable together with audit of
interest expense and interest payable is practical because it shorten the verification time for
notes payable and reduces likelihood of overlooking errors in notes payable balance. If balance
in notes payables in conjunction with interest rates and due dates for each notes was satisfied,
auditor is easy to test accuracy of accrued interest. Also, if interest expense was tested with the
same date, the probability of omitting notes payable in connection with paid interest is
minimized.
3. Which internal controls should the auditor be most concerned about in the audit of notes
payable? Explain the importance of each.
Answer: There are four important controls over notes payable. First is Proper authorization for
the issue of new notes wherein responsibility for issuance of new notes should be vested in the
board of directors or high-level management personnel in order to ensure that all issued debt
arrangements are authorized and there’s no fictitious debt arrangements committed. Second is
Adequate controls over the repayment of principal and interest wherein periodic payment of
interest and principal should be subjected to the controls in expenditure cycle in order to ensure
that payment of principal and interest is paid for what is required. Third is Proper documents
and records wherein subsidiary records and control over blank and paid notes by an authorized
person in order to ensure that all amounts are properly recorded. Lastly is Periodic independent
verification wherein detailed note records should reconciled with general ledger and compared
with note holders’ records by an employee who is not responsible for maintaining the detailed
records in order to ensure that all controls over notes payable are functioning.

4. List four types of restrictions long-term creditors often put on companies when granting them a
loan. How can the auditor find out about each of these restrictions?
Answer: When a company granting loans to long-term creditors, financial ratio restrictions,
dividend payment restrictions, operation restrictions and issuance of additional debt restrictions
are the restrictions for them. Auditor can determine these four restrictions by means of
examining and confirming loan agreement in conjunction with associated loan. Auditor shall also
perform calculations and observe whether client’s activities follows the four restrictions
established by the company.

5. What are the major internal controls over owners’ equity?

Answer: There are several internal controls for owners’ equity activities, however three of the
important. First is Proper authorization of transactions wherein owner’s equity transaction is
typically material and many of these transactions must be approved by the board of directors
such as issuance of capital stock, repurchase of capital stock and declaration of dividends.
Second is Proper record keeping and segregation of duties wherein company must adequately
maintains its own record of stock transactions and outstanding stocks in order to ensure that
actual owners of stock are recognized in corporate records, correct amount of dividends is paid
to stockholders owning the stock as of dividend record date and potential misappropriation of
assets is minimized. Proper assignment of personnel, adequate record-keeping procedures and
independent internal verification of information in the records are useful controls for these
purposes. Lastly is Independent registrar and stock transfer agent, wherein independent
registrar is the one who make sure that stock is issued by a corporation in accordance with
capital stock provisions in corporate charter and authorization of board directors while Stock
transfer agent is to maintain stockholder records including those documenting transfers of stock
ownership.
6. Evaluate the following statement: “The most important audit procedure to verify dividends for
the year is a comparison of a random sample of canceled dividend checks with a dividend list
that has been prepared by management as of the dividend record date.”
Answer: In audit of dividends, verification of properly authorized paid dividends to stockowners
at dividend record date is very important. Comparison between random sample of canceled
dividend checks and dividend list prepared by management at dividend record date is not
enough. Auditor must verify whether payment was made to the stockholder who owned the
stock as of dividend date Auditor can test this by selecting a sample of recorded dividend
payments and tracing the payee’s name on cancelled check to dividend payments and tracing
payee’s name on cancelled check to the dividend records. By doing this, auditor can verify the
amount and authenticity of dividend check.

7. What are the relevant accounts related to debt obligations?

Answer: When an entity issued bond, increase in Cash account is affected, also Increase in
Bonds Payable account. If it issued greater than its face value, Bonds Premium account is
affected. If it issued at less than its face value, Bond Discount account is affected. If there are
related issuance cost on bond, Bond Issue Cost account is affected. If there are related accrual of
interest on bonds, increase in Interest Expense account is affected, also increase in Accrued
Interest or Interest Payable account is affected. When an entity issued long term note or
mortgage payable, increase in Cash account is affected for both issuance, increase in Notes
Payable – Long-term account is affected if long term notes is issued and increase in Mortgage
Payable account is affected if mortgage is issued. When an entity pays periodic interest expense,
decrease in Accounts Payable account is affected and decrease in Cash account is also affected.
When an entity refinance a debt, accounts affected are the same when issuing long term
liabilities.

