"What Are the Four Stages of the Business Cycle - DOC"
Audit Stages FIRST INTERIM AUDIT STAGE 1: Understand the Business Understand the business and industry in which it operates. An example of business risk factors evaluation report is shown in Illustration 1. Other aspects of understanding the business: A general understanding may lead to other areas of investigation and planning. (1) First time audits require more work than a repeat engagement. (2) Work with company internal auditors. (3) Analyses of the client’s financial statements. (4) Employment of specialists on the audit. The auditor must have a knowledge and understanding of the client’s business. The understanding aids in planning and developing an audit program, which is a list of procedures necessary to obtain sufficient competent evidence. Methods and sources of information: The auditor obtains an understanding of the client’s business and industry by: Inquiry and reviews with client management and personnel. Review of prior year audit work papers. Observation and tour of company’s physical facilities. Study and review of published materials, guides, Web sites, and references on industry and client. Financial Statements There are two important points to remember about client financial statements: (1) Manage ment is responsible for preparing them, and they contain management’s assertions about economic actions and events. (2) The financial statement numbers are produced by the company’s accounting system, and summarized in the trial balance. The Financial Statements are mainly Balance Sheet and Income Statement (profit and loss account) and additional statement; cash flow statement, fond flow statement, cost of sales statement, as are identified as being within the scope of the audit opinion. The Balance Sheet gives a statement of financial position of a company at a particular date. Assets represent the resources owned by the firm, whereas liabilities and shareholders’ equity indicate how those resources are financed. The Income Statement gives a statement of profit or loss of the company for the specified period. An income statement answers the question “how profitable is the business?” For the preparation of the financial statements, every company must keep accounting records and they must be sufficient to show and explain the company 's transactions and financial position. All transactions in the company must show source documents, which are; Invoices, checks, receipts, delivery notes, payrolls... These documents are attached with the cash receipt voucher, cash payment voucher. The source documents are first authorized by senior staff and then entered in accounting records, which are: Daily book, ledger, cashbook, inventory book, check book. According to the Turkish Tax and Commerce Code, Notary public must stamp these books. The company has on the right to keep auxiliary book if necessary (Customers book, Suppliers book, Debtors book...). The balances on the ledger accounts are extracted to form a trial balance to prove that they are arithmetically correct. The financial statements are produced from the trial balance to provide a balance sheet and profit and loss account. Accounting records must be kept for; 5 years according to the Turkish Tax Code, 10 years according to the Commerce Code. STAGE 2: Plan the Audit Use audit planning tools to guide the audit work. After these planning tools, plan the audit program. Record the work in the auditors' working papers. Audit Planning Tools Audit planning tools used to guide and direct audit work are classified as: Preliminary Risk Assessment Preliminary Materiality Decisions Preliminary Analytical Procedures Audit Programs Preliminary Assessment of Audit Risks Preliminary analytical review can help auditors make broad risk assessments. However, the following technical risks must also be assessed. Audit risk is the probability that an auditor will give an inappropriate opinion on financial statements. The auditing profession has no official standard for an acceptable level of overall audit risk, except that it should be “acceptably low.” Inherent risk is the probability that material misstatements have occurred in transactions entering the accounting system used to prepare financial statements. Relative risk refers to conditions of more or less inherent risk. Audit care attention should be greater where relative and inherent risk are judged to be higher. Control risk is the probability that the clients internal control system will fail to detect material misstatements. Control risk should not be assessed so low that complete reliance is on controls and no other audit work is performed. Detection risk is the probability that audit procedures will fail to produce evidence of material misstatements. Detection risk is realized when substantive procedures fail to detect material misstatements. Substantive procedures include(1) audit of the details of transactions or balances, and (2) analytical procedures. Risk Model Audit risk can be expressed in the following model which assumes the elements to be independent: Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR) Auditors want to perform an audit of a balance or disclosure well enough to hold audit risk (AR) to a relatively low level. AR is a quality criterion based on professional judgement. All other risk assessments are estimates based on professional judgement and evidence. Preliminary Assessment of Planning Materiality When planning an audit, materiality is considered to be the largest amount of uncorrected dollar misstatement that could exist in published financial statements. Financial Statement Materiality: Materiality is described in the following way: Information is material and should be disclosed if it is likely to influence the economic decisions of financial statement users. Accounting numbers are not perfectly accurate because of the nature of accounting, but accountants and auditors want to maintain that financial reports are materially accurate and do not contain material misstatement. Materiality Judgement Criteria: Auditors are generally left without definite, quantitative guidelines to determine materiality. A rule of thumb is that anything less 5 percent is probably not material, and anything greater than 10 percent probably is material. Some of the common factors auditors use in making judgment are: - Absolute size - Relative size - Nature of the item or issue - Circumstances - Uncertanity - Cumulative effects Top-Down Approach for Materiality Assignment: To plan the audit of various accounts, auditors need to assign part of the planning materiality to each account. The amount assigned is the tolerable misstatement, the amount by which an account may be misstated and yet still not cause the financial statements taken as a whole to be materiality misleading. Some methods of assigning tolerable misstatement based on overall materiality include assigning amounts: (1) that add up to twice the overall materiality, (2) such that the square root of the sum of the squared tolerable misstatement is equal to overall materiality, and (3) that exactly add up to materiality. Two methods of assigning overall materiality to tolerable misstatement for accounts are: Bottoms-up approach: Judging materiality amounts in each account separately, then combining them to determine the overall effect, and Top-down approach: Judging an overall material amount for the financial statement and then allocating it