UNIT ONE: AUDIT SAMPLING
UNIT INTRODUCTION
Dear learner! In any auditing situation, the auditor seeks to obtain sufficient appropriate audit
evidence as the basis for his/ her opinion on the information under audit. The auditor collects the
evidence through the performance of compliance tests (i.e. tests to obtain reasonable assurance
that those internal controls on which audit reliance is to be placed are operating effectively) and
substantive tests (i.e., tests of details of transactions and balances and analytical procedures).
Auditors select a sample of transactions from an account or class of transactions, applies his
audit producers to such sample, and draws there from conclusions about the entire account or
class of transactions. Therefore, this unit discusses the different types of audit tests used in
gathering audit evidence and various issues relating to use of sampling in auditing.
Learning objectives
Dear learner! After reading this unit you should be able to;
 Understand Definition and Purpose of Sampling and rationale for audit sampling
 Identify the major types of audit test
 Understand Methods of audit sampling
 Understand Audit sampling for tests of controls and for substantive tests
 Distinguish Non-statistical sampling vs. statistical sampling
 Understand Selection of sample items, Sampling plans
 Distinguish Non sampling risk vs. sampling risk
1.1 Definition, purpose and rationale for audit sampling:
Audit sampling: Process of obtaining information about an entire population or universe
by examining only part of it. The auditor seeks to obtain sufficient appropriate audit evidence as
the basis for his/ her opinion on the information under audit. The auditor collects the evidence
through the performance of compliance procedures (i.e. tests to obtain reasonable assurance that
those internal controls on which audit reliance is to be placed are operating effectively) and
substantive procedures (i.e. tests of details of transactions and balances and analytical
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procedures). Auditors normally select a sample of transactions from an account or class of
transactions, applies his/ her audit procedures to such sample, and draws there from conclusions
about the entire account or class of transactions. This is known as audit sampling.
What is the main purpose of sampling in an audit? Put in writing on space provided below:
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Purpose: To estimate characteristic of group without complete examination of all items
constituting the group.
1.2 The rationale for audit sampling:
Some people argue that to express a proper opinion an auditor should examine all the
transactions. They feel that an auditor cannot reach valid conclusions unless he has examined all
the transactions. This view is, however, not correct. (Imagine what it would be like if, to see
whether the rice has been cooked properly, housewives were to taste each and every grain!). An
auditor can obtain sufficient appropriate audit evidence even by performing his audit procedures
on a sampling basis, provided he exercises adequate skill and care. As a matter of fact,
application of sampling in auditing is a recognized practice not only in Ethiopia but throughout
the world.
Can you call the reasons why sampling is recognized as an acceptable auditing practice?
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Let us now discuss why sampling is recognized as an acceptable auditing practice.
Sampling is recognized as an acceptable auditing practice due to the rationales of:
1. Large number of Transactions
2. Objective of an audit
3. Internal control system
4. Computerized information Processing
5. Audit in depth
1. Large number of Transactions:The number of transactions in modern enterprises is enormous. Take the case of a bank branch
where thousands of transactions may take place every day. If an auditor attempts to examine
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each and every transaction, it will be almost impossible for him to complete the audit within the
stipulated time and the cost budget.
2. Objective of an audit:Dear learner! As we have already seen, the objective of an audit is to enable the auditor to form
and express an opinion on the information under audit. In this regard, the auditor should obtain
sufficient appropriate audit evidence to enable him to draw reasonable conclusions there form to
form the basis or his opinion. In most auditing situations, the auditor can draw reasonable
conclusions by carrying out a selective examination of transactions, account balances and
internal controls.
3. Internal control system:Generally, most of the medium and large-sized enterprises have sound systems of internal
control to ensure proper accounting and information processing. For example, for routine
payments of Cheques, a bank normally has adequate internal controls which minimize the
possibility of frauds and errors once the auditor has satisfied himself (through compliance
procedures) that the relevant internal controls are actually in force, it would be useless for him to
examine 100 percent of the payments. Similarly, the system of self-balancing ledgers and other
such systems have made it unnecessary to check 100 percent of totals. Thus, where the auditor
concludes that the internal control system is effective, he can decide to apply his audit
procedures on a sampling basis.
4. Computerized information Processing:In the last few years, there has been a tremendous growth in the use of electronic computers for
information processing. The use of computers has a significant effect on the manner of
processing of data. The traditional audit approach of checking vouchers, totals and posting on a
100 percent basis is not effective in a computerized accounting environment and is, therefore,
giving way to a new, more effective audit approach. Sampling is an important constituent of this
approach.
5. Audit in depth:An advantage of sampling is that it enables the auditor to conduct audit in depth-a process which
may not be possible due to time and cost constraints, if 100 percent checking is carried out.
Audit in depth refers to an intensive, step-by-step examination of selected transactions, tracing
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all the links from the beginning to the end. While conducting an audit in depth, the auditor
reviews all the accounting and operational aspects of a transaction, from the beginning to the
end. This enables him to gain a complete understanding of the nature of the transaction, the
stages involved in its processing, and the controls at each stage. It is often argued that an indepth audit of transactions selected at random provides the auditor, with more valuable audit
evidence than a superficial/shallow examination of all the transactions. For example, suppose
there are 10,000 sale invoices in an organization. The auditor has budgeted 100 man–hours to
audit the sale transactions. He then has choice either to spend half a minute on each invoice (if
100 percent checking is carried out) or to spend some time in evaluating internal controls and
conducting analytical procedures and then spending the remaining time on checking in detail 500
invoices selected by him at random. The latter checking can be in – depth.
1.3 Methods of audit sampling:
An auditor can carry out a selective examination by way of:a) test checking (or judgmental sampling), or
b) statistical sampling
How can you distinguish statistical sampling from judgmental sampling?
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The main difference between these two approaches is that in the case of statistical sampling,
statistical tools and techniques are applied in determining the sample size, in selecting the
sample, and in evaluating the results of sample checking. In the case of judgmental sampling, on
the other hand, these are determined by the auditor primarily through the application of his
judgment.
Test checking or judgmental sampling:Test checking implies that the auditor does not apply his compliance procedures or substantive
procedures to 100 percent of the transactions. Instead, he selects and checks a certain proportion
of the transactions, such proportion being determined by the auditor on the basis of his
experience and judgment about the enterprise under audit. For example, the audit program
relating to a medium sized enterprise may contain one of the following instructions.
a) check 25 percent of the postings from journal to the ledger, or
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b) select any three months (sometimes, even the months are specified) and check 100
percent postings from journal to ledger relating to transactions of these months,
It is obvious that in the above situation, the auditor is not carrying out an examination of 100
percent of the transactions. Instead, he is resorting to selective examination through test checking
or judgmental sampling.
Sample size in test checking
In the case of test checking, the auditor determines the sample size (i.e., the extent of test
checking) primarily through the application of his judgment in a particular situation. It is difficult
to lay down any precise parameters in this regard.
Generally, an auditor considers the following factors in determining the extent of test checking:
1. Nature of the item
2. Effectiveness of internal controls
3. Materiality of the item
4. Previous experiences of the auditor
5. Results of initial test checks
1. Nature of the item:The nature of an item influences the judgment of the auditor regarding the extent of test checking
if the items are similar or of a repetitive nature, the auditor can draw conclusions regarding the
same on the basis of a small sample. On the other hand, if the items are of a diverse nature, the
auditor needs to carry out a more extensive checking. Thus, other things being the same, the
auditor can obtain the same degree of assurance by examining a smaller sample of sale
transactions in an enterprise manufacturing a standard product than in the case of an enterprise
which manufactures diverse types of goods against special orders.
It should also be recognized that some account balances or classes of transactions are more
susceptible to misstatement. For example, transactions with a firm in which a director of the
company under audit is a partner may have to be examined by the auditor to a greater extent as
compared to similar transactions with other parties. Examples of other item which are more
susceptible to misstatement are: accounts involving a high degree of management judgment (e.g.,
provision for doubtful debts), accounts involving highly valuable and movable assets (e.g.,
jewellery), and accounts that are particularly susceptible to changes in customer demand or
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technology that could affect their value (e.g., realizable value of stock in the case of a dealer in
fashion garments).
2. Effectiveness of internal controls:If, in relation to a class of transactions or an account balance, the auditor finds that the internal
controls are effective, he may limit the extent of test checking. If, on the other hand, the internal
controls are found not to be effective, the auditor may check a higher percentage of items.
3. Materiality of the item:An item is material if its misstatement could influence the economic decisions of a user of
financial information. Usually, materiality of an item depends on its size or magnitude (though
other factors may also affect the materiality of an item). Thus, in an audit of financial statements,
the amount of a transaction or an account balance often determines its materiality for the auditor.
Materiality of an item influences the judgments of the auditor regarding the extent of its test
checking.
In general, an auditor would carry out a more extensive checking of transactions of higher
amount as compared to transactions of lower amounts. For example, in an audit of a large
enterprise, the auditor may decide to examine 50 percent of the debtor account with outstanding
balances of more than Br 50,000, 30 percent of accounts with outstanding balances between Br
10,000 and Br 50,000 and ten percent of debtor accounts with balances below Br 10,000.
It should, however, be remembered that materiality of an item has to be judged in the particular
facts and circumstances of a case. What is material in one situation may not be so in another.
4. Previous experiences of the auditor:In most circumstances, the auditor determines the extent of test checking on the basis of his
previous experience with the enterprise in general and with the relevant class of transactions (or
account balance) in particular. For example suppose an auditor knows from his past experience
that the payroll of the enterprise under audit does not normally contain any material errors. On
the other hand, he is aware that in the previous year, there were frauds with regard to cash sales.
It is obvious that with this knowledge, the auditor would proceed to check the wages through a
smaller sample, whereas in the case of cash sales, he would most likely decide to carry out a
much more extensive checking.
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5. Results of initial test checks:In many cases, the auditors initially carry out their audit procedures on a small sample and on the
basis of the results of such test checking, they decide whether they should carry out further audit
procedures. For example, an auditor may decide to initially check 20 percent of the sale invoices.
Suppose, his procedures reveal proper documentation, arithmetical accuracy, correct recording in
books of account, etc; he may then decide not to carry out further procedures. If, however, the
results of the initial test checking reveal material errors, the auditor may decide to carry out
further checking of sale invoices.
1.4 Non-statistical sampling vs. statistical sampling:
Non-statistical (or judgmental) sampling:
 Use of samples which are chosen without regard for the statistical requirements that
govern the sample size and the method of selection.
 Used where statistical sampling will not satisfy the audit purpose.
 Major limitation – provides no mathematical basis for projecting sample results to the
entire population.
Statistical sampling: A technique or methodology for selecting items to be tested and of
evaluating the results of the test on the basis of mathematical laws of probability. Advantages of
using statistical sampling; Auditors may be able to design more efficient samples and avoid
―over auditing‖ or ―under auditing.‖ Permits auditors to optimize sample size, given the
acceptable sampling risk. Enables auditors to objectively measure the reliability of the evidence
obtained from the sample. Auditor can calculate and control the risk of reliance on a sample.
 Should the auditor be placed in the position of defending their auditing procedures in
a court proceeding, they would be able to demonstrate mathematically that their
sampling procedures or conclusions were statistically justifiable. Similarly, the
auditor would be able statistically to justify their work to a client who was critical of
the extent of their testing.
Areas requiring the auditor to make judgment decisions
 Defining population, characteristics to be tested, and exceptions.
 Determining the appropriate statistical selection techniques for drawing a random
sample.
 Establishing the required precision and reliability (confidence) level.
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a) Precision – The ―allowable margin of sampling error.‖ Also, referred to the
―Allowance for sampling risk.‖ Range set by + or – limits from the sample
results, within which the true characteristics of the population are likely to lie.
b) Reliability (Confidence) Level – Also, referred to as the ―Risk of Sampling.‖
Expresses the proportion of cases in which the actual value will be somewhere
within the stated precision limits.
 Determining tolerable rate or misstatement.
a) Tolerable rate (attribute sampling) – Maximum rate of deviation from
prescribed internal control structure that auditor would be willing to accept
without altering planned assessed level of control risk.
b) Tolerable misstatement (variable sampling) – When planning a sample for a
substantive test, how much monetary misstatement may exist in the account
balance without causing financial statements to be misstated?
 Interpret sample results. This requires decisions as to whether the client‘s figures are
to be accepted, or rejected, or whether additional sampling is necessary.
 Following up on the discovery of critical errors (discovery sampling) or unacceptable
error rates (sampling for attributes).
 Determine under what circumstances statistical sampling is appropriate.
Selection of sample items: An unbiased sample must be obtained before statistical sampling can
be used to evaluate and interpret the results of sample data. Sampling Techniques:
1) Unrestricted random sampling- Selection of a sample from a population of items in
such a manner that each item in the population has an equal chance of being chosen
for examination.
1. Random number table or random number generators are generally used for
applying this selection approach.
2. Population items must be numbered.
2) Systematic selection – sample items are selected according to some predetermined
fixed interval (selection of every nth item). The first sample item is selected at random
thus establishing the sequential pattern.
1. Population items should be arranged in random order or the auditor should use
multiple random starts.
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2. Population items do not need to be numbered.
3) Stratified selection – Population is divided into classes or strata which are more
homogeneous than the population as a whole.
1. Generally used to control variability in the population and reduce sample size.
2. Enables auditor to relate sample selection to materiality.
Sample Plans
Can you mention some of some of the common types of sample plans in auditing?
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Dear learner! The following are the common sample plans that you should know and apply in
your work environment.
1. Attribute sampling:
Characteristics:
 Used to estimate the frequency or rate of occurrence of a particular attribute in a
population.
 Concerned with the question of ―How Many.‖
 Primarily use to test controls-Are internal control procedures being carried out
properly?
Factors used to determine sample size:
 Risk of assessing risk too low (the converse of confidence or reliability level
 Tolerable deviation rate (estimated deviation rate + upper precision.
 Expected pop deviation rate
 Population size
2. Discovery sampling: A form of attribute sampling designed to locate at least one critical
deviation or exception in the population. It may be used to locate one example of fraud
(example-fraudulent disbursement transaction). Used when estimate of occurrence rate is near 0
percent.
3. Classical variable sampling:
Characteristics:

Used to provide the auditor with an estimate of a numerical
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
quantity, such as the dollar amount of an account balance or the

Estimated error amount in an account balance.

