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Auditing 8e SM Ch08 Final R
Principles of Auditing (Mount Royal University)
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Six basic types of evidence and six general techniques to gather it: (1) inspection, (2) observation, (3) confirmation,
(4) recalculation/reperformance, (5) analysis, and (6) inquiry.
External authoritative documents are prepared or validated by other parties and sent to the auditee. Even though
these are internal sources of audit evidence, they will contain original signatures, seals, engravings and other
distinctive stylistic formal attributes that make them less susceptible to alteration by the auditee, and thus more
reliable and convincing as audit evidence. Ordinary documents prepared by outsiders that could easily be forged or
altered in ways that the auditor could not easily detect are less reliable source of documentary audit evidence.
“Vouching” means the examination of documents. Generally, an item of financial information is selected from an
account, and the auditor then goes backward through the bookkeeping-filing system to find the source
documentation which supports the item selected.
“Tracing” essentially is the opposite direction compared to “vouching.” In the process of tracing, the auditor selects
sample items of basic source documents and proceeds forward through the bookkeeping process to find the final
recording of the accounting transactions.
“Scanning” refers to the auditor’s scrutinizing documentation or bookkeeping records (account details or entries in
journals) for unusual items and events.
Strengths of computation-based evidence from recalculations are its reliability and objectivity. Limitation is the that
its results are only as good as the underlying components the auditor uses in the computations, as these still need
to be audited to ensure they are reliable.
Strengths of observation are objectivity, but a limitation is that it only provides evidence at the time of the auditor’s
observation not other times. If people know the auditor is watching they may perform differently than they usually
do. Another weakness that the evidence is a function of the observer’s judgment and ability to properly assess
what is being observed, which could be biased or ill-informed.
Auditors need to control the entire confirmation process so there is no opportunity for the auditee to alter the
confirmation requests or responses.
Auditors can help the effectiveness of confirmation requests by:
Having the confirmation letters printed on the auditee’s letterhead and signed by an auditee officer.
Being careful to be assured of reliable addresses for recipients; that is, being assured that the confirmations
are not misdirected (for example, to an auditee’s accomplices in fraud).
Asking confirmation of information that recipient can supply, like the amount of a balance or the amounts of
specified invoices or notes (not the balances of homeowners’ mortgages or financial amounts, like
certificates of deposit with accrued interest, for which people usually do not keep their own accounting
Controlling the mailing and return of confirmations so the auditee cannot tamper with them.
Receiving the reply directly, so the auditee cannot intercept and alter them.
Following up on any confirmations that have no response to determine the reason. This may indicate a
customer that does not exist.
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Analysis consists of identifying the components of a financial statement item or account to on the basis of
particular characteristics that are relevant to designing analytical or other audit procedures; studying meaningful
relationships among components of financial and non-financial information to form expectations about what
amounts recorded in the accounts should be; comparing such expectations with the recorded amounts to identify
inconsistencies ; and using the results of this comparison to help determine what, if any, other audit procedures are
needed to obtain sufficient appropriate audit evidence that the recorded amounts are not materially misstated.
[CAS 520]
Analysis is used at:
the planning stage to identify risks and guide the design of audit work
the field work stage as substantive procedures for generating evidence
the end of the audit as an overall review and evaluation when forming a conclusion as to whether the
financial statements as a whole are consistent with the auditor’s understanding of the business as the basis
of the audit opinion.
Information sources for analysis include:
Financial account information for comparable prior period(s).
Company budgets and forecasts.
Financial relationships among accounts in the current period.
Industry statistics.
Nonfinancial information from the company’s information systems.
When analysis is used to provide substantive evidence, auditors need to use independent, reliable information to
perform the analytical procedures. Thus, the sources of information need to be assessed for independence and
objectivity. Quantitative information must be verified by the auditor if a high level of reliance is placed on the
evidence provided by analysis.
Analysis can be very effective because it integrates evidence from a variety of information sources and often
provides an independent way of providing evidence about whether the financial statement assertions hold true,
i.e., it can corroborate other evidence. Analysis also allows the auditor to assess or detect unusual or unexpected
patterns in account relationships, making it an effective risk assessment procedure as well as a revealing risk
response procedure.
Methods and sources of information for understanding an auditee’s business and industry:
Inquiry, Including Prior Working Papers--prior audit working papers, personnel who worked on the audit in prior
years are available to convey their understanding of the business, inquiry and interviews with the company’s
management, directors, and audit committee.
Observation--take a tour of the company’s physical facilities, keeping eyes open for activities and things that should
be reflected in the accounting records. The tour is the time to see company personnel in their normal workplaces.
Study. Numerous sources--CPA-Canada and AICPA industry accounting and auditing guides, specialized trade
magazines and journals, registration statements and Annual Reports filed with the securities market regulators,
general business magazines and newspapers (Financial Post, Report on Business, Business Week, Forbes, Fortune,
Harvard Business Review, Barron’s, and the Wall street Journal).
Experts are needed in audits where the auditors need understanding and evidence that can only be obtained by
consulting with persons skilled in fields other than accounting and auditing, such as actuaries, appraisers, legal
counsel, engineers, chemists and geologists. When using evidence from experts as audit evidence, the auditor is
required to ensure the expert has appropriate professional qualifications and a good reputation.
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Internal audit programs may be used to determine strength of internal controls and the performance of the
business process in relation to corporate strategy. This information can increase external audit efficiency and
improve design of the external audit program. Further, being able to utilize existing work of internal auditors can
allow external auditors to increase audit efficiency (so long as CAS 610 requirements are adhered to).
The auditor requires evidence to judge rationally the financial statement assertions in management’s financial
statements. If evidence does not relate to one of the management assertions, the evidence is not relevant to the
auditor. Sufficient audit evidence refers to quality and relates to gathering enough audit evidence to support the
assertions and audit decisions must be based on enough evidence to stand the scrutiny of other auditors; whereas
appropriate audit evidence refers to its qualitative aspects: is it relevant and reliable? Evidence that is relevant and
highly reliable is persuasive as proof regarding the financial statement assertions. For assertions that have a high
risk of material misstatement, auditors need the most persuasive evidence they can get. Further, relevant audit
evidence means that it must relate logically to at least one of the financial statement assertions; otherwise it is not
relevant to the auditor.