to particular accounts. Materiality and Planning: Auditors use the concept of materiality as a guide (1) to planning the audit program, (2) to evaluation of the evidence, and (3) for making decisions about the audit report. Preliminary Analytical Procedures Analytical procedures must be applied in the beginning stages of each audit. Five general types of procedures for analysis of current year account balance are as follows: (1) compare to balances for one or more comparable periods. (2) Compare to anticipated results (budget and forecasts). (3) Evaluate relationships to other current-year balances for conformity with predictable patterns. (4) Compare with similar industry information. (5) Study relationships with relevant non- financial information. Analysis of Unaudited Financial Statements Analytical Procedures Analysis: There are two kinds of analysis of the unaudited financial statements: Horizontal analysis examines changes of financial statement number and ratios across two or more years. Vertical analysis examines financial statement amounts expressed each year as proportions of a base. Auditors look for relationships in accounts as indicators of problems and to plan further audit work. The analysis can also include: (1) Attention directing, pointing out accounts that may contain errors and frauds and help plan the audit program; (2) An organized approach, that begins with preliminary analytical procedures that can provide familiarity with the client’s business; (3) A description of the financial changes and relationships that can be seen in the data; (4) Asking relevant questions about what would account for the financial results being wrong, or having errors and frauds; and (5) Preparing a cash flow analysis to see the crucial information from operating, investment, and financing activities. Analytical Procedures Requirement: Analytical procedures are re quired at the beginning of an audit for planning, and at the end of an audit as part if the quality review. Planning Memorandum Auditors usually prepare a planning memorandum summarizing the preliminary analytical procedures and the materiality assessment with specific directions about the effect on the audit. All the planning becomes the basis for preparing an audit program, a specification of procedures that auditors use to guide the work of inherent and contro l risk assessment and to obtain sufficient competent evidence that serves as basis for the audit report. Audit Programs It has been stated that after those planning tools, the audit program should be planned. An audit program is a specification of procedures that guide to work for control risk & inherent risk and to obtain sufficient competent evidence that serves as the basis of the audit report. While assessing control risk & inherent risk, they will be based on preliminary risk assessments. While obtaining sufficient evidence that serves as the basis of the audit report, auditing team should develop the audit program. There are mainly two types of audit programs. An inte rnal control program contains procedures to obtain and understanding of the client’s business and management’s control structure, and for assessing the inherent and control risk. A balance-audit program contains substantive procedures for gathering direct evidence about the five assertions about dollar amounts in the account balances (i.e. existence, completeness, valuation, rights and obligations, presentation and disclosure). The audit procedures are intended to enable auditors to conduct the work in accordance with the three fieldwork standards concerning: planning and supervision of the audit, obtaining an understanding of the central structure and obtaining sufficient competent evidence. Developing Audit Program- Cycles in the Accounting System While developing the audit program, the auditors use cycles approach; in order to simplify the audit plan, auditors group the accounts into several cycles (a set of accounts that go together in an accounting system). These cycles are mainly: Revenue & Collection Cycle Acquisition & Expenditure Cycle Production & Payroll Cycle Finance & Investment Cycle By grouping the accounts, the auditor makes sufficient supervision and review the work done. 1) Revenue and Collection Cycle We will first explain the typical revenue and collection cycle, the specific accounts affected, and the elements of control within the cycle. The following includes special technical notes on the existence assertion, confirmations, and bank reconciliation auditing. It is important to recognize that the control objectives and management assertions introduced before should be applied to every cycle. The exact specification of the objectives and assertions will vary in each cycle, however. Revenue and Collection Cycle: Typical Activities The revenue and collection cycle includes transactions that flow through the following business activities: Receiving and processing customers orders, including credit granting. Delivering goods and services to the customers. Billing customers and accounting for accounts receivable. Collecting and depositing cash received from customers. Reconciling bank statements. Sales and Accounts Receivable The activities and transactions for the sales and accounts receivable control structure involve the following elements: (1) Authorization: Processing customers orders and granting of credit. (2) Custody: Physical custody of goods and accounts receivable records. (3) Recording: Produces shipping records and sales invoices. (4) Periodic reconciliation: Comparison of the sum of customers unpaid balances with the accounts receivable control account total. Cash Receipts and Cash Balances The activities and transactions for the cash receipts and cash balances control structure involve the following elements: (1) Authorization: Approving customers discounts and allowances. (2) Custody: Control and custody of the physical cash. (3) Recording: Accountants who record cash receipts and credits to customer accounts should not handle the cash. (4) Periodic Reconciliation: Bank accounts should be reconciled carefully. Control Risk Assessment Control risk assessment governs the nature, timing, and extent of substantive audit procedures that will be applied in the audit of the account balances in the revenue and collection cycle. These account balances include cash in bank; accounts receivable; allowance for doubtful accounts; bad debt expenses; sales revenue; and sales returns, allowances, and discounts. General Control Considerations 1. Proper segregation of responsibilities for authorization, custody, recording and reconciliation 2. Persons who handle cash should be insured under a fidelity bond 3. Provide for detail error-checking activities 4. Information about the control system can be gathered by (a) an internal control questionnaire, (b) a “walk-through” or a “sample of one.” Detail Test of Controls Audit Procedures An organization should have input, processing, and output control procedures in place and operating to prevent, detect, and correct accounting errors. The general control objectives (validity, completeness, authorization, accuracy, classification, accounting and posting, and proper period recording) must be related to the revenue cycle activities. Details tests of control procedures can be performed to determine whether controls are being performed properly. These include: (1) identification of the data population from which a sample