Concerned with the question of ―How Much.‖

Primarily used by auditors to perform substantive procedures.
Variable sampling plans:
a) Mean-per- unit estimation: - Used to estimate the mean audited value of the items in a
population by determining the mean audited value of the items in a sample. The
estimated audited value of the population equals the average audited value of the sample
(sample mean) multiplied by the number of item in the population.
b) Ratio estimation: - Used to estimate the projected amount of error in an account balance
(population) or the audited value of the account (population). Used when the size of
misstatements is nearly proportional to the book values of the items (larger accounts have
large misstatements and smaller accounts have small misstatements.
Projected misstatement = Sample net misstatement
(PM) of population
Book value of sample
X Population
book value
Audited value of population = Book value of pop. + Or – PM. (plus (+) if book value is
understated or minus (-) if book value is overstated in relation to audited value)
c) Difference estimation: – Used to estimate the average difference between the audited
value and book value of item in a population. Most appropriate when the size of the
misstatements is independent of the book values of the items.
Projected misstatement = Sample net misstatement X Pop. Items
(PM) of population
Sample items
Audited value of Pop = Book value of Account + or – PM (plus (+) if
book value is understated or minus (-) if book value is overstated in
relation to audited value)
Activity 1.1
The auditors for Company A are auditing accounts payable to determine if all accounts payable
have been recorded as of the end of the year. The following information is provided concerning
the population and sample taken.
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Accounts
Payable
Population
Sample
Required:
Number of
accounts
4100
200
Book Value
$5,000,000
$250,000
Audited
Value
?
$300,000
1. Using Difference estimation
i.
Estimate the amount of misstatement of the population or accounts
payable.
ii.
Estimate the audited value of the population or accounts payable
2. Using Ratio estimation, Estimate the audited value of the population or accounts
payable.
3. Using Mean-per-unit estimation, Estimate the audited value of the population or
accounts payable.
Solution:
Dear learner! As we have discussed above, we will have the following solutions:
1.
Using difference estimation,
i.
The estimated misstatement of accounts payable (population) i.e.
Projected misstatement = Sample net misstatement X Pop. Items
(PM) of population
Sample items
($50,000/200)*4100 = $1,025,000 understated.
(I.e. $50,000=$300,000-$250,000)
ii.
the audited value of the population or accounts payable
Audited value of Pop = Book value of Account + or – PM
$5,000,000 + $1,025,000 = $6,025,000.
2.
Using Ratio estimation, the estimated audited value of the population or accounts
payable
Projected misstatement = Sample net misstatement
(PM) of population
Book value of sample
X Population
book value
($300,000/$250,000)*$5,000,000 = $6,000,000
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3.
Using Mean-per-unit, the estimated audited value of the population equals the
average audited value of the sample (sample mean) multiplied by the number of item
in the population.
$300,000/200*4,100 = $6,150,000
4. Probability-proportional-to-size (PPS) sampling (dollar-unit sampling):
Characteristics
 An alternative to classical variable sampling and is used for
 Performing substantive tests of account balances.
 Each dollar in the population is view as a sample unit.
 Permits the auditor to state, with a certain level of confidence, that the dollar amount of
error in the account does not exceed a certain amount.
 The amount of error in any item cannot be more than the book value of the item. Thus,
PPS is primarily used to audit for overstatement.
Advantages over classical variable sampling
 Generally easier to use than classical variables sampling.
 Size of the sample is not based on the estimated variation of audited amounts.
 PPS sampling automatically results in a stratified sample.
 Individually significant items are automatically identified.
 Sample selection can begin before the complete population is available.
 If no errors are expected, PPS sampling will usually result in a smaller sample size than
classical variable samples.
Application
a) Determine sample size: - Use sample-size tables for attribute sampling by converting
tolerable error and expected error amounts to a rate representing the percent of population
value.
Sample size = Record amount of population
Sampling interval (SI)
Sampling interval (SI) = Tolerable error
Reliability Factor for errors of
Overstatement
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b) Evaluate sample results:1) Compute projected error (PE) – computed for each recorded amount (logical unit)
containing error and totaled.
PE = % of error to record amount (taint %) x SI.
 If recorded amount is larger than SI (sampling interval), PE equals the actual amount of
the error.
2) Compute upper limit on errors- if less than tolerable error, accept population.
Upper limit on error = Projected error (PE) + Basic Precision + Incremental allowance for
projected error
Basic precision = Reliability Factor (for 0 errors) x SI
Incremental allowance = rank errors for recorded amounts (which are less than sampling
interval) from highest to lowest and consider incremental change in reliability factors for actual
errors found.
5. Dual purpose test (sample): test or sample has two purposes 1) to determine the
effectiveness of internal control and 2) to determine if material error exists
Non sampling risk vs. sampling risk – risks that auditor may reach erroneous conclusions
about a population.
How can you differentiate sampling risk from non sampling risk in an audit
engagement?
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------A. Non sampling risk: – risks due to factors not related to sampling. Failure to recognize
error in a document or transaction or failure to apply appropriate audit procedures.
B. Sampling risk: – Risk that sample results may not be representative of population.
Sample risk varies inversely with sample size.
1. Sample efficiency – The risk of under reliance on internal control and the
risk of incorrect rejection of the account or population.
a) risk of assessing control risk too high
b) risk of incorrect rejection of the account
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2. Sample effectiveness – The risk of overreliance on internal control and the
risk of incorrect acceptance of the account or population.
a) risk of assessing control risk too low
b) risk of incorrect acceptance of the account
1.5 Approach to statistical sampling:
The following stages are involved in the application of statistical sampling
1. Determination of sample size
The size of the sample is of utmost importance. For a given population, as the sample size
increases, the auditor can be more confident that the sample is representative of the population.
In other words, there is an inverse relationship between the size of the sample and the degree of
risk that the sample may not be representative of the population and that the auditor may, as a
result, reach inappropriate conclusions. Statistical techniques enable an auditor to evaluate the
risk which he is taking when he reaches certain conclusions about the population on the basis of
a random sample of a certain size (this is called ‗sampling risk‘).
In case, on the basis of a given sample size, the auditor finds that the risk which he is taking is
too high; he can simply increase the size of the sample. If, on the other hand, the auditor finds
that in the case of a particular category of transactions, the given sample size entails a risk which
is lower than what he would normally accept for the given category of transactions, he can
reduce the sample size ( and thus save time and cost). A major advantage of the statistical
sampling approach is that it enables the auditor to recognize the relationship between the size of
the sample and the degree of the risk that he is taking.
It should be remembered that one can never be 100 percent sure that the conclusions about the
population arrived at on the basis of the sample represent the characteristics of the population
with 100 percent accuracy. This is because even if a sample of 9,999 items is taken from a
population of 10,000 items, there would still be a sampling risk (howsoever small) that the
estimate based on the sample is different than the actual value. However, as we have stated
earlier, in any auditing situation, the auditor seeks to obtain reasonable and not absolute,
assurance as the basis for his opinion on the financial or other information.
All standard auditing procedures are designed to help the auditor to obtain reasonable assurance
as the basis for his opinion on the information under audit. Thus, on the basis of his judgment
about how material a category of transactions is, the auditor can decide about the sampling risk
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which he can take in an auditing situation. Once the sampling risk is defined, the auditor can
determine the sample size with the help of statistical techniques. Determination of sample size
and understanding of its relationship with audit risk is central to statistical sampling.
2. Selection of sample
Once the sample size is determined, the next step is to select the sample out of the population. It
is of paramount importance that the selection of sample is on a random basis. As stated earlier, a
random sample (also known as probability sample) is one in the selection of which all the
elements of the population have an equal chance of selection.
Can you cite some of the ways of selecting random sample?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------There are various ways in which a random sample can be selected. The methods commonly
employed by the auditors for selecting a random sample are discussed below.
Methods for selecting a random sample
1. Use of Random Number Tables
A random number table is a matrix of rows and columns in which each cell (i.e.
intersection of a row and a column) contains randomly-generated number.
Steps in using random tables
A random number table can be used as follows to select a random sample:
1. Identify each item in the population with a unique number.
2. Decide the number of digits to use in the random number table and publish a random
number table.
3. Establish a route for using the table. You can decide to precede selecting column- wise
(from top to bottom) or row- wise (From left to right).
4. Select a cell at random, e.g. By putting the pencil on the random number table while
closing your eyes.
5. Proceed column-wise or row-wise and select each successive cell in that column or
row depending on the established route in (3). Then proceed to the first cell in the next
column or row, as the case may be, and repeat the above process till the number of cells
selected equals the sample size.
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6. Select items from the population corresponding to the random numbers selected.
Consider figure 1.1 below which shows a part of a random number table. Suppose the
first random number selected by you is 62337. Suppose further that the debtor accounts,
from which you want to select the sample, are numbered consecutively from 1 to 870.
You may decide to ignore the first two digits and select debtor account no. 337 (you can
decide to ignore any two digits) If the next random number in your selection is 5121 (if
your selection is column-wise), you will select debtor account no. 21 and so on. While
selecting the random numbers, you will have to keep in view the range of debtor account
numbers. Thus, in case a random number selected is beyond this range (e.g., 25995), you
will have to ignore it (Since 995 is not in the range) and select another random number.
The use of random number tables is a scientific method of the random selection.
Figure 1.1
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
1
97469
95491
99071
21990
93319
28301
58872
65668
30719
37353
9835
60773
58055
23855
28287
61135
89852
88494
8036
38673
83403
38996
89999
24409
Extract from a random number table
2
98911
66814
36504
74972
29843
97698
71170
89076
6467
89564
20034
9618
38523
51984
96917
49259
98824
7549
41853
99092
50052
3434
55460
76250
3
40414
54945
85633
95280
97920
21250
28350
24801
41059
83129
31951
47280
96844
14058
84429
2182
86907
76602
42927
24950
84651
88498
34685
73029
4
56294
5430
59829
31551
80057
58255
13688
96218
55325
4705
3052
30448
18976
79811
37909
35911
48476
61064
75532
33904
14979
41428
50605
9901
5
44502
71851
83190
63309
45844
29652
39898
55941
34996
90458
81787
96023
25274
57412
60751
88573
55840
20140
43127
36914
55536
82725
62249
12697
6
48116
7435
32631
48433
91800
44132
3207
13469
62337
5121
33074
75291
76314
25995
57044
98084
1389
66053
23702
46251
76864
37615
42965
45804
7
17753
46135
97783
57674
35428
55496
51600
82520
75107
3361
39361
32851
27834
23256
20663
10191
19578
25216
89681
99538
86055
64626
11761
7984
8
65261
65529
6647
93009
8785
251
74854
13157
3559
73698
52521
98574
92152
93294
16029
16383
41142
46733
32205
58386
74988
32516
10413
67348
9
9860
29573
78307
50365
49475
78476
65064
48123
84152
18983
42377
89483
78593
3481
28797
46560
22288
13413
48182
27908
72745
18597
10868
50974
10
24687
95703
68804
9569
9333
89860
19875
10395
51203
2255
3015
69385
14991
83916
73785
5631
2199
65011
6252
68538
11435
59656
77356
80175
16
2. Use of computer Programs
For generating random numbers, many computer programs are also available. These
programs are more convenient to use as compared to random number tables. They are
faster, and one can generate the requisite number of random numbers within the specified
range (e.g. 1 to 870 in the above example).
3. Systematic random sampling
This involves selection of items using a constant interval between successive selections,
the first selection being made on a random basis. Thus, if the auditor wishes to select a
sample of 40 cash receipts out of a total of 360, the interval is 9(=360/40) and he may
select every 9th cash receipt. The first cash receipt may be any receipt from the first to the
9th. Suppose, the auditor selects the 3rd receipt, he would then select 12th, 21st, 30th, 39th,
48th and 57th receipts and so on. Systematic selection produces representative sample only
if the population is not structured in such a manner that the sampling interval corresponds
to a particular pattern in the population.
4. Stratified sample selection
For sampling to be effective, population should be more or less homogenous. In auditing
situations (as in many other cases), population can seldom be homogenous in all respects.
For example, in a business enterprise, some of the items of raw materials or components
may cost more than Br. 10,000 per unit whereas others may cost less than Br. 100 per
unit. Similarly, the sundry debtors in an organization may include some debts which are
outstanding only for a day or a week or a month whereas some others may be outstanding
for more than, say, three years. To make sampling more efficient, the total population in
such a situation is divided into several sub populations (each sub-population is called
‗stratum‘) each of which is in itself, more homogenous in nature, size, importance or
other characteristics than the population as a whole. A sample is then selected out of each
stratum.
1.6 Audit Testing
Selecting the best mix of audit tests will result in an effective and efficient audit.
Auditors have five types of tests they can use to determine whether financial statements are fairly
stated. Those tests include:
17
1. Procedures to obtain an understanding of internal control
2. Tests of controls
3. Substantive tests of transactions
4. Analytical procedures
5. Tests of details of balances
All five of these tests will be now discussed in detail, including the relationships among the, cost
of each type of test and relationship between types of tests and audit producers.
What aspects of internal control you think that an independent internal auditor should
know?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------1. Procedures to obtain an understanding of internal control:
In an independent financial audit, the auditor‘s objective is to express an opinion on the financial
statements. The auditor is, therefore, concerned with only those internal controls which may
affect the financial statement, VIZ, accounting controls. Generally, an independent financial
auditor is not concerned with those internal controls which do not have a bearing on the financial
statements. For example, he would generally not be concerned with those controls over
personnel function which seek to ensure that only skilled personnel are recruited for various
positions in the enterprise (the internal auditor, on the other hand, would study these controls
also).
The very reason why an independent financial auditor should study and evaluate internal controls
is not to identify weaknesses in internal controls with a view to making suggestions to the
management to overcome them but rather to determine the nature, timing and extent of his
substantive procedures.
There are three stages involved in the evaluation of an internal control system.
1. At the first sage, the auditor gains an understanding of the accounting system and of the
design of the related internal controls.
2. At the second stage, the auditor examines whether the various internal controls were
actually in operation.
18
3. Based on the above, the auditor evaluates the efficiency (effectiveness) of the internal
control system. This enables him to determine the nurture, timing and extent of his
substantive procurers.
The first stage in evaluation of an internal control system is to understand the accounting system
and the design or related internal controls. The auditor gains an understanding of the accounting
system by making a study of the following:
a) major classes of transactions of the enterprise;
b) manner in which such transactions are initiated and executed;
c) accounting records, supporting documents and specific accounts in the financial
statements;
d) The accounting process- from the initiation of a transaction to its inclusion in the
financial statements.
The auditor also gains an understanding of the design of internal controls over various aspects of
the accounting system. The auditor‘s study of the accounting system and related internal controls
may indicate that some of the controls are so defective in design that the auditor cannot place any
reliance on them. Even in respect of controls which are properly designed, the auditor has to first
examine whether they were actually in operation. This is because the prescribed controls often
tend to be ignored in practice. The auditor can use a number of methods and techniques for study
of the accounting system and the related internal controls.
 The following are procedures to determine the design and placement in operation.
1. Update and evaluate auditor’s previous Experience with the entity
Most audits of a company are done annually the same CPA firm. Except for initial
engagements, the auditor begins the audit with a great deal of information developed in prior
years about the client‘s internal control. Because systems and controls usually do not change
frequently, this information can be updated and carried forward to the current year‘s audit.
2. Make inquires of client personnel
A logical starting place for updating information carried forward from the previous audit, or
for obtaining information initially, is with appropriate client personnel. Inquiries of client
personnel at the management, supervisory, and staff level will usually be conducted as part of
obtaining an understanding of internal control.
19
3. Read client’s policy and systems manuals
To design, implement and maintain internal controls, an entity must have extensive
documentation of its own. This includes policy manuals and documents (such as a corporate
code of conduct) and systems manuals document (such as an accounting manual and an
organization chart). This information is read by the auditor and discussed with company
personnel to ensure that it is properly interpreted and understood.
4. Examine documents and records
The components of internal control all involve the creation of many documents and records.
These will have been presented to some degree in the policy and systems manuals. By
examining completed documents, records and computer files, the auditor can bring the
contents of the manuals to life and better understand them. Examination of the documents
and records also provides evidence that the control policies and procedures have been placed
in operation.
5. Observe entity activities and operations
In addition to examining completed documents and records, the auditor can observe client
personnel in the process of preparing them and carrying out their normal accounting and
control activities. This further enhances understanding and knowledge that controls have
been placed in operation.
Two most important tools for understanding and documenting the internal control system are
the flow charts and the internal control questionnaires. A flow chart shows the flow of
transactions and documents in a diagrammatic form. A flow chart is a graphic representation
of a system. It depicts the various operations, stages and controls involved in a system with
the help of graphic symbols. An internal control questionnaire contains various questions to
which the auditor seeks answers to gain an understanding of the various aspect of the internal
control system.
The answer to these questions, as stated above, are obtained by the auditor by:
a) Examination of relevant documents like procedures manuals.
b) Observation of relevant processes or operations, and/or,
c) Discussions with staff and management of the enterprise.
2. Tests of controls:
20
A procedure to obtain an understanding of internal control enables the auditor to determine the
presence or absence of adequate controls. This procedure helps to make initial control risk
assessment. This assessment is a measure of the auditor‘s expectation that internal controls will
neither prevent material misstatements from occurring nor detect and correct them if they have
occurred. However, the auditor does not have to make the initial assessment in a formal, detailed
manner. Thus, to determine the degree of reliance on the internal control system, additional
evidence must be obtained about their operating effectiveness.
In other words, in assessing control risk, the auditor has to consider the design of controls and
placement in operation. Same evidence will have been gathered in support of the design of the
controls, as well as evidence that they have been in operation, during the understanding phase.
To use specific controls as a basis for reliance, however, specific evidence must be obtained
about their operating effectiveness throughout all, or at least most, of the period under audit. This
additional evidence about the effectiveness of controls is obtained through tests of controls. It
should, however, be noted that the auditor performs tests of controls only if the initial control
risk assessment is below maximum.
What are the main procedures an auditor can follow to understand the operating effectiveness of
a business under audit?
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Procedures for tests of controls
The following procedures are employed while performing tests of controls:
1. Make Inquires of Appropriate Client Personnel
Although inquiry is not generally a strong source of evidence about the effective operation of
controls, it is an appropriate form of evidence. For example, the auditor may determine that
unauthorized personnel are not allowed access to computer files by making inquiries of the
person who controls the computer library.
2. Examine Documents, Records and Reports
Many controls leave a clear trail of documentary evidence and evaluation of such documents
helps to judge the operating effectiveness of controls.
3. Observe Control- Related Activities
21
Other types of control related activities do not leave an evidential trial. For example, separation
of duties relies on specific persons performing specific tasks and there is typically no
documentation of the separate performance. For controls that leave no documentary evidence,
the auditor generally observes them being applied at various points during the year.
4. Re perform Client Procedures
There are also control – related activities for which there are related documents and records, but
their content is insufficient for the auditor‘s purpose of assessing whether controls are operating
effectively. For example, assume that prices on sales invoices are to be verified with a standard
price list by client personnel as an internal verification procedure, but no identification of
performance is entered on the sales invoices. In these cases, it is common for the auditor to
actually re perform the control activity to see whether the proper results were obtained. For this
example, the auditor can re perform the procedure by tracing the sales prices to the authorized
price list in effect at the date of the transaction. If no misstatements are found, the auditor can
conclude that the procedure is operating as intended.
Relationship of Tests of Controls to Procedures to obtain an understanding:
There is a significant overlap between tests of controls and procedures to obtain an
understanding. Both include inquiry, documentation and observation. There are two primary
differences in the application of these common producers between phases.
First, in obtaining an understanding, the procedures are applied to all the controls identified as
part of the understanding of internal control. Tests of controls, on the other hand, are applied
only when the assessed control risk is blow the maximum, and then only to the key controls.
Second, procedures to obtain an understanding are performed only on one or a few transactions
or, in the case of observations, at a single point in time. Tests of controls are performed on larger
sample of transaction (perhaps 20 to 100) and often observations are made at more than one
point in time.
Decide Planned Detection Risk and Design Substantive Tests:We have discussed on how auditors assess control risk and support control risk assessment that
are below the maximum with specific tests of controls. The auditor uses the results of control
risk assessment process and tests of controls to determine the planned detection risk and related
substantive tests.
22
The following table has given you a brief summary of the relationship among internal control
effectiveness, control risk, planned detection risk and the extent of audit evidence to be gathered.
Internal Control
Control
risk
Planned detection
Risk
Audit Evidence
Weak
Strong
Higher
Lower
Lower
Higher
Larger
Smaller
Notice that control risk and audit evidence are directly related whereas planned detection risk
and audit evidence are inversely related.
Audit Risk Model:Audit risk (also referred to as residual risk) refers to the risk that an auditor may issue
unmodified report due to auditor's failure to detect material misstatement either due to error or
fraud. This risk is composed of inherent risk (IR), control risk (CR) and detection risk (DR), and
can be calculated thus:
AR = IR × CR × DR
Where, IR is inherent risk, CR is control risk and DR detection risk. IR refers to the risk involved
in the nature of business or transaction. Example, transactions involving exchange of cash may
have higher IR than transactions involving settlement by cheques. CR refers to the risk that a
misstatement could occur but may not be detected and corrected or prevented by entity's internal
control mechanism. DR is the probability that the audit procedures may fail to detect existence of
a material error or fraud. While CR depends on the strength or weakness of the internal control
procedures, DR is either due to sampling error or human factors.
Solving for DR (detection risk):Detection risk has to be restricted and occurs when the correct audit procedure is used or the
audit procedure is used incorrectly. The auditor assesses the inherent risk and control risk and
then solves the audit risk by assigning detection risk to reduce the audit risk to an acceptable
amount. The major elements of detection risk are misapplying an audit procedure,
23
misinterpreting audit results, and selecting the wrong audit test method. To solve for the
detection risk:
DR = AR/ (IR x CR) or DR = AR/RMM
From the result of solving this equation, it is understood that if the detection risk is low, the
auditor must collect additional appropriate evidence and the detection risk is high, the less
evidence is needed. Since detection risk is a function of the effectiveness of the audit procedures
performed, detection risk is the only risk that is completely a function of sufficiency of the
procedures performed by the auditors.
The audit evidence that the auditor collects must be sufficient and appropriate. Sufficiency is the
measure of quantity of audit evidence that must be obtained and appropriateness is the measure
of quality of audit evidence obtained. The audit evidence has to be both reliable and relevant in
order for it to affect the detection risk.
Implementing the model:The reason for using the audit risk model is to help prevent the risk of fraud and misstatements.
When an auditor audits a company, their main objective is to provide the best assurance possible
that the financial statements do not contain material mistakes. This will help the future decisions
made by the company and its current and future investors. The audit risk model is used to help
the auditor determine which auditing procedures for accounts or transactions shown on the
financial statements are used to help decrease the audit risk to an appropriate level. The financial
statements consist of the income statements, balance sheet, and statement of cash flows. The
income statements show the company‘s operating performance, from the accounts of revenues,
expenses, and net income. The balance sheet shows a company‘s assets, liabilities, and owner‘s
equity and the statement of cash flows shows the company‘s cash and cash payments. These are
important to look over this information because it is not always trusted. These financial
statements may be inaccurate and auditors may need to find additional information to make sure
that the information provided by these financial statements is reliable. Auditors might have a
situation where the client impeded the ability for the auditor to assess the financial statement.
This situation will increase audit risk and the auditor responses in two ways, that is; the auditor
issues an adverse opinion when it is not warranted or an unqualified opinion when it is not
warranted.
24
Risk of Material Misstatement/RMM:RMM = IR x CR
What is material misstatement? And why we bother about materiality?
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Risks of material misstatement at the financial statement level relate pervasively to the financial
statements as a whole and potentially affect many assertions. Risks of material misstatement
(RMM) at the financial statement level may be especially relevant to the auditor's consideration
of the risk of material misstatement due to fraud. For example, an ineffective control
environment, a lack of sufficient capital to continue operations, and declining conditions
affecting the company's industry might create pressures or opportunities for management to
manipulate the financial statements, leading to higher risk of material misstatement.
Risks of material misstatement at the assertion level are consisted of two components, that is;
inherent risk and control risk. Inherent risk refers to the susceptibility of an assertion to a
misstatement due to error or fraud that could be material, individually or in combination with
other misstatements, before consideration of any related controls. Control risk is the risk that a
misstatement due to error or fraud that could occur in an assertion and that could be material,
individually or in combination with other misstatements, will not be prevented or detected on a
timely basis by the company's internal control. Control risk is a function of the effectiveness of
the design and operation of internal control. Inherent risk and control risk are related to the
company, its environment, and its internal control, and the auditor assesses those risks based on
evidence he or she obtains. The auditor assesses inherent risk using information obtained from
performing risk assessment procedures and considering the characteristics of the accounts and
disclosures in the financial statements. The auditor assesses control risk using evidence obtained
from tests of controls and from other sources. There is an inverse relationship between RMM and
detection risk which is the risk that auditors will not detect a misstatement.
If RMM increases, this means that the auditor will do more substantive testing and this leads
to a decrease of the detection risk. If RMM decreases, this means the auditor will not do as much
25
testing and the detection risk will increase because limited testing will increase the chances of
the auditor missing something.
3. Substantive Tests of Transactions:
Substantive tests are procedures designed to test for dollar misstatements directly affecting the
correctness of financial statement balances. Such misstatements (often termed monetary
misstatements) are a clear indication of the misstatement of the accounts. There are three types of
substantive tests; substantive tests of transactions, analytical procedures, and tests of details of
balances. The purpose of substantive tests of transactions is to determine whether all six
transaction – related audit objectives have been satisfied for each class of transactions.
What are the six transaction – related audit objectives need detailed substantive tests?
What are the six transaction related audit objectives? List on the space provided
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Dear leaner! The six transactions related audit objectives will be discussed below:
1. Existence: - Recorded Transactions Exist. This objective deals with whether recorded
transactions have actually occurred. Inclusion of a sale in the sales journal when no sale
occurred violates the existence objective. The purpose is to examine whether there has
been recorded transactions which actually doesn‘t exist (overstatement)
2. Completeness: - Existing transactions are recorded. This objective deals with whether all
transactions that should be included in the journals have actually been included. Failure
to include a sale in the sale journal and general ledger when a sale occurred violates the
completeness objective.
The existence and completeness objectives emphasize opposite audit concerns; existence
deals with potential overstatement and completeness with unrecorded transaction
(understatement)
3. Accuracy: - Recorded transactions are stated at the correct amounts. This objective deals
with the accuracy of information for accounting transactions. For sales transactions, there
would be a violation of accuracy objective if the quantity of goods shipped was different
from the quantity billed, the wrong selling price was used for billing, extension or adding
errors occurred in billing or the wrong amount was included in the sales journal.
26
It is important to distinguish between accuracy and existence or completeness. For
example, if a recorded sales transaction should not have been recorded because the
shipment was on consignment; the existence objective has been violated, even if the
amount of the invoice was accurately calculated. If the recorded sale was for a valid
shipment but the amount was calculated incorrectly, there is a violation of the accuracy
objective but not of existence. The same relationship exists between completeness and
accuracy.
4. Classification: - transactions included in the client‘s journals are properly classified.
Examples of misclassifications for sales are including cash sales as credit sales, and
recording a sale of operating fixed assets as revenue:
5. Timing: - Transactions are recorded on the correct dates. A timing error occurs if
transactions are not recorded on the dates the transactions took place. A sales
transaction, for example, should be recorded on the date of shipment.
6. Posting and Summarization: - Recorded transactions are properly included in the
master files and are correctly summarized. This objective deals with the accuracy of the
transfer of information from recorded transactions in journals to subsidiary records and
the general ledger. For example, if a sales transaction is recorded in the wrong
customer‘s record or at the wrong amount in the master file; it is a violation of this
objective.
Because the posting of transactions from journals to subsidiary records, the general
ledger, and other related master files is typically accomplished automatically by
computerized accounting systems, the risk of random human error in posting is minimal.
Once the auditor can establish that the computer is functioning properly, there is a
reduced concern about posting process errors.
Remember that both tests of controls and substantive tests of transactions are performed
for transaction in the cycle, not on the ending account balances.
4. Analytical Procedures:
Analytical procedures involve comparisons of recorded amounts to expectations developed by
the auditor. They often involve the calculation of ratios by the auditor for comparison. With the
previous years‘ ratios and other related data. The two most important purposes of analytical
27
procedures in the audit of account balances are to(1) indicate the presence of possible
misstatements in the financial statements and (2) reduce tests of details of balances.
When the auditor develops expectations using analytical procedures and concludes that the
client‘s ending balances in certain accounts appear reasonable, certain tests of details of balances
audit procedures may be eliminated or sample sizes may be reduced.
5. Tests of Details of Balances:
Tests of details of balances focus on the ending general ledger balances for both balance sheet
and income statement accounts, but the primary emphasis in most tests of details of balances is
on the balance sheet. Examples include confirmation of customer balances for accounts
receivable, physical examination of inventory, and examination of vendor‘s statements for
accounts payable. These tests of ending balances are essential because the evidence is usually
obtained from a source independent of the client and thus is considered highly reliable. The
extent of these tests depends on the results of tests of controls, substantive tests of transactions,
and analytical procedures.
Tests of details of balances have the objective of establishing the monetary correctness of the
accounts they relate to end therefore are substantive tests. For example, confirmations test for
monetary misstatements and are therefore substantive. Similarly, counts of inventory and cash on
hand are also substantive tests.
Selecting which Types of Tests to Perform
Typically, auditors use all five types of tests when performing an audit, but certain types are
emphasized, depending on the circumstances. Factors such as the availability of different types
of evidence, the cost of each type of test, the effectiveness of internal controls, and the existence
of inherent risks all affect the mix of the types of tests the auditor selects. Each of the five types
of tests involves only certain types of evidence (confirmation, documentation, and so forth).
Procedures to obtain an understanding of internal control and tests of controls involve only
observation, documentation, inquiry, and re performance. Substantive tests of transactions
involve only the last three of these types of evidence. More types of evidence are obtained by
using tests of details of balances than by using any other type of test only tests of details of
balances involve confirmation and physical examination. Inquiries of clients are made with
every type of test. Documentation and re performance are used for every type of test except
analytical procedures.
28
This relationship between types of tests and evidence is summarized in the table below.
Figure 1.2: Relationship between types of tests and evidence
Type of Evidence
Physical examination
Confirmation
Documentation
Observation
Inquiries of the client
Re performance
Analytical procedures