To be considered appropriate, evidence must be relevant and reliable. To be relevant, audit evidence must relate to
at least one of the assertions. The reliability of audit evidence depends on its nature and source. The hierarchy of
evidence reliability indicates the range from the strongest and most reliable (physical observation and
computation) to the weakest and least reliable (management representations).
Judgment is applied to decide what is the most persuasive evidence that can be obtained in a cost-effective manner
relative to a particular audit objective. Trade-off may be required if audit evidence that would be highly reliable and
relevant is prohibitively costly. For example, if we wait till all the accounts receivable are collected we have 100%
assurance that they existed and were correctly valued, but this evidence is impossible to obtain as it would take a
very long time. In situations where no highly reliable single source of evidence is available, the auditor uses
judgment to decide whether there may be two or more less reliable pieces of evidence that, when evaluated
together, are adequate to support the assertion. Good professional judgment is required to make the decision on
what is appropriate, sufficient evidence in a particular audit.
External documentary evidence is evidential matter obtained from the other party to an arm’s-length transaction
or from outside independent agencies. External evidence reaches the auditor directly and does not pass through
the hands of the auditee.
External-internal documentary evidence is documentary material that originates outside the bounds of the
auditee’s data processing system but which has been received and processed by the auditee.
Internal documentary evidence consists of documentary material that is produced, circulates, and is finally stored
within the auditee’s information system. Such evidence is not touched by outside parties at all or is several steps
removed from third-party attention.
Inspection of documents and inspection of physical assets: because it allows the auditor to see if there are true
amounts to help ascertain that the asset/liability/equity actual exists. External confirmation helps the auditor
ascertain the existence assertion because a third party is confirming the balance. Recalculation performed by the
auditor allows the auditor to gain comfort that the amount calculated is not only accurate but therefore actually
exists and belongs on the statement. From auditors inquiring with management and employees, they can gain
comfort if an asset/liability/equity exists. A simple “How many printers does your company have?” can allow the
auditor to know there are three assets for example and they indeed exists
If an auditor has not been able to obtain sufficient appropriate audit evidence about a material financial statement
assertion, CAS 330 states that the auditor should express a qualified opinion or a disclaimer of opinion.
Some key components of audit programs include:
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Communicate with predecessor auditors (for new engagements). This is a good starting point to gain an
understanding of the business, industry, controls etc. It is further helpful in leveraging documentation as a
starting point.
Examine prior-year audit working papers, professional audit and accounting guides, and industry publications
concerning the company and its industry. This process provides valuable insights into key entity characteristics,
likely risk areas, findings, and evidence relevant to the current year’s financial statements, such as the audited
opening balances. Auditors need to make necessary updates based on changes from the year; external guides
provide valuable information on industry and business changes that will need to get incorporated for the
current year audit.
Interview management regarding business risks, processes and controls, accounting policies, and any
significant changes in the current year. This provides a starting point for a general idea on the business and
industry, risk controls and processes; also sheds light on management competency
One type of audit program is called the “internal control program,” and its objective is to guide the work involved
Obtaining an understanding of the auditee’s business and industry.
Obtaining an understanding of management’s control structure.
Assessing the inherent risk and the control risk related to the financial account balances.
The other type of audit program is called the “balance-audit program,” and its objective is to specify the
substantive procedures for gathering direct evidence on the assertions (i.e. existence, completeness, valuation,
rights and obligations, presentation and disclosure) about dollar amounts in the account balances.
The nature of audit procedures refers to their identification with one of the general types of procedures-recalculation, physical observation, confirmation, verbal inquiry, examination of documents, scanning, and
analytical procedures.
The extent of the application of procedures usually refers to the sample sizes of data examined, such as the number
of customer accounts receivable to confirm, or the number of inventory types to count. In audit sampling
applications, there is also a decision related to extent of which items to select from the population of items
sampled. Extent may also refer to how frequently a scanning procedure is performed, e.g. review all sales entries
for four days in each of four months.
The timing of audit procedures refers to when they are performed, usually at (1) interim, at (2) year-end, or after
year end during the field work. However, timing may have other aspects such as surprise procedures (unannounced
to auditee personnel).
Audit file working papers contain the documentation that supports the decisions regarding procedures necessary in
the circumstances and all other important decisions made during the audit. They are the auditors’ proof they
complied with generally accepted auditing standards and hence are support for the value of the audit to outsider
users who rely on audited financial statements. The situation when Andersen was found destroying audit working
papers for an auditee under SEC investigation, Enron, shows the impact of documentation on the reputation of the
audit firm and the value of an audit.
In the permanent audit file:
Copies or excerpts of the corporate or association charter, bylaws, or partnership agreement.
Copies or excerpts of continuing contracts such as leases, bond indentures, and royalty agreements.
A history of the company, its products, markets and background.
Copies or excerpts of stockholders, directors, and committee minutes on matters of lasting interest.
Continuing schedules of accounts whose balances are carried forward for several years, such as owners’
equity, retained earnings, partnership capital and the like.
Copies of prior years’ financial statements and audit reports.
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Permanent audit file documents contain information of continuing interest over many years’ audits of the same
auditee, such as articles of incorporation, shareholder agreements and long-term contracts. Financial or other
information in the current year that is related to these agreements and contracts will be verified by comparing to
these permanent records.
Audit administration papers filed in the current working paper file (usually in the first part of the file).
Engagement letter.
Staff assignments.
Auditee organization chart.
Memoranda of conferences with management.
Memoranda of conferences with the director’s audit committee
Preliminary analytical review notes.
Initial risk assessment notes.
Initial materiality assessment notes.
Engagement planning memorandum/Overall Audit Strategy document
Audit engagement time budget.
Internal control questionnaire and control analyses.
Management controls questionnaire.
Computer control questionnaire.
Internal control system flow charts.
Audit program.
A working trial balance of general ledger accounts.
Working paper record of preliminary adjusting and reclassifying entries.
Memoranda of review notes and unfinished procedures (all cleared by the end of the field work.)
The most important aspect of the current audit evidence papers is the requirement that they show the audit
decision problems and their conclusions. These papers must record the proposition to be audited, the evidence
gathered, and the final decision. The working papers should demonstrate satisfaction of the field work standards
and provide support for the audit report.
