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Unformatted text preview: CHAPTER 15 Debt and Equity Capital Review Questions 15-1 A trust indenture is drawn to protect the position of bondholders by imposing restrictions upon the borrowing corporation. One of the most common of these restrictions is that the company must not declare dividends that would cause the working capital to fall below a specified amount. An overly generous dividend policy could leave the company so short of cash as to endanger the position of bondholders. 15-2 Restrictions commonly imposed on a borrowing company by long-term creditors relate to (a) dividend payments, (b) acquisition of property and equipment, (c) increases in managerial compensation and (d) acquisition of additional debt. Such actions are usually permitted only if they will not reduce the current ratio and amount of working capital below specified levels, or increase the debt to equity ratio above a specified level. Creation of a sinking fund is another common requirement designed to assure that cash will be available to pay the long-term debt at maturity. 15-3 The trustee protects the interests of the bondholders by accounting for the issuance and redemption of bond certificates, determining that provisions of the borrowing agreement are observed by the corporation, and reporting periodically on the amount of the liability and of any related sinking fund. This work by the trustee leaves little opportunity for either error or fraud in the issuance, servicing, or redemption of bonds. 15-4 The auditors should request from the trustee responsible for the debenture issue an exact description of the issue, a statement of the amount outstanding, amounts redeemed or purchased during the year, and the balance of the sinking fund. 15-5 The sources of information for preparation of the notes payable analysis for the audit working papers are the notes payable register (if one is maintained), or duplicate copies of the notes issued. Information is also obtainable from the general ledger controlling account for notes payable and from the paid notes that matured during the year. Information about interest expense, interest payable, and prepaid interest may be obtained from the cash disbursements journal and the general ledger. 15-6 The confirmation of notes payable to financial institutions is accomplished as part of he procedure for confirming cash on deposit. 15-7 Testing the reasonableness of the Interest Expense account may disclose the existence of unrecorded notes payable upon which interest payments are being made. 15-8 To satisfy themselves that all interest-bearing liabilities of the client are recorded, the auditors include questions about liabilities to financial institutions in the standard confirmation for deposits and loans at financial institutions, review minutes of directors' meetings, analyze the Interest Expense account to detect payments applicable to unrecorded long-term debt, and review the sources of cash receipts and the financing of property acquisitions. A liability representation stating that all known liabilities have been recorded is also obtained from the client. 15-9...
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This note was uploaded on 11/09/2010 for the course BUS 651 taught by Professor Shastr during the Spring '10 term at University of Louisville.
- Spring '10