Chapter 22Audit of the Capital Acquisition and Repayment Cyclen Review Questions22-1Four examples of interest bearing liability accounts commonly found on balance sheets are:1.Notes payable2.Contracts payable3.Mortgages payable4.Bonds payableThese liabilities have the following characteristics in common:1.Relatively few transactions affect the account balance, but each transaction is often highly material in amount.2.The exclusion of a single transaction could be material in itself.3.There is a legal relationship between the client entity and the holder of the stock, bond, or similar ownership document.4.There is a direct relationship between interest and dividend accounts and debt and equity.These liabilities differ in what they represent and the nature of their respective liabilities.22-2The 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.Relatively few transactions affect the account balance, but each transaction is often highly material in amount.2.The exclusion of a single transaction could be material in itself.3.There is a legal relationship between the client entity and the holder of the stock, bond, or similar ownership document.4.There is a direct relationship between interest and dividend accounts and debt and equity.22-3It is common to audit the balance in notes payable in conjunction with the audit of interest expense and interest payable because it minimizes the verification time and reduces the likelihood of overlooking misstatements in the balance. 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 accuracy of accrued interest. If the interest expense for the year is also tested at the same time, the likelihood of omitting a note from notes payable for which interest has been paid is minimized. When there are a large number of notes or a large number of transactions during the year, it is usually too time consuming to completely tie out interest expense as a part of the audit of the notes payable and related accrued interest. Normally, however, there are only a few notes and few transactions during the year.22-4The most important controls the auditor should be concerned about in the audit of notes payable are:1.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.2.Controls over the repayment of principal and interest to insure that the proper amounts are paid.3.Proper records and procedures to insure that all amounts in all transactions are properly recorded.4.Periodic independent verification to insure that all the controls over notes payable are working.22-5The most important analytical procedures used to verify notes payable is a test of interest expense. By the use of this test, auditors can uncover misstatements in interest calculations or possible unrecorded notes payable.22-6It is more important to search for unrecorded notes payable than unrecorded notes receivable because the omission of an asset is less likely to occur than the omission of a debt. Several audit procedures the auditor can use to uncover unrecorded notes payable are:1.Examine the notes paid after year-end to determine whether they were liabilities at the balance sheet date.2.Obtain a standard bank confirmation that includes specific reference to the existence of notes payable from all banks with which the client does business.3.Review the bank reconciliation for new notes credited directly to the bank account by the bank.4.Obtain confirmation from creditors who have held notes from the client in the past and are not currently included in the notes payable schedule.5.Analyze interest expense to uncover a payment to a creditor who is not included on the notes payable schedule.6.Review the minutes of the board of directors for authorized but unrecorded notes.22-7The primary purpose of analyzing interest expense is to uncover a payment to a creditor who is not included on the notes payable schedule. The primary considerations the auditor should keep in mind when doing the analysis are:1.Is the payee for the interest payment listed in the cash disbursements journal also included in the notes payable list?2.Has a confirmation for notes payable been received from the payee?22-8The tests of controls and substantive tests of transactions for liability accounts in the capital acquisition and repayment cycle consists of tests of the control and substantive tests over the payment of principal and interest and the issuance of new notes or other liabilities, whereas the tests of details of balances con