will be selected for audit, and (2) the action to be taken to produce relevant evidence (the action involves vouching, tracing, observing, scanning, and recalculation). Test of controls audit procedures can be used to audit the accounting transactions in two directions: (1) Completeness: determines whether all transactions that occurred were recorded (none omitted). (2) Validity: determines whether recorded transactions actually occurred (were valid). Summary: Control Risk Assessment If control risk is assessed very low, then substantive audit procedures can be limited in cost-saving ways. If it assessed very high, then substantive procedures will need to be designed to lower the risk of failing to detect material errors in the account balances. A letter to the client should describe any “reportable conditions.” Special Note: The Existence Assertion When considering assertions and obtaining evidence about assets, auditors must put emphasis on the existence and rights (ownership) assertions. For liability accounts, the emphasis is on completeness and obligations assertions. The following audit procedures can be used to obtain evidence about the existence and ownership of accounts receivable and other assets: (1) Recalculation, (2) Physical observation, (3) Confirmation, (4) verbal inquiry, (5) Examination of Documents (Vouching), (6) Scanning, (7) Analytical procedures. Special Note: Using Confirmations In general, the use of confirmations for cash balances and trade accounts receivable is considered a required generally accepted audit procedure. Auditors may decide not to use confirmations if suitable alternatives procedures are available and applicable in particular circumstances. Justifications for not using confirmations include: (1) receivable are not material, (2) confirmations would be ineffective and unreliable, and (3) analytical procedures and other tests provide sufficient competent evidence. Confirmation of Cash and Loans balances Auditors should use a standard bank confirmation form approved by Minister of Finance. Confirmation of Accounts and Notes Receivable Two types of confirmations are used: (1) Positive confirmation: asks for a response, regardless of correctness of balance, (2) Negative confirmation: asks for a response only if something is wrong with the balance. Confirmations yield evidence about existence and gross valuation, bit not necessarily about the collectibility of the accounts. Special Note: Audit of Bank Reconciliations With Attention To Lapping and Kitting The company’s bank reconciliation is the primary means of valuing cash in the financial statements. A normal procedure is to audit the reconciliation. A cutoff bank statement is used by the auditor ro vouch the bank reconciliation items. Accounts Receivable Lapping Lapping is the process whereby an employee takes receipts and attempts to cover up by using later receipts to credit accounts of customers from which receipts were taken. To test for the possibility of stolen receipts, compare deposits slips to the detail of customers credits posted to customers accounts receivable. Check Kitting Check kitting is the practice of building up apparent balances in one bank account based on uncollected checks drawn against similar accounts in other banks. Test for check kitting by preparing a schedule of interbank transfers. Bank Transfer schedule and “Proof of Cash” The “proof of cash” is a reconciliation in which the bank balance, the bank report of cash deposited, and the bank report of cash paid are all reconciled to the clients general ledger. It is often used as a more extensive procedure to find check kitting. Audit Cases: Substantive Audit Procedures Auditors should not place total reliance on controls to the exclusion of substantive audit procedures. Substantive procedures are designed to obtain direct evidence about the dollar amounts in account balances, while test of control procedures are designed to obtain evidence about the company’s control activities. A dual-purpose procedure can be used for both purposes. The objectives in performing substantive procedures is to detect evidence of errors and frauds, and material overstatements or understatements of the account balance. The case illustrate the approach by first presenting the misstatement, followed by an “audit approach.” (1) Case Description: (a) Method: A cause of misstatement by some kind of failure of controls. (b) Paper trail: A set of telltale signs of erroneous accounting. (c) Amount: The dollar amount of overstated assets and revenue, or understated liabilities and expenses. (2) Audit Approach: (a) Audit objective: A recognition of a financial statement assertion for which evidence must be obtained. (b) Control: Recognition of the control procedures that should be used by an organization to prevent and detect errors and frauds. (c) Test of controls: Ordinary and extended procedures designed to test the effectiveness of the controls that should be in operation. (d) Audit of balance: Ordinary and extended substantive procedures designed to find errors and frauds in account balanc es and classes of transactions. 2) Acquisition and Expenditure Cycle In this cycle, we will learn the cycle for the acquisition of goods and services, the acquisition of property, plant, and equipment, and the expenditure of cash to pay for the acquisitions. The following includes control risk assessment, and special notes on the completeness assertion and physical inventory observation. Remember that the same general control objectives and management assertions should be applied to each cycle. Acquisition and Expenditure Cycle: Typical Activities The acquisition and expenditure cycle includes transactions that flow through the following business activities: (1) Purchasing goods and services. (2) Paying the bills. The activities and transactions of the acquisition and expenditure control system includes the following elements: (1) Authorization: Purchase requisition, order, and payment. (2) Custody: Receipt of goods, and supporting documents and records. (3) Recording: Record in accounts payable and cash accounts. (4) Periodic Reconciliation: Periodic comparison of existing assets to recorded amounts in various accounts. Control Risk Assessment Control risk assessment governs the nature, timing, and extent of substantive audit procedures that will be applied in the audit of the account balances in the acquisition and expenditure cycle. These accounts include inventory; fixed assets; depreciation expense; accumulated depreciation; accounts and notes payable; cash disbursements; and various administrative, selling, and manufacturing expenses. General Control Considerations 1. Proper segregation of responsibilities for authorization, custody, recording, and reconciliation 2. Persons who have custody of assets and cash disbursement authority should not do accounting. 