Auditing long term debt and equity

The session focuses on auditing debt and stockholder equity. Much of the work involves analytical and substantive procedures, especially concerning debt obligations like bonds, notes, and mortgages. These items are often easily calculable based on present value, interest rates, and instrument life.

The main objective is to ensure all debt obligations are reported and classified correctly. Key assertions include proper valuation of premiums or discounts, gains/losses on refinancing, and appropriate presentation and disclosure, including debt restriction. These restrictions protect lenders by limiting borrower activities, and auditors must understand their financial implications.

Auditors develop a schedule to identify periodic payments, interest expenses, and debt covenants. For bond indentures, which are long-term contracts, auditors verify payment periods, interest amounts, convertibility, call features, and repayment terms. Once established, this information remains consistent year over year.

Stockholder equity accounts include common stock, preferred stock, treasury stock, additional paid-in capital, dividends, and retained earnings. Auditors primarily focus on changes to these accounts, such as new stock issuances, treasury stock purchases or sales, dividend declarations and payments, and stock options. Retained earnings changes due to net income and dividends are also scrutinized.

Challenges include valuing non-cash stock transactions, accounting for stock exchanges in business acquisitions, and measuring the fair value of stock options, especially for executives. Presentation and disclosure aspects involve describing stock classes, rights, convertible features, warrants, retained earnings restrictions, and prior period adjustments. Diluted earnings per share calculation is also impacted by convertible features and stock warrants.

Inherent risks for debt include unauthorized debt, proper receipt of debt funds (especially during refinancing), appropriate expensing of amortized costs, and correct recording of debt transactions. Interest expense accrual and reporting, and correct allocation between long-term and short-term debt, are also critical. Auditors verify compliance with debt covenants and associated disclosures.

For stock sales and issuance, auditors check for existence and valuation. For treasury stock purchases, completeness and valuation (especially cost allocation for subsequent retirement or resale) are key. Dividends require verification of existence, authorization, approval, and proper recording. Stock warrants and options involve assessing existence, valuation, rights, and obligations.

Fraud risks in debt include undisclosed covenant violations, unauthorized obligations, and miscalculations or misrecording of interest expense, potentially for earnings management. For equity, risks include inappropriate expenses charged directly to retained earnings, unauthorized stock sales or issuance (especially for non-cash assets where valuation is critical), debt covenant violations related to stock, backdated stock options, and improper dividend payments or misappropriated stock sales.

Controls for debt involve disclosure policies, board approval of new debt, updated interest accounts, review of financial statements for proper disclosure, and prepared debt obligation schedules. For equity, controls include board approval of stock transactions, CEO/CFO authorization, updated equity accounts, financial statement reviews, details of shares maintained by an outside party, and proper accounting research for stock option grants.

Analytical procedures, especially in the planning stage, help in understanding processes and identifying potential misstatements by analyzing trends in debt balances, ratios, and interest expenses. This understanding guides substantive testing. For debt and equity, substantive procedures often involve mathematical calculations due to the small number of transactions and their high monetary value. These analytical procedures serve as substantive tests to accurately determine expenses and account values, identifying material errors.