Indexing allows for each section to be given to different audit team members and for easy expansion within a given
section without affecting other sections. Cross-indexing documents the connections between different accounts
and transaction streams that are audited in different sections of the file so the links can be followed by other audit
team members or by the audit supervisor or manager who is reviewing the working papers.
Software is used in public practice to prepare audit documentation files, automate tasks (carrying adjustments),
access, review, and change the format, content, or order of the files. Audit working paper software also facilitates
analysis by establishing links to other databases. Quality control considerations related to use of audit
documentation software include hardware and software integrity, access security, staff training, documentscanning procedures, and continuous upgrades.
MC 8-1 [LO4] An audit program contains:
a. specifications of audit standards relevant to the financial statements being audited.
b. specifications of procedures the auditors believe appropriate for the financial statements under audit.
c. documentation of the assertions under audit, the evidence obtained, and the conclusions reached.
d. reconciliation of the account balances in the financial statements with the account balances in the auditee’s
general ledger.
MC 8-2 [LO2] When auditing the existence assertion for an asset, auditors proceed from:
a. the financial statement numbers back to the potentially unrecorded items.
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b. the potentially unrecorded items forward to the financial statement numbers.
c. the general ledger back to the supporting original transaction documents.
d. the supporting original transaction documents to the general ledger.
MC 8-3 [LO2] The objective in an auditor’s review of credit ratings of an auditee’s customers is to obtain evidence related to
management’s assertion about:
a. compliance.
b. existence.
c. ownership.
d. valuation.
MC 8-4 [LO3] Sarah, a Senior Manager from an audit firm, D&F LLP, is coaching her staff accountants on the hierarchy of
audit evidence. At the end of the session, she quizzes the team and asks "What types audit evidence is considered the
most reliable?"
a. External-internal documentation, internal documentation (with good internal controls), Observation, Analytical
b. Internal documentation (poor internal controls), inquiry, Broad analytical procedures.
c. Internal documentation (with good internal controls), Inquiry, Broad analytical procedures.
d. Recalculation/reperformance, External documentation, Confirmation, Physical inspection.
MC 8-5 [LO3] The evidence considered most reliable by auditors consists of:
a. internal documents, such as sales invoice copies produced under conditions of strong internal control.
b. written representations made by the president of the company.
c. documentary evidence obtained directly from independent external sources.
d. direct personal knowledge obtained through physical observation and mathematical recalculation.
MC 8-6 [LO2] Confirmations of accounts receivable provide evidence primarily about these two assertions:
a. Completeness and valuation
b. Valuation and ownership
c. Ownership and existence
d. Existence and completeness
MC 8- 7 [LO-3] Obtaining sufficient audit evidence over the sales of a given company means that the auditor
a. tested all sales transactions for the given period
b. tested more than 50% of the sales transactions for the given period
c. tested a reasonable sample of sales transactions for the given period
d. tested only the sales transactions with an amount higher than the materiality
MC 8-8 [LO5] An audit working paper that shows the detailed evidence and procedures regarding the balance in the
accumulated depreciation account for the year under audit will be found in the:
a. current file evidence working papers.
b. permanent file working papers.
c. administrative working papers in the current file.
d. planning memorandum in the current file.
MC 8-9 [LO5] An auditor’s permanent file working papers would most likely contain:
a. internal control analysis for the current year.
b. the latest engagement letter.
c. memoranda of meetings with management.
d. excerpts of the corporate charter and bylaws.
MC 8-10 [LO1] Mary is working on the audit of Stellar Productions Inc. Today she is touring the factory with the production
manager, and she is discussing the procedures for recording the flow of goods through the production process with
various factory employees. Mary is applying which kinds of audit evidence techniques?
a. Inquiry and inspection.
b. Observation and confirmation.
c. Observation and documentation.
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d. Inquiry and observation.
MC 8-11 [LO1] Jim is performing the following auditing procedures related to revenues: i) Obtaining production records of
physical quantities sold and calculating an estimate of sales dollars based on average sale prices; ii) Comparing
revenue dollars and physical quantities with prior-year data and industry economic statistics. Which types of evidence
gathering procedures is Jim using?
a. i) observation; ii) confirmation
b. i) recalculation; ii) analysis
c. i) recalculation; ii) inspection vouching
d. i) analysis; ii) analysis
MC 8-12 [LO1] PV Properties Inc. records its real estate investment properties at fair value under IFRS. Chiara is performing
the following procedures as part of the audit program for the valuation assertion for this asset: (i) For investment
property valued at fair value, examine and verify appraisal reports that PV’s CFO has obtained from an independent
professional real estate valuator. (ii) Summarize the additions and disposals recorded in PV’s detailed investment
property subsidiary records, and agree the balance to the general ledger control account. Which types of evidencegathering procedures is Chiara using?
a. i) confirmation; ii) inspection (scanning)
b. i) recalculation/reperformance; ii) analysis
c. i) inspection (vouching); ii) recalculation/reperformance
d. (i) confirmation; (ii) recalculation/reperformance
MC 8-13 [LO1] Daniel, a junior auditor, attended the inventory count of Flo’s Office Depot, a large retailer of office supplies
and electronics. Daniel watched Flo’s employees doing the count and reported on whether or not the inventory
count’s directives were followed. The above procedure is an example of:
a. Inspection
b. Observation
c. Reperformance
d. Analysis
MC 8-14 [LO1] As part of the review of McMaster Auto Parts, Ruben met with the CEO to obtain an explanation for their
decreasing gross margin percent for this year as compared to last year. The above procedure is an example of
a. Confirmation
b. Inquiry
c. Observation
d. Reperfomance
Audit procedures
Types of procedures used by auditors in general, with examples:
Recalculation by the auditor
recomputing the auditee’s calculation of depreciation expense
Observation by the auditor
observation, test-counting of auditee’s physical inventory-taking
Confirmation by letter
obtaining accounts receivable confirmations
obtaining auditee’s lawyer’s letter
Inquiry and written representations
ask auditee personnel about accounting events
complete an internal control questionnaire
obtain written representation letter from auditee management
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find brokers’ invoices and cancelled checks showing agreement with record amounts for securities
select a sample of shipping documents and trace them to sales invoices, sales journal recording and
posting to general ledger
scan expense accounts for credit entries
scan payroll check lists for unusually large checks
Analytical procedures--any example that fits one of these:
compare financial information with prior periods
compare financial information with budgets and forecasts
study predictable financial information patterns (e.g., ratio analysis)
compare financial information to industry statistics
study financial information in relation to nonfinancial information
Potential Audit Procedure Failures
This is a very open-ended discussion topic. Students’ responses could be quite varied depending upon their
experience and imagination. The best classroom strategy is to start with one of the procedures, then list the
students’ suggestions on the chalkboard. The discussion can become very lively!
