CHAPTER 10

AUDIT OF THE FINANCING CYCLE

INTRODUCTION

This chapter covers the explanation of the financing cycle, the types of transactions in this cycle and the
internal control environment and objectives pertaining thercto.Consideration is then given to compliance
tests of controls and substantive tests of transactions in the financing cycle.

In the audit of the financing cycle,the following activities should be undertaken:

1. Identify the activities and types of transactions that occur in a company's financing cycle;

2. Relate the internal accounting control objectives to financing activity;

3. Determine the essential features of internal control over the above-mentioned transactions;

4.Perform compliance tests of controls over these transactions; and

5.After evaluating the effectiveness of internal control, perform substantive audit procedures to
determine whether financial statement assertions are materially correct on accounts affected by the
financing cycle.

6. Design tests of details of account balances and analytical procedures to satisfy balance-related
audit objectives.

Steps 1 to 5 are discussed in this chapter while Step 6 is covered in Chapters 17 and 18.

NATURE OF THE FINANCING CYCLE

Financing cycle includes the processes,procedures and policies for authorizing. executing and recording
transactions involving bank loans, leases, bonds payable and equity share capital.
This cycle involves the responsibilities of planning the cash needs and raising capital. Every business must
receive money to finance the acquisition of productive assets used to produce revenue. Manager of the
business may obtain funds from investors who become owners or from lenders who become creditors,
thus creating owners' equity and long-term debts.
 Andit of the Financing Cycle 303

Activities Related to Financing Cycle

A. Debt Obligations B. Shareholders Equity

1. Bond Issuance; amortization of bond 1. Share Issuance

discount/premium(if any)

2.Issuance of Long-term note/mortgage 2. Purchase/Sale of Treasury Shares

payable

3.Refinancing debt of principal 3. Declaration/payment of dividend

4.Periodic payments and interest 4. Gravity/exercise of share options and

expense warrants

5. Transfer of net income to retained

earnings.

Overview of the Accounts Associated with the Financing Cycle

Figure 10-1 and Figure 10-2 show the overview of the accounts and entries to record the transactions in the Financing
Cycle.

Figure 10-1:Debt Financing

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Figure 10-2:Equity Financing

 Audit of the Financing Cycle 305

Accounts affected by the Financing Cycle

The following are accounts often found in the cycle:
Notes payable Paid-in capital in excess of par

Contracts payable Donated capital

Mortgages payable Retained earnings Bonds payable

Interest expense Appropriations of retained

earnings
Treasury stock

Accrued interest Dividends declared

Cash in the bank Dividends payable

Capital stock-common Proprietorship-capital account

Capital stock-preferred Partnership-capital account

Documents and Records

The pertinent documents and records used in the Expenditure Cycle(Chapter 7) are also used in the
financing cycle. In addition, the following forms may also be encountered:

Share Certificate. An engraved form showing the number of shares of shares owned by a shareholder
in a corporation.
Bond Certificate. An engraved form showing the number of bonds owned by a bondholder.

Bond Indenture. A contract stating the terms of the bond issue between the bondholder and the
issuing entity.
Broker's Advice. A statement from a broker specifying the details of an investing transaction.
Promissory Note. A financial instrument evidencing the promise to pay a loan granted to the
enterprise.
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AUDITING THE FINANCING CYCLE

PHASE I-RISK ASSESSMENT
Basic Considerations
An entity's financing cycle consists of transactions pertaining to the acquisition of capital funds through
borrowings from others,short-term and long-term excluding_trade credit,and share capital and the subsequent
redemption and reacquisition of these securities.This cycle includes the sequence of procedures for authorizing,
executing and recording transactions that involve bank loans, mortgages, bonds payable and share capital. The
payments of interest and dividends are also an integral part of the financing cycle.
Audit risk is similar to the risk for investing cycle transactions and balances. Ordinarily,control risk is low and the
auditor can also keep detection risk at a low level.Possible errors related to financing activities include the
following:

Failing to make interest accruals, or making them twice

Accruing interest in the wrong period

· Making incorrect estimates of allowances for obligations

Failing to recognize that the entity violated a debt agreement
Failing to record dividend that were declared