3. Provide for detail control checking activities 4. Information about the control structure can be gathered by the use of an internal control questionnaire. Detail Test of Controls Audit Procedures An organization should have input, processing, and output control activities in place and operating to prevent, detect, and correct accounting errors. The general control objectives (validity, completeness, authorization, accuracy, classification, accounting, and proper period recording) must be related to the acquisition a nd expenditure cycle. Auditors perform detail tests of control audit procedures to determine whether controls are operating. The actions to be taken to produce the relevant evidence include vouching, tracing, observing, scanning, and recalculating. Details Test of Controls for Inventory Records Auditors need to determine whether they can rely on the accuracy of perpetual inventory records. Tests of controls over accuracy involve tests of the additions (purchases) and reductions (issues) of the item balances. A dual direction test of audit samples should be performed. Summary: Control Risk Assessment If the control risk is assessed very low, substantive audit procedures can be limited in cost-saving ways. If it is assessed very high, substantive procedures will need to be designed to lower the risk of failing to detect material misstatement in the account balances. A letter to the client should describe any “reportable conditions.” Special Note: The Completeness Assertion When considering assertions and obtaining evidence about accounts payable and other liabilities, auditors must put emphasis on the completeness and obligations assertions. The emphasis is on completeness because companies tend to be less concerned about recording expenses and liabilities. Auditors cannot rely entirely on the management assertion of completeness. The search for unrecorded liabilities is designed to yield audit evidence of liabilities that were not recorded in the reporting period. Special Note: Physical Inventory Observation The audit procedures for inventory and related cost of sales accounts frequently are extensive in an audit engagement. A material error or fraud in inventory has a pervasive effect on the financial statement. Auditing standards require that the auditor observe the inventory-taking and make test counts. They seldom take or count the entire inventory. Many physical inventories are counted at year-end when the auditor is present to observe and perform dual-direction testing to gather evidence for the existence and completeness assertions. Physical Inventory Not on Year-End Date The inventory on the count date is reconciled to the year-end inventory and auditing procedures are performed on purchases, inventory additions, and issues for the intervening period. Cycle Inventory Counting The auditor must be present during some counting operations to evaluate the counting plans and execution and must evaluate the accuracy of perpetual records. Auditors Not Present at Clients Inventory Count The auditor must review the clients plan for the completed count. Some test counts of current inventory should be made and traced to current records to determine reliability of perpetual records. Inventories Located Off the Clients Premises The auditor must determine the amount and location of the inventory off the client premises. If amounts are material and controls are not strong, the auditor may wish to visit locations and conduct on—site test counts. If amounts are not material, and control risk is low, direct confirmation with the custodian may be sufficient competent evidence. Inventory Existence and Completeness The physical observation procedures are designed to audit for existence, completeness, and valuation. Special Note: Finding Fraud Signs in Accounts Payable A company’s accounts payable and cash disbursements systems may be used by fraudsters to generate false payments. This may be done by sending false invoices to the company and having an insider manipulate controls or documents to make payment. Examples of the fraud signs auditors should look for include photocopies of invoices, vendors invoices submitted in numerical order, vendors invoices that are always in round numbers, and vendors invoices that are always slightly lower than a review threshold. Audit Cases: Substantive Audit Procedures The audit of account balances consists of procedural efforts to detect errors and frauds that might exist in the balances, thus making them misleading in financial statements. The cases present first the method, paper trail, and amount, followed by the audit approach, consisting of the audit objective, control, test of controls, and audit of balances. Self-Assessment True or False Questions: Indicate in the space provided if the following statements are true or fa lse. ___1. The basic acquisition and expenditure activities are (1) purchasing the goods and (2) paying the bills. ___2. Purchases are requisitioned by a purchasing department that seeks the best prices and quality ___3. Checks are signed by the accounts payable department after assembling the invoice, purchase order and receiving report. ___4. Purchase order are “open” from the time they are issued until the goods are received. ___5. Normally, liabilities should be recorded on the date the goods are received and accepted by the receiving department or by a responsible person. ___6. The audit “search for unrecorded liabilities” should emphasize the large balances, especially for regular vendors ___7. Auditors can inspect the “unmatched invoice file” and compare it to the “unmatched receiving report” file to determine whether liabilities are unrecorded. ___8. Proper segregation involves authorization of purchases by persons who do not have custody, recording, or reconciliation duties. ___9. If personnel in the organization are not performing their control procedures very well, auditors will need to design substantive audit procedures to try to detect whether control failures have produced misleading account balances. __10. If the control risk is assessed very low additional substantive audit procedures will be required. __11. Auditors emphasize the existence assertion when auditing liabilities because companies typically are less concerned about timely recording of liabilities than of revenues and assets. __12. Evidence is much easier to obtain to verify the completeness assertion for liabilities than the existence assertion for assets. __13. The search for unrecorded liabilities should normally be performed up to the report date in the period following the audit clients balance sheet date. __14. The audit procedures for inventory and related cost of sales accounts frequently are extensive in the audit engagement. __15. The auditors best opportunity to detect inventory errors and frauds is during the physical observation of the inventory count. 3) Production and Payroll Cycle We will learn the production and payroll cycle in two sections. Part I covers the production cycle, dealing with inventory valuation, depreciation, and cost of goods sold accounting. Part II covers the audit of payrolls and labor cost accounting. The following includes control risk assessment for the production and payroll cycle. As with all of the cycles, remember that the same general control objectives and management assertions apply. Part I: Production Cycle Typical Activities The production cycle includes transactions that flow through the following business activities: (1) Production planning, inventory planning and management. (2) producing goods and services. (3) Cost accounting and cost of goods sold determination. The activities and transactions for the production control structure involve the following elements: (1) Authorization: Production authorization based on sales forecasts interacts with production orders, bills of materials, materials requisitions. (2) Custody: Physical custody of materials, equipment and labor, and cost accounting records. (3) Recordkeeping: Determination of cost-per-unit, standard costs, and variances. (4) Periodic reconciliation: Periodic reconciliation of physical inventory to recorded amounts, analyses of internal production information. Control Risk Assessment Control risk assessment governs the nature, timing, and extent of substantive audit procedures that will be applied in the audit of the account balances in the production cycle. These accounts include raw materials inventory, work- in-process inventory, finished goods inventory, cost of goods sold, depreciation expenses, and accumulated depreciation. General Control Considerations 1. Proper segregation of responsibilities for authorization, custody, recording and reconciliation. 