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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.
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