A.PERFORMING RISK ASSESSMENT FOR DEBT OBLIGATION TRANSACTIONS

As part of performing risk assessment procedures, the auditor obtains information that is useful in assessing
the risk of material misstatement.This includes information about inherent risks at the financial statement
level(for example, the client's business and operational risks, financial reporting risks) and at the account and
assertion levels, fraud risks including feedback from audit team brainstorming sessions, strengths and
weaknesses in internal control, and results from preliminary analytical procedures.Once the risks of material
misstatement have been identified, the auditor then determines how best to respond to them as part of the
audit opinion formulation process.
 Audit of the Financing Cycle 307

Identifying Inherent Risks

Inherent risks related to debl obligations primarily concern the authorization of debt,receipt of
funds,recording of debt transactions,and compliance with any debt covenants. For
authorization,inherent risks include incurring debt that is not properly authorized or reviewed.Similarly,
there are risks that new debt, debt extinguishments,or debt payment transactions are not properly
authorized. In terms of recording debt transactions, risks include interest expense not being properly
recorded or accrued and debt not being classified or recorded in accordance with PFRS. Regarding debt
covenant compliance issues, inherent risks relate to whether debt covenants are calculated accurately
and whether compliance with_debt covenants is appropriately reviewed and disclosed.

Identifying Fraud Risk Factors

Standards of auditing require the auditor to identify and assess the risks of material misstatement
due to fraud at the financial statement level and at the assertion leveļ. As part of brainstorming
activities, the auditor should identify possible frauds that could occur such as violation of debt
covenants.

Other potential frauds related to debt obligations include the following:

Debt obligations are not properly authorized.

Long-term or short-term debt is misclassified.

Interest expense is recorded in the wrong period, at the wrong amount, not recorded at all, or is
misclassified.

Entire loan payments are charged to either principal or interest.

Identifying Control Risks

Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement associated with debt obligations, the auditor needs to understand the controls that the
client has designed and implemented to address those risks. Remember, the auditor is required to gain
an overall understanding of internal controls for both integrated audits and financial statement only
audits. Such understanding is normally gained by means of a walkthrough of the process, inquiry,
observation, and review of the client's documentation. The auditor considers both entity-wide controls
and transaction controls at the account and assertion levels. This understanding provides the auditor
with a basis for making an initial control risk assessment.
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Performing Preliminary Analytical Procedures

When planning the audit, the auditor is required to perform preliminary analytical procedures.These
procedures can help auditors identify areas of potential misstatements.

The following are examples of typical analytical procedures related to debt obligations:
Perform a trend analysis of the balances in notes payable, interest expense,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 ratios and perform a trend analysis with prior periods.

Calculate the times interest earned ratio and perform a trend analysis with prior periods.

B.PERFORMING RISK ASSESSMENT PROCEDURES FOR SHAREHOLDERS'EQUITY

TRANSACTIONS

Identifying Inherent Risks

Inherent risks relate to shareholder's equity transactions vary across the specific activities. Figure 10-3
outlines some of the common inherent risks associated with typical shareholders' equity activities.
 Audit ofthe Financing Cycle 309

Figure 10-3: Inherent Risks Associated with Shareholders' Equity Activities

Inherent Risk

Sales and Issuances of

Equity Shares Issuances/sales are not authorized in accordance

withorganization's bylaws.Stock issuances/sales are
recorded in the wrong period.Stock issued in exchange for
goods / services is not properlyvalued.Equity activities
are not properly disclosed in accordance withPFRS.

Purchase of Treasury All shàres repurchased is not recorded as treasury

Shares shares.Treasury share transactions are recorded in the
wrongperiod.The cost of treasury shares that is
subsequently retired is notproperly allocated among the
appropriate accounts.
Dividend Dividends may be recorded and paid before being declared.

Dividends may not be properly approved before being

declared.

Dividends are recorded in the wrong period.

Share Options and

Warrants
Options warrants are granted without being properly
approved.Inadequate records as to options / warrants
issued but not exercised.Options exercised or expired
remain on the organization's books.Option/ warrant grants
are not properly valued due toinappropriate assumptions or
models.Inappropriate amortization methods are
used.Inaccurate period of service is used.