Confirmation procedure
An audit confirmation is a written statement to the PA from someone outside the enterprise on a fact which
that person is qualified to affirm.
The two main characteristics a confirmation should possess are:
The party supplying the information requested must be knowledgeable and independent, i.e., he
must have knowledge of information of interest to the auditor and he must be outside the scope of
influence of the organization being audited, and
The auditor must obtain the information directly from the informed party.
Audit Procedure Terminology
Scanning for debit balances in accounts payable
Recalculation of amounts on supporting documents
Vouching of account entries to supporting documents
Vouching of policies from expense and prepayment entries
Recalculation of expiration of insurance premium
Analysis of interrelationships--compare insurance coverage to assets owned and leased
Scanning inventory records for “old” last-issue dates
Verbal inquiry--question inventory control personnel about slow-moving inventory
Vouching--examine journal entries for evidence of actual book writedown of the specific inventory items
Tracing--trace remittance amounts to appropriate customer’s account
Recalculation--recalculate amount of discounts and allowances
Vouching--examine authoritative documents supporting unusual discounts and/or allowances
Observation and examination by the auditor--of the inventory and the inventory-taking procedures
Confirmation by letter--of inventory held in outside warehouses
Recalculation--of the accuracy of cost-flow calculations
General Audit Procedures and Financial Statement Assertions
The related assertions are taken from the textbook explanation of the procedures.
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General Audit Procedures
Related Management Assertions
1. Recalculation
Existence, Valuation
2. Physical observation
Existence, Valuation
3. Confirmation
Existence, Rights (Ownerships)
Valuation (sometimes)
Cutoff (sometimes)
4. Verbal inquiry
All assertions: however, responses typically yield more
assertions, in turn subject to audit with corroborating
5. Examination of documents
Existence (vouching direction)
Completeness (tracing direction)
Valuation or allocation
Rights and obligations
Presentation and disclosure
6. Scanning
Raises questions that may be relevant to all objectives, but
may not produce actual “evidence.”
Since it is performed on recorded amounts, it works best for
Existence, Valuation, Rights, and Presentation/Disclosure.
When applied to source documents, it might work for the
completeness assertion.
7. Analytical Procedures
Existence or occurrence
Relative Appropriateness of Evidence
Evidential matter obtained from independent sources outside an enterprise provides greater assurance of
reliability (competency) than that which is secured solely within the enterprise.
Accounting data and financial statements developed under satisfactory conditions of internal control are
more reliable (competent) than those which are developed under unsatisfactory conditions of internal
Direct personal knowledge obtained by the independent auditor through physical examination, observation,
computation, and inspection is more persuasive than information obtained indirectly.
Relative Appropriateness of Evidence
Types of evidence
in reliability rank
1. External
2. External-internal
3. Internal
4. Mathematical (based on
unaudited data)
Evidential items/sources
d. Letter from creditor
a. Monthly statements
b. Accounts payable register
c. Audit computation of
Mathematical (based on
audited data)
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Letter from bond trustee
Cancelled cheques
Minutes of directors’
Audit Working Papers
The functions of audit working papers are to aid the auditor in the conduct of his or her work and to
provide support for the opinion and the compliance with auditing standards.
Working papers are the auditor’s records of the procedures performed, and conclusions reached in
the audit.
The factors that affect the auditor’s judgment of the type and content of the working papers for a particular
engagement include:
The nature of the auditor’s report.
The nature of the auditee’s business.
The nature of the financial statements, schedules or other information upon which the auditor is
reporting and the materiality of the items included therein.
The nature and condition of the auditee’s records and internal controls.
The needs for supervision and review of work performed by assistants.
Evidence which should be included in audit working papers to support an auditor’s compliance with
generally accepted auditing standards includes:
Evidence that the financial statements or other information upon which the auditor is reporting were
in agreement or reconciled with the auditee’s records.
Evidence that the auditee’s system of internal control was reviewed and evaluated to determine the
nature, timing, and extent of audit procedures.
Evidence of the auditing procedures performed in obtaining evidential matter for evaluation.
Evidence of how exceptions and unusual matters disclosed by auditing procedures were resolved or
Evidence of the auditor’s conclusions on significant aspects of the engagement with appropriate
The auditor should perform an adequate examination as cost-effectively as possible, and the preceding
year’s programs will aid in doing this. The preceding year’s audit programs ordinarily contain information
useful in the current examination (such as descriptions of the unique features of an auditee’s operations or
records, a formalized sequence of audit steps in logical order, and approximate time requirements to
perform various phases of the work.) The auditor should decide whether it is still appropriate to use the old
program or prepare a new one.
Audit procedure for error detection.
a) Sales are understated, A/R are understated.
b) It is a cut off error. It affects the completeness assertion because a sale that occurred in the current
year was left out of this year’s sales total, making it understated/incomplete. The sale was put in the
following year. Unless the error is corrected, the following year will be overstated by a sale that did
not occur/exist in that period.
Cut off test procedures would detect this error, e.g. Inspect internal sales documentation, and trace
documentation of last completed jobs before the year end to the sales records to ensure they are all
recorded in correct period.
d) Accounts receivable turnover with error
= $3,200,000 / $450,000 = 7.1 times
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Accounts receivable turnover after correcting error
= ($3,200,000 + $145,000) / ($450,000 + $145,000) = $3,345,000 / $595,000= 5.6 times
Correcting the error makes the turnover lower, indicating poorer performance to a user, such as the bank
e) In size the error amounts to 5% of total revenue so it could be considered material based on its size
(quantitative factor). The error also has the effect of shifting revenues to following year. The general manager
has already received her maximum bonus this year - note: 3,200,000 * 1% = $32,000 and maximum is $24,000
so maximum is already exceeded. So the error may affect bonus plan, by shifting profit to next year she will be
more likely to make the bonus next year. This qualitative factor also suggests the error is material as it affect
important users and decisions whether manager should receive a bonus. This qualitative factor could make the
error more significant for the Board as it may affect decisions they make, and it may indicate to them
management has attempted to manipulate the financial statements.
