Auditing Debt and Equity

The financing cycle encompasses debt, equity, and payroll transactions. These areas involve significant management judgments, complex contractual arrangements, and transactions that directly affect the company's capital structure. Auditing procedures in these areas emphasize confirmation, recomputation, and careful review of legal documents and board authorizations.

Debt (Financing Cycle)

Key Audit Procedures for Debt

1. Confirming with Creditors

The auditor sends confirmations directly to lenders and creditors to verify:

• Outstanding principal balances
• Interest rates and payment terms
• Maturity dates
• Collateral or security pledged
• Debt covenants and any violations
• Lines of credit (used and unused)

tip

Debt confirmations should be sent to all known creditors, including those with zero balances, to detect any unrecorded borrowings.

2. Recomputing Amortization

The auditor independently recalculates:

• Amortization of bond premiums or discounts using the effective interest method
• Amortization of debt issuance costs
• Verification that the carrying value of debt at year-end is correct

3. Testing Interest Expense

The auditor recalculates interest expense by multiplying the outstanding principal balance by the stated interest rate for the applicable period. The recalculated amount is compared to the recorded interest expense and accrued interest payable.

Example: Interest Expense at Gies Co.

Gies Co. has a $2,000,000 term loan at 6% annual interest. The auditor recalculates annual interest expense: $2,000,000 × 6% = $120,000. The auditor compares this to the $120,000 recorded in the income statement and verifies the December accrued interest of $10,000 (one month: $120,000 / 12).

4. Cutoff Testing

The auditor verifies that debt transactions near the period end are recorded in the correct period:

• New borrowings initiated before year-end are recorded as liabilities
• Repayments made before year-end are reflected in reduced balances
• Interest is accrued through the balance sheet date

5. Reviewing Board Minutes

Board minutes are examined for evidence of:

• Authorization of new borrowings or debt issuances
• Approval of refinancing arrangements
• Awareness of covenant violations
• Authorization of debt repayments or modifications

6. Tracing Contract Terms to Financial Statements

The auditor reads loan agreements and bond indentures and traces key terms to the financial statements to verify:

• Proper classification between current and long-term debt
• Disclosure of restrictive covenants
• Identification of collateral/pledged assets
• Disclosure of scheduled maturities

Example: Debt Audit at Kingfisher Industries

Kingfisher Industries has outstanding bonds payable of $5,000,000 with a 5% coupon rate, issued at a discount. The auditor:

• Confirms the balance directly with the bond trustee
• Recalculates discount amortization using the effective interest method
• Recalculates interest expense and accrued interest
• Reviews the bond indenture for restrictive covenants (minimum current ratio of 1.5:1) and verifies compliance
• Examines board minutes for authorization of a new $1,000,000 line of credit entered during the year
• Verifies that $500,000 of bonds maturing within 12 months are classified as current

Equity

Key Audit Procedures for Equity

1. Vouching Stock Transactions

The auditor examines documentation supporting stock issuances and repurchases:

• Stock certificates or electronic registration records
• Cash receipts from stock issuances
• Board or shareholder authorizations
• Cash disbursements for treasury stock purchases

2. Reviewing Board Minutes

Board minutes provide evidence of:

• Authorization of stock issuances, splits, or dividends
• Declaration of cash and stock dividends
• Authorization of treasury stock transactions
• Changes to authorized share capital

info

Board minutes are one of the most important sources of audit evidence for equity transactions because virtually all significant equity transactions require board or shareholder approval.

3. Reviewing Articles of Incorporation and Bylaws

The auditor examines the articles of incorporation (or charter) to verify:

• Classes of stock authorized (common, preferred)
• Number of shares authorized for each class
• Par or stated value
• Rights and preferences of each class (voting, dividend, liquidation)

4. Analyzing Retained Earnings

The auditor reconciles the beginning and ending retained earnings balance by accounting for:

• Net income (or loss) per the income statement
• Dividends declared
• Prior period adjustments
• Other comprehensive income reclassifications
• Appropriations or restrictions

5. Confirming with the Transfer Agent and Registrar

If the company uses an independent transfer agent and registrar, the auditor confirms:

• Total shares issued and outstanding
• Treasury shares held
• Dividends paid during the period

note

When a company uses an independent transfer agent, the auditor can rely on the agent's records as strong evidence of shares outstanding, reducing the need for detailed testing of stock certificate records.