2. Custody of inventories in hands of persons who do not authorize or account for production. 3. Cost accounting performed by persons who do not authorize production or have custody of production assets. 4. Provide for detail control checking procedures 5. Complex computer systems may be used to manage production and materials flow. 6. Information about the control structure can be gathered by the use of an internal control questionnaire. Detail Tests of Controls Audit Procedures An organization should have input, processing, and output control activities in place and operating to prevent, detect, and correct accounting errors. The general control objective (validity, completeness, authorization, accuracy, classification, accounting and posting, and proper period recording) must be related to the production cycle. Auditors perform detail test of controls audit procedures to determine whether controls are operating. The actions to be taken to produce the relevant evidence include vouching, tracing, observing, scanning, and recalculating. Direction of the Test of Controls Procedure The test of controls procedures are designed to test the production in the following two directions: (1) Completeness: the recording of all the production that was ordered to be started. (2) Validity: proper recording of work in process and finished goods in the general ledger. Summary: Control Risk Assessment If the control risk is assessed very low, substantive a udit procedures can be limited in cost-saving ways. If it is assessed very high, substantive procedures will need to be designed to lower the risk of failing to detect material errors in inventory and cost of goods sold account balances. A letter to the client should describe any “reportable conditions.” Computerized production cycle records will require computer audit of balances. Audit Cases: Substantive Audit Procedures The audit of account balances consist of procedural efforts to detect errors and fra uds that might exist in the balances, thus making them misleading in financial statements. The cases present first the method, paper trail and amount, followed by the audit approach, consisting of the audit objective, control, test of controls, and audit o f balances. Part II: Payroll Cycle Typical Activities Personnel management and the payroll accounting cycle include transactions that affect the wage and salary accounts and a number of related accounts. The payroll cycle typically would include the following five functional responsibilities performed by separate people or departments. (1) Personnel and Labor Relations: hiring and firing. (2) Supervision: approval of work time. (3) Timekeeping and cost accounting: payroll preparation and cost accounting. (4) Payroll accounting: check preparation and related payroll reports. (5) Payroll Distribution: actual custody of checks and distribution to employees. The activities and transactions of the payroll control system involve the following elements: (1) Authorization: The personnel department, supervision, timekeeping, and cost accounting have authorization over their independent functions. (2) Custody: Possession of payroll checks, payroll distribution, supervision and timekeeping documents. (3) Recordkeeping: Payroll accounting prepares checks and related state and federal tax reports. (4) Periodic reconciliation: Payroll records and reports should be reconciled. (5) Employees on fixed salary: The control system is simplified by not having to collect timekeeping data. Control Risk Assessment The major risks in the payroll cycle are: (1) Paying fictitious “employees.” (2) Overpaying for time or production. (3) Incorrect accounting for costs and expenses General Control Considerations 1. Proper segregation of responsibilities for authorization, custody, recording, and reconciliation of payroll functions. 2. Custody of payroll distribution by persons who do not authorize employees pay or prepare payroll checks. 3. Recordkeeping is performed by payroll and cost accounting personnel who do not make authorizations or distribute pay. 4. Provide for detail control checking activities 5. Even in complex computer-based payroll systems, basic management and control functions should be in place. 6. Information about the control structure can be gathered by the use of an internal control questionnaire. Detail Test of Controls Audit Procedures An organization should have input, processing, and output control procedures in place and operating to prevent, detect, and correct accounting errors. The general control objectives (validity, completeness, authorization, accuracy, classification, accounting and posting, and proper period reporting) must be related to the payroll cycle. Auditors perform detail tests of control audit procedures to determine whether controls are operating. The actions to be taken to produce the relevant evidence involve vouching, tracing, observing, scanning, and recalculating. Direction of the Test of Controls Procedures The test of controls procedures are designed to test the payroll accounting in the following two directions: (1) Completeness: the matching of personnel file content to payroll department files and the payroll register. (2) Validity: preparation of the payroll register. Summary: Control Risk Assessment If the control risk is assessed very low, substantive audit procedures can be limited in cost-saving ways. If it is assessed very high, substantive procedures will need to be designed to lower the risk of failing to detect material errors in financial statements. Audit Cases: Substantive Audit Procedures The audit of account balances consist of procedural efforts to detect errors and frauds that might exist in the balances, thus making them misleading in financial statements. The cases present first the method, paper trail and amount, followed by the audit approach, consisting of the audit objective, control, test of controls, and audit of balances. 