EP8-10 Identifying the type of audit procedure
1 – Inspection
2 – Reperformance / Recalculation
3 – Confirmation
4 – Inquiry
5 – Inspection
6 - Observation
7 – Analysis
8 – Inquiry
EP8-11 Information sources and reliability of evidence
Situation 1 The summary of the inventory count would be considered of lower quality than Griffin and Fox’s accountant
observation of the count. This is because the summary of the inventory count is an internally generated document
that could be influenced by a bias of Melba’s employee with a desired outcome for the company’s financial
performance. Griffin and Fox’s staff accountant should be independent and therefore, his observations should be
Situation 2 –
The estimate of the legal counsel provided during a discussion would be considered of lower quality than the
confirmation letter obtained from the external counsel. The fact that the external counsel is independent from
Melba increases the quality of the information as he should be more objective. Further, it would be easier for the
auditor to prove the support for his conclusion in his audit file with a signed confirmation letter than by a summary
of a discussion with the internal legal counsel.
Situation 3- The automated report from the computer system would be considered of higher quality than the
overall analysis performed by the auditor. This is true only since the control environment and internal controls of
Melba have been assessed as strong. This assessment indicates that systems are working according to
expectations and the output from the system can be trusted. This is better than a high level analysis, even if the
analysis is performed by the auditor.
Situation 4 – The sales invoices would be considered of higher quality than the sales ledger. The sales invoices are
internal / external documents while the sales ledger is only an internal document. As the sales invoices are sent to
clients, if there was an error in the invoice, the client would likely review it and report it. As a result, there is a
higher chance that an incorrect sales invoice would be detected. The sales ledger is only used internally and
therefore, an internal bias could be present or there is a higher chance that an error could go undetected.
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Financial Assertions and Audit Procedures
The objectives for the audit of Karwan’s securities investments at December 31 are to obtain evidence about the
assertions implicit in the financial presentation, specifically:
Existence. Obtain evidence that the securities are bona fide and held by Karwan or by a responsible
Occurrence. Obtain evidence that the loan transaction and securities purchase transactions actually took
place during the year under audit.
Completeness. Obtain evidence that all the securities purchase transactions were recorded.
Ownership/Rights. Obtain evidence that the securities are owned by Karwan.
Obligation. Obtain evidence that $500,000 is the amount actually owed on the loan.
Valuation. Obtain evidence of the cost and market value of the securities held at December 31. The
investments are being held for trading, so will need to be marked to market in the year-end financial
Presentation and Disclosure. Obtain evidence that the investments have been properly classified as financial
instruments held for trading, and that the notes to the financial statements contain correct disclosures
regarding their measurement at fair value, as well as the required disclosures related to their risks.
Note also that in understanding these transactions, the auditors also have obtained evidence regarding the
loan and the committed nature of the existing plant assets. As part of the audit programs for the loan and
the plant assets, the audit team should obtain evidence that restrictions on the use of the assets are
disclosed fully and agree with the loan documents, that the loan is properly classified as a long-term
financial liability, and that the other details of the loan agreement, such as repayment terms and interest
rate, are fully disclosed.
Financial Assertions and Audit Objectives
The objectives for the audit of Karachi’s product warranty liability at December 31 are to obtain evidence about the
assertions implicit in the financial presentation, specifically:
Existence. Obtain evidence that the warranty liability is not overstated and that all appropriate warranty
related costs have been recorded as a reduction of the liability balance.
Occurrence. Obtain evidence that the sales giving rise to increases in warranty liability actually took place
during the year under audit.
Completeness. Obtain evidence that all the sales transactions giving rise to warranty liability were
considered in determining the liability amount.
Ownership/ Obligation. Obtain evidence that the warranty liability is an actual legal obligation of Karachi by
considering trade practice, terms of sale.
Valuation. Obtain evidence to verify the warranty amount has been calculated correctly as of December 31
based on accurate inputs from sales and warranty costs incurred, as well as considering warranties that have
Presentation and Disclosure. Assess whether the presentation of the liability in the balance sheet, and
disclosure of the liability and the underlying accounting policy in the footnotes are appropriate and in
accordance with GAAP.
The completeness and valuation assertions may be assessed as having ‘High’ RMM. Presentation also may
be high since this is a new policy and the company will need to determine the appropriate financial
statement presentation and accounting policy note and specific disclosures required by GAAP. The other
assertions are probably ‘not High.’
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Specific auditing procedures that could be performed in this business to obtain the required evidence can
be developed, using the evidence techniques listed in the chapter to develop the ‘nature’ of the procedures.
One possible approach is:
Appropriateness of Evidence and Related Parties
Do you perceive any problems with related party involvement in the evidence used by M. Johnson? Explain.
Yes, there are problems. Verbal assurance of collectability from Bumpus, the S&L officer with an
investment in the Smith Street property, is the weakest type of self-serving information.
Bumpus is a related party and information from him ought to be regarded as biased.
Another problem lies in the appraisal company. With the name of Guaranteed Appraisal Partners, Inc.,
the appraisers may be related, even owned by, the auditee--Guaranteed Savings & Loan Company. An
auditor’s general knowledge of financial institution difficulties in real estate lending and the
widespread problems with appraisers should alert Johnson to the possible relation of the appraisers
to the auditee. Further investigation should be carried out to identify the appraisers.
Do you perceive any problems with M. Johnson’s reasoning or the competence of evidence used in that
Existence. Enquiry of management regarding new warranty policy. Inspection of sales invoice
documents that state the warranty offered. Trace the warranty costs incurred to the warranty ledger
balance to ensure it is reduced appropriately. Recalculate the estimated warranty using the audited
sales revenues, which has been audited for existence/occurrence in the sales transactions audit
Completeness. Recalculate the estimated warranty using the audited sales revenues, which has been
audited for completeness in the sales transactions audit testing. Take into account the actual
warranty costs and trends, and expiry dates of the outstanding warranty obligations.