6. Checking Restrictions and Appropriations

The auditor identifies any restrictions on retained earnings or equity, such as:

• Restrictions imposed by loan covenants (e.g., minimum retained earnings requirement)
• Legal restrictions on treasury stock
• Appropriations for specific purposes (e.g., plant expansion)

Example: Equity Audit at Illini Entertainment

Illini Entertainment issued 50,000 shares of $1 par value common stock at $25 per share during the year. The auditor:

• Vouches the issuance to the board resolution authorizing the sale
• Verifies the cash receipt of $1,250,000
• Confirms shares outstanding with the independent transfer agent
• Reviews the articles of incorporation to confirm sufficient authorized but unissued shares existed
• Verifies the accounting entry: Dr. Cash $1,250,000; Cr. Common Stock $50,000; Cr. Additional Paid-in Capital $1,200,000
• Reviews the loan agreement, which restricts dividend payments if retained earnings fall below $2,000,000, and verifies proper disclosure

Payroll Cycle

The payroll cycle involves the authorization, recording, and payment of employee compensation. Proper segregation of duties and effective controls are essential because payroll involves recurring cash disbursements.

Segregation of Duties (ARC Framework)

Function	Responsibility	Segregation Requirement
Authorization	Human Resources approves hiring, firing, pay rates, and deductions	Separate from recording and custody
Recording	Payroll department calculates gross pay, deductions, and net pay; maintains payroll records	Separate from authorization and custody
Custody	Treasurer signs and distributes paychecks or authorizes direct deposits	Separate from authorization and recording

warning

A common payroll fraud scheme is the ghost employee—a fictitious employee on the payroll whose checks are diverted by a perpetrator. Proper segregation between HR (authorization) and payroll (recording) helps prevent this fraud.

Common Payroll Audit Procedures

Procedure	Purpose
Observe paycheck distribution	Detect ghost employees by physically distributing checks and requiring identification
Vouch payroll transactions	Select employees from the payroll register and trace to HR authorization (hire letter, pay rate approval)
Compare payroll records to HR files	Verify that employees on the payroll are legitimate, authorized employees
Recalculate gross pay, deductions, and net pay	Verify mathematical accuracy of payroll calculations
Test payroll tax remittances	Verify proper withholding and timely remittance of payroll taxes
Analytical procedures	Compare payroll expense by department or month to prior periods and budgets; investigate unusual fluctuations

Example: Payroll Audit at MAS Inc.

The auditor of MAS Inc. selects a sample of 25 employees from the December payroll register. For each employee, the auditor:

• Traces the employee to an authorized hire letter in the HR file
• Verifies the pay rate per the HR file matches the rate used in the payroll calculation
• Recalculates gross pay (hours × rate), federal and state tax withholdings, and net pay
• Verifies the direct deposit was made to the employee's authorized bank account
• Observes a surprise paycheck distribution for one payroll cycle to detect potential ghost employees

Exam Focus

For the CPA exam, remember these key payroll controls:

• HR authorizes all personnel changes (hiring, termination, pay rates)
• Payroll department records compensation transactions
• Treasurer distributes payments
• Surprise observations of paycheck distribution help detect ghost employees

Summary

Area	Key Procedures	Primary Assertions
Debt	Creditor confirmations, amortization recomputation, interest recalculation, covenant review	Existence, Completeness, Valuation, Disclosure
Equity	Stock transaction vouching, board minute review, transfer agent confirmation, retained earnings analysis	Existence, Rights, Valuation, Disclosure
Payroll	Observation, vouching to HR files, recalculation, comparison procedures	Occurrence, Accuracy, Completeness