4) Finance and Investment Cycle The finance and investment cycle deals with the major activities of a typical business (1) obtaining funds to finance the operation either from lenders who become creditors or from investors who become owners, and (2) investing funds not immediately needed to finance operations. We will explain the flow of transactions of both the finance and investment activities, the accounts affected, and the elements of control within the cycle. The following includes control risk assessment for the financial and investment cycle. Financing and Investment Cycle: Typical Activities The finance and investment cycle major functions are: (1) Financial planning and raising capital. (2) Interacting with the acquisition and expenditure, production and payroll, and revenue and collection cycles. (3) Entering into mergers, acquisitions and other investments. Debt and Stockholder Equity Capital Transactions in debt and stockholder equity capital are normally few in number but large in monetary amount, and are handled by the highest level of management. The activities and transactions involve the following elements: (1) Authorization: Financial planning includes a cash flow forecast and capital budget. Authorizations for sale of stock and debt financing is usually at the board of director level. (2) Custody: Large companies use registrars and transfer agents for custody of the stock certificate book. Small companies keep their own stockholders records. Originals of debt instruments are held by lenders. (3) Recordkeeping: Notes, bonds payable, and calculated liabilities are maintained by accounting departments. (4) Periodic Reconciliation: Inspect and reconcile stock certificate book. Confirm bonds held by trustee. Investments and Intangibles Transactions in investments and intangibles may vary depending on the size and type of company. The activities and transactions involve the following elements: (1) Authorization: Investments approved by the board of directors or investment committee. (2) Custody: Custody of investments and intangibles depend on the nature of the assets. Some investments may be in physical custody, others in the form of “management responsibility.” (3) Recordkeeping: Investment and intangible recordkeeping will vary depending on complexity and nature. (4) Periodic Reconciliation: Inspect and count negotiable security certificates. Control Risk Assessment Because finance and investment transactions are usually individually material, each transaction usually is audited in detail. Reliance on control does not normally reduce the extent of substantive audit work on finance and investment cycle accounts. However, lack of control can lead to significant extended procedures. General Control Considerations 1. Responsibilities in the hands of senior management officials 2. Difficult to have strict segregation of functional responsibilities when senior management officials are involved 3. A compensating control feature involving two or more persons in each kind of important functional responsibility. Control ove r Accounting Estimates A clients management is responsible for making estimates and maintaining the controls designed to reduce the likelihood of material misstatements. Auditors test of controls over estimates amounts to inquiries and observations related to the specific features of estimates. Substantive audit procedures include procedures to determine whether (a) the valuation principles are acceptable under the general accounting principles (b) the valuation principles are consistently applied, (c) the valuation principles are supported by the underlying documentation, and (d) the method of estimation and the significant assumptions are properly disclosed according to the laws. Summary: Control Risk Assessment The involvement of senior officials in a relatively small number of high-dollar transactions makes control risk assessment a process tailored specifically to the company’s situation. Substantive audit procedures are not limited in extent. Control deficiencies and unusual or complicated transactions can adjust the nature and timing of the audit procedures. Assertions, Substantive Procedures, and Audit Cases The audit of three sections: (1) owners’ equity, (2) long-term liabilities and related accounts, and (3) investment and intangibles are presented. The audit of the account balance consists of procedural efforts to detect errors and frauds that might exist in the balances, thus making them misleading in financial statements. The cases present first the method, paper trail and amount, followed by an audit approach, consisting of the audit objective, control, test of controls, and audit of balances. Owners Equity The typical specific assertions include: 1. The number of shares shown as issued is in fact issued. 2. No other shares have been issued and not recorded or reflected in the accounts and disclosures 3. The accounting is proper for options, warrants, and other stock plans and related disclosures are adequate. 4. The valuation of shares issued for non-cash consideration is proper, and in conformity with accounting principles 5. All owners equity transactions have been authorized by the board of directors. Documentation: Owners equity transactions are well documented (e.g., board of directors minutes, proxy statements) and transactions can be vouched to these documents. Confirmation: Capital stock may be confirmed when independent registrars and trans fer agents are employed. When there are no independent agents, most audit evidence is gathered by vouching stock record documents. Long-Term Liabilities and Related Accounts The primary audit concern is that all liabilities are recorded and that the interest expense is properly paid or accrued. The assertion of completeness is paramount. The typical specific assertions include: 1. All material long-term liabilities are recorded 2. Liabilities are properly classified according to their current or long-term status 3. New long-term liabilities and debt payments are properly authorized 4. Terms, conditions, and restrictions relating to non-current debt are adequately disclosed. 5. Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate. 6. All important contingencies are either accrued in the account or disclosed in footnotes. Confirmation: When auditing long-term liabilities, auditors usually obtain independent written confirmation for notes and bonds payable. Off-balance Sheet Financing: Confirmation and inquiry procedures may be used to obtain responses for off-balance sheet information including off-balance sheet commitments. Analytical Relationships : Analytical relationships exist for debt, recorded interest expense and accrued interest accounts. The auditor can compare audit results with recorded interest to identify unrecorded debt and errors in interest accounts. Deferred Credits- Calculated balances: Several types of deferred credits depend on calculations for their existence and valuation and should be recalculated for accuracy. Investments and Intangibles Companies can have a wide variety of investment and relationship with affiliates. The typical specific assertion includes: 1. Investment securities are on hand or held in safekeeping by a trustee 2. Investments are properly valued 3. Controlling investments are accounted for by the equity method 4. Purchased goodwill is properly valued 5. Capitalized intangible costs relate to intangible acquired in exchange transactions 6. Research and development costs are properly classified 7. Amortization is properly calculated 8. Investment income has been received and recorded 9. Investment are adequately classified, described and disclosed in the balance sheet Confirmation: The practice of obtaining independent written confirmation from outside parties is limited in the investment, intangible, and related accounts Inquires about Intangibles: Company counsel can be queried about knowledge of any lawsuits, and legal questions in a specific attorneys letter. Income from Intangible : Income from intangibles can be confirmed or vouched, depending on the intangible. Inspection: Investment property may be inspected to determine existence and conditions of the property. Documentation Vouching: Investment property may be inspected to determine existence and conditions