Ownership/ Obligation. Similar evidence as for existence will relate to the obligation assertion.
Analysis of normal trade terms in the industry may also be relevant.
Valuation. In addition to recalculation using management’s assumptions and data, verify all
significant data used are audited (e.g. warranty costs, timing of sales/warranty expiry). Assess the
reasonability of the assumptions regarding future warranty returns by performing an independent
analysis of the factors giving rise to the obligation.
Presentation and Disclosure. Analyze disclosures required by GAAP and appropriate accounting
policy. Analyze the presentation and classification to ensure it complies with GAAP. Assess whether
the presentation of the liability in the balance sheet, and disclosure of the liability and the underlying
accounting policy in the footnotes are appropriate and in accordance with GAAP.
Yes, there are problems. In addition to the dubious related party sources of information just
mentioned, Johnson’s “assumption” about the collectability of the Baker Street loan is unwarranted.
Auditors are not entitled to “assume” collectability on any grounds with supporting evidence. The fact
that a loan is new or construction is still in progress is no reason to “assume” collectability.
Audit Plan with Weaknesses in Revenue Controls, Not-for-Profit Auditee.
The main business risk factors affecting the nursing home’s continuing operations are the uncertainty about
being able to renew the bank loan, and the change in the industry towards more new government funded
nursing homes. These risks affect KH’s future viability as its revenues may be reduced if the new homes draw
away patients, and if the loan cannot be renewed it may lack the working capital to keep its operations
going. These factors increase the risk of financial failure, and this high level of business risk would likely lead
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the auditor to lower the level of audit risk that is acceptable on this engagement.
The risk of material misstatement appears to be high because there is a history of errors in invoicing patients
and accounts receivable recording. The accounts receivable balance is likely to be highly material since it is
the main revenue source. A further concern is the nature of the revenues in this organization - these come
from patients who are not very able to provide confirmation evidence, and this lowers the reliability of
evidence available to support the revenue existence and valuation. Also, control risk is high in some areas as
accounting staff appears to be unable to apply effective independent verification in the invoicing and
receivables recording processes. The effectiveness of management supervisory controls over cash
transactions, and the lack of indicators of fraud risk, lowers the concern about the control weaknesses
having significant impact on the financial statements.
The main stages of the audit and the procedures used in this case are outlined below.
Understanding the auditee and its risks
 The case indicates the auditor has obtained an understanding of KH’s internal control and performed
a preliminary assessment. Enquiries of auditee personnel and study of prior-year audit working paper
information would be the procedures used. Enquiries of management, external parties and industry
research sources would have provided information about the plans to build new government funded
homes that will possibly compete with KH.
Assessing the risk of material misstatement (inherent and control risks combined)
 Based on inquiry of auditee personnel and observation of accounting information system and internal
control there appear to be weaknesses in controls over invoicing and accounts receivable recording.
While it would not be effective to test these controls, the auditor would need to consider these
control weaknesses by assessing whether the organization’s procedures are adequate to prevent
fraud. The auditor has assessed that controls over cash receipts are effective, so testing the controls
over cash receipts would be planned for. Dual purpose tests would be most efficient to provide both
control and substantive assurance. These tests would involve enquiry and observation of the control
procedures, and examination of the documents and records recording the cash receipts.
Substantive tests of details of transactions and account balances
 The overall audit approach planned would emphasize substantive tests of transactions for revenues.
For a sample of patient invoices from the sales journal, the auditor will obtain evidence about
existence and valuation by examining supporting documents such as the invoice and the supporting
patient records showing the services KH provided, by verifying the service fee agrees to the approved
fee schedule, and by recalculating the service revenues to ensure accuracy. Verifying there are no
recording misstatements would be tested by tracing invoice details (patient, amounts and dates) to
the accounts receivable subledger, and tracing posting totals from the sales journal to the general
 As the confirmation responses are unreliable, alternative procedures such as verification of
subsequent cash receipts to banking records would be used to verify the existence and ownership of
receivables (this was outlined above as a component of the dual purpose testing on cash receipts
transactions). Other substantive tests of transactions for revenues would also address completeness
by searching for unrecorded revenues (direction of this completeness testing is tracing from a sample
of patient records to revenue billings). If there are any large, long overdue, or unusual invoices, these
would be confirmed. Given the nature of the patients, bad debts are likely and so a careful
examination of overdue accounts and consideration of the adequacy of the allowance for doubtful
accounts is necessary to provide evidence that accounts receivable are valued at net realizable value.
Analytical procedures
 Analysis would be used extensively to provide substantive evidence. In addition to analysis of financial
relations and trends in revenues, receivables, and bad debts, comparisons with non-financial
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information such as number of beds, occupancy statistics, and service capability of the nursing staff
could provide very powerful evidence of any material misstatements in revenues.
Working paper review
The following information is missing:
The date of purchase of S security
The date of purchase and sale of R security
Data concerning the accrual and/or receipt of interest due on R to date of sale
Data concerning the accrual and/or payment of interest due on S to the date of purchase
Justification for accrual of dividends
Accounting treatment of bond discounts
Data concerning the December 31, 2002 revenue accruals
Data required to evaluate the classification of securities
The following procedures were not noted as having been performed:
The securities were not physically inspected or confirmed.
The broker’s advice (or other independent corroborating evidence) verifying the sale of R was not
Dividend rates were not verified by reference to public records (Standard & Poor’s) of dividend
The stated interest rates, maturity dates, and market values were not verified.
Computations of year-end accruals were not made.
Not all amounts (for example, loss on sale of R) were traced to the general ledger.
Comprehensive Audit Planning Case
Factors that support accepting/continuing ECR, based on facts given in case, include:
Obtaining and reviewing financial information about prospective client - are there unusual accounts or
business practices that audit firm is not familiar with? Need to understand business risks.
--ECR imports processes and sells fair trade coffee beans to retail-level businesses in Ontario - we need to
understand factors such any regulations affecting this business, nature of sales and purchasing
agreements, - we may have valuation or ownership challenges in doing audit based on foreign purchases
and long shipping times, also letter of credit arrangements , risks do not appear unusually high
Is the financial condition good?