Identifying Fraud Risk Factors

Other potential frauds related to sharcholders' equity accounts include the following:

Sales or issuances of equity shares are not authorized.

Stales or issuances of equity shares violate debt covenants.

Sales or issuances of equity shares are not recorded.

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Share options exercised are not authorized or are not in accordance with the terms of options
granted.

Share options are backdated.

Dividends are paid in violation of restrictive covenants.

Dividends are paid to wrong partics or at in incorrect amounts.

·Proceeds from stock sales are misappropriated.

·Identifying Control Risks

Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement associated with shareholders' equity transactions, the auditor needs to understand the
controls that the client has designed and implemented to address those risks. Remember, the auditor is
required to gain an overall understanding of internal controls for both integrated audits and financial
statement only audits. Such understanding is normally gained by means of a walkthrough of the
process, inquiry, observation, and review of the client's documentation. The auditor considers both
entity-wide controls and transaction controls at the account and assertion levels. This understanding
provides the auditor with a basis for making an initial control risk assessment.

Performing Preliminary Analytical Procedures

When planning the audit, the auditor is required to perform prelifminary analytical procedures. These
procedures can help auditors identify areas of potential misstatements.

The primary preliminary analytical procedure for shareholders' equity account is a comparison of
current year account balances with prior-year account balances. The auditor should have an
expectation as to the nature and magnitude of any account balance changes.

If preliminary analytical procedures do not identify any unexpected relationships, the auditor would
conclude that a heightened risk of material misstatement does not exist in these accounts.
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PHASE II-RISK RESPONSE

I.Obtaining Evidence About Internal Control Operating Effectiveness for Debt Obligations and Stockholders' Equity
Transactions
Some effective internal control measures over financing cycle transactions that may be adopted by
the client and assessed by the auditor are as follows:
1. Current liabilities (other those arising from trade credit and operating expenses)

a) A system authorization on both as to original transaction resulting in a liability and as to

payment of the liability should be well-defined as established. Authorization may be noted in the
corporate minutes or on such appropriate documents such as purchase order, invoices, etc.

b)A satisfactory system of record keeping with adequate forms and documentation should be
instituted.

c) There should be a plan of organization with appropriate division of duties, provision for
fixing responsibility and requiring authorization and approval, periodic review of computations and
entries in the records should be established and implemented.

2. Long-term liabilities
a) Long-term obligations should be properly authorized by the board of directors or by a
required majority of the shareholders.
b) There should be proper control over issued and unissued obligations as in bonds, by an
independent bond trustee or transfer agent.

c) Redeemed bonds should be canceled, properly mutilated and retained for auditor in
order to prevent the authorized issuance.

d) Bond ledger should be used in which details of bonds issued, canceled and outstanding
are shown. A subsidiary bondholders' ledger should also be maintained by the issuing corporation or the
bond trustee for bonds registered, as to principal and payment.

Proper control should be exercised over the payment of interest on long-term liabilities.
Payment may be done by an independently engaged interest-paying agent.
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Chapter 10

3. Equity share capital.

a) Internal control measures regarding the issuance of share certificates and proper accounting for
transfer and registration of shares should be established. One of these measures is the appointment of share
and transfer agent or an independent register.

b)Share certificates should be serially prenumbered by the-printer and that the authority for signing
and issuing the certificates e designated by the board of directors.

c) As individual certificates are issued, corresponding records of the certificates should be prepared
containing the name and address of the shareholders and the number of shares issued to each.

d) Canceled certificates should be mutilated and any necessary documentary stamps should be
attached to the canceled certificates.

e) Entries for share issuances and transfers should be made by a person who does not have
authority to sign and issue certificates.
II. Obtaining Substantive Evidence in 'Auditing Debt Obligations and Shareholders' Equity Transactions'

The audits of debt obligàtion and shareholder's equity transactions typically involve only substantive
procedures. Debt obligation accounts are tested with both substantive analytical procedures and tests of
details. In contrast, only tests of details are typically used to audit shareholders' equity accounts. Further, the
transactions in the shareholders' equity accounts are typically tested 100% because they are usually so few, and
yet they are highly material.