of the property External Docume ntation: Market value of securities and related income can be determined from external sources. Equity method Investment: When equity method accounting is used for investments, auditors need to obtain audited financial statements of the investee company for recalculating the amount of the clients share of income to recognize in the accounts. Amortization Recalculation: Amortization of goodwill and other intangibles should be recalculated. Inquiries about Management Intentions: Inquiries should be held with management to determine the nature of investments and reasons for holding them. Self-Assessment True or False Questions: Indicate in the space provided if the following statements are true or false. ___1. Financial planning starts with the chief financial officers capital budget ___2. Sales of capital stock and debt financing transactions usually are authorized by the board of directors ___3. In large companies, custody of stock certificate books is a significant management problem. ___4. Ownership of bonds can be handled by a trustee having duties and responsibilities similar to those of registrars and transfer agents ___5. All investment policies should be approved by the board of directors or its investment committee. ___6. the most significant reconciliation opportunity in the investment and intangible accounts is the inspection and count of negotiable securities ce rtificates. ___7. reliance on controls normally reduces the extent of substantive audit work on finance and investment cycle accounts. ___8. the segregation of functional responsibilities is relatively easy for the finance and investment cycle ___9. auditors test of controls over the production of estimates amounts to inquiries and observations __10. it is very common for auditors to perform substantive audit procedures on 100 percent of the details in finance and investment accounts. __11. when there are no independent agents, most audit evidence about capital stock is gathered by confirmation directly with the holders __12. owners equity transactions usually are not well documented __13. The primary audit concern with the verification of long-term liabilities is that all liabilities are recorded and that the interest expense is properly paid or accrued. __14. when fixed assets are acquired during the year under audit, auditors should inquire about the source of funds for financing the new asset. __15. Confirmation requests should be sent only to lenders with a liability balance at the audit date __16. Confirmation and inquiry procedures are not required for a class of items loosely termed off-balance sheet information. __17. Interest expense generally is audited primarily by analytical procedures. __18. Purchase-method consolidations usually create problems of accounting for the fair value of acquired assets and related goodwill. __19. The practice of obtaining independent written co nfirmation from outside parties is fairly limited in areas of investments and intangibles. __20. the balance sheet classification of investment by management should be confirmed with outside parties. Auditors Working Papers An audit must document the audit procedures performed to support the understanding, tests, and evaluation of risks and the substantive tests performed directly on the amounts and disclosures shown in the financial statements. This evidence is accumulated in files of audit working papers. Although the term working papers suggests paper documents, much audit evidence now exists only in electronic files. A number of accounting firms are now developing paperless auditing systems. Spreadsheets, text, checklists, and other evidence are prepared and saved in an electronic format. Even confirmation letters from outside parties can be electronically scanned into the audit files. The term working papers is used here to include all audit documentation, both electronic and paper. Working papers are records kept by the auditor of the procedures applied, the tests performed, the information obtained, and the pertinent conclusions reached in the engagement. Working papers should be sufficient to show that the financial statements or other information on which the auditor is reporting were in agreement with the client’s records. Listed below are general guidelines as to what working papers should include: i. The work has been adequately planned and supervised, indicating observance of the first standard of fieldwork. ii. A sufficient understanding of the internal controls has been obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed, indicating observance of the second standard of fieldwork. iii. The audit evidence obtained, the auditing procedures applied, and the testing of performed has provided sufficient component evidential matter to afford a reasonable basis for an opinion, indicating observance of the third standard of fieldwork. Reasons for audit working papers I. Reporting partner needs to be able to satisfy himself that work delegated by him has been properly performed. II. Working papers provide, for future reference, details of problems together with evidence of audit and conclusions in arriving at the audit opinion. III. The preparation of working papers encourages the auditor to adopt a methodical approach. IV. To use working papers in the following years. In summary, properly prepared working papers are necessary for an auditor to demonstrate compliance with the standards of fieldwork. They should show how the work was planned (e.g. the use of audit programs) and the extent of supervision of assistants (indication of reviews made by the auditor). They should contain sufficient, competent evidence (e.g. control risk checklists, confirmations from creditors, bank reconciliations) on which to base an opinion. Contents of working pape rs a. Information of continuing importance of audit b. Audit planning information including the audit program. c. The auditor assessment of the company's accounting system, his review and evaluation of internal control. d. Details of audit work, notes of errors, action taken together with the opinion of the staff. e. Evidence with the staff review. f. Records of balances, other financial information including analyses and summaries of the financial statements. g. A summary of significant points effects the financial statements and audit report preparations. Types of Working Pape rs Auditors normally maintain two types of working paper files. One is referred to as a permanent or continuing audit file, and the other often is called the current-year audit file. Permanent Audit Files The permanent audit file is composed of documents, schedules and other data that will be of continuing significance to several years’ audits. For example, an auditor must obtain a copy of a client’s articles of incorporation as evidence of the types (common and preferred), par values, and number of authorized shares of stock that the company may issue, as well as restrictions on payment of dividends, purchase of treasury stock, or other matters requiring disclosure in the financial statements. Rather than obtaining a copy of the same document each year, the auditor places one copy in the permanent file, which is a part of each year’s audit evidence. Of course, it is necessary to check each year for any amendment to the articles of incorporation and to indicate any changes on the document in the permanent file. Amendments normally would be detected by the