--ECR profits are around $2 million, have Assets-Liabilities around $2.2 million - strong balance sheet &
earnings, high certainty it will continue as a going concern
Evaluation of audit firm’s independence
-- no facts given in case, no indication of conflicts in this regards, firm should re-examine if there are any
changes from previous year, or any concern audit team members becoming too familiar over time
indicating they should be rotated off the engagement.
Does audit firm have competency and resources to do an effective audit?
--Consider ECR size, location, nature of operations, and business seems simple enough that can assume
audit firm has competence to audit this business, stated in case this is a continuing audit so can assume
have competence
Determine management’s willingness to accept responsibility for financial statements that are fairly
presented in accordance with GAAP/acceptable framework and accept responsibility for adequate internal
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-- management seems willing to provide auditors with information, last year audit found an error (<~1% of
inventory) but not corrected - paid bonus before audit finding were in may suggest lack of regard for audit
value, or confidence in accuracy of accounting. No facts given about control, fair presentation etc.
Communicate with predecessor auditor, if new engagement (assumption required in this case) to learn any
reasons not to accept audit engagement, key risks and carryforward information from past audits.
Calculate net income from trial balance data
= $2493k* (or 2993 before bonus if bonus considered arbitrary, not ‘normal’)
Take 5-10% to provide a preliminary range of $125 to 250K
Note relevant qualitative considerations to determine the Overall Materiality level from the preliminary
range A significant error was found last year - we should consider the possibility that similar errors exist this
year; this indicates we should go to a lower level in the range. It also has implications for the performance
materiality decisions, as discussed below.
Main users are pension funds. These are sophisticated investors who will have other information sources.
This supports going to the higher end of range
Relative size of other financial items, AR, Inventory, have large balances, suggests using the higher end of
This suggests a reasonable materiality judgment, consistent with our supporting reasons is to set the
Overall Materiality level at $200k.
Following the guideline provided in the case, the Overall Performance Materiality is calculated by simply
taking 70% or other amount, this is $140,000. Using this lower level of materiality for deciding on extents
of testing and performance of other auditing procedures will increase our chances of finding all material
misstatements. However we should also consider whether any other reasons indicate a different approach
is more valid (In this case an alternate approach is to use last year’s error discovered, so $200-65 = $135k)
Auditor’s decision on acceptable audit risk (AR) level is based on nature of engagement, consequences of
audit failure. Three factors with appropriate impact on audit level acceptance, such as:
• Public vs. private company - It is not stated in the case if ECR is public, but it has fairly sophisticated
investors such as pension funds - this would lower AR willing to accept. If there are public investors
who are making risky financial decisions based on the audited financial statements, this also leads to
wanting a lower AR
• Auditee financial health/risk of business failure - The company appears sound. This may raise AR that
could be accepted. However, business risk factors suggest economic conditions may affect future
financial health (premium product, fluctuating market prices), so keeping a lower AR may still be
• Management’s reputation/integrity, willingness to accept responsibilities for preparing GAAP financial
statements, for designing and implementing adequate internal control, and to provide written
representations. There may be some questions here since there are errors in a major account,
inventory, so this may tend to decrease acceptable AR level
In order to design an effective audit, auditors must understand the business and the economic
environment of the business including factors such as:
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economic conditions - growth in sales in past years, but the recession may affect future expected growth
in luxury coffee
geographic locations - purchasing coffee beans around the world, with long time with risk of loss/damages
developments in taxation and regulation - import duties, sales taxes changes to consider
specific industry characteristics & risks - reputation based on quality and ‘fair trade’ buying policy, extends
reporting interests of investors to a compliance assertion - are their claims true?
business objectives - grow sales, maintain premium pricing position
key strategies employed to meet those objectives - quality control, research/improve production
processes, etc.
risks that threaten achievement of those objectives - obtaining quality beans - price changes risk, product
quality & reputation to defend
Inventory in a coffee business will be made up of raw and roasted beans, beans on hand, and beans
shipped and in transit but already owned.
Assertions- Consider the following risk assessments with supporting reasons
Existence: high
- Inventory on ships can be lost or damaged by moisture/insects, ECR may not be able to establish legal
ownership due to complex payment arrangements with foreign suppliers, uncertainty
Completeness: medium
- Depends on good controls over recording all purchases that ECR has legal ownership of, possible to miss
recording unless controls are good
Valuation: high
- are the raw beans of suitable quality once they arrive? Long shipping times impose risk of damage and
- are all shipping, insurance, duty, etc. costs captured? There will be a valuation impact if prices drop or
recover. This may increase complexity of valuation and increase risk of misstatement. Error in pricing
/valuation in prior year suggests higher risk
Ownership: High
- Similar factors as existence risks (but if ECR has good controls, that could lower this risk)
Presentation: medium
- classification is fairly straightforward, but disclosure of policies regarding valuation, ownership need to be
examined for accuracy
One example of an evidence procedure and the assertion the evidence is relevant is:
Examination of Inventory ‘in transit’ involving verification of inventory in terms of ownership, existence,
valuation (damage?) by confirmation of quantities & types of beans with suppliers, and with the shipping
Verify that terms of sale that allow ECR to take title have been met.
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DC 8-7 Comprehensive Audit Planning case
a. The audit firm’s acceptance procedures should include:
Enquiry and analysis to Obtain and review financial information about the client, assess whether any significant
changes have occurred that can affect its auditability (i.e. the ‘preconditions for an audit in the CAS).
Evaluation of your audit firm’s independence, and its competency and resources to do an effective audit and be
able to comply with the professional ethics code and all relevant CASs
Enquiry and analysis to understand business risks
Enquiry to determine management’s willingness to accept responsibility for financial statements- responsibility for
internal control and acceptable financial reporting framework
Analysis to assess integrity of management - Look for news reports, consult with auditee’s banker, legal counsel or
b. Materiality decision will consider quantitative and qualitative factors.
Consider financial statement user needs: Bank is main user. Bank will be interested in the profitability and
sustainability of SSL’s business, but will also be concerned with assets, as they are collateral for the loan, so we
should use the NIBT based starting point for the materiality decision, but also benchmark the income based
materiality level against one based on total assets.