Substantive Tests of Details: Debt Obligations Transactions

Typical substantive procedures include:

Reading new loan agreements

Determining what changes, if any, have been made to prior loan agreements
Confirming with relevant outside parties the significant factors and transactions that have occurred
 Andit of the Financing Cycle 313

As a starting point for these procedures,the auditor will have the client provide a schedule of debt obligations
and interest. The client should also have a bond premium/discount amortization schedule that the auditor can
review in assessing whether bonds are appropriately valued and disclosed in the financial statements. For additions
to debt,the auditor traces the proceeds into the cash receipts records and the bank statement. The auditor might
also examine the debt instrument and obtain assurance regarding board approval of the debt through review of
board meeting minutes. For debt reductions. the auditor examines payments through the cash disbursements
records. possibly including canceled checks. Also, for notes or mortgages that have been paid in full,the auditor
should examine the canceled notes.

Debt and Bond Covenants

The auditor should obtain an understanding of the procedures the client uses to determine whether they are in
compliance with their debt covenants.The auditor should then independently determine if the client is in
compliance.

Substantive Tests of Details÷Shareholders' Equity Transactions

a. As a starting point for testing capital stock and equity transactions,the auditor should review a copy
of the client's article of incorporation.This document provides relevant information with respect to each
class of stock. The auditor can agree that information to the disclosures included in the client's financial
statements. The auditor will also prepare.or ask the client to prepare, an analysis of all capital stock
transactions.

b. The auditor will inspect documentation related to the client's record keeping of capital stock and
contributed capital.This documentation may be maintained by the client or held by a transfer agent. Review of this
documentation provides the auditor with evidence related to the existence and completeness of capital.

c. To obtain evidence related to the valuation of capital stock,the auditor should review the minutes of the
board of directors meetings and examine the stock records books (or confirm with the registrar and transfer agent)
to determine issuance and repurchase of capital stock.

d. For those clients with treasury stock, the auditor will examine documentation supporting changes in the
number of shares since the prior year. This documentation might include obtaining contirmation from the stock
transfer agent and tracing the transaction through the cash receipts or cash disbursements journal.
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e. Dividends
1. The auditor examines the minutes of the board of directors meetings for authorization of the
dividends per share amount and the dividend record date.

2. The auditor will also want to obtain evidence as to whether the payment was made to the
stockholders who owned the stock as of the dividend record date. The auditor can trace the payee's name on
the canceled check to the dividend records to make sure the payee was to have received the dividend.

3. The auditor also needs to be aware of restrictions related to dividend payments and determine that
the restrictions are adequately disclosed in the financial statements.

f.Retained earnings-The auditor typically examines 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 common entry
includes dividends. If there are additional entries, the auditor examines documentation supporting that the
entries should be included. For example, if there is correction of an error from a prior period, the auditor
determines that the correction is made in accordance with relevant accounting standards.
 Audit of the Financing Cycle 315

REVIEW QUESTIONS AND EXERCISES

Questions

1. Identify the transactions involved in financing activities and explain their relationship to other
cycles.
2. It is common practice to audit and the balance in notes payable in conjunction with the audit of
interest expense and interest payable. Explain the advantages of this approach.
3. Which internal controls should the auditor be most concerned about in the audit of notes payable?
Explain the importance of each.
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?
5. What are the major internal controls over owners' equity?
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.”
7. What are the relevant accounts related to debt obligations?
8.:What are the relevant accounts and related to shareholders' equity transactions?

9. Identify common transactions affecting shareholders' equity accounts.

10.Identify common inherent risks associated with debt obligations.
11.Identify fraud risks associated with debt obligations.

12.Identify fraud risks associated with shareholders' equity accounts.

13. Given typical inherent and fraud risks related to material misstatement of debt obligations,
identify controls that an auditor would expect a client to havé implemented.