auditor during his or her review of minutes of stockholders’ and directors’ meetings, because approval is generally required by one or both of these parties. Although the organization of permanent files varies, most would contain the following sections: 1) Historical information regarding the client: This section usually includes a memorandum describing the company and its operations, major plants and manufacturing processes, and products, distribution facilities, and important customers. An organizat ion chart listing the names and positions of key officers and employees and any recurring audit administrative matters are also shown. This type of information is particularly important to auditors assigned to a client for the first time. It allows them to learn something about the operations of the company in a brief period of time and makes them aware of any unusual matters concerning the audit, such as timing deadlines and reporting requirements. The client is saved the task of acquainting different members of the auditing firm with basic information about the company. A partial example of such a memorandum is shown in Illustration 2. Illustration 2: X Co. Company Operation and Audit Administration Memo X Co. was formed in 19X0 by Mr. Fitzgerald and Mr. Hamilton, both of who remain 50% stockholders. X Co. operates a 40,000-barrel per day refinery near Granville, Arkansas (also the location of its administrative offices), at the intersection of Highways 65 and 71. The President and Plant Manager is Mr. Foote and the Treasurer, with whom we arrange the timing of our work, is Ms. Johnson. The company acquires most of its raw materials (crude oil) in the open market and is subject to the regulations of the Department of Energy (a copy of the DOE regulations is filled behind this memo). The crude oil is refined into premium and regular gasoline, which is sold to a chain of independent gasoline stations. The company reports on a December 31 fiscal year. Out audit report is to be delivered to the shareholders by February 10. In the past we have experienced difficulty and delay in obtaining confirmation of a significant accounts receivable from the chain of independent gasoline stations, so we must be sure to mail the confirmation at the earliest possible date and include sufficient details to …………. By regarding the memorandum, an auditor who had never worked on the X Company engagement would know where the company is located and what it does, whom to contact at the company, what some of the important reporting and timing requirements are, and that he or she would need a knowledge of regulations in the auditing about the company. 2) A description of the entity’s internal controls: This material might consist of narrative descriptions of the client’s control environment, accounting and control procedures, internal control questionnaires, flowcharts, decision tables, or any combination of these items. A chart of accounts and samples of any records that would aid in understanding company procedures may also be included. A brief example of a description of accounting procedures to notes payable and long-term debt is shown in Illustration 3. Illustration 3: X Co. Procedures for Notes Payable and Long-Term Debt X Co. has outstanding a $5 million issue of 8% bonds due in installments of $500,000 per year beginning in 20X2. All refinery property and equipment is pledged to these bonds. The bond indenture restricts payment of dividends of $200,000 per year. The company also borrows on short-term notes for working capital purposes. All borrowings are authorized by the Board of Directors, and the banks or other creditors are specifically mentioned. Both the President and the Treasurer must sign any notes that are issued. The Treasurer maintains a schedule showing the due dates of all bond, note, and interest payments………. 3) Legal Documents: In addition to the articles of incorporation, the permanent file normally contains copies of loan agreements, bond indentures, labor contracts, stock option plans, pension plans, important long-term operating agreements or contracts, and other documents. Because all of these documents could significantly affect the company’s operations and its financial statements, the auditor must have evidence of the provisions of these documents and his or her reviews thereof. 4) Continuing analyses of certain accounts: It is often more efficient to maintain cumulative schedules in the permanent files for certain accounts with little activity, or for which comparisons with several prior years are helpful, than to prepare such schedules each year in the current files. Continuing analysis might be used for capital stock, long- term debt, checklists for compliance with loan agreements, equity in earnings of subsidiaries, and gross profit ratios by major product class. An illustration of such an analysis is shown in Illustration 4. Illustration 4: X Co. Analyses of Uncollectible Accounts 19X6 19X7 19X8 19X9 Sales $4,365,000 $5,837,000 $5,679,000 $5,928,000 Bad debt provision 54,000 68,000 63,000 71,000 Bad debt charge-offs 54,000 67,000 63,000 91,000 Accounts receivable balance 12- 31 Current $372,000 $498,000 $501,000 $530,000 30-60 days 31,000 54,000 53,000 57,000 Over 60 days 2,000 19,000 16,000 52,000 Total $405,000 $571,000 $570,000 $639,000 Allowance for doubtful accounts $30,000 $35,000 $35,000 $15,000 Ratios- Bad debt charge-offs to sales 1,2% 1,1% 1,1% 1,5% Allowance to total accounts 7,4% 6,1% 6,1% 2,3% receivable Allowance to accounts 15,0 1,8 2,2 0,3 receivable over 60 days Days’ sales in accounts 33,9 35,7 36,6 39,3 receivable This analysis should alert the auditor that there has been deterioration in accounts receivable during the year, and it should raise a question as to the adequacy of the allowance for doubtful accounts. 5) Audit planning: This section would include a master copy of the audit program (often on computer diskettes) that could be revised and copied each year than completely written; schedules of plant capacity and volumes of tanks, bins and other containers (an auditor would be embarrassed to discover, after being satisfied as to inventory, that his or her client didn’t have the physical capacity to store the amount of inventory shown in the accounting records), and if certain procedures are performed on a rotating basis, a record of the accounts (cost centers, bank accounts, etc.) or locations (branch offices, subsidiaries, etc.) tested each year to ensure that nothing is overlooked. The permanent audit file can be very useful tool of the auditor if it is kept current and used. Occasionally, in his or her haste of complete the current-year audit, an audit will neglect to review and update the permanent file. When this happens, the file becomes less useful and less used each succeeding year, until it becomes a file of obsolete data. At that point, it becomes less than useless to the auditor; it becomes a threat because it is evidence of negligent and inadequate work. Curre nt Audit Files The current audit files for each year contain the evidence gathered and the conclusions reached in the audit for that year. The material in the current files includes schedules and analyses of accounts; memoranda of audit work performed and audit problems considered and resolved; an audit program; correspondence with third parties (banks, customers, creditors, legal counsel, etc.) confirming balances, transactions and other data, and other documents.