Analytical
procedures
Reperformance

Inquiries of the
client

Observation
Procedures to obtain an understanding of
internal control
Tests of controls
Substantive tests of transactions
Analytical procedures
Tests of details of balances
Alternatively;
Documentation
Type of Test
Confirmation
Physical
Examination
Type of Evidence


Types of Tests
Tests of details of balances
Tests of details of balance
All except analytical procedures
Procedures to obtain an understanding of
internal control and tests of controls
All five types
Tests of controls, substantive tests of
transactions, and tests of details of balances
Analytical procedures
Summary
In deciding which type of test to select for obtaining sufficient competent evidence, the cost of
the evidence is one important consideration. The types of tests are listed in order of increasing
cost as follows:
 The five types of tests auditors use to determine whether financial statements are fairly
stated include the following: Procedures to gain an understanding of internal control,
Tests of controls, Substantive tests of transactions, Analytical procedures and Tests of
details of balances
 While procedures to gain an understanding of internal control help the financial statement
auditor obtain information to make an initial assessment of control risk, tests of controls
29
must be performed as support of an assessment of control risk that is below maximum.
The purpose of tests of controls is to obtain evidence regarding the effectiveness of
controls, which may allow the auditor to assess control risk below maximum. If controls
are found to be effective and functioning, the substantive evidence may be reduced.
Substantive evidence is obtained to reduce detection risk. Substantive evidence includes
evidence from substantive tests of transactions, analytical procedures, and tests of details
of balances.
 For audits of internal control over financial reporting, the auditor only performs the first
two types of audit tests: procedures to obtain an understanding of internal control and
tests of controls. Because a public company auditor must issue a report on internal
control over financial reporting, the extent of the auditor‘s tests of controls must be
sufficient to issue an opinion about the operating effectiveness of those controls. That
generally requires a significant amount of testing of controls over financial reporting.
 Tests of controls are audit procedures to test the operating effectiveness of control
policies and procedures in support of a reduced assessed control risk. Tests of controls
provide the primary basis for a public company auditor‘s report on internal controls over
financial reporting. Specific accounts affected by performing tests of controls for the
acquisition and payment cycle include the following: cash, accounts payable, purchases,
purchase returns and allowances, purchase discounts, manufacturing expenses, selling
expenses, prepaid insurance, leasehold improvements, and various administrative
expenses.
30
 Tests of controls are audit procedures to test the operating effectiveness of control
policies and procedures in support of a reduced assessed control risk. Examples include:
o The examination of vendor invoices for indication that they have been clerically
tested, compared to a receiving report and purchase order, and approved for
payment.
o Examination of employee time cards for approval of overtime hours worked.
o Examination of journal entries for proper approval.
o Examination of approvals for the write-off of bad debts.
 Substantive tests of transactions are audit procedures testing for monetary misstatements
to determine whether the six transaction-related audit objectives have been satisfied for
each class of transactions. Examples are:
o Recalculation of amounts (quantity times unit selling price) on selected sales
invoices and tracing of amounts to the sales journal.
o Examination of vendor invoices in support of amounts recorded in the
acquisitions journal for purchases of inventories.
o Recalculation of gross pay for selected entries in the payroll journal.
o Tracing of selected customer cash receipts to the accounts receivable master file,
agreeing customer names and amounts.
 A test of control audit procedure to test that approved wage rates are used to calculate
employees' earnings would be to examine rate authorization forms to determine the
existence of authorized signatures.
 A substantive test of transactions audit procedure would be to compare a sample of rates
actually paid, as indicated in the earnings record, to authorized pay rates on rate
authorization forms.
 Audit Risk (AR): risk that auditor will opine (render an opinion) with an unqualified
opinion when unknown to auditor, FS are materially misstated (ultimate risk)
 Inherent Risk (IR): risk that errors (or misstatements or deviations) will occur," clientcontrolled.
 Control Risk (CR): risk that client's internal control system will fail to prevent/
detect/correct errors ... client- controlled.
31
 Detection Risk (DRI_ risk that auditor's procedures will fail to detect errors ... auditor controlled
 AR IR * CR * OR
 Audit risk = inherent risk * control risk * detection risk
 Audit risk: always set priority at a low level (.0 1, 05, 10)
 Inherent risk: controlled by client ... function of type of business, degree of liquidity,
complexity
 Control risk: controlled by client ... relates to effectiveness of client's control system in
preventing, detecting, and correcting errors.
 Detection risk: controlled by auditor ... function of nature, timing, and extent of audit
procedures applied ... allowable or acceptable
 Solution Set:
o Detection risk = audit risk / (inherent risk * control risk)
o Detection risk low ... the more evidence you have to collect
o Detection risk high ... the less evidence you have to collect
 Audit Risk: Risk that auditor issues unqualified opinion when statements are materially
misstated, audit risk and detection risk closely related. IR/CR and detection risk
inversely related.
 Management‘s five Assertions:a. Existence or Occurrence
b. Completeness
c. Rights and Obligations
d. Valuation
e. Presentation and Disclosure
*auditor's judgments about risks are based on assertions.
*assertions translated to account balances, then create audit objectives and procedures
Inherent Risk Factors:
a. Nature of Activities (Complexity)
b. Regulatory Nature
c. Degree of Estimates
32
d. Competency and Training Of Those Reporting The Financial Statements
e. Previous History with Entity
f. Preliminary Analysis Testing ( Required By SAS In Planning)…Indicates Areas
Where Misstatements Occur
 Control Risk: SAS 78 requires auditor to document control risk assessment ... if controls
are not working, control risk is assessed at maximum
 Detection Risk: test of details and analytical procedures (ratios)... 1-DR = confidence
level... The detection risk cannot be lower than the audit risk (the highest of CR or IR):
 If CR is moderate or low, test must be designed to prove it
 IR - no implied tests, more efficient, doesn't require tests, simply
document assessment
Model examination questions:
Use the following information to answer questions 1 through 5
Mean book value of items in sample:
$32
Mean audited value of items in sample:
$31
Mean book value of items in population:
$33
Number of items in population:
10,000
1. The total book value of this population is:
A. $310,000
C. $330,000
B. $320,000
D. $374,222
2. Using the mean-per-unit estimation, the estimated total audited value is:
A. $310,000
C. $330,000
B. $320,000
D. $374,222
3. Using mean-per-unit estimation, the projected misstatement is:
A. $10,000 overstatement
C. $20,000 overstatement
B. $10,000 understatement
D. $20,000 understatement
4. Using ratio estimation, the estimated total audited value is:
A. $300,606
C. $319,688
B. $310,000
D. $320,000
5. Using difference estimation, the estimated total audited value is:
A. $300,000
C. $320,000
B. $310,000
D. $330,000
6. Which one of the following is true about the purpose of audit sampling?
A. To obtaining information about an entire population or universe by examining only part
of it.
33
B. To estimate characteristic of group without complete examination of all items
constituting the group.
C. To use samples which are chosen without regard for the statistical requirements that
governs the sample size and the method of selection?
D. All
E. All except ―C‖
7. Identify the true statement about non-statistical (or judgmental) sampling?
A. Use of samples which are chosen without regard for the statistical requirements that
govern the sample size and the method of selection.
B. Used where statistical sampling will not satisfy the audit purpose.
C. Provides no mathematical basis for projecting sample results to the entire population.
D. Used to estimate characteristic of group without complete examination of all items
constituting the group.
E. All
F. None
8. Which of the following is (are) true about the advantage of using statistical sampling?
A. Auditors may be able to design more efficient samples and avoid ―over auditing‖ or
―under auditing.‖ Permits auditors to optimize sample size, given the acceptable sampling
risk.
B. Enables auditors to objectively measure the reliability of the evidence obtained from the
sample. Auditor can calculate and control the risk of reliance on a sample.
C. Should the auditor be placed in the position of defending their auditing procedures in a
court proceeding, they would be able to demonstrate mathematically that their sampling
procedures or conclusions were statistically justifiable. Similarly, the auditor would be
able statistically to justify their work to a client who was critical of the extent of their
testing.
D. All
E. None
9. ____ is the ―allowable margin of sampling error‖, also, referred to the ―Allowance for
sampling risk.‖ Ranged by + or – limits from the sample results, within which the true
characteristics of the population are likely to lie.
A. Precision
D. Attribute sampling
B. Reliability (Confidence) Level
E. None
C. Risk of Sampling
10. Identify areas requiring the auditor to make judgment decisions in sampling?
A. Defining population, characteristics to be tested, and exceptions.
B. Determining the appropriate statistical selection techniques for drawing a random sample.
C. Establishing the required precision and reliability (confidence) level.
D. Determining tolerable rate or misstatement.
E. All
F. None
34
11. When planning a sample for a substantive test, how much monetary misstatement may exist
in the account balance without causing financial statements to be misstated? This question is
answered more appropriately by which of the following?
A. Tolerable rate
D. Attribute sampling
B. Tolerable misstatement
E. Variable sampling
C. Projected misstatement
12. Selection of a sample from a population of items in such a manner that each item in the
population has an equal chance of being chosen for examination is;
A. Unrestricted random sampling
D. All
B. Systematic selection
E. None
C. Stratified selection
13. Which of the following is not true about the characteristics of attribute sampling?
A. Used to estimate the frequency or rate of occurrence of a particular attribute in a
population.
B. Concerned with the question of ―How Many.‖
C. Primarily use to test controls-Are internal control procedures being carried out properly?
D. Primarily used by auditors to perform substantive procedures.
E. All
F. None
35
UNIT TWO: AUDIT OF BALANCE SHEET ITEMS
UNIT INTRODUCTION
Dear learner! Here, our discussion turns to the major auditing activity; the examination of
underlying evidence to substantiate the financial statements developed from the related ledger
balances. In attempting to substantiate a statement figure the auditor will have certain objectives
in mind and these objectives will in turn guide the selection of audit procedures and their
application in light of the particular circumstances. Audit procedures are a set of audit tests
(techniques) and they are developed to accomplish the desired audit objectives. Audit objectives
are the key to audit procedures, and the procedures flow logically from the stated objectives. If
the objectives are thoroughly understood, audit procedures that will accomplish the desired
objectives become almost self-evident. Thus, in this unit we shall discuss the audit objectives
and procedures for different balance sheet and income statement accounts.
Meaning and objectives of audit programs (general)
An audit program is a detailed list of the audit procedures to be performed in the course of the
examination. The audit program usually is divided in to two major sections. The first section
deals with the procedures to obtain an understanding of the client‘s internal control structure, and
the second section deals with the substantiation of specific financial statement amounts, as well
as the adequacy of financial statement disclosures.
 The systems portion of the program
Audit procedures in the systems portion of the program typically include preparation of internal
control questionnaire, flowcharts for each transaction cycle (e.g. sales and collection cycle,
Purchase cycle etc), and tests of the significant internal controls, identification of strengths and
weaknesses, and assessment of control risk.
After their consideration of internal control, the auditors will make appropriate modifications in
the substantive test portion of the audit program. For example, as a result of weaknesses in
internal control in the sales transaction, the auditors may assess control risk for accounts
receivable to be high and decide to perform more extensive substantive test of receivables.
36
 The substantive test portion of the program
This portion of the audit program is aimed at substantiating financial statement amounts.
Systems approach Vs substantive approach
The systems approach involves heavy reliance upon the client‘s internal control, whereas the
substantive approach relies more heavily up on substantive testing as the basis for the auditor‘s
opinion. Actually, every audit involves a blend of reliance on internal control and substantive
testing. Thus, systems approach and substantive approach are relative terms, indicating the
emphasis that a particular CPA firm places in the systems or substantive portions of its audit
program on a given engagement. Some CPA firms may lean toward one approach or the other as
a matter of firm policy. However, in the audit of a client with weak internal control, the auditor
has no choice but to emphasize the substantive approach.
Objectives of Audit Programs:
Audit procedures are designed to accomplish certain objectives with respect to each major
account in the financial statements. These objectives follow directly from the assertions that are
contained in the client‘s financial statements.
Management assertions- Assertions are representations of management that are set forth in the
financial statements. Broadly speaking, a set of financial statements contains the following five
management assertions:
1. Existence or occurrence: - Assets, Liabilities, and owner‘s equity reflected in the financial
statements exist; the recorded transactions have occurred.
2. Completeness: - all transactions, assets, liabilities, and owners‘ equity that should be
presented in the financial statements are included.
3. Rights and Obligations: - the client has rights to assets and obligations to pay liabilities that
are included in the financial statements.
4. Valuation or allocation: - assets, liabilities, owner‘s equity, revenues, and expenses are
presented at amounts that are determined in accordance with generally accepted accounting
principles.
5. Presentation and disclosure: - accounts are described and classified in the financial
statements in accordance with generally accepted accounting principles, and all material
disclosures are provided.
37
From these assertions, general objectives may be developed for each major type of balance sheet
account, including assets, liabilities, and owners‘ equity.
 General objectives of audit programs for asset accounts:The specific objectives for auditing cash are not identical to the specific objectives for auditing
inventory. Although the specific audit objectives and, therefore, the audit procedures differ for
each account, it is useful to realize that each audit program follows basically the same approach
to verifying the balance sheet items and related income statement amounts.
The audit program for every asset category includes procedures designed to accomplish the
following general objectives:
I. Consideration of internal control:A) Obtain an understanding of internal control sufficient to plan the audit.
B) Assess control risk and design additional tests of controls.
C) Conduct additional tests of controls.
D) Reassess control risk and design substantive tests.
II. Substantiate account balances (substantive tests):A) Establish the existence of assets.
B) Establish that the company has rights to the assets.
C) Establish completeness of recorded assets.
D) Determine the appropriate valuation of the assets.
E) Establish the clerical accuracy of the underlying records.
F) Determine the appropriate financial statement, presentation and disclosure of the assets.
These general objectives are common to all audit programs for asset accounts.
Dear learner! Henceforth, we will discuss the specific audit objectives for various balance sheet
and income statement accounts.
38
2.1 SECTION 1: AUDITING OBJECTIVES AND PROCEDURES FOR CASH AND
MARKETABLE SECURITIES
Dear learner! After reading this chapter you should be able to achieve the following learning
objectives:
 Identify the significant accounts, disclosures, and relevant assertions in auditing cash
accounts
 Identify inherent, fraud and control risks of material misstatement in cash accounts
 Describe how to use preliminary analytical procedures to identify possible material
misstatements for cash accounts, disclosures, and assertions
 Determine appropriate tests of controls and consider the results of tests of controls for
cash accounts, disclosures, and assertions
 Determine and apply sufficient appropriate substantive audit procedures for testing cash
accounts, disclosures, and assertions
 Identify types of marketable securities, articulate the risks and controls typically
associated with these accounts, and outline an audit approach for testing these accounts
 Apply frameworks for professional decision making and ethical decision making to
issues involving the audit of cash accounts, disclosures, and assertions
2.1.1 Sources and Nature of Cash:
Dear learner! Would you able to define cash? Her let you know what cash items and sources.
Cash normally includes checking accounts; cash on hand, petty cash fund and less frequently,
savings accounts. Cash sales, collections of receivables, and investment of additional capital
typically increase the account; business expenditures decrease it.
What are the main sources of cash in the company you are working in?
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Sources:
 General checking account
 Payroll checking accounts
39
 Petty cash
 Savings accounts
 Cash equivalents
 Money market funds
 Certificates of deposit
 Savings certificates
2.1.2 Audit Objectives for Cash:
1. Use the understanding of the client and its environment to consider inherent risk,
including fraud risks, related to cash
2. Obtain an understanding of internal control over cash.
3. Assess the risks of material misstatement of cash and design tests of controls and
substantive procedures that:
a. Substantiate the existence of recorded cash and occurrence of the related
transactions
b. Establish the completeness of recorded cash
c. Verify the cutoff and accuracy of cash transactions
d. Determine that the client has rights to recorded cash
e. Determine that the presentation and disclosure of cash, including restricted funds,
are appropriate
Audit time for cash
Cash typically has a small account balance, but auditors devote a large proportion of total audit
hours because:

Liabilities, revenues, expenses and most other assets flow through cash

Most liquid asset so greater temptation for misappropriation

High risk account
Management Assurance
Finance and accounting department work together to provide assurance that:

All cash that should have been received was in fact received, recorded accurately
and deposited promptly

Cash disbursements have been made for authorized purposes only and have been
properly recorded
40

Cash balances are maintained at adequate, but not excessive, levels by forecasting
2.1.3 Internal Control over Cash Transactions:
Most of the functions relating to cash handling are the responsibility of the finance department,
under the direction of the treasurer. These functions include handling and depositing cash
receipts; signing checks; investing idle cash; and maintaining custody of cash, marketable
securities, and other negotiable assets. In addition, the finance department must forecast cash
requirements and make both short term and long-term financing arrangements.
Ideally, the functions of the finance department and the accounting department should be
integrated in a manner that provides assurance for guideline of internal control as universal rules.
How is cash controlled from embezzlement in your company?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Guidelines for Internal Control
1. Do not permit any one employee to handle a transaction from beginning to end.
2. Separate cash handling from recordkeeping.
3. Centralize receiving of cash to the extent practical.
4. Record cash receipts on a timely basis.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit cash receipts daily.
7. Make all disbursements by check or electronic funds transfer, with the exception of small
expenditures from petty cash.
8. Have monthly bank reconciliations prepared by employees not responsible for the
issuance of checks or custody of cash. The completed reconciliation should be reviewed
promptly by an appropriate official.
9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted
amounts
Internal Control over –Cash Receipts
Key Internal Controls Cash Receipts
 Cash sales

Involvement of two or more employees
41

Cash Registers

Electronic point of sale (POS) systems
 Collections of receivables

Initial listing of cash receipts (mailroom)

Custody and prompt depositing of cash receipts

Maintenance of customer account records

Reconciliation of customer sub ledgers with control A/Cs

Mailing monthly statements to customers

Collection and follow-up past-due accounts
Most Likely Misstatements Cash Receipts
Recording fictitious cash receipts, not recording receipts from cash sales, early (late) recognition
of cash receipts and not recording cash from collection of accounts receivables as well. The
following are the common once
Lapping
Starts with embezzling customer payments (usually by accounts receivable clerk) and then
concealing it by posting subsequent payments from other customers on a continual overlapping
basis to keep individual accounts as current as possible.
Prevention: (1) Segregate payment from remittance advice form or (2) making a record of the
payments before sending to accounts receivable clerk and comparing list to daily deposit details.
Audit Detection: (1) confirmation of balance with customers or (2) comparing accounts
receivable sub-ledger credits per day to daily deposit details.
Figure 2.1: Illustration (lapping)
Date
Dec1
Dec1
Dec2
Dec2
Dec3
Dec4
Actual
Received
From
Wanza
Crane
Zigba
White
Crawford
Miller
Recorded as
Cash
Received Cash
Theft
Received From
Received
$750
-0$750
1,035
Crane
$1,035
750
Wanza
750
130
White
130
1,575
Zigba
750
825
400
Miller
400
42
Key Internal Controls for Cash Disbursements