8. What are the relevant accounts and related to shareholders’ equity transactions?
Answer: When an entity issued ordinary and preference shares, increase in Ordinary and
Preference Share Capital Account is affected, also increase in Cash account is affected if paid in
cash. If shares was subscribed, increase in Ordinary and Preference Share Receivable is affected
and Subscribed Ordinary and Preference Share Capital is affected. If it is issued above par value,
Ordinary and Preference Share Premium is affected. If it is issued below par value, Ordinary and
Premium Share Discount is affected. When an entity purchased its own shares, increase in
Treasury Shares account is affected and decrease in Cash account is also affected. Is
subsequently sold, decrease in Treasury Shares account is affected, increase in Cash account is
affected, increase and decrease in Retained Earnings account is affected for appropriation of
treasury shares. If it is sold more than its cost, Treasury Share Premium and related
Appropriation in Retained Earnings is affected. If it is sold below than its cost, Treasury Share
Discount and related Appropriation in Retained Earnings is affected. When an entity declared a
dividend, increase in Dividends Payable account is affected and decrease in Retained Earning
account is also affected. If subsequently paid, decrease in Dividends Payable account and
decrease in Cash account. When an entity received donation, increase in related Asset account
in accordance if asset donated and increase in Donated Capital account.
9. Identify common transactions affecting shareholder’s equity accounts.
Answer: There are many transaction that affecting shareholders’ equity accounts, such as but
not limited to, issuance of shares, purchase and sale of entity’s own shares, declaration and
payment of dividend, exercise of share options and warrants, transfer of net income to retained
earnings and donation received.

10. Identify common inherent risks associated with debt obligations.

Answer: There are four inherent risk associated with debt obligation. First is authorization of
debt wherein inherent risks include incurring debt that is not properly authorized or reviewed
also there are risks that new debt, debt extinguishments or debt payment transactions are not
properly authorized. Second is receipt of funds. Third is recording of debt transactions wherein
inherent risks include interest expense not being properly recorded or accrued and debt not
being classified or recorded in accordance with Philippine Financial Reposting Standards. Lastly
is compliance with any debt covenants wherein inherent risks relate to whether debt covenants
is appropriately reviewed and disclosed.

11. Identify fraud risks associated with debt obligation.

Answer: There are many potential fraud risks related to debt obligation, such as but not limited
to, debt obligation not properly authorized, misclassification of long-term or short-term debt,
recorded interest expense was recorded in wrong period at wrong amount, not recorded at all
or misclassified and loan payments as a whole are charged to either principal or interest.

12. Identify fraud risks associated with shareholder’s equity accounts.

Answer: There are many fraud risks related to shareholders’ equity transactions, such as but not
limited to, issuance or sales of equity shares are not authorized in accordance with
organization’s bylaws, issuance or sales of equity shares are recorded in the wrong period, share
issued in exchange for goods or services is not properly valued, equity activities are not properly
disclosed in accordance with Philippine Financial Reporting Standards when it comes to fraud
associated with sales and issuances of equity shares. Entity’s purchased own shares are not
recorded as treasury shares, treasury share transactions are recorded in wrong period and cost
of treasury shares subsequently retired is not properly allocated among appropriate accounts
when it comes to fraud associated with purchase of treasury shares. Dividends may be recorded
and paid before being declared, dividends may not properly approved before being declared
and dividends are recorded in wrong period when it comes to fraud associated with dividends.
Option or warrants are granted without being properly approved, inadequate records as to
options or warrants issued but not exercised, options exercised or expired remain on
organization’s books, option or warrant grants are not properly valued due to inappropriate
assumptions or models, inappropriate amortization methods are used and inaccurate period of
service is used when it comes to fraud associated with share options and warrants.
 13. Given typical inherent and fraud risks related to material misstatement of debt obligations,
identify controls that an auditor would expect a client to have implemented.
Answer: First of all, auditor must gain an overall understanding about entity’s internal controls
for both integrated audits and financial statement audits by means of walkthrough of the
process, inquiry, observation and review of client’s documentation. Next, auditor must consider
both entity-wide controls and transaction controls at account and assertion level wherein this
leads with a basis for making initial control risk assessment.