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

1. One control objective of the investing and financing cycle is the proper authorization of company transactions
dealing with debt and equity instruments. Which of the following controls would best meet this objective?

a. Separating responsibility for custody of funds from responsibility for recording the transactions

b.Maintaining written company policies that require the board of directors to review major
funding or repayment proposals

c.Using an underwriter in all cases of new issue of debt or equity instrument

d. Requiring two signatures on all organization checks of a material amount

2. During the year under audit, a company has completed a private placement of substantial amount of
bonds. Which of the following is the most important step in the auditor's program for the examination of
bonds payable?

a. Confirming the amount issued with the bond trustee.

b. Tracing the cash received from the issue to the accounting records.

c. Examining the bond records maintained by the transfer agent.

d. Recomputing the annual interest cost and the effective yield.

3. Several years ago, Conway Inc., secured a conventional real:estate mortgage loan. Which of the
following audit procedures would be least likely to be performed by an auditor examining the mortgage
balance?

a. Examine the current years' canceled checks.

b. Review the mortgage amortization schedule.

c. Inspect public records of lien balances.

d. Recomputed mortgage interest expense.

4. Which of the following can be used by organizations for obtaining financing?

a. Notes
b. Mortgages

c. Bonds
d. All of the above
 Audit of the Financing Cycle 317

5. Which of the following accounts would not typically be included in the audit of debt obligations?

a. Interest income

b. Interest expense

c. Bonds payablé

d. Notes payable

6.Inherent risks related to debt obligations primarily include which of the following?

a. Debt is not properly authorized

b. Interest expense is not properly accrued

c. Debt covenants are not properly disclosed

d.. All of the above are inherent risks related to debt obligations

7. Which of the following is not an inherent risk typically associated with the existence of
dividends?

a. Dividends are recorded before being declared

b. Dividends are not properly amortized

c. Dividends have not been approved before being declared

d. Dividends are recorded in the wrong period

8. Which of the following would an auditor typically not perform as part of gaining an understanding
of the client's controls related to debt obligations?

a. Review the client's documentation of controls

b. Recalculate interest expense

c. Inquire of management about the process of reviewing compliance with debt covenants

d. Review policies related to approval required for new debt

9. Which of the following is a control the auditor would expect a client to have related to
shareholders' equity transactions?

a. A policy requiring approval by the board of directors for all stock transactions

b. Reconciliation of equity accounts to the general ledger

c. CFO and CEO authorization of all stock transaction approved by the board of directors.

d.The auditor would typically expect all of the above controls to be in place
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10.Which of the following statements is true regarding preliminary analytical procedures for debt
obligations and shareholders' equity transactions?

a. Because there are typically only a few shareholders' equity transactions, the auditor is not required to
perform preliminary analytical procedures for shareholders' equity accounts

b. Trend analysis would not typically be performed for debt obligations

c. The long-term debt to equity ratio could be considered by the auditor as part of the preliminary
analytical procedures

d. All of the above statements are true

Exercises

Exercise 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 master 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?
Required:

a. For each of the preceding questions, state the purpose of the control.

b. For each of the preceding questions, identify the type of financial statement error that could occur if the
control were not in effect.

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.
 Audit ofthe Financing Cycle 319

Exercise 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.

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.

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.

d. Explain how the auditor could verify that semiannual interest payments are made on the bond
each year.
e. The company has a 15-year, P20 million loan that is due on September 30 of next year. It is the
company's intent to refinance the bond before it is due, but it 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?

Exercise 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 1 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 P500,000.
Executive officers for this purpose shall include the chairman of the board of directors,
president, all vice presidents, the secretary, and the treasurer
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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.

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 and shall receipted tax bills or equally acceptable
evidence of payment of the same with the trustee.

d. A sinking fund shall be deposited with the trustee by semianmal payments of P300,000, from which the
trustee shall, at her discretion, purchase bonds of this issue.

Note:The Substantive Tests of Details of Balances of the Principal

Accounts affected bythe Financing Cycle are covered in ...

Chapter 11 -Audit ofCash Balances

Chapter 17.-Audit of Non-Tradle Payables and Other

Long-Term Liabilities

Chapter 18-Audit of Owners' Equity