Segregation of duties

Payment by check or electronic funds transfer

Match of purchase order and receiving documents with vendor‘s invoice

Review of supporting documents by authorized check signer

Cancel supporting documents

Authorized check signer should mail checks
Most Likely Misstatements for Cash Disbursements
 Inaccurate recording of a purchase or disbursement
 Duplicate recording/payment of purchases
 Unrecorded disbursement
2.1.4 Audit Procedures for Cash:
The following audit procedures indicate the general pattern of work performed by the auditors in
the verification of cash. Selection of the most appropriate procedures for a particular audit will
be guided, of course, by the nature of the internal controls in force and by other circumstances of
the engagement.
How is cash audited in your company? List some of the procedures on your own
words?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------A) Consider internal control for cash
1) Obtain an understanding of internal control for cash.
In the audit of a small business, auditors may prepare a written description of controls in force,
based up on the questioning of owners and employees and up on first hand observation. For
larger companies, a flow chart or internal control questionnaire is usually employed to describe
the internal control structure. Among the questions included in a questionnaire for cash
disbursements are whether all disbursement (except those from petty cash) are made by pre
numbered checks and whether voided checks are mutilated, preserved, and filed. The existence
of these controls permits the auditors to determine that all disbursements have been recorded by
accounting for the sequence of checks issued or voided during the period.
43
Other points to be made clear by the questionnaire include;(a) whether check–signing authority
is restricted to selected executives not having access to accounting records or to vouchers and
other documents supporting checks submitted for signature, and (b) whether checks are mailed
directly to the payees after being signed.
The internal control questionnaire will also cover cash disbursements for payroll and for
dividends, as well as bank reconciliation procedures. All questions on the internal control
questionnaire are designed to require affirmative answers when a satisfactory control exists.
After the auditors have prepared a flowchart (or other description) of internal control, they
should conduct a walk-through of a system. The term walk-through means to trace a few
transactions through each step of the system to determine that transactions actually are being
processed in the manner indicated by the flow chart.
2. Assess control risk and design additional tests of controls for cash.
Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost justified restrictions of
substantive tests.
3. Perform tests of controls for those controls which auditors plan to rely upon to restrict
their assessment of control risk, and reduce the extent of substantive testing such as:
a)
Prove footings of cash journals and trace postings to ledger accounts.
The purpose of proving footings and postings of the cash records is to verify the mechanical
accuracy of the journals and ledger. In a computer based system, journal and ledger entries
are created simultaneously from the same source documents. The auditors might choose to
use a test data approach to test controls over the postings of ledgers. The accuracy of
footings may be proved with the auditors‘ generalized audit software.
In a manual system, information on source documents is entered first in a journal; at a later date
the information is summarized and posted from journals to ledgers. Therefore, in a manual
system, the auditors must manually determine that journals are accurately footed and the data
properly posted to the ledger. The auditors also should trace the monthly posting of column total
from the cash receipts journal to the cash account and to the controlling account for accounts
44
receivable. Similar Verification may be made for the totals posted from the cash payments
journal to the cash account and to the accounts payable account in the general ledger.
b) Compare the detail of a sample of cash receipts listings to the cash receipts journals,
accounts receivable postings, and authenticated deposit slips.
Satisfactory internal control over cash receipts demands that each day‘s collections be deposited
intact no later than the next banking day. To provide assurance that cash receipts have been
deposited intact, the auditors should compare the detail of the original cash receipts listings (mail
room listings and register tapes) to the detail of the daily deposit tickets.
Comparison of the daily entries in the cash receipts journal with bank deposits may disclose a
type of fraud known as lapping. Lapping means the concealment of a cash shortage by delaying
the recording of cash receipts. If cash collected from customer A is withheld by the cashier, a
subsequent collection from customer B may be entered as a credit to A‘s account. B‘s account
will not be shown as paid until a collection from customer C is recorded as a credit to B.
c) Compare the detail of a sample of recorded disbursements in cash payments journal,
accounts payable postings, purchase orders, receiving reports, invoices, and paid checks.
Satisfactory internal control over cash disbursements requires that controls exist to provide
assurance that disbursements are properly authorized. Testing cash disbursements involves
tracing selected items back through the cash payments journal to original source documents,
including vouchers, purchase orders, receiving reports, invoices, and paid checks
4. Reassess control risk and design substantive tests
When the auditors have completed the procedures described in the preceding sections, they
should assess the extent of control risks for each financial statement assertion regarding cash.
The auditors then draft the portion of the audit program devoted to the substantive tests of cash
transactions and balances.
B) Perform substantive tests of cash transactions and balances.
Can you list some of the substantive tests of cash transactions in your organization
(community)?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------45
5. Obtain analyses of cash balances and reconcile to general ledger.
The auditors will prepare or obtain a schedule that lists all of the client‘s cash accounts. For cash
in bank accounts, this schedule will typically list the bank, the account number, account type,
and the yearend balance per books. The auditors will trace and reconcile all accounts to the
general ledger as necessary.
6. Send Confirmation letters to banks to verify amounts on deposit.
One of the objectives of the auditors‘ work on cash is to substantiate the validity of the amount
of cash shown on the balance sheet. A direct approach to this objective is to confirm amounts on
deposit, count the cash on hand, and obtain or prepare reconciliations between bank statements
and the accounting records.
7. Obtain or prepare reconciliations of bank accounts as of the balance sheet date and
consider need to reconcile bank activity for additional months.
Determination of a company‘s cash positions at the close of the period requires a reconciliation
of the balance per the bank statement at that date with the balance per the company‘s accounting
records. Even though the auditors may not be able to begin their field work for some time after
the close of the year, they will prepare bank reconciliation as of the balance sheet date or review
the one prepared by the client. Inspection of a reconciliation prepared by the client will include
verifying the arithmetical accuracy, tracing balances to the bank statement and ledger account,
and investigating the reconciling items.
8. Obtain a cutoff bank statement containing transactions of at least seven business days
subsequent to balance sheet date.
A cut off bank statement is a statement covering a specified number of business days (usually
7 to 10) following the end of the client‘s fiscal year. The client will request the bank to prepare
such a statement and deliver it directly to the auditors. This statement is used to test the accuracy
of the year-end reconciliation of the Company‘s bank accounts. It allows the auditors to examine
firsthand the checks listed as outstanding and the details of deposits in transit on the company‘s
reconciliation.
46
9. Count and list cash on hand
Cash on hand ordinarily consists of un-deposited cash receipts, petty cash funds, and change
funds. The petty cash funds and change funds may be counted at any time before or after the
balance sheet date; many auditors prefer to make a surprise count of these funds.
The count of cash on hand is of special importance in the audit of banks and other financial
institutions. Whenever auditors make cash count, they should insist that the custodian of the
funds be present throughout the count. At the completion of the count, the auditors should obtain
from the custodian a signed and dated acknowledgement that the funds were counted in the
custodian‘s presence and were returned intact by the auditors. Such procedures avoid the
possibility of an employee trying to explain a cash shortage by claiming that the funds were
intact when turned over to the auditors.
10. Verify the client’s cutoff of cash transactions
The balance sheet figure for cash should include all cash received on or before the final day of
the year and none received subsequently. Such tests help to uncover misleading actions known
as window dressing. The term window dressing refers to actions taken shortly before the
balance sheet date to improve the cash position or in other ways to create an improved financial
picture of the company. For example, if the cash receipts-journal is held open for a few days
after the close of the year, the balance sheet figure for cash is improperly increased to include
cash collections actually received after the balance sheet date
11. Trace all bank transfers for the last week of audit year and first week of following year.
The purpose of tracing bank transfers is to disclose overstatements of cash balances resulting
from kiting (Deposited in bank may not recorded on book)
12. Investigate any checks representing large or unusual Payments to related parties
Any large or unusual checks payable to directors, officers, employees, affiliated companies, or
cash should be carefully reviewed by the auditors to determine whether the transactions (a) were
Properly authorized and recorded and (b) are adequately disclosed in the financial statements. If
checks have been issued payable to cash, the auditors should determine who received these
payments and why this form of check was used.
To provide assurance that cash disbursements to related parties were authorized transactions and
were properly recorded, the auditors should determine that each such transaction has been
47
charged to the proper account, is supported by adequate vouchers or other records, and was
specifically approved in advance by an officer other than the one receiving the funds.
13. Determine proper financial statement presentation and disclosure.
The balance sheet figure for cash should include only those amounts that are available for use in
current operations. Most users of the balance sheet are not interested in the breakdown of cash by
various bank accounts or in the distinction between cash on hand and on deposit. Consequently,
all cash on hand and in banks that is available for general use is presented as a single amount on
the balance sheet. Change funds and petty cash funds are usually not material in amount and are
included in the balance sheet figure for cash. A bank deposit that is restricted in use (for
example, cash deposited with a trustee for payments on long-term debt) should not be included in
cash.
Generally, Audit Objectives: Substantive Tests of Cash:
Substantiate the Existence of recorded cash

Establish the Completeness of recorded cash

Determine that the client has Rights to recorded cash

Establish the clerical accuracy of cash schedules

Determine that the Presentation and disclosure of cash

Determine proper Valuation per GAAP
Substantive Tests - Cash Balances:
Obtain analyses of cash balances and reconcile to GL

Send standard confirmation forms to banks

Consider reconciling bank activity (proof of cash)

Obtain reconciliations of yearend bank balances

Obtain bank cutoff statement

Count cash on hand, if significant

Verify the client‘s cutoff of cash transactions

Analyze bank transfers occurring around yearend

Investigate payments to/receipts from related parties

Evaluate financial statement presentation and disclosure
48
Table 2.1: Substantive testing- Cash
Financial statement assertion
Existence
Completeness
Rights and obligations
Valuation
Assertions relating to presentation and
disclosure (classification and
understandability, occurrence and rights and
obligations, accuracy and valuation,
completeness)
Audit objective
Recorded cash balances exist at the period-end
Recorded cash balances include the effects of
all transactions that have occurred
The entity has legal title to all cash balances
shown at the period-end
Recorded cash balances are realizable at the
amounts stated
Disclosures relating to cash are adequate and in
accordance with accounting standards and
legislation
Consider reconciling bank activity (proof of cash) - Reconciles bank account balance and
activity (cash in bank transactions) during a specified period between client & bank records. It is
used to identify Cash receipts & disbursements recorded in the accounting records, but not on the
bank statement, Cash deposits & disbursements recorded on the bank statement, but not in the
accounting records, Cash receipts and disbursements recorded at different amounts by the bank
than in the accounting records. To do proof of cash transactions; Start with what the bank
statement shows as to balances (beginning & ending), credits and debits to A/C. Then, we either
add or subtract from these four amounts to attempt to reconcile to GL beginning and ending
balances and deposits and disbursements. Most are timing differences (DIT, outstanding checks
at beg and end of period) or items not recorded yet (bank charges).
Kiting – Three Types

Transferring funds between bank accounts, but recording the increase (debit) in the
current FY (fiscal year) and the decrease (credit) in the next FY (funds on B.S. twice).

Depositing funds in current FY, but recording the deposit in the next FY (to cover a cash
shortage or when bank balance < GL).