14. Given typical inherent and fraud risks related to material misstatement of shareholders’ equity
accounts, identify controls that an auditor would expect a client to have implemented.
Answer: Identifying controls for debt obligation and shareholders’ equity transactions are the
same. First of all, auditor must gain an overall understanding about entity’s internal controls for
both integrated audits and financial statement audits by means of walkthrough of the process,
inquiry, observation and review of client’s documentation. Next, auditor must consider both
entity-wide controls and transaction controls at account and assertion level wherein this leads
with a basis for making initial control risk assessment.

15. What are typical preliminary procedures related to debt obligations?

Answer: Performing preliminary procedures related to debt obligation help auditors identify
areas of potential misstatement, this procedures includes performing trend analysis of balances
in notes payable, interest expenses and accrued interest with prior periods, considering known
client activities related to debt; estimate interest expense based on average interest rates and
average debt outstanding; calculate debt-to-equity rations and perform trend analysis with prior
periods and calculate times interest earned ratio and perform trend analysis with prior periods.

Exercises: (Chapter 10: Audit of Financing Activities)

1. Items 1 through 6 are questions typically found in a standard internal control questionnaire used
by auditors to obtain an understanding of internal control structure for notes payable. In using
the questionnaire for a particular client, a “yes” response indicates a possible internal control,
whereas a “no” indicates a potential weakness.
1) Are liabilities for notes payable incurred only after written authorization by a proper
company official?
2) Is a notes payable master file maintained?
3) Is the individual who maintains the notes payable master file someone other than the
person who approves the issue of new notes or handles cash?
4) Are paid notes canceled and retained in the company files?
5) Is a periodic reconciliation made of the notes payable file with the actual notes outstanding
by an individual who does not maintain the master file?
6) Are interest expense and accrued interest recomputed periodically by an individual who
does not record interest transactions?

Requirements:
a. For each of the preceding questions, state the purpose of the control.
Answer:
1. Purpose of this control is to assure that all note liabilities are authorized by proper
management
2. Purpose of this control is to assure that note transactions are recorded in full and in
detail
3. Purpose of this control is to prevent misuse of notes and funds earmarked for notes
4. Purpose of this control is to assure that notes are not paid more than once
5. Purpose of this control is to assure that all note-related transactions agree with account
balances
6. Purpose of this control is to assure that only the proper interest amount is paid and
recorded

b. For each of the preceding questions, identify the type of financial statement error that could
occur if the control were not effect.
Answer:
1. Potential financial statement error could be loss of assets through payment of excess
interest rates or diversion of cash to unauthorized persons
2. Potential financial statement error could be improper disclosure or errors in note
payable through duplication
3. Potential financial statement error could be misstatement of liabilities and cash
4. Potential financial statement error could be loss of cash
5. Potential financial statement error could be misstatement of notes payable
6. Potential financial statement error could be misstatement of interest expense and
related accrual

c. For each of the potential errors in part b, list an audit procedure that can be used to
determine whether a material error exists.
Answer:
1) Audit procedure to be conducted is to check note request forms for proper
authorization
2) Audit procedure to be conducted is to determine if master file is maintained and
reconcile detailed contents to control
3) Audit procedure to be conducted is to determine if duties are segregated and perform
all substantive procedures on extended basis
4) Audit procedure to be conducted is to check paid notes for cancellation
5) Audit procedure to be conducted is to determine if reconciliations are periodically made
and verify reconciliation
6) Audit procedure to be conducted is to determine if interest computations are internally
verified and re-compute interest on test basis.
2. The auditor should review the bond indenture at the time a bond is issued and anytime
subsequent changes are made to it.
a. Briefly identify the information the auditor would expect to obtain from a bond indenture.
List at least five specific pieces of information that would be relevant to the conduct of the
audit.
Answer: Bond indenture provides important information regarding the bond which includes
the time period before repayment and amount of interest paid. I believe that the
information that would be relevant to conduct an audit in regards with bond indenture are
stated interest rate, maturity date of bond, callable provisions, amount to be repaid and
time period before repayment.