Calculate NIBT = 1,015,057 (excluding tax expense and bonus)
Apply rules of thumb percentages:
10%= 101,506
Calculate TOTAL ASSETS =11,554,148
Apply rules of thumb percentages:
0.5%= 57,771
1.0%= 115,541
Both the NIBT and TA bases yield similar materiality level range of around $50-100k
Materiality for the financial statements as a whole will be chosen at the lower end since the bank is relying on
audited financial statements to assess riskiness of its loans to SSL
Decision (judgment): Material for f/s as a whole: 60k
Performance materiality is less than ‘Materiality for the financial statements as a whole - We can use 70% rule of
thumb can be applied since no information given in case to support a more precise level judgment
Calculate: Performance materiality: 43k
Other valid approaches may be taken to determine appropriate materiality levels for the SSL audit.
c. Three business factors are identified based on considering economic and industry factors and how they might
lead to material misstatement in SSL’s financial statements.
- there is a recession
- SSL’s customer companies may be in financial difficulty, default or be late with payments of lease payments - this
risk can affect valuation of the lease receivables - allowance for bad debts (AFDA)
- interest rates are changeable, if rates are low due to recession SSL may write leases at a lower rate that can affect
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SSL’s profitability, affecting the valuation of lease receivables
- credit worthiness of customers can change with economic conditions - this can affect AFDA estimates
- increasing competition brings other financial service businesses, banks into the business - can tighten margins and
create incentives to overstate profit.
- lease contract terms may need to be written to take riskier clients and assets to compete -this can affect valuation
of receivables
-equipment vendors may decide to do their own financing - can reduce profitability and ability to repay loans,
continue as a going concern
Other valid business risk points
d. Ratios that relate lease receivables and interest revenues, and lease receivables and AFDA, would be informative
about profitability and credit risk.
Bank loans and interest expense could be analyzed to assess financial condition.
Other information would include the list of leases, lease terms, interest rates, indicators of slow payment,
e. Assessments for RMM for Lease receivables in a direct finance leasing business, at the level of the five principle
assertions, with reasons that logically support the level assessed for each assertion, are suggested below.
Note that this solution is just based on one auditor’s judgments - other auditors’ approaches and reasoning could
differ, yet also be as valid or even better reasoned...
Existence: not high
Reasons: unlikely to be set up unless actually made a lease, verification by inspection of lease documents can
provide evidence, also inspection of cash collection records and documents
Completeness: not high
Reasons: this assessment depends on SSL having good controls over recording all new leases in their accounting
process, since it is possible to miss recording unless controls are good - we will evaluate controls accordingly to
confirm this but since SSL would likely not survive if it failed to record lease receivables it is reasonable to start
with this assessment
Valuation: high
Reasons: It is very uncertain whether repayments will be made, complex calculations of unearned interest revenue
are required, e.g. principle vs interest components, bad debt allowance,
Ownership: not high
Reasons: It is unlikely SSL will record leases it is not on title to, since legal documentation and signatures are
required that would be quite involved to fabricate
Presentation: high
Reasons: The accounting policies for lease valuation are complex and require understandable and complete
disclosure of details - all details in notes need to be verified to supporting documents
Other valid points
f. AR=IR x CR x DR (IR x CR= RMM)
The meaning of each term is as follows:
AR – Audit Risk - how much risk the auditor is willing to take of giving a clean opinion when the financial
statements are materially misstated, i.e., the risk of audit failure, AR is the complement of assurance
(AR=1/assurance). The auditor make a decision at the start of the audit on how much risk is acceptable, and must
achieve this level to complete the audit and form an opinion
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IR – Inherent Risk - risk misstatement occurs in first place
CR – Control Risk - risk company’s controls will not prevent a misstatement, or detect a misstatement that occurred
DR - Detection Risk - the risk the auditor’s procedures will not detect a misstatement that occurred and wasn’t
caught by controls. Note that the IR and CR factors are not controlled by the auditor - they just exist in the client’s
business and have to be dealt with. The DR factor is controlled by the auditor, and if the auditor lowers this risk by
gaining assurance from performing evidence gathering procedures, it will reduce the AR to the acceptably low level
required to obtain high assurance.
Explanation of how this model would help SSL’s auditors.
The factors can be viewed IR, CR, DR are the risk measures related to possible sources of assurance that can reduce
AR to the acceptable level
We have made a preliminary decision to assess CR less than maximum (100%) over the completeness assertion,
this means the auditor needs to plan control testing – to test effectiveness of controls. If the results of the control
testing do not support a low assessment of CR (i.e. we find the controls are not actually effective) then we will need
to revise our audit plan and get a lot more direct substantive evidence about this assertion (possibly by confirming
a lot more receivables with customers).
Finally, since DR is determined based on the assessed IR, CR levels, and the acceptable AR chosen by the auditors,
the lower the DR that is required to reach the required low level of AR, the more substantive evidence gathering
work the auditors need to plan to do.
g. Some financial reporting fraud risk (management fraud) exists if there are debt covenant creating incentives for
the owner/manager to overstatement of revenues/assets to the bank, misallocation of principle/interest
components might allow profit to be overstated, underestimating AFDA could allow assets to be overstated.
We will assess this risk through analysis of estimates - looking for bias, inspection and vouching of unusual journal
entries, enquiry and observation of unusual conditions or actions
The main risk however, probably is employee fraud since SSL is an owner/managed business (so M. Silva would be
stealing from himself), but it is a cash business. Cash receipts could be misappropriated (e.g., by a lapping trick).
We can assess this risk by ‘thinking like a crook’ considering presence of fraud triangle factors and paying attention
to opportunities present to employees, and following up on any suspicions.
h. Two procedures for the high risk assertions for lease receivables:
- analysis of estimate for AFDA
- vouching of lease receivables and payments to cash receipts, bank records, and lease contracts
- confirmation of a sample of new leases added in the year with customers
- recalculation of lease accounting that supports information presented in financial statement notes regarding
expected valuation and expected cash inflows
- recalculation of current and long-term portions of leases
- analysis of lease contracts to ensure they are accounted for in accordance with GAAP as to whether they are
finance type or operating.
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