Taking advantage of float or bank check clearance time to cover temporary cash shortage
or to earn interest on same funds being transferred between bank accounts.
49
Summary
Table 2.2: Objectives of major substantive procedures for cash transactions and balances
Substantive procedures
Obtain analysis of cash balance and reconcile
them to general ledger
Send standard confirmation form to financial
institutions.
Obtain reconciliations of bank balance and
consider; reconciling bank activity, obtain bank
cutoff statement, count cash on hand
Verify the client‘s cutoff of cash transactions
Analyze bank transfer occurring around year
end
Investigate payments to related parties.
Evaluate financial statement presentation and
disclosure
Primary audit objective
Existence and accuracy
Existence, occurrence, accuracy, cutoff, and
rights
Cutoff, existence, occurrence and rights
Completeness
Presentation and disclosure
Lapping: Employee steals a payment from one customer, and covers it up by using payments
from another customer to disguise the theft
Skimming: Type of fraud that occurs when an employee makes a sale but does not record it, and
steals the cash
Table 2.3: Potential misstatement-cash receipts
Description of
misstatement
Examples
Recording fictitious
cash receipts
Fraud:
.overstating cash receipts on the
books by transferring cash between
bank accounts without appropriate
recording of the transfer to cover up
an embezzlement of cash
Fraud:
.a cashier fails to ring up and record
cash sales and embezzles the cash
Error:
.a book keeper accidentally omits
the recording of the receipts from
one cash register for the day.
Failure to record
receipts from cash
sales
Failure to record
cash from collection
of accounts
Fraud:
.a cashier embezzles cash payments
by customers on receivables
Internal control weakness/factors
that increase the risk of the
misstatement
.lack of segregation of duties of the
functions of access to cash and
record keeping; no effective
review of bank reconciliations
.inadequate supervision of
cashiers; failure to encourage
customers to obtain cash receipts
.inadequate control for reconciling
cash register tabs and accounting
records; inadequate controls for
reconciling bank accounts
. Lack of segregation of duties
between personnel who have
access to cash receipts and those
50
receivables
Early (late)
recognition of cash
receipts-―cutoff
problems‖
without recording the receipts in
the customers‘ accounts
.A bookkeeper who has access to
cash receipt embezzles cash
collected from customers and
writes off the related receivables
Error:
.a bookkeeper accidentally fails to
record payments on a receivable.
Fraud:
.holding the cash receipts journal
open to record next year‘s cash
receipts as having occurred in this
year.
Error:
.recording cash receipts based on
bad information about date of
receipt.
who make entries in to the
accounts receivable records.
. Lack of segregation of duties
between personnel who have
access to cash receipts and those
who make entries into the accounts
receivable records.
.inadequate reconciliation of
subsidiary records of accounts
receivable with the general ledger
control account.
Ineffective board of directors,
audit committee, or internal audit
functions: ―tone at the top‖ not
conducive to ethical conduct;
undue pressure to show improved
financial position.
.failure to list and deposit cash
receipts on timely basis.
2.1.5 Marketable Securities:
? Dear learner! What do you mean by marketable securities?
The most important group of investments, from the viewpoint of the auditors, consists of
stocks and bonds because they are found more frequently and usually are of greater dollar value
than other kinds of investment holdings. Bank certificates of deposit, commercial paper issued
by corporations, and the cash surrender value of life insurance policies are other types of
investments often encountered. Investment of temporarily idle cash in selected types of
marketable securities is an element of good financial management. Such holdings are regarded
as a secondary cash reserve, capable of quick conversion to cash at any time, although producing
low rate of return.
Investment in securities made for the purpose of maintaining control or influence over affiliated
companies should not be classified under marketable securities.
2.1.5 The Auditors’ Objectives in Examination of Marketable Securities
The auditors‘ objectives in the examination of marketable securities are to determine that:
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1. Use the understanding of the client and its environment to consider inherent risk,
including fraud risks, related to financial instruments
2. Obtain an understanding of internal control over financial instruments.
3. Assess the risks of material misstatement of financial instruments and design tests of
controls and substantive procedures that:
a. Substantiate the existence of recorded financial investments and the occurrence of
investment transactions.
b. Establish the completeness of financial investments and investment transactions.
c. Verify the cutoff of investment transactions.
d. Determine that the client has rights to recorded investments.
2.1.6 Internal Control for Marketable Securities:
What internal control mechanisms of marketable securities, (if any), you know in your
working place? List some of them?
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The major elements of adequate internal control over marketable securities include the
following:
 Establishment of formal investment policies
 Review and approval of investment activities by the investment committee of the board
of directors
 Separation of duties among employees
1. Authorizing purchases and sales
2. Having custody of the securities
3. Maintaining records
 Detailed records of all securities owned and the related revenue from interest and
dividends
 Registration in the name of the company
 Periodic physical inspection of securities
 Determination of accounting for complex instruments by competent personnel
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2.1.7 Audit Procedures for Securities:
Assume you as an internal auditor, what will be your first step to accomplish your
engagement in financial investment audit?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The following procedures are typically performed by auditors to achieve the objectives described
earlier.
A. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks related to financial investments.
B. Obtain an understanding of internal control over financial investments
C. Assess the risks of material misstatement and design further audit procedures.
D. Perform further audit procedures—tests of controls.
1. Examples of tests of controls:
a. Trace several transactions for purchases and sales of investments through the accounting
system.
b. Review and test reports of investment activity prepared for the investment committee.
c. Inspect reports by internal auditors regarding their periodic inspection and review of
securities and derivative instruments.
d. Inspect monthly reports on securities owned, purchased, and sold and amounts of revenue
earned and budgeted.
2. If necessary, revise the risk of material misstatement based on the results of tests of controls.
E. Perform further audit procedures—substantive procedures for investment transactions and
year-end balances.
a. Obtain or prepare analyses of the investment accounts and related revenue, gain,
and loss accounts and reconcile them to the general ledger.
b. Inspect securities on hand and review agreements underlying derivatives.
c. Confirm securities and derivative instruments with holders and counterparties.
d. Vouch selected purchases and sales of financial investments during the year and
verify the client‘s cutoff of investment transactions.
e. Review investment committee minutes and reports.
f. Perform analytical procedures.
g. Make independent computations of revenue from securities.
h. Inspect documentation of management‘s intent to classify derivative transactions
as hedging activities.
i. Evaluate the method of accounting for investments.
j. Test the valuation of financial investments.
k. Evaluate financial statement presentation and disclosure of financial investments.
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Summary of Substantive Procedures for Financial Investments: objectives of major table
2.4: substantive procedures for marketable securities
Substantive procedures
Obtain analysis of investment and related accounts and reconcile
to ledger
Inspect securities on hand and review agreements underlying
derivatives.
Confirm securities and derivative instruments with holders and
counterparties
Vouch selected purchase and sales of investment during the year.
Verify the client‘s cutoff of investment transactions.
Review investment committee minutes and reports.
Perform analytical procedure. Make independent computations
of revenue from securities.
Inspect documentations of management‘s intent to classify
derivative transactions as hedges.
Evaluate the method of accounting for investment.
Test the valuation of financial investments.
Evaluate financial statement presentation and disclosure of
financial investment
Primary audit objective
Existence, rights and
occurrence
Existence and rights
Occurrence and accuracy
Completeness
Cutoff
Valuation
Valuation
Completeness
Existence, rights, occurrence,
completeness
Valuation
Presentation
Presentation
Activity 2.1
The following are misstatements that might be found in the client‘s year-end cash balance (assume that the
balance sheet date is June 30):
1. The outstanding checks on the June 30 bank reconciliation were under footed by $2,000.
2. A loan from the bank on June 26 was credited directly to the client‘s bank account.
The loan was not entered as of June 30.
3. A check was omitted from the outstanding check list on the June 30 bank reconciliation. It cleared the
bank July 7.S
4. A check was omitted from the outstanding check list on the bank reconciliation. It cleared the bank
September 6.
5. Cash receipts collected on accounts receivable from July 1 to July 5 were included as June 29 and 30
cash receipts.
6. A bank transfer recorded in accounting records on July 1 was included as a deposit in transit on June 30.
7. A check that was dated June 26 and disbursed in June was not recorded in the cash disbursements
journal, but it was included as an outstanding check on June 30.
Required:
a. Assuming that each of these misstatements was intentional (fraud), state the most likely
motivation of the person responsible.
……………………………………………………………………………………………………………
b. What control can be instituted for each fraud to reduce the likelihood of occurrence?
……………………………………………………………………………………………………………
c. List an audit procedure that can be used to discover each fraud.
……………………………………………………………………………………………………………
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2.2 SECTION 2: AUDITING OBJECTIVES AND PROCEDURES FOR ACCOUNTS
RECEIVABLE, NOTES RECEIVABLE, AND SALES TRANSACTIONS
The overall objective in the audit of the sales and collection cycle is to evaluate whether the
account balances affected by the cycle are fairly presented in accordance with accounting
standards. Figure 2-2 shows typical accounts included in the sales and collection cycle using T
accounts. The nature of the accounts may vary, of course, depending on the industry and client
involved. There are differences in the nature and account titles for a service industry, a retail
company, and an insurance company, but the key concepts remain the same. To provide a frame
of reference for understanding the material in this chapter, let‘s assume we‘re dealing with a
wholesale merchandising company.
Figure 2-2 shows the way accounting information flows through the various accounts in the sales
and collection cycle. This figure shows that there are five classes of transactions in the sales and
collection cycle:
Figure 2.2: Accounts in the Sales and Collection Cycle
Accounts in the cycle include:
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1. Sales (cash and sales on account)
2. Cash receipts
3. Sales returns and allowances
4. Write-off of uncollectible accounts
5. Estimate of bad debt expense
Figure 2-2 also shows that, with the exception of cash sales, every transaction and amount is
ultimately included in one of two balance sheet accounts, accounts receivable or allowance for
uncollectible accounts. For simplicity, we assume that the same internal controls exist for both
cash and credit sales.
Learning objectives
After studying this chapter, you should be able to
 Identify the accounts and the classes of transactions in the sales and collection cycle.
 Describe the business functions and the related documents and records in the sales and
collection cycle.
 Understand internal control, and design and perform tests of controls and substantive
tests of transactions for sales.
 Apply the methodology for controls over sales transactions to controls over sales returns
and allowances.
 Understand internal control, and design and perform tests of controls and substantive
tests of transactions for cash receipts.
 Apply the methodology for controls over the sales and collection cycle to write-offs of
uncollectible accounts receivable.
2.2.1 Sources and Nature of Receivables:
What are the main sources of accounts receivables in your company?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Receivable include not only claims against customers arising from the sale of goods or services,
but also a variety of miscellaneous claims such as loans to officers or employees, loans to
subsidiaries, uncollected stock subscriptions, claims against various other firms, claims for tax
refunds, and advances to suppliers.
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Trade notes and accounts receivable usually are relatively large in amount and should appear as
separate items in the current assets section of the balance sheet at their net realizable value.
Auditors are especially concerned with the presentation and disclosure of loans to officers,
directors, and affiliated companies. These related party transactions are commonly made for the
convenience of the borrower rather than to benefit the lending company. Consequently, such
loans are often collected only at the convenience of the borrower.
2.2.2 The Auditors Objectives in Examination of Receivables:
The auditors‘ objectives are to determine that:
1. Internal control over receivables is adequate.
2. The recorded receivables are valid (existence and rights).
3. All receivables are recorded (completeness).
4. Receivable records and supporting schedules are mathematically correct and agree with
general ledger accounts (clerical accuracy).
5. The valuation of receivables approximates their realizable value.
6. The presentation and disclosure of receivables is adequate, including the separation of
receivables into appropriate categories, and adequate reporting of any receivables
pledged as collateral and related party receivables.
Tests of details of financial balances and Tests of controls for the sales and collection cycle
Tests of details of financial balances are designed to determine the reasonableness of the
balances in sales, accounts receivable, and other account balances which are affected by the sales
and collection cycle. Such tests include confirmation of accounts receivable, and examining
documents supporting the balance in these accounts.
Tests of controls for the sales and collection cycle are intended to determine the effectiveness of
internal control and to test the substance of the transactions which are produced by this cycle.
Such tests would consist of examining sales invoices in support of entries in the sales journal,
reconciling cash receipts, or reviewing the approval credit.
The results of the tests of controls will be used to affect the procedures, sample size, timing and
particular items selected for the tests of details of financial balances (i.e., effective internal
control will result in reduced testing when compared to the tests of details of balances required in
the case of inadequate internal control).
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The following are analytical procedures for the sales and collection cycle, and potential
misstatements uncovered by each procedure. Each ratio should be compared to previous years.
Table 2.5: analytical procedures, and potential misstatements for the sales and collection
cycle
Analytical Procedure
Potential Misstatement
1. Gross margin by product line
Including in the physical inventory items for
which the corresponding liability had not yet
been recorded.
All returns were not recorded, or shipments to
customers were not in accordance with
specifications and were returned (this could
result in significant operating problems).
Discounts that were taken by customers and
allowed by the company were not recorded.
Allowance for doubtful accounts misstated.
2. Sales returns and allowances as a
percentage of gross sales by product line
or segment
3. Trade discounts taken as a percentage
of net sales
4. Bad debts as a percentage of gross
Sales
5. Days sales in receivables outstanding.
6. Aging categories as a percentage of
accounts receivable
7. Allowance for uncollectible accounts
as a percentage of accounts receivable
8. Comparison of the balances in individual
customer‘ accounts over a stated amount with
their balances in
the previous year
A problem with collections, and
understatement of bad debts and allowance for
doubtful accounts.
Collection problems and understatement of bad
debts and allowance for doubtful accounts.
Allowance for doubtful accounts misstated.
A problem with collections, and therefore, a
misstatement of the allowance for doubtful
accounts.
The sales and collection cycle involves the decisions and processes necessary for the transfer of
the ownership of goods and services to customers after they are made available for sale. It begins
with a request by a customer and ends with the conversion of material or service into an account
receivable, and ultimately into cash.
The eight business functions for the sales and collection cycle are shown in the third column of
Table 2-6 below. They occur in every business in the recording of the five classes of transactions
in the sales and collection cycle. Under ―Business Functions,‖ observe that the first four
processes are for recording sales, while every other class of transactions includes only one
business function.
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In this section, we‘ll explain each of the eight business functions and describe typical documents
and records for each function, which appear in the fourth column of Table 2-6. Before auditors
can assess control risk and design tests of controls and substantive tests of transactions, they need
to understand the business functions and documents and records in a business.
Table 2.6 Classes of Transactions, Accounts, Business Functions, and Related Documents
and Records for the Sales and Collection Cycle
Classes of
transactions
Sales
Accounts
Business functions
Sales
Processing customer
orders
Accounts receivables
Sales order
Granting credit
Customer order or
Shipping goods
sales order
Billing customers and Shipping documents
recording sales
Sales invoices
Sales transaction file
Sales journal or listing
Accounts receivable
master file
Accounts receivable
trial balance
Monthly statements
Processing and
Remittance advice
recording cash
Relisting of cash
receipts
receipts
Cash receipt
transaction file
Cash receipt journal
or listing
Processing and
Credit memo
records sales return
Sales return and
and allowances
allowance journal
Writing off
Uncollectible account
uncollectible accounts authorization form
receivable
General journal
Providing for bad
General journal
dents
Cash receipts
Cash in bank (debit
from cash receipts)
Accounts receivable
Sales return and
allowance
Sales return and
allowance
Accounts receivable
Accounts receivable
Allowance for
uncollectible account
Bad debt expense
Allowance for
uncollectible accounts
Write- off of
uncollectible accounts
Bad debt expense
Documents and
records
Customer order
Processing Customer Orders:
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How Customer Orders are processed in your work environment? List some of the
requirements in to process?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------A customer‘s request for goods initiates the entire cycle. Legally, it is an offer to buy goods
under specified terms. The receipt of a customer order often results in the immediate creation of
a sales order.
Customer Order: A customer order is a request for merchandise by a customer. It may be
received by telephone, letter, a printed form that has been sent to prospective and existing
customers, through salespeople, electronic submission of the customer order through the Internet,
or other network linkage between the supplier and the customer.
Sales Order: A sales order is a document for communicating the description, quantity, and
related information for goods ordered by a customer. This is often used to indicate credit
approval and authorization for shipment.
Granting Credit: Before goods are shipped, a properly authorized person must approve credit to
the customer for sales on account. Weak practices in credit approval often result in excessive bad
debts and accounts receivable that may be uncollectible. An indication of credit approval on the
sales order often serves as the approval to ship the goods. In some companies, the computer
automatically approves a credit sale based on preapproved credit limits maintained in a customer
master file. The computer allows the sale to proceed only when the proposed sales order total
plus the existing customer balance is less than the credit limit in the master file.
Shipping Goods: This critical function is the first point in the cycle at which the company gives
up assets. Most companies recognize sales when goods are shipped. A shipping document is
prepared at the time of shipment, which can be done automatically by a computer, based on sales
order information. The shipping document, which is often a multi copy bill of lading, is essential
to the proper billing of shipments to customers. Companies that maintain perpetual inventory
records also update them based on shipping records.
Shipping Document: A shipping document is prepared to initiate shipment of the goods,
indicating the description of the merchandise, the quantity shipped, and other relevant data. The
company sends the original to the customer and retains one or more copies. The shipping
document serves as a signal to bill the customer and may be in electronic or paper form.
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One type of shipping document is a bill of lading, which is a written contract between the carrier
and the seller of the receipt and shipment of goods. Often, bills of lading include only the
number of boxes or pounds shipped, rather than complete details of quantity and description.
(For the purpose of this textbook, however, we will assume that complete details are included on
bills of lading.)
The bill of lading is often transmitted electronically, once goods have been shipped, and
automatically generates the related sales invoice as well as the entry in the sales journal. Many
companies use bar codes and handheld computers to record removal of inventory from the
warehouse. This information is used to update the perpetual inventory records.
Billing Customers and Recording Sales: Because billing customers is the means by which the
customer is informed of the amount due for the goods, it must be done correctly and on a timely
basis. The most important aspects of billing are:
 All shipments made have been billed (completeness)
 No shipment has been billed more than once (occurrence)
 Each one is billed for the proper amount (accuracy)
Billing the proper amount is dependent on charging the customer for the quantity shipped at the
authorized price, which includes consideration for freight charges, insurance, and terms of
payments. In most systems, billing of the customer includes preparation of an electronic record
or a multi copy sales invoice and real-time updating of the sales transactions file, accounts
receivable master file, and general ledger master file for sales and accounts receivable. The
accounting system uses this information to generate the sales journal and, along with cash
receipts and miscellaneous credits, to prepare the accounts receivable trial balance.
Sales Invoice: A sales invoice is a document or electronic record indicating the description and
quantity of goods sold, the price, freight charges, insurance, terms, and other relevant data. The
sales invoice is the method of indicating to the customer the amount of a sale and the payment
due date. Companies send the original to the customer, and retain one or more copies. Typically,
the computer automatically prepares the sales invoice after the customer number; quantity,
destination of goods shipped, and sales terms are entered. The computer calculates the invoice
extensions and total sales amount using the information entered, along with prices in the
inventory master file.
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Sales Transaction File: This is a computer-generated file that includes all sales transactions
processed by the accounting system for a period, which could be a day, week, or month. It
includes all information entered into the system and information for each transaction, such as
customer name, date, amount, account classification or classifications, salesperson, and
commission rate. The file can also include returns and allowances or there can be a separate file
for those transactions.
The information in the sales transaction file is used for a variety of records, listings, or reports,
depending on the company‘s needs. These may include a sales journal, accounts receivable
master file, and transactions for a certain account balance or division.
Sales Journal or Listing: This is a listing or report generated from the sales transaction file that
typically includes the customer name, date, amount, and account classification or classifications
for each transaction, such as division or product line. It also identifies whether the sale was for
cash or accounts receivable. The journal or listing is usually for a month but can cover any
period of time. Typically, the journal or listing includes totals of every account number for the
time period.
The same transactions included in the journal or listing are also posted simultaneously to the
general ledger and, if they are on account, to the accounts receivable master file. The journal or
listing can also include returns and allowances or there can be a separate journal or listing of
those transactions.
Accounts Receivable Master File: This is a computer file used to record individual sales, cash
receipts, and sales returns and allowances for each customer and to maintain customer account
balances. The master file is updated from the sales, sales returns and allowances, and cash
receipts computer transaction files. The total of the individual account balances in the master file
equals the total balance of accounts receivable in the general ledger. A printout of the accounts
receivable master file shows, by customer, the beginning balance in accounts receivable, each
sales transaction, sales returns and allowances, cash receipts, and the ending balance.
In this book, we use the term master file to refer to either the computer file or a printout of that
file, but it is sometimes called the accounts receivable subsidiary ledger or sub ledger.
Accounts Receivable Trial Balance: This list or report shows the amount receivable from each
customer at a point in time. It is prepared directly from the accounts receivable master file, and is
usually an aged trial balance that includes the total balance outstanding and the number of days
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the receivable has been outstanding, by category of days (such as less than 30 days, 31 to 60 days
and so on).
Monthly Statement: This is a document sent by mail or electronically to each customer
indicating the beginning balance of their accounts receivable, the amount and date of each sale,
cash payments received, credit memos issued, and the ending balance due. It is, in essence, a
copy of the customer‘s portion of the accounts receivable master file.
Processing and Recording Cash Receipts: The four sales transaction functions are necessary
for getting the goods into the hands of customers, correctly billing them, and reflecting the
information in the accounting records. The remaining four functions involve the collection and
recording of cash, sales returns and allowances, write-off of uncollectible accounts, and
providing for bad debt expense.
Processing and recording cash receipts includes receiving, depositing, and recording cash. Cash
includes currency, checks, and electronic funds transfers.
The most important concern is the possibility of theft. Theft can occur before receipts are entered
in the records or later. It is important that all cash receipts are deposited in the bank at the proper
amount on a timely basis and recorded in the cash receipts transaction file. This file is used to
prepare the cash receipts journal and update the accounts receivable and general ledger master
files.
Remittance Advice: A remittance advice is a document mailed to the customer and typically
returned to the seller with the cash payment. It indicates the customer name, the sales invoice
number, and the amount of the invoice. A remittance advice is used as a record of the cash
received to permit the immediate deposit of cash and to improve control over the custody of
assets. If the customer fails to include the remittance advice with the payment, it is common for
the person opening the mail to prepare one at that time.
Prelisting of Cash Receipts: This is a list prepared when cash is received by someone who has
no responsibility for recording sales, accounts receivable, or cash, and who has no access to
accounting records. It is used to verify whether cash received was recorded and deposited at the
correct amounts and on a timely basis.
Many companies use a bank to process cash receipts from customers. Some companies use a
lockbox system in which customers‘ mail payments directly to an address maintained by the
bank. The bank is responsible for opening all receipts, maintaining records of all customer
63
payments received at the lockbox address, and depositing receipts into the company‘s bank
account on a timely basis. In other cases, receipts are submitted electronically from a customer‘s
bank account to a company bank account through the use of electronic funds transfer (EFT).
When customers purchase goods by credit card, the issuer of the credit card uses EFT to transfer
funds into the company‘s bank account.
For both lockbox systems and EFT transactions, the bank provides information to the company
to prepare the cash receipt entries in the accounting records.
Cash Receipts Transaction File: This is a computer-generated file that includes all cash
receipts transactions processed by the accounting system for a period, such as a day, week, or
month. It includes the same type of information as the sales transaction file.
Cash Receipts Journal or Listing: This listing or report is generated from the cash receipts
transaction file and includes all transactions for a time period. The same transactions, including
all relevant information, are included in the accounts receivable master file and general ledger.
Processing and Recording Sales Returns and Allowances: When a customer is dissatisfied
with the goods, the seller often accepts the return of the goods or grants a reduction in the
charges. The company prepares a receiving report for returned goods and returns them to storage.
Returns and allowances are recorded in the sales returns and allowances transaction file, as well
as the accounts receivable master file. Credit memos are issued for returns and allowances to aid
in maintaining control and to facilitate record keeping.
Credit Memo: A credit memo indicates a reduction in the amount due from a customer because
of returned goods or an allowance. It often takes the same general form as a sales invoice, but it
supports reductions in accounts receivable rather than increases.
Sales Returns and Allowances Journal: This is the journal used to record sales returns and
allowances. It performs the same function as the sales journal. Many companies record these
transactions in the sales journal rather than in a separate journal.
Writing off Uncollectible Accounts Receivable: Regardless of the diligence of credit
departments, some customers do not pay their bills. After concluding that an amount cannot be
collected, the company must write it off. Typically, this occurs after a customer files for
bankruptcy or the account is turned over to a collection agency. Proper accounting requires an
adjustment for these uncollectible accounts.
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Uncollectible Account Authorization Form: This is a document used internally to indicate
authority to write an account receivable off as uncollectible.
Providing for Bad Debts: Because companies cannot expect to collect on 100% of their sales,
accounting principles require them to record bad debt expense for the amount they do not expect
to collect. Most companies record this transaction at the end of each month or quarter.
2.2.3 Methodology for Designing Tests of Controls and Substantive Tests of Transactions
for Sales:
So far, in this unit, we have discussed account balances, classes of transactions, business
functions, and related documents and records for the sales and collection cycle. Now, we will
study the design of tests of controls and substantive tests of transactions for each of the five
classes of transactions in the cycle.
How do auditors obtain an understanding of internal control over sales in your
company?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Figure 2.3 Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for Sales
Understand internal
control-sales
Assess planed control
risk-sales
Determine extent of testing
controls*
Design test of controls and substantive
Audit procedure
tests of transactions to meet transaction-
Sample size
related audit objectives
Items to select
Timing
65
*extent of testing of controls is determined by planned reliance on controls. For accelerated filer
public companies, testing must be sufficient to issue an opinion on internal control over financial
reporting.
Understand Internal Control— Sales:
Using one typical approach for sales, auditors study the client‘s flowcharts, make inquiries of the
client using an internal control questionnaire, and perform walkthrough tests of sales.
Assess Planned Control Risk— Sales:
The auditor uses the information obtained in understanding internal control to assess control risk.
Four steps are essential steps to this assessment:
1. The auditor needs a framework for assessing control risk. The six transactions related
audit objectives provide this framework.
2. The auditor must identify the key internal controls and deficiencies for sales. These will
differ for every audit because every client has different internal controls.
3. After identifying the controls and deficiencies, the auditor associates them with the
objectives.
4. The auditor assesses control risk for each objective by evaluating the controls and
deficiencies for each objective. This step is critical because it affects the auditor‘s
decisions about both tests of controls and substantive tests. It is a highly subjective
decision.
We next examine key control activities for sales. Knowledge of these control activities assists in
identifying the key controls and deficiencies for sales.
Adequate Separation of Duties: Proper separation of duties helps prevent various types of
misstatements due to both errors and fraud. To prevent fraud, management should deny cash
access to anyone responsible for entering sales and cash receipts transaction information into the
computer. The credit-granting function should be separated from the sales function, because
credit checks are intended to offset the natural tendency of sales personnel to optimize volume
even at the expense of high bad debt write-offs. Personnel responsible for doing internal
comparisons should be independent of those entering the original data. For example, comparison
of batch control totals with summary reports and comparison of accounts receivable master file
66
totals with the general ledger balance should be done by someone independent of those who
input sales and cash receipt transactions.
Proper Authorization: The auditor is concerned about authorization at three key points:
1. Credit must be properly authorized before a sale takes place.
2. Goods should be shipped only after proper authorization.
3. Prices, including basic terms, freight, and discounts, must be authorized.
The first two controls are meant to prevent the loss of company assets by shipping to fictitious
customers or those who will fail to pay for the goods. Price authorization is meant to ensure that
the sale is billed at the price set by company policy. Authorization may be done for each
individual transaction or general authorization may be given for specific classes of transactions.
General authorizations are often done automatically by computer.
Adequate Documents and Records: Because each company has a unique system of originating,
processing, and recording transactions, auditors may find it difficult to evaluate whether each
client‘s procedures are designed for maximum control. Nevertheless, adequate record-keeping
procedures must exist before most of the transaction related audit objectives can be met. Some
companies, for example, automatically prepare a multi copy renumbered sales invoice at the time
a customer order is received.
Copies of this document are used to approve credit, authorize shipment, record the number of
units shipped, and bill customers. This system greatly reduces the chance of the failure to bill a
customer if all invoices are accounted for periodically, but controls have to exist to ensure the
sale isn‘t recorded until shipment occurs. Under a system in which the sales invoice is prepared
only after a shipment has been made, the likelihood of failure to bill a customer is high unless
some compensating control exists. In many organizations, all sales documents are electronic and
no paper documents are prepared.
Pre numbered Documents: Pre numbering is meant to prevent both the failure to bill or record
sales and the occurrence of duplicate billings and recordings. Of course, it does not do much
good to have pre numbered documents unless they are properly accounted for. To use this
control effectively, a billing clerk will file a copy of all shipping documents in sequential order