b. Because auditors are especially concerned with the potential understatement of liabilities,
should they confirm the existence of the liability with individual bondholders? State your
rationale.
Answer: It is not necessary to confirm the existence of the liability with the individual
bondholders because it can be verified by the bond trustees. If the auditors want to confirm
the existence of the liability, they can also check it by checking the transactions of money
received and the reduction of repayment.

c. A company issued bonds at a discount. Explain how the amount of the discount is computed
and how the auditor could determine whether the amount is properly amortized each year.
Answer: The amount of the discount can be computed by comparing the net proceeds
available to the bond offering with the stated interest rate. The auditor could determine
whether the amount are properly amortized each year by the net proceeds can be used to
figure out the effective interest rate.

d. Explain how the auditor could verify that semiannual interest payments are made on the
bond each year.
Answer: Most organizations does have agreements with the bond trustees to handle the
registration of the current bondholders to make periodic interest payments. This means that
the auditor could verify the semiannual interest payments made on the bond each year by
asking the bond trustee.

e. The company has a 15-year, 20 million loan that is due on September 30 of next year. It is
company’s intent to refinance the bond before it is due, but is waiting for the best time to
issue new debt. Because its intent is to issue the bond next year, the company believes that
the existing $20 million bond need not be classified as a current liability. What evidence
should the auditor gather to determine the appropriate classification of the bond?
Answer: I believe that the evidence that the auditor should gather in order to determine
appropriate classification of the bond by getting copies of debt agreement as well as any
legal documentation regarding the bond, also the schedule of debt obligations and interest.
Since the bond is due next year, the bond should be classified as current liability as of this
balance sheet date until it is refinanced.
3. The following covenants are extracted from a bond indenture. The indenture provides that
failure to comply with its terms in any respect automatically advances the due date of the loan
to the date of noncompliance (the maturity date is 20 years hence). Identify the audit steps that
should be taken or reporting requirements necessary in connection with each one of the
following scenarios:

a. The debtor company shall endeavor to maintain a working capital ratio of 2 to 2 at all times
and in any fiscal year following a failure to maintain the said ratio, the company shall restrict
compensation of the CEO and executive officers to a total of no more than 500,000.
Executive officers for this purpose shall include the chairman of the board of directors,
president, all vice presidents, the secretary and the treasurer.
Answer: Audit step can be that check balance sheets at beginning and through the previous
fiscal year for working capital ratio. If under 2 to 1, check compensation of officers for
compliance with limitation

b. The debtor company shall insure all property that is security for this debt against loss by fire
to the extent of 100% of its value. Insurance policies securing this protection shall be filed
with the trustee.
Answer: Audit step can be that examine client’s copies of insurance policies or certificates of
insurance for compliance with the covenant, preparing schedule of book value, appraised or
estimated actual value and coverage for report. Confirm policies held with trustee

c. The debtor company shall pay all taxes legally assessed against the property that serves as
security for this debt within the time provided by law for payment without penalty ad shall
receipted tax bills or equally acceptable evidence of payment of the same with the trustee.
Answer: Audit step can be that examine vouchers supporting tax payments on all property
covered by the indenture. By reference to the local tax laws and vouchers, determine that
all taxes have been paid before the penalty-free period expired. If vouchers in any case are
inadequate, confirm with trustee who holds the tax receipts

d. A sinking fund shall be deposited with the trustee by semiannual payments of 300,000, from
which the trustee shall, at her discretion, purchase bonds of this issue.
Answer: Audit step can be that vouch payments to sinking fund. Confirm bond purchases
and sinking fund balance with trustee. Observe cremation certificates or equal evidence of
destruction of bonds for bonds cancelled. Report the fund as an asset, preferably giving the
composition as to cash and bonds held alive if any.