CLASS 27 - In class exercise

The ending general ledger balance of $186,000 in notes payable for Natura Vitahealth Corp. is made up of 20 notes
to eight different payees. The notes vary in duration anywhere from 30 days to two years and in amounts from
$1,000 to $10,000. In some cases, the notes were issued for cash loans; in other cases, the notes were issued
directly to vendors for the purchase of inventory or equipment. The use of relatively short-term financing is
necessary because all existing properties are pledged for mortgages. Nevertheless, there is still a serious cash
shortage.

Recordkeeping procedures for notes payable are not good, considering the large number of loan transactions. There
is neither a notes payable master file nor an independent verification of ending balances; however, the notes payable
records are maintained by a secretary who does not have access to cash.

The audit has been done by the same public accounting firm for several years. In the current year, the following
procedures were performed to verify the notes payable:
1. Obtain a list of notes payable from the client, foot the notes payable balances on the list, and trace the total

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to the general ledger.

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2. Examine duplicate copies of notes for all outstanding notes included on the listing. Compare the name of

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the lender, amount, and due date on the duplicate copy with the list.

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3. Obtain a confirmation from lenders for all listed notes payable. The confirmation should include the due
date of the loan, the amount, and interest payable at the balance sheet date.

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4. Recompute accrued interest on the list for all notes. The information for determining the correct accrued
interest is to be obtained from the duplicate copy of the note. Foot the accrued interest amounts, and trace
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the balance to the general ledger.

What are the most important assertions that the auditor should be focusing on when auditing notes payable?
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Completeness and valuation are most important for notes payable. Completeness, accuracy, and cut-off are most
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important for the related account, interest expense.

What is the purpose of each of the four audit procedures listed?

1 To determine if the notes payable list reconciles to the general ledger.

2 To determine if the notes payable on the list exist and are correctly recorded and disclosed.
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3 To verify that all recorded notes payable exist and are properly recorded and disclosed.

4 To ensure that interest expense is accurately recorded on the books.

Was each of the four audit procedures necessary?

Procedure 2 is not necessary in light of procedure 3. They both perform the same function and the confirmation from
procedure 3 is from an independent source (stronger evidence than procedure 2).

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 Evaluate the sample size for each procedure.

The auditor did not use sampling, but audited the amounts 100%. It is normal to do certain audit tests 100%, such
as confirmation and reconciling to the general ledger. However, not all interest amounts need to be recalculated, if
the interest rates have not changed from year to year and the potential for material error is small.

What other audit procedures should be performed in the audit of notes payable in these circumstances?

There must be procedures to address completeness to ensure there are no unrecorded note payable liabilities:
 Analyze interest expense and send a confirmation for notes payable to all payees not receiving a
confirmation for notes.
 Confirm the balance in notes payable to payees included in last year’s notes payable list but not confirmed
in the current year.

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 Examine notes paid after year end to determine whether they were liabilities at the balance sheet date.

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 Obtain a standard bank confirmation that includes a specific reference to notes payable from all banks with

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which the client does business.

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 Obtain a confirmation for secured notes.
 Examine paid notes for cancellation to make sure they are not still outstanding.

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 Review the minutes of the board of directors.
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