after each shipment is billed, while someone else will periodically account for all numbers and
investigate the reason for any missing documents.
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Monthly Statements: Sending monthly statements is a useful control because it encourages
customers to respond if the balance is incorrectly stated. These statements should be controlled
by persons who have no responsibility for handling cash or recording sales or accounts
receivable to avoid the intentional failure to send the statements. For maximum effectiveness, all
disagreements about the account balance should be directed to a designated person who has no
responsibility for handling cash or recording sales or accounts receivable.
Internal Verification Procedures: Computer programs or independent personnel should check
that the processing and recording of sales transactions fulfill each of the six transaction-related
audit objectives. Examples include accounting for the numerical sequence of pre numbered
documents, checking the accuracy of document preparation, and reviewing reports for unusual or
incorrect items.
Determine Extent of Testing Controls
After auditors identify the key internal controls and control deficiencies, they assess control risk,
often using a matrix format. For audits of accelerated filer public companies, the auditor must
perform extensive tests of key controls and evaluate the impact of the deficiencies on the
auditor‘s report on internal control over financial reporting. The extent of testing of controls in
audits of non accelerated filers and nonpublic companies depends on the effectiveness of the
controls and the extent to which the auditor believes they can be relied on to reduce control risk.
In determining the extent of reliance to place on controls, the auditor also considers the cost of
the increased tests of controls compared to the potential reduction in substantive tests. A lower
assessed level of control risk will result in increased testing of controls to support the lower
control risk, with a corresponding increase in detection risk and decrease in the amount of
substantive tests.
Design Tests of Controls for Sales
For each key control, one or more tests of controls must be designed to verify its effectiveness.
In most audits, it is relatively easy to determine the nature of the test of the control from the
nature of the control. For example, if the internal control is to initial customer orders after they
have been approved for credit, the test of control is to examine the customer order for proper
initials.
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To simultaneously provide evidence of both the occurrence and completeness objectives, an
auditor can check the sequence of sales invoices selected from the sales journal and watch for
duplicate and omitted numbers or invoices outside the normal sequence. Assume the auditor
selects sales invoices #18100 to #18199. The completeness objective for this procedure will be
satisfied if all 100 sales invoices are recorded. The occurrence objective will be satisfied if there
is no duplicate recording of any of the invoice numbers.
The appropriate tests of controls for separation of duties are ordinarily restricted to the auditor‘s
observations of activities and discussions with personnel. For example, it is possible to observe
whether the billing clerk has access to cash when incoming mail is opened or cash is deposited. It
is usually also necessary to ask personnel what their responsibilities are and if there are any
circumstances where their responsibilities are different from the normal policy. For example, the
employee responsible for billing customers may state that he or she does not have access to cash.
Further discussion may reveal that he or she actually takes over the cashier‘s duties when the
cashier is on vacation.
Design Substantive Tests of Transactions for Sales
In deciding substantive tests of transactions, auditors commonly use some procedures on every
audit regardless of the circumstances, whereas others are dependent on the adequacy of the
controls and the results of the tests of controls. The substantive tests of transactions are related
to the transaction-related audit objectives and are designed to determine whether any monetary
misstatements for that objective exist in the transaction. The audit procedures used are affected
by the internal controls and tests of controls for that objective.
Determining the proper substantive tests of transactions procedures for sales is relatively difficult
because they vary considerably depending on the circumstances.
Note that some audit procedures fulfill more than one transaction-related audit objective is
included for three objectives).
The following paragraphs discuss substantive tests of transaction audit procedures that are done
only when there are specific circumstances that require special audit attention, such as when
there is a deficiency in internal control.
Recorded Sales Occurred- For this objective, the auditor is concerned with the possibility of
three types of misstatements:
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i. Sales included in the journals for which no shipment was made.
ii. Sales recorded more than once.
iii. Shipments made to nonexistent customers and recorded as sales.
The first two types of misstatements can be due to an error or fraud. The last type is always a
fraud. The potential consequences of all three are significant because they lead to an
overstatement of assets and income.
Unintentional overstatements of sales are typically more easily discovered than fraudulent
overstatements. An unintentional overstatement normally also results in an overstatement of
accounts receivable, which the client can detect by sending monthly statements to customers.
Unintentional misstatements at year-end can often be easily found by the auditor through
confirmation procedures. With fraudulent overstatements, the perpetrator will attempt to conceal
the overstatement, making it more difficult for auditors to find. Substantive tests of transactions
may be necessary to discover overstated sales in these circumstances.
The appropriate substantive tests of transactions for testing the occurrence objective depend on
where the auditor believes misstatements are likely. Many auditors do substantive tests of
transactions for the occurrence objective only if they believe that a control deficiency exists.
Therefore, the nature of the tests depends on the nature of the potential misstatement as follows:
Recorded Sale for Which There Was No Shipment: The auditor can vouch selected entries in
the sales journal to related copies of shipping and other supporting documents to make sure they
occurred. If the auditor is concerned about the possibility of a fictitious duplicate copy of a
shipping document, it may be necessary to trace the amounts to the perpetual inventory records
as a test of whether inventory was reduced.
Sale Recorded More Than Once: Duplicate sales can be determined by reviewing a
numerically sorted list of recorded sales transactions for duplicate numbers. The auditor can also
test for the proper cancellation of shipping documents. Proper cancellation decreases the
likelihood that a shipping document will be used to record another sale.
Shipment Made to Nonexistent Customers: This type of fraud normally occurs only when the
person recording sales is also in a position to authorize shipments. Deficient internal controls
make it difficult to detect fictitious shipments, such as shipments to other locations of the
company. To test for nonexistent customers, the auditor can trace customer information on the
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sales invoice to the customer master file. These revenue frauds are often referred to as ―sham
sales.‖ Another effective approach to detecting the three types of misstatements of sales
transactions just discussed is to trace the credit in the accounts receivable master file to its
source. If the receivable was actually collected in cash or the goods were returned, a sale must
have originally occurred.
If the credit was for a bad debt write-off or a credit memo, or if the account was still unpaid at
the time of the audit, this could indicate an inappropriately recorded sales transaction. The
auditor must examine shipping and customer order documents to determine if there is adequate
support that a sales transaction actually occurred.
SAS 99 indicates that the auditor should normally identify improper revenue recognition as a
fraud risk. However, substantive tests of transactions should be necessary for improper revenue
recognition only if the auditor is concerned about fraud due to inadequate controls.
Existing Sales Transactions Are Recorded: In many audits, no substantive tests of transactions
are done for the completeness objective. This is because overstatements of assets and income
from sales transactions are more likely than understatements, and overstatements also represent a
greater source of audit risk. If controls are inadequate, which is likely if the client does no
independent internal tracing from shipping documents to the sales journal, substantive tests are
necessary.
To test for unbilled shipments, auditors can trace selected shipping documents from a file in the
shipping department to related duplicate sales invoices and the sales journal. To conduct a
meaningful test using this procedure, the auditor must be confident that all shipping documents
are included in the file. This can be done by accounting for a numerical sequence of the
documents.
Direction of Tests: Auditors need to understand the difference between tracing from source
documents to the journals and vouching from the journals back to source documents. The former
tests are for omitted transactions (completeness objective) where as the latter tests are for
nonexistent transactions (occurrence objective).
To test for the occurrence objective, the auditor starts by selecting a sample of invoice numbers
from the journal and vouches them to duplicate sales invoices, shipping documents, and
customer orders. In testing for the completeness objective, the auditor typically starts by
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selecting a sample of shipping documents and traces them to duplicate sales invoices and the
sales journal as a test of omissions.
When designing audit procedures for the occurrence and completeness objectives, the starting
point for the test is essential. For example, if the auditor is concerned about the occurrence
objective but tests in the wrong direction (from shipping documents to the journals), a serious
audit deficiency exists. In testing for the other four transaction-related audit objectives, the
direction of tests is usually not relevant. For example, the accuracy of sales transactions can be
tested by testing from a duplicate sales invoice to a shipping document or vice versa.
Sales Are Accurately Recorded: The accurate recording of sales transactions concerns:
o Shipping the amount of goods ordered
o Accurately billing for the amount of goods shipped
o Accurately recording the amount billed in the accounting records
Auditors typically do substantive tests of transactions in every audit to ensure that each of these
three aspects of accuracy are done correctly by recalculating information in the accounting
records and comparing information on different documents.
Auditors commonly compare prices on duplicate sales invoices with an approved price list,
recalculate extensions and footings, and compare the details on the invoices with shipping
records for description, quantity, and customer identification. Often, auditors also examine
customer orders and sales orders for the same information.
Sales Transactions Are Correctly Included in the Master File and Correctly Summarized:
The proper inclusion of all sales transactions in the accounts receivable master file is essential
because the accuracy of these records affects the client‘s ability to collect outstanding
receivables. Similarly, the sales journal must be correctly totaled and posted to the general ledger
if the financial statements are to be correct. In most engagements, auditors perform some clerical
accuracy tests, such as footing the journals and tracing the totals and details to the general ledger
and the master file, to check whether there are errors or fraud in the processing of sales
transactions. The extent to which such tests are needed is determined by the quality of internal
controls.
Generalized audit software allows for efficient testing of the accuracy of electronic journals and
records.
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Tracing from the sales journal to the master file is typically done as a part of fulfilling other
transaction-related audit objectives, but footing the sales journal and tracing the totals to the
general ledger are done as separate procedures.
Posting and summarization tests differ from those for other transaction-related audit objectives
because they include footing journals, master file records, and ledgers, and tracing from one to
the other among these three. When footing and comparisons are restricted to these three records,
the transaction related audit objective is posting and summarization. When the journals, master
files, or ledgers are traced to or from a document, the objective is one of the other five
objectives, depending on what is being verified. To illustrate, when an auditor compares an
amount on a duplicate sales invoice with either the sales journal or master file entry, it is an
accuracy audit objective procedure. When an auditor traces an entry from the sales journal to the
master file, it is a posting and summarization procedure.
Recorded Sales Are Correctly Classified: Although it is less of a problem in sales than in some
transaction cycles, auditors must still be concerned that transactions are charged to the correct
general ledger account. With cash and credit sales, company personnel should not debit accounts
receivable for a cash sale or credit sales for collection of a receivable. They should also not
classify sales of operating assets, such as buildings, as sales. For those companies using more
than one sales classification, such as companies issuing segmented earnings statements, proper
classification is essential.
Auditors commonly test sales for proper classification as part of testing for accuracy.
They examine supporting documents to determine the proper classification of a given transaction
and compare this with the actual account to which it is charged.
Sales Are Recorded on the Correct Dates: Sales should be billed and recorded as soon after
shipment takes place as possible to prevent the unintentional omission of transactions from the
records and to make sure that sales are recorded in the proper period. Timely recorded
transactions are also less likely to contain misstatements.
When auditors do substantive tests of transactions procedures for accuracy they commonly
compare the date on selected bills of lading or other shipping documents with the date on related
duplicate sales invoices, the sales journal, and the accounts receivable master file. Significant
differences indicate potential cutoff problems in the test of year-end balances.
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Sales Returns and Allowances
The transaction-related audit objectives and the client‘s methods of controlling misstatements are
essentially the same for processing credit memos as those described for sales, with two
differences. The first is materiality. In many instances, sales returns and allowances are so
immaterial the auditor can ignore them.
The second difference is emphasis on the occurrence objective. For sales returns and allowances,
auditors usually emphasize testing recorded transactions to uncover any theft of cash from the
collection of accounts receivable that was covered up by a fictitious sales return or allowance.
(Although auditors usually emphasize the occurrence objective for sales returns and allowances
transactions, the completeness objective is especially important in tests of account balances to
determine if sales and returns are understated at year-end.)
Naturally, other objectives should not be ignored. But because the objectives and
methodology for auditing sales returns and allowances are essentially the same as for sales, we
do not include a detailed study of them. If you need to audit sales returns and allowances, you
should be able to apply the same logic to arrive at suitable controls, tests of controls, and
substantive tests of transactions to verify the amounts.
2.2.4 Methodology for Designing Tests of Controls and Substantive Tests of Transactions
for Cash Receipts:
What are the main tests of controls and substantive tests of transactions designed in your
work environment?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Auditors use the same methodology for designing tests of controls and substantive tests of
transactions for cash receipts as they use for sales. Cash receipts tests of controls and substantive
tests of transactions audit procedures are developed around the same framework used for sales,
but of course the specific objectives are applied to cash receipts. Given the transaction-related
audit objectives, the auditor follows this process:
•
Determine key internal controls for each audit objective
•
Design tests of control for each control used to support a reduced control risk
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•
Design substantive tests of transactions to test for monetary misstatements for each
objective
As in all other audit areas, the tests of controls depend on the controls the auditor identifies, the
extent they will be relied on to reduce assessed control risk, and whether the company being
audited is publicly traded.
Because the methodology for cash receipts is similar to that for sales, our discussion is not as
detailed as our discussion of the internal controls, tests of controls, and substantive tests of
transactions for the audit of sales. Instead, we focus on the substantive audit procedures that are
most likely to be misunderstood.
An essential part of the auditor‘s responsibility in auditing cash receipts is to identify
deficiencies in internal control that increase the likelihood of fraud.
Determine Whether Cash Received Was Recorded
The most difficult type of cash embezzlement for auditors to detect is when it occurs before the
cash is recorded in the cash receipts journal or other cash listing, especially if the sale and cash
receipt are recorded simultaneously. For example, if a grocery store clerk takes cash and
intentionally fails to record the sale and receipt of cash on the cash register, it is extremely
difficult to discover the theft.
Prepare Proof of Cash Receipts
A useful audit procedure to test whether all recorded cash receipts have been deposited in the
bank account is a proof of cash receipts. In this test, the total cash receipts recorded in the cash
receipts journal for a given period, such as a month, are reconciled with the actual deposits made
to the bank during the same period. A difference in the two may be the result of deposits in
transit and other items, but the amounts can be reconciled and compared. This procedure is not
useful in discovering cash receipts that have not been recorded in the journals or time lags in
making deposits, but it can help uncover recorded cash receipts that have not been deposited,
unrecorded deposits, unrecorded loans, bank loans deposited directly into the bank account, and
similar misstatements. Ordinarily, this somewhat time-consuming procedure is used only when
the controls are deficient. In rare instances, when controls are extremely weak, the period
covered by the proof of cash receipts may cover the entire year.
Test to Discover Lapping of Accounts Receivable
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Lapping of accounts receivable is the postponement of entries for the collection of receivables to
conceal an existing cash shortage. The embezzlement is perpetrated by a person who handles
cash receipts and then enters them into the computer system. He or she defers recording the cash
receipts from one customer and covers the shortages with receipts of another. These in turn are
covered from the receipts of a third customer a few days later. The employee must continue to
cover the shortage through repeated lapping, replace the stolen money, or find another way to
conceal the shortage.
This embezzlement can be easily prevented by separation of duties and a mandatory vacation
policy for employees who both handle cash and enter cash receipts into the system. It can be
detected by comparing the name, amount, and dates shown on remittance advices with cash
receipts journal entries and related duplicate deposit slips. Because this procedure is relatively
time-consuming, it is ordinarily performed only when specific concerns with embezzlement exist
because of a deficiency in internal control.
Audit Tests for the Write-Off of Uncollectible Accounts
The same as for sales returns and allowances, the auditor‘s primary concern in the audit of the
write-off of uncollectible accounts receivable is the possibility of client personnel covering up an
embezzlement by writing off accounts receivable that have already been collected (the
occurrence transaction-related audit objective). The major control for preventing this fraud is
proper authorization of the write-off of uncollectible accounts by a designated level of
management only after a thorough investigation of the reason the customer has not paid.
Normally, verification of the accounts written off takes relatively little time.
Typically, the auditor examines approvals by the appropriate persons. For a sample of accounts
written off, it is also usually necessary for the auditor to examine correspondence in the client‘s
files establishing their uncollectibility. In some cases, the auditor also examines credit reports
such as those provided by Dun & Bradstreet. After the auditor has concluded that the accounts
written off by general journal entries are proper, selected items should be traced to the accounts
receivable master file to test whether the write-off was properly recorded.
Methodology for Designing Tests of Details of Balances
In the preceding discussions of this chapter, we examined tests of controls and substantive tests
of transactions for the sales and collection cycle. Both types of tests are part of phase II of the
audit process. We now move to phase III as shown in figure 2.4 bellow and turn our attention to
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substantive analytical procedures and tests of details of balances for the sales and collection
cycle. The appropriate evidence to be obtained from tests of details of balances must be decided
on an objective-by-objective basis. Because several interactions affect the need for evidence
from test of details of balances, this audit decision can be complex.
Figure 2.4: Methodology for Designing Tests of Details of Balances for Accounts
Receivable
In designing tests of details of balances for accounts receivable, auditors must satisfy each of the
eight balance-related audit objectives first discussed so far.
These eight general objectives are the same for all accounts, specifically applied to accounts
receivable, they are called accounts receivable balance-related audit objectives and are as
follows:
a. Accounts receivable in the aged trial balance agree with related master file
amounts, and the total is correctly added and agrees with the general ledger
(Detail tie-in)
b. Recorded accounts receivable exist (Existence)
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c. Existing accounts receivable are included (Completeness)
d. Accounts receivable are accurate (Accuracy)
e. Accounts receivable are correctly classified (Classification)
f. Cutoff for accounts receivable is correct (Cutoff)
g. Accounts receivable is stated at realizable value (Realizable value)
h. The client has rights to accounts receivable (Rights)
Figur2.5: Relationship between Transaction-Related Audit Objectives for the Sales and
Occurrence
Completeness
Accuracy
Posting and summarization
Classification
Timing
Realizable value
Rights
Rights
Cut-off
classification
Accuracy
Completeness
Existence
X
X
X
X
Cut-off
classification
Accuracy
X
Completeness
Translation-related
audit objectives cash receipts
X
Existence
Occurrence
Completeness
Accuracy
Posting and summarization
Classification
Timing
ACCOUNTS RECEIVABLE
BALANCE-RELATED AUDIT
OBJECTIVES
Detail tie-in
Translation-related audit objectives
Sales
Detail tie-in
ACCOUNTS RECEIVABLE
BALANCE-RELATED AUDIT
OBJECTIVES
Realizable value
Collection Cycle and Balance-Related Audit Objectives for Accounts Receivable
X
X
X
X
X
X
Design and Perform Analytical Procedures (Phase III)
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Analytical procedures are often done during three phases of the audit: during planning, when
performing detailed tests, and as a part of completing the audit. Most analytical procedures
performed during the detailed testing phase are done after the balance sheet date but before tests
of details of balances. It makes little sense to perform extensive analytical procedures before the
client has recorded all transactions for the year and finalized the financial statements.
Auditors perform analytical procedures for the entire sales and collection cycle, not just accounts
receivable. This is necessary because of the close relationship between income statement and
balance sheet accounts. If the auditor identifies a possible misstatement in sales or sales returns
and allowances using analytical procedures, accounts receivable will likely be the offsetting
misstatement. Because analytical procedures are substantive tests, they reduce the extent to
which the auditor needs tests of further procedures.
Table 2.7: Analytical Procedures for the Sales and Collection Cycle
Analytical procedure
Compare gross margin percentage with
previous years (by product line )
Compare sales by month ( by product line )
over time
Compare sales return and allowances as a
percentage of gross sales with previous years
(by product line).
Compare individual customer balances over
stated amount with previous years.
Compare bad debt expense as percentage of
gross sales with previous years.
Compare number of days that accounts
receivable are outstanding with previous years
and related turnover of accounts receivable.
Compare aging categories as percentage of
accounts receivable with previous years.
Compare allowance for uncollectible accounts
as a percentage of total accounts receivable
with previous years.
Compare write-off of uncollectible accounts a
percentage of total accounts receivable with
previous years.
Possible misstatements
Overstatement or understatement of sales and
accounts receivable
Overstatement or understatement of sales and
accounts receivable
Overstatement or understatement of sales
returns and allowance and accounts receivable.
Misstatement in accounts receivable and
related income statement accounts
Uncollectible accounts receivable that have not
been provided for.
Overstatement or understatement of allowance
for uncollectible accounts and bad debt
expense; also may indicate fictitious accounts
receivable.
Overstatement or understatement of allowance
for uncollectible accounts and bad debt
expense.
Overstatement or understatement of allowance
for uncollectible accounts and bad debt
expense.
Overstatement or understatement of allowance
for uncollectible accounts and bad debt
expense.
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Design and Perform Tests of Details of Accounts Receivable Balance (Phase III)
When analytical procedures in the sales and collection cycle uncover unusual fluctuations,
however, the auditor should make additional inquiries of management.
Management‘s responses should be critically evaluated to determine whether they adequately
explain the unusual fluctuations and whether they are supported by corroborating evidence.
The task of combining the factors that determine planned detection risk is complex because the
measurement for each factor is imprecise and the appropriate weight given to each factor is
highly subjective. Conversely, the relationship between each factor and planned detection risk is
well established. For example, auditors know that a high inherent risk or control risk decreases
planned detection risk and increases planned substantive tests, whereas good results of
substantive tests of transactions increase planned detection risk and decrease other planned
substantive tests.
Designing Tests of Details of Balances
Even though auditors emphasize balance sheet accounts in tests of details of balances, they are
not ignoring income statement accounts because the income statement accounts are tested as a
by-product of the balance sheet tests. Confirmation of accounts receivable is the most important
test of details of accounts receivable.
Accounts Receivable Are Correctly Added and Agree with the Master File and the General
Ledger
How accounts receivables are reconciled with the master file in your company?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Most tests of accounts receivable and the allowance for uncollectible accounts are based on the
aged trial balance. An aged trial balance lists the balances in the accounts receivable master file
at the balance sheet date, including individual customer balances outstanding and a breakdown of
each balance by the time passed between the date of sale and the balance sheet date.
Recorded Accounts Receivable Exist
Confirmation of customers‘ balances is the most important test of details of balances for
determining the existence of recorded accounts receivable. When customers do not respond to
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confirmations, auditors also examine supporting documents to verify the shipment of goods and
evidence of subsequent cash receipts to determine whether the accounts were collected.
Normally, auditors do not examine shipping documents or evidence of subsequent cash receipts
for any account in the sample that is confirmed, but they may use these documents extensively as
alternative evidence for non responses.
Existing Accounts Receivable Are Included
It is difficult for auditors to test for account balances omitted from the aged trial balance except
by relying on the self-balancing nature of the accounts receivable master file. For example, if the
client accidentally excluded an account receivable from the trial balance, the only likely way it
will be discovered is for the auditor to foot the accounts receivable trial balance and reconcile the
balance with the control account in the general ledger.
If all sales to a customer are omitted from the sales journal, the understatement of accounts
receivable is almost impossible to uncover by tests of details of balances. For example, auditors
rarely send accounts receivable confirmations to customers with zero balances, in part because
research shows that customers are unlikely to respond to requests that indicate their balances are
understated. In addition, unrecorded sales to a new customer are difficult to identify for
confirmation because that customer is not included in the accounts receivable master file.
The understatement of sales and accounts receivable is best uncovered by substantive tests of
transactions for shipments made but not recorded (completeness objective for tests of sales
transactions) and by analytical procedures.
Accounts Receivable Are Accurate
Confirmation of accounts selected from the trial balance is the most common test of details of
balances for the accuracy of accounts receivable. When customers do not respond to
confirmation requests, auditors examine supporting documents in the same way as described for
the existence objective. Auditors perform tests of the debits and credits to individual customers‘
balances by examining supporting documentation for shipments and cash receipts.
Accounts Receivable Are Properly Classified
Normally, auditors can evaluate the classification of accounts receivable relatively easily, by
reviewing the aged trial balance for material receivables from affiliates, officers, directors, or
other related parties. Auditors should verify that notes receivable or accounts that should be
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classified as noncurrent assets are separated from regular accounts, and significant credit
balances in accounts receivable are reclassified as accounts payable.
There is a close relationship between the classification balance-related objective and the related
classification and understandability presentation and disclosure objective. To satisfy the
classification balance-related audit objective, the auditor must determine whether the client has
correctly separated different classifications of accounts receivable. For example, the auditor will
determine whether receivables from related parties have been separated on the aged trial balance.
To satisfy the objective for presentation and disclosure, the auditor must make sure that the
classifications are properly presented by determining whether related party transactions are
correctly shown in the financial statements during the completion phase of the audit.
Cutoff for Accounts Receivable Is Correct
Cutoff misstatements: exist when current period transactions are recorded in the subsequent
period or vice versa. The objective of cutoff tests, regardless of the type of transaction, is to
verify whether transactions near the end of the accounting period are recorded in the proper
period. The cutoff objective is one of the most important in the cycle because misstatements in
cutoff can significantly affect current period income.
For example, the intentional or unintentional inclusion of several large, subsequent period sales
in the current period—or the exclusion of several current period sales returns and allowances—
can materially overstate net earnings.
Cutoff misstatements can occur for sales, sales returns and allowances, and cash receipts. For
each one, auditors require a threefold approach to determine the reasonableness of cutoff:
a. Decide on the appropriate criteria for cutoff.
b. Evaluate whether the client has established adequate procedures to ensure a reasonable
cutoff.
c. Test whether the cutoff was correct.
Sales Cutoff: Most merchandising and manufacturing clients record a sale based on shipment of
goods criterion. However, some companies record invoices at the time title passes, which can
occur before shipment (as in the case of custom-manufactured goods), at the time of shipment, or
subsequent to shipment. For the correct measurement of current period income, the method must
be in accordance with accounting standards and consistently applied.
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The most important part of evaluating the client‘s method of obtaining a reliable cutoff is to
determine the procedures in use. When a client issues prenumbered shipping documents
sequentially, it is usually a simple matter to evaluate and test cutoff.
Moreover, the segregation of duties between the shipping and the billing function also enhances
the likelihood of recording transactions in the proper period. However, if shipments are made by
company truck, if the shipping records are unnumbered, and if shipping and billing department
personnel are not independent of each other, it may be difficult, if not impossible, to be assured
of an accurate cutoff.
When the client‘s internal controls are adequate, auditors can usually verify the cutoff by
obtaining the shipping document number for the last shipment made at the end of the period and
comparing this number with current and subsequent period recorded sales.
Sales Returns and Allowances Cutoff: Accounting standards require that sales returns and
allowances be matched with related sales if the amounts are material. For example, if current
period shipments are returned in the subsequent period, the sales return should appear in the
current period. (The returned goods should be treated as current period inventory.)
For most companies, however, sales returns and allowances are recorded in the accounting
period in which they occur, under the assumption of approximately equal, offsetting amounts at
the beginning and end of each accounting period. This approach is acceptable as long as the
amounts are not material. Some companies establish a reserve, similar to the allowance for
uncollectible accounts, for the expected amount of returns in the subsequent period.
When the auditor is confident that the client records all sales returns and allowances promptly,
the cutoff tests are simple and straightforward. The auditor can examine supporting
documentation for a sample of sales returns and allowances recorded during several weeks
subsequent to the closing date to determine the date of the original sale. If auditors discover that
the amounts recorded in the subsequent period are significantly different from unrecorded returns
and allowances at the beginning of the period under audit, they must consider an adjustment. For
example, a company may experience an increase in sales returns when it launches a new product.
In addition, if the internal controls for recording sales returns and allowances are evaluated as
ineffective, a larger sample is needed to verify cutoff.
Cash Receipts Cutoff: For most audits, a proper cash receipts cutoff is less important than either
the sales or the sales returns and allowances cutoff because the improper cutoff of cash affects
83
only the cash and the accounts receivable balances, not earnings. Nevertheless, if the
misstatement is material, it can affect the fair presentation of these accounts, especially when
cash is a small or negative balance.
It is easy to test for a cash receipts cutoff misstatement (often called holding the cash receipts
book open) by tracing recorded cash receipts to subsequent period bank deposits on the bank
statement. If a delay of several days exists, that could indicate a cutoff misstatement.
Accounts Receivable Is Stated at Realizable Value
Accounting standards require that companies state accounts receivable at the amount that will
ultimately be collected. The realizable value of accounts receivable equals gross accounts
receivable less the allowance for uncollectible accounts. To calculate the allowance, the client
estimates the total amount of accounts receivable that it expects to be uncollectible. Obviously,
clients cannot predict the future precisely, but it is necessary for the auditor to evaluate whether
the client‘s allowance is reasonable, considering all available facts.
Bad Debt Expense: After the auditor is satisfied with the allowance for uncollectible accounts;
it is easy to verify bad debt expense. Assume that:

The beginning balance in the allowance account was verified as a part of the previous
audit.

The uncollectible accounts written off were verified as a part of the substantive tests of
transactions.
The Client Has Rights to Accounts Receivable
The client‘s rights to accounts receivable ordinarily cause no audit problems because the
receivables usually belong to the client. In some cases, however, a portion of the receivables may
have been pledged as collateral, assigned to someone else, factored, or sold at discount.
Normally, the client‘s customers are not aware of the existence of such matters, so the
confirmation of receivables will not bring them to light. To uncover instances in which the client
has limited rights to receivables, the auditor may review the minutes, discuss with the client,
confirm with banks, examine debt contracts for evidence of accounts receivable pledged as
collateral, and examine correspondence files.
Accounts Receivable Presentation and Disclosure
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Tests of the four presentations and disclosure-related audit objectives are generally done as part
of the completion phase of the audit. However, some tests of presentation and disclosure are
often done with tests to meet the balance-related audit objectives. For example, when testing
sales and accounts receivable, the auditor must understand and evaluate the appropriateness of
the client‘s revenue recognition policy to determine whether it is properly disclosed in the
financial statements. The auditor must also decide whether the client has properly combined
amounts and disclosed related party information in the statements. To evaluate the adequacy of
the presentation and disclosure, the auditor must have a thorough understanding of accounting
standards and presentation and disclosure requirements.
Confirmation of Accounts Receivable
What audit objectives will be satisfied through accounts receivable confirmation?
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Confirmation of accounts receivable was a recurring concept in our discussion about designing
tests of details of balances for accounts receivable. The primary purpose of accounts receivable
confirmation is to satisfy the existence, accuracy, and cutoff objectives.
Types of Confirmation
Can you mention some commonly known types of confirmation?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------In performing confirmation procedures, the auditor must first decide the type of confirmation to
use.
Positive Confirmation: A positive confirmation is a communication addressed to the debtor
requesting the recipient to confirm directly whether the balance as stated on the confirmation
request is correct or incorrect.
A blank confirmation form is a type of positive confirmation that does not state the amount on
the confirmation but requests the recipient to fill in the balance or furnish other information.
Because blank forms require the recipient to determine the information requested, they are
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considered more reliable than confirmations that include balance information. Blank forms are
rarely used in practice because they often result in lower response rates.
An invoice confirmation is another type of positive confirmation in which an individual invoice
is confirmed, rather than the customer‘s entire accounts receivable balance. Many customers use
voucher systems that allow them to confirm individual invoices but not balance information. As
a result, the use of invoice confirmations may improve confirmation response rates. Invoice
confirmations also result in fewer timing differences and other reconciling items than balance
confirmations. However, invoice confirmations have the disadvantage of not directly confirming
ending balances.
Sales to major customers often involve special terms or side-agreements for the return of goods
that may affect the amount and timing of revenue to be recognized from the sale. When this has
been identified as a significant risk, positive confirmations often request the customer to confirm
the existence of any special terms or side agreements between the client and customer.
Negative Confirmation
A negative confirmation is also addressed to the debtor but requests a response only when the
debtor disagrees with the stated amount. A positive confirmation is more reliable evidence
because the auditor can perform follow-up procedures if a response is not received from the
debtor. With a negative confirmation, failure to reply must be regarded as a correct response,
even though the debtor may have ignored the confirmation request.
Offsetting the reliability disadvantage, negative confirmations are less expensive to send than
positive confirmations, and thus more can be distributed for the same total cost. Negative
confirmations cost less because there are no second requests and no follow-up of non responses.
The determination of which type of confirmation to use is an auditor‘s decision and it should be
based on the facts in the audit. Auditing standards state that it is acceptable to use negative
confirmations only when all of the following circum stances are present:
1. The auditor has assessed the risk of material misstatement as low and has obtained
sufficient appropriate evidence regarding the design and operating effectiveness of
controls relevant to the assertion being tested by the confirmation procedure.
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2. The population of items subject to negative confirmation procedures is made up of a large
number of small, homogenous account balances, transactions, or other items.
3. The auditor expects a low exception rate.
4. The auditor reasonably believes that recipients of negative confirmation requests will
give the requests adequate consideration. For example, if the response rate to positive
confirmations in prior years was extremely high or if there are high response rates on
audits of similar clients, it is likely that recipients will give negative confirmations
reasonable consideration as well.
Typically, when negative confirmations are used, the auditor puts considerable emphasis on the
effectiveness of internal controls, substantive tests of transactions, and analytical procedures as
evidence of the fairness of accounts receivable, and assumes that the large majority of the
recipients will provide a conscientious reading and response to the confirmation request.
Negative confirmations are often used for audits of hospitals, retail stores, banks, and other
industries in which the receivables are due from the general public. Auditors may use a
combination of negative and positive confirmations by sending the latter to accounts with large
balances and the former to those with small balances.
Timing
The most reliable evidence from confirmations is obtained when they are sent as close to the
balance sheet date as possible. This permits the auditor to directly test the accounts receivable
balance on the financial statements without making any inferences about the transactions taking
place between the confirmation date and the balance sheet date. However, as a means of
completing the audit on a timely basis, it is often necessary to confirm the accounts at an interim
date. This is permissible if internal controls are adequate and can provide reasonable assurance
that sales, cash receipts, and other credits are properly recorded between the date of the
confirmation and the end of the accounting period. The auditor is likely to consider other factors
in making the decision, including the materiality of accounts receivable and the auditor‘s
exposure to lawsuits because of the possibility of client bankruptcy and similar risks.
Selection of the Items for Testing: Some type of stratification is desirable with most
confirmations. In a typical approach to stratification for selecting the balances for confirmation,
an auditor considers both the dollar size of individual accounts and the length of time an account
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has been outstanding. In most audits, the emphasis should be on confirming larger and older
balances because these are most likely to include a significant misstatement.
Figure 2.6: Summary of type of audit tests for the sales and collection cycle
Activity 2.2
Assume the following are audit procedures in the sales and collection cycle:
1. Add the columns on the aged trial balance and compare the total with the general ledger.
2. Examine a sample of shipping documents to determine whether each has a sales invoice number included
on it.
3. Examine a sample of customer orders and see if each has a credit authorization.
4. Compare the date on a sample of shipping documents a few days before and after the balance sheet date
with related sales journal transactions.
5. Discuss with the sales manager whether any sales allowances have been granted after the balance sheet date
that may apply to the current period.
6. Observe whether the controller makes an independent comparison of the total in the general ledger with the
trial balance of accounts receivable.
7. Compare the date on a sample of shipping documents throughout the year with related duplicate sales
invoices and the accounts receivable master file.
8. Compute the ratio of allowance for uncollectible accounts divided by accounts receivable and compare with
previous years.
Required
a. For each procedure, identify the applicable type of audit evidence.
……………………………………………………………………………………………………………………
……………………………………………………………………………………………………………
b. For each procedure, identify which of the following it is:
(1) Test of control
(3) Analytical procedure
(2) Substantive test of transactions
(4) Test of details of balances
c. For those procedures you identified as a test of control or substantive test of transactions, what transactionrelated audit objective or objectives are being satisfied?
d. For those procedures you identified as a test of details of balances, what balance related audit objective or
objectives are being s
……………………………………………………………………………………………………………………
………………………………………………………………………………………………………
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2.3 SECTION 3: AUDITING OBJECTIVES AND PROCEDURES FOR INVENTORIES
AND COST OF GOODS SOLD
Nature of the conversion cycle
The conversion cycle encompasses the production of finished products for sale. The cycle relates
directly to two other cycles; it uses resources and information provided by the
expenditure/disbursement cycle, and it provides resources and information to the revenue/receipt
cycle.
Learning objectives
After studying this section, you should be able to:
 Describe the business functions and the related documents and records in the inventory
and warehousing cycle.
 Explain the five parts of the audit of the inventory and warehousing cycle.
 Design and perform audit tests of cost accounting.
 Apply analytical procedures to the accounts in the inventory and warehousing cycle.
 Design and perform physical observation audit tests for inventory.
 Design and perform audit tests of pricing and compilation for inventory.
 Integrate the various parts of the audit of the inventory and warehousing cycle.
2.3.1 Sources and nature of inventories and cost of goods Sold:
Can you list some of the sources of inventories and cost of goods sold?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The term inventory is used in this section to include:
1) Goods on hand ready for sale, either the merchandise of a trading concern or the finished
goods of a manufacturer;
(2) Goods in the process of production; and
(3) Goods to be consumed directly or indirectly in production, consisting of raw materials,
purchased parts, and supplies.
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Inventories have received much attention in both the accounting and auditing literature, as well
as in discussions among professional accountants. The reasons for the special significance
attached to inventories are readily apparent:
1. The valuation of goods on hand and in process often presents complex and difficult issues
2. Determining the quantities of inventories may require specialized techniques
3. Inventories often represent the largest current asset of a company
4. Misstatements of inventories directly affect cost of goods sold and, therefore, net income
5. Management fraud has often involved the fraudulent overstatement of inventories
2.3.2 The auditors’ objectives in examination of inventories and cost of goods sold:
What are the main objectives of auditor‘s to examine inventories and cost of goods sold in
their audit engagement?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The auditors‘ objectives in the examination of inventories (and cost of goods sold) are to
determine that:
1. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods sold.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:
a. Verify the existence of inventories and the occurrence of transactions affecting cost of
goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.
e. Establish the proper valuation of inventories and the accuracy of transactions
affecting cost of goods sold.
f. Determine that the presentation and disclosure of information about inventories and
cost of goods sold are appropriate, including disclosure of the classification of
inventories, accounting methods used, and inventories pledged as collateral for debt
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2.3.3 Internal control over inventories and cost of goods sold:
What internal control mechanisms over inventories you experienced in your work place?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The importance of adequate internal control over inventories and cost of goods sold from the
viewpoint of both management and the auditors can scarcely be overemphasized. In some
companies, management stresses internal controls over cash and securities but pays little
attention to control over inventories. Since many types of inventories are composed of items not
particularly susceptible to theft, management may consider internal controls to be unnecessary in
this area. Such thinking ignores the fact that an internal control performs other functions just as
important as fraud prevention.
Good internal control is a means of providing accurate cost data for inventories and cost of goods
sold as well as accuracy in reporting physical quantities. Inadequate internal control may cause
losses by permitting erroneous cost data to be used by management in setting prices and in
making other decisions based on reported profit margins. If the accounts do not furnish a
realistic picture of the cost of inventories on hand, the cost of goods manufactured, and the cost
of goods sold, the financial statements may be grossly misleading both as to earnings and as to
financial position.
Purchasing, receiving, storing, issuing, processing, and shipping are the physical functions
directly connected with inventories; the cost accounting system and the perpetual inventory
records comprise the recording functions. Since the auditors are interested in the final products
of the recording functions, it is necessary for them to understand and appraise the cost
accounting system and the perpetual inventory records, as well as the various procedures and
original documents underlying the preparation of financial data.
The Purchasing function
Adequate internal control over purchases requires, first of all, an organizational structure that
delegates to a separate department of the company exclusive authority to make all purchases of
materials and services. The purchasing, receiving, and recording functions should be clearly
separated and lodged in separate departments.
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Serially numbered purchase orders should be prepared for all purchases, and copies forwarded to
the accounting and receiving department.
The receiving function
All goods received by the company-without exception- should be cleared through a receiving
department that is independent of purchasing, storing, and shipping departments. The receiving
department is responsible for:1) The determination of quantities of goods received
2) The detection of damaged or defective merchandise
3) The preparation of a receiving report, and
4) The prompt transmittal of goods received to the stores department.
The storing function
As goods are delivered to stores, they are counted, inspected, and receipted for. The stores
department will then notify the accounting department of the amount received and placed in
stock. In performing these functions, the stores department makes an important contribution to
overall control of inventory. By signing for the goods, it fixes its own responsibility, and by
notifying the accounting department of actual goods stored, it provides verification of the
receiving department‘s work.
The issuing function
The stores department, being responsible for all goods under its control, has reason to insist that
for all items passing out of its hands it be given a prenumbered requisition, which serves as a
signed receipt from the department accepting the goods. Requisitions are usually prepared in
triplicate one copy is retained by the department making the request; another acts as the stores
department‘s receipt; and the third is a notice to the accounting department for cost distribution.
The production function
The system of internal control over goods in process may include regular inspection procedures
to reveal defective work. This aids in disclosing inefficiencies in the productive system and also
tends to prevent inflation of the goods in process inventory by the accumulation of cost for goods
that will eventually be scrapped.
Control procedures should also assure that goods scrapped during the process of production are
promptly reported to the accounting department So that the decrease in value of goods in process
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inventories may be recorded. Scrapped materials may have substantial salvage value, and this
calls for segregation and control of scrap inventories.
The shipping function
Shipments of goods should be made only after proper authorization has been received. This
authorization will normally be a sales order approved by the credit department; although the
shipping function also includes the returning of defective goods to suppliers. In this latter case,
the authorization may take the form of a shipping advice from a purchasing department
executive.
The cost accounting system
To account for the usage of raw materials and supplies, to determine the content and value of
goods in process inventories, and to compute the finished goods inventory, an adequate cost
accounting system is necessary. This system comprises all the records, orders, requisitions, time
tickets, and the like needed in a proper accounting for the disposition of materials as they enter
the flow of production and as they continue through the factory in the process of becoming
finished goods. The cost accounting system also serves to accumulate labor costs and indirect
costs that contribute to the goods in process and the finished goods inventories. The cost
accounting system thus forms an integral part of the internal control for inventories.
The perpetual inventory system
Perpetual inventory records constitute a most important part of internal control. These records,
by showing at all times the quantity of goods on hand, provide information essential to intelligent
purchasing, sales, and production-planning policies. With such a record it is possible to guide
procurement by establishing points of minimum and maximum quantities for each standard item
stocked.
The use of a perpetual inventory system allows companies to control the high costs of holding
excessive inventory, while minimizing the risk of running out of stock. The company can
control inventories through reorder points and economic order quantities, including just-in-time
systems in which inventory levels are kept to a minimum.
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2.3.4 Audit procedures for inventories and cost of goods sold:
What is the common audit steps for inventories and cost of goods sold?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The following audit procedures for the verification of inventories and cost of goods sold are
appropriate for a manufacturing company.
A) Consider internal control for inventories and cost of goods sold
1 Obtain an understanding of internal control.
As previously indicated, the consideration of internal controls may involve the filling out of a
questionnaire, the writing of descriptive memoranda, or the preparation of flowcharts depicting
organizational structure and the flow of materials and documents. All these approaches utilize
the same basic investigative techniques of interview and the conduct of a walk-through of the
system to determine that the system is accurately described.
During the review of internal controls over inventory, the auditors should become thoroughly
conversant with the procedures for purchasing, receiving, storing, and issuing goods and for
controlling production, as well as acquiring an understanding of the cost accounting system and
the perpetual inventory records. The auditors should also give consideration to the physical
protection for inventories.
2. Assess control risk and design additional tests of controls.
Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost justified restrictions of
substantive tests.
3. Perform additional tests of controls
a) Examine significant aspects of a sample of purchase transactions.
The proper recording of purchase transactions and of cash disbursements is essential to reliable
accounting records. Therefore, the auditors test the key control procedures in the client‘s
purchasing transaction cycle. Tests of this cycle may include the following steps:
1) Select a sample of purchase transactions.
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2) Examine the purchase requisition or other authorization for each purchase transaction in the
sample.
3) Examine the related vendor‘s invoice, receiving report, and paid check for each purchase
order in the sample. Trace transactions to the voucher register and check register.
4) Review invoices for approval of prices, extensions, footings, freight, and credit terms.
5) Compare quantities and prices in the invoice, purchase order, and receiving report.
6) Trace postings from voucher register to general ledger and any applicable subsidiary
ledgers.
b) Test the cost accounting system
For a client in the manufacturing field, the auditors must become familiar with the cost
accounting system in use as a part of their consideration of internal control.
In any cost accounting system, the three elements of manufacturing cost are direct materials
costs, direct labor costs, and manufacturing overhead. Cost accounting systems may accumulate
either actual costs or standard costs according to processes or jobs. The auditors‘ tests of the
client‘s cost accounting system are designed to determine that costs allocated to specific jobs or
processes are appropriately compiled.
To achieve this objective, the auditors test the appropriateness of direct materials quantities and
unit costs, direct labor hours and hourly rates, and overhead rates and allocation bases.
4. Reassess control risk and design substantive tests.
The description and tests of controls of the client‘s internal control for inventories and cost of
goods sold provide the auditors with evidence as to weaknesses and strengths of the system.
Based on this information, the auditors reassess control risk and design their substantive testing
of inventories and cost of sales accordingly.
B) Substantive tests
5. Obtain listings of inventory and reconcile to ledgers.
The auditor will obtain a schedule of listings of inventory which will be reconciled to both the
general ledger and appropriate subsidiary ledgers. The auditors‘ goal in performing this step is
to make sure the inventory records agree with what is recorded in the accounting system.
6. Evaluate the client’s planning of physical inventory.
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Efficient and effective inventory taking requires careful planning in advance. Once the plan has
been developed, it must be documented and communicated in the form of written instructions to
the personnel taking the physical inventory. These instructions normally will be drafted by the
client and reviewed by the auditors, who will judge their adequacy.
If the instructions for taking inventory are adequate, then the auditors‘ responsibility during the
count is largely a matter of seeing that the instructions are followed conscientiously.
7. Observe the taking of physical inventory and make test counts.
It is not the auditors‘ function to take the inventory or to control or supervise the taking; this is
the responsibility of management. The auditors observe the inventory taking in order to obtain
sufficient competent evidence as to the existence and completeness of audit objectives.
Observation by the auditors also includes determining that all usable inventory owned by the
client is included in the count and that the client‘s employees comply with the written inventory
instructions. As part of the process of observing the physical inventory, the auditors will be alert
to detect any obsolete or damaged merchandise included in inventory. Such merchandise should
be segregated by the client and written down to net realizable value. During their inventory
observation, the auditors will make test counts of selected inventory items.
8. Review the year-end cut off of purchases and sales transactions
An accurate cut off of purchases is one of the most important factors in verifying the accuracy
and completeness of the year-end inventory. Assume that a shipment of goods costing Br.
10,000 is received from a supplier on December 31, but the purchase invoice does not arrive
until January 2 and is entered as a January transaction. If the goods are included in the December
31 Physical inventory but there is no December entry to record the purchase and the liability, the
result will be an overstatement of both net incomes for the year and retained earnings and an
understatement of accounts payable, each error being in the full amount of Br. 10, 000 (ignoring
income taxes).
An opposite situation may arise if a purchase invoice is received and recorded on December 31,
but the merchandise covered by the invoice is not received until several days later and is not
included in the physical inventory taken at the year-end. How can the auditors determine that the
liability to suppliers has been recorded for all goods included in inventory? Their approach is to
examine on a test basis the purchase invoices and receiving reports for several days before and
after the inventory date.
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The sales cutoff is mentioned at this point to emphasize its importance in determining the
fairness of the client‘s inventory and cost of goods sold as well as accounts receivable and sales.
9. Obtain a copy of the completed physical inventory, determine its clerical accuracy, and
trace test counts.
The testing of extensions and footings on the final inventory listing may disclose misstatements
of physical inventories. In testing extensions, the auditors should be alert for two sources of
substantial errors- misplaced decimal points and incorrect extension of count units by price units.
For example, an inventory listing that extends 1,000 units times Br.1C (Per hundred) as Br.1,000
will be overstated by Br.990. An inventory extension of 1,000 sheets of steel times Br. 1 per
pound will be substantially understated if each sheet of steel weighs more than one pound.
The auditors also should trace to the completed physical inventory their test counts made during
the observation of physical inventory. Another test of the clerical accuracy of the completed
physical inventory is the reconciliation of the physical counts to inventory records. Both the
quantities and the values of the items should be compared to the company‘s perpetual records.
10. Review inventory quality and condition
The auditors should also be alert during the course of their inventory observation for any
inventory of questionable quality or condition. Excessive dust or rust on raw materials inventory
items may be indicative of obsolescence or infrequent use.
The auditors should also review perpetual inventory records for indications of slow-moving
inventory items. Then, during the course of observing inventory taking, the auditor should
examine these slow-moving items and determine that the client has identified the items as
obsolete if appropriate.
11. Evaluate the bases and methods of inventory pricing.
The auditors are responsible for determining that bases and methods of pricing inventory are in
accordance with generally accepted accounting principles. The investigation of inventory
pricing often will emphasize the following three questions:
1) What method of pricing does the client use?
2) Is the method of pricing the same as that used in prior years?
3) Has the method officially selected by the client been applied consistently and accurately in
practice?
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For the first question a long list of alternatives is possible, including such methods as cost; cost
or market, whichever is lower; the retail method; and quoted market price. The cost method, of
course, includes many diverse systems, such as last-in, first-out (LIFO); first-in, first-out (FIFO);
specific identification; weighted average.
For the second question the nature and justification of the change in method of valuing inventory
and its effect on income should be disclosed. To answer the third question the auditors must test
the pricing of a representative number of inventory items.
12. Test the pricing of inventories.
To determine whether the inventory valuation method used by the client has been properly
applied, the auditors must make tests of the pricing of selected items of finished goods, goods in
process and raw materials.
As a general rule, inventories should not be carried at an amount in excess of net realizable
value. The lower-of-cost-or-market rule is a common means of measuring any loss of utility in
the inventories. If the inventory includes any discontinued lines or obsolete or damaged goods,
the client should reduce these items to net realizable value, which is often scrap value.
13. Perform analytical procedures
Material errors in counting, pricing, and calculating the physical inventory, as well as fictitious
or obsolete inventory, may be disclosed by analytical procedures designed to establish the
general reasonableness of the inventory figures.
A comparative summary of inventories classified by major types, such as raw materials, goods in
process, finished goods, and supplies, should be obtained or prepared. Explanations should be
obtained for all major increases or decreases from the prior year‘s amounts.
14. Determine whether any inventories have been pledged and review purchase and sales
commitments.
The verification of inventories includes a determination by the auditors as to whether any goods
have been pledged. In some lines of business, it is customary to enter into firm contracts for the
purchase of merchandise or materials well in advance of the scheduled delivery dates.
Comparison by the auditors of the prices quoted in such commitments with the vendors‘ prices
prevailing at the balance sheet date may indicate substantial losses if firm purchase commitments
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are not protected by firm sales contracts. Such losses should be reflected in the financial
statements.
15. Evaluate financial statement presentation of inventories and cost of goods sold,
including the adequacy of disclosure.
One of the most important factors in proper presentation of inventories in the financial
statements is disclosure of the inventory pricing method or methods in use. Other important
points in presenting inventories in the financial statements include the following:
1) Changes in methods of valuing inventory should be disclosed and the dollar effect and
justification for the change reported.
2) A separate listing is desirable for the various classifications of inventory, such as finished
goods, goods in process, and raw materials.
3) If any portion of the inventory has been pledged to secure liabilities, full disclosure of the
arrangement should be made.
4) Deduction of valuation allowance for inventory losses from the related inventory.
5) Disclosure of the existence and the terms of inventory purchase commitments.
Table 2.8: Assertions, Objectives and Procedures for Purchases and Inventory
Financial report
assertions
Existence
Occurrence
Specific audit objective
Inventories included in the
statement of financial position
physically exist and represent
items held for sale in the
ordinary course of business.
Transaction of purchase and
cash payments occurred during
the period.
Completeness
Inventory quantities include all
items on hand or in transit.
Inventory listings are accurately
compiled and properly included
in the inventory accounts.
Rights and
The entity has legal title or
Common audit procedures to achieve
objectives
.inspection of physical inventory
(checking from inventory records to
physical stock)
.analytical procedures
.Confirm stock held at other location
.Select transactions from purchases
journal and agree to supporting
documentation ( i.e. goods received
note)
.select transaction from cash payments
journal and agree to supporting
documents (e.g. supplier‘s invoices)
.inspection of physical inventory
(checking from physical stock to
records)
.analytical procedures
.inquire about stock held at other
locations
Check legal ownership or goods being
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obligations
Measurement
Valuation
Disclosure
ownership rights to inventory
items, and inventories exclude
items billed to customers or
owned by others.
Inventory transactions are
recorded in the correct amount
and period
shipped and goods on consignment
Inventories are properly stated
with respect to:
.cost determined by an
acceptable method consistently
applied
.slow-moving, excess,
defective, and obsolete items
identified
.reduced to net realizable value
if lower than cost
Inventories are properly
described and classified in the
statement of financial position
and related disclosures are
adequate.
.test of pricing and summarization
.analytical procedures
.observation of physical inventory (look
for obsolete or damaged items)
.Inquire and scanning
.check subsequent sales price and
compare with cost
.check dollar value of purchases to
inventory price list.
.agree dollar value of cash payments to
supporting documents (e.g. supplier‘s
invoice)
.check last purchase and sales recorded
before balance date and first purchases
recorded after balance date are recorded
in correct period (cut-off)
.test clerical accuracy of inventory
listing
.inquiry and scanning
.general procedures
There are 4 internal control objectives and associated potential errors or frauds and their
related audit procedures for inventory. These objectives are:
1. Authorization
2. Execution/implementation
3. Recording
4. Access to assets
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Table 2.9: Authorization: Inventory Objective, Error, And Procedure
Objective
Error
Production should be authorized
in accordance with management‘s
criteria
Procedure
Unauthorized quantities, Prepare statements of
or products may be
Criteria for determining
produced; potentially
which products are to be
resulting in obsolete,
produced & in what
excess, or otherwise
quantities.
unusable inventory and
excess carrying cost
Execution: Inventory Objective, Error, Procedure
Objective
Error
Procedure
Procedures for using and
Unauthorized personnel may
physically transferring
avoid existing procedures,
inventory should be
potentially resulting in stolen,
established in accordance with or misused inventory
management‘s authorization
Inventory may be misplaced,
potentially resulting in unused
assets
Prepare Inventory processing manuals
including procedures for controlling
inventory movement.
Restrict access to inventory to
authorized personnel.
Recording: Inventory Objectives, Errors, Procedures
Objectives
Inventory used or transferred
should be recorded at proper
amounts, period, and
classification
Errors
Inventory placed in
production may not be
recorded, potentially
resulting in misstated
inventory and CGS.
Inventory-related Adjustments Unauthorized adjustments
should be authorized in
may be recorded to conceal
accordance with
physical storages,
management‘s criteria
potentially resulting in
misused and , misstated
inventory
Procedures
Establish processing and recording
procedures;
Pre-number, and control materials
release forms and production orders
Establish policies for approving and
recording adjustments;
Pre-number, and control inventory
adjustment forms
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Access: Inventory Objectives, Errors, Procedures
Objectives
Errors
Procedures
Access to inventory should Inventory could be stolen, Establish Physical controls over inventory;
be restricted personnel
lost, or diverted, potentially
authorized by management resulting in misapplied and Maintain insurance and fidelity bonds for
misstated assets
personnel handling valuable inventory
Maintain adequate insurance coverage for
assets
Segregate responsibility for handling
inventory from inventory recording.
Access to production, cost
Inventory Records could be Establish Physical controls over unused
accounting and perpetual
misused, destroyed, or lost, forms and records; Maintain files of
inventory records should be, potentially resulting in
authorized signatures,
records restricted to
misstated inventory.
personnel authorized by
management.
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2.4 SECTION 4: AUDITING OBJECTIVES AND PROCEDURES FOR PROPERTY, PLANT
AND EQUIPMENT INCLUDING DEPRECIATION
Transactions in the acquisition and payment cycle affect several asset accounts: supplies,
property, plant and equipment, and prepaid expenses accounts, to name a few. Payments made
for services also affect many expense accounts. To continue our discussion of the acquisition and
payment cycle, this section examines audit issues related to other accounts commonly found in
the acquisition and payment cycles of most businesses.
Property, plant, and equipment are assets that have expected lives of more than one year, are
used in the business, and are not acquired for resale. The intent to use the assets as part of the
operation of the client‘s business and their expected lives of more than one year are the
significant characteristics that distinguish these assets from inventory, prepaid expenses, and
investments.
Learning objectives
After studying this section, you should be able to:
 Recognize the many accounts in the acquisition and payment cycle.
 Design and perform audit tests of property, plant, and equipment and related accounts.
 Design and perform audit tests of prepaid expenses.
 Design and perform audit tests of accrued liabilities.
 Design and perform audit tests of income and expense accounts.
2.4.1 The auditors’ approach in examination of property, plant and equipment:
How is the auditor‘s approach in the examination of PPE differing from their approaches
to audit inventories?
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Property plant and equipments are tangible assets with a service life of more than one year that
are used in the operation of the business and are not acquired for the purpose of resale
Three major subgroups:

Land
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
Buildings, machinery, equipment and land improvements

Natural resources
Acquisitions and disposals of property, plant, and equipment are usually large in dollar amount,
but concentrated in only a few transactions. Individual items of plant and equipment may remain
unchanged in the accounts for many years.
2.4.2 Objectives for the Audit of Property, Plant and Equipment:
Can you cite the main focus of auditors in the audit of PPE?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The auditors‘ objectives are to determine that:
1. Use the understanding of the client and its environment to consider inherent risk, including
fraud risks, related to property, plant, and equipment.
2. Obtain an understanding of internal control over property, plant, and equipment.
1. Assess the risks of material misstatement and design tests of controls and
substantive procedures that:
a. Substantiate the existence of property, plant, and equipment
b. Establish the completeness of recorded property, plant, and equipment
c. Verify the cutoff of transactions affecting property, plant, and equipment
d. Determine that the client has rights to recorded property, plant, and equipment
e. Establish the proper valuation or allocation of property, plant, and equipment and
the accuracy of transactions affecting property, plant, and equipment
f. Determine that the presentation and disclosure of property, plant, and equipment
are appropriate
In conjunction with the audit of property, plant and equipment, the auditors also obtain evidence
about the related accounts of depreciation expense, accumulated depreciation, and repairs and
maintenance expense.
Contrast with audit of current assets
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In many companies, the investment in plant and equipment amounts to 50 percent or more of the
total assets. However, the audit work required to verify these properties is usually a much
smaller proportion of the total audit time spent on the engagement.
The verification of plant and equipment is facilitated by several factors not applicable to audit
work on current assets.
First, a typical unit of property or equipment has a high dollar value, and relatively few
transactions may lie behind a large balance sheet amount. Second, there is usually little change in
the property accounts from year to year. The land account often remains unchanged for a long
span of years. The durable nature of buildings and equipment also tends to hold accounting
activity to a minimum for these accounts. By way of contrast, such current assets as accounts
receivable and inventory may have a complete turnover several times a year.
A third point of contrast between the audit of plant asset and the audit of current assets is the
significance of the year-end cut off of transactions for current assets, the year end cutoff is a
critical issue; for plant assets, it is generally not.
Audit approach – current accounts vs. non current accounts
Cash
securities
the
accrued
accounts payable
high turnover accounts
audit approach –audit
balance
Accounts receivable
short-term note
Inventories
Property, plant and equipment
long-term liabilities
low turnover
accounts
Intangible assets
owner‘s equity
Audit approach-
audit the changes
In the accounts
Internal controls over plant and equipment
The principal purpose of internal controls relating to plant and equipment is to obtain maximum
efficiency from the dollars invested in plant assets.
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The amounts invested in plant and equipment represents a large portion of the total assets of
many industrial concerns. The expenses of maintenance, rearrangement, and depreciation of
these assets are a major factor in the income statement. The sheer size of the amounts involved
makes strong internal controls essential to the production of reliable financial statements.
Major control devices
Can you mention some of the controls over plants and equipments in your work place?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Important controls applicable to plant and equipment are as follows:
1. There should be an annual plant budget used to forecast and to control acquisitions and
retirements of plant and equipment.
2. A subsidiary ledger consisting of a separate record for each unit of property.
3. A system of authorization requiring advance executive approval of all plant and
equipment acquisitions, whether by purchase, lease, or construction.
4. A reporting procedure assuring prompt disclosure and analysis of variances between
authorized expenditures and actual costs.
5. An authoritative written statement of company policy distinguishing between capital and
revenue expenditures. A dollar minimum ordinarily will be established for
capitalization; any expenditures of lesser amount automatically are classified as charges
against current revenue.
6. A policy requiring all purchases of plant and equipment to be handled through the
purchasing department and subjected to standard routines for receiving, inspection, and
payment.
7. Periodic physical inventories, designed to verify the existence, location, and condition of
all property listed in the accounts and to disclose the existence of any unrecorded units.
8. A system of retirement procedures, including serially numbered retirement work orders,
stating reasons for retirement and bearing appropriate approvals.
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2.4.3 Audit procedure for property, plant, and equipment:
How is PPE audited in your community?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The following procedures are typical of the work required in many engagements for the
verification of property, plant and equipment.
A. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to property, plant, and equipment.
B. Obtain an understanding of internal control over property, plant, and equipment.
In the study of internal control for plant and equipment, the auditors may utilize a written
description, flowcharts, or an internal control questionnaire.
The following are typical of the questions included in a questionnaire;
 Are plant ledgers regularly reconciled with general ledger controlling accounts?
 Are periodic physical inventories of plant asset compared with the plant ledgers?
 Are variances between plant budgets and actual expenditures for plant assets subject to
review and approval of executives?
 Does the sale, transfer, or dismantling of equipment require written executive approval on
a serially numbered retirement work order?
 Is there a written policy for distinguishing between capital expenditures and revenue
expenditures?
C. Assess the risks of material misstatement and design further audit procedures.
Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost justified restrictions of
substantive tests.
D. Perform further audit procedures—tests of controls.
1. Nature of tests of controls.
2. If necessary, revise the risks of material misstatement based on the results of tests of
controls.
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The purpose of tests of controls for plant assets is to determine whether the internal controls
established by the client are being followed consistently in practice. For example, if the client
uses serially numbered retirement work orders to authorize the disposal of plant assets, the
auditors may test this control by matching known retirements with retirement work orders and by
comparing individual work orders with entries in the subsidiary ledgers for plant and equipment.
Another test is to examine copies of reconciliations of the subsidiary ledgers with general ledger
controlling accounts to determine whether these reconciliations have, in fact, been regularly
prepared and have been approved by an appropriate official.
E. Perform further audit procedures—substantive procedures for property, plant, and equipment:
1. Obtain a summary analysis of changes in property owned and reconcile to ledgers.
The auditors may verify the beginning balances of plant and equipment assets by reference to the
prior year‘s audit working papers. In addition to beginning balances, the summary analysis will
show the additions and retirements of plant and equipment during the year under audit. As the
audit progresses, the auditors will verify in detail these additions and retirements.
2. Vouch additions to property, plant, and equipment during the year.
The vouching of additions to the property accounts during the period under audit is one of the
most important substantive tests of plant and equipment. The extent of the vouching is
dependent up on the auditors‘ assessment of control for plant and equipment expenditures. The
vouching process utilizes a working paper analysis of the general ledger controlling accounts and
includes the tracing of entries through the journals to original documents, such as contracts,
deeds, construction work orders, invoices, canceled checks, and authorization by directors.
3. Make a physical inspection of major acquisitions of plant and equipment.
The auditors usually make a physical inspection of major units of plant and equipment acquired
during the year under audit. This step is helpful in maintaining a good working knowledge of the
client‘s operations and also in interpreting the accounting entries for both additions and
retirements. Physical inspection is particularly appropriate if there appear to be weaknesses in
the client‘s internal controls over plant assets.
The audit procedure of Physical inspection may flow in either direction between the plant assets
and the records of plant assets. By tracing items in the plant ledger to the Physical assets, the
auditors prove that the assets shown in the accounting records actually exist and are in current
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use. The alternative testing procedure is to inspect selected assets in the plant and trace these
assets to the detailed records. This test provides evidence that existing assets are recorded.
4. Analyze repair and maintenance expense accounts.
The auditors‘ principal objective in analyzing repair and maintenance expense accounts is to
discover items that should have been capitalized. Many companies have a written policy setting
the minimum expenditure to be capitalized. For example, company policy may prescribe that no
expenditure for less than Br. 300 shall be capitalized regardless of the service life of the item
purchased. In such cases, the auditors will analyze the repair and maintenance accounts with a
view toward determining the consistency of application of this policy as well as compliance with
generally accepted accounting principles.
5. Investigate the status of property, plant, and equipment not in current use.
Land, buildings, and equipment not in current use should be investigated thoroughly to
determine the prospects for their future use in operations. Plant assets that are temporarily idle
need not be reclassified, and depreciation may be continued at normal rates. On the other hand,
idle equipment that has been dismantled, or that for any reason appears unsuitable for future
operating use, should be written down to an estimated realizable value and excluded from the
plant and equipment classification.
6. Test the client’s provision for depreciation.
We have emphasized the importance of determining the overall reasonableness of the amount of
depreciation expense, which is usually a very material amount on the income statement. An
overall test of the annual provision for depreciation requires the auditors to perform the
following steps:
1. List the balances in the various asset accounts at the beginning of the year.
2. Deduct any fully depreciated assets, since these items should no longer be subject to
depreciation.
3. Add one half of the asset additions for the year.
4. Deduct one half of the asset retirements for the year (exclusive of any fully depreciated
assets).
These four steps produce average amounts subject to depreciation at the regular rates in each of
the major asset categories. By applying the appropriate rates to these amounts, the auditors
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determine on an overall average basis- the amount of the provision for depreciation. The
computed amount is then compared with the client‘s figures. Precise agreement is not to be
expected, but any material difference between the depreciation expense computed in this manner
and the amount set up by the client should be investigated fully.
Here is Auditors’ Approach for Depreciation
 Depreciation is an estimate. Client makes

Estimate of useful economic life

Choice of several depreciation methods
 Audit approach for estimate

Review and test management‘s process of developing the estimate

Review subsequent events or transactions bearing on the estimate

Independently develop an estimate of the amount to compare to management‘s
estimate
Audit Program – Depreciation
1. Review the depreciation policies set forth in company manuals or other management
directives. Determine whether the methods in use are designed to allocate costs of plant and
equipment assets systematically over their service lives.
a) Inquire whether any extra working shifts or other conditions of accelerated production are
present that might warrant adjustment of normal depreciation rates.
b) Discuss with executives the possible need for recognition of obsolescence resulting from
technological or economic developments.
2. Obtain or prepare a summary analysis of accumulated depreciation for the major property
classifications as shown by the general ledger control accounts, listing beginning balances,
provisions for depreciation during the year, retirements, and ending balances.
a) Compare beginning balances with the audited amounts in last year‘s working papers.
b) Determine that the totals of accumulated depreciation recorded in the plant and
equipment subsidiary records agree with the applicable general ledger controlling
accounts
3. Test the provisions for depreciation.
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a) Compare rates used in the current year with those employed in prior years and investigate
any variances.
b) Test computations of depreciation provisions for a representative number of units and
trace to individual records in the property ledger. Be alert for excessive depreciation on
fully depreciated assets. Generalized audit software can be used to test the depreciation
calculations in the client‘s records if the client maintains computer based records.
c) Compare credits to accumulated depreciation accounts for the year‘s depreciation
provisions with debit entries in related depreciation expense accounts.
4. Test deductions from accumulated depreciation for assets retired.
a) Trace deductions to the working paper analyzing retirements of assets during the year.
b) Test the accuracy of accumulated depreciation to date of retirement.
c) Perform analytical procedures for depreciation.
d) Compute the ratio of depreciation expense to total cost of plant and compare with prior
years.
e) Compare the percentage relationships between accumulated depreciation and related
property accounts with those prevailing in prior years. Discuss significant variations from
the normal depreciation program with appropriate members of management.
7. Investigate potential impairments of property, plant, and equipment.
Long-lived assets must be reviewed for impairment whenever events or changes in
circumstances indicate that carrying value may not be recoverable, Test involves projecting
future cash flows, If impairment is indicated by cash flows asset must be written down to fair
value, May require the use of a valuation specialist
8. Investigate retirements of property, plant, and equipment during the year.
The principal purpose of this procedure is to determine whether any property has been replaced,
sold, dismantled, or abandoned without such action being reflected in the accounting records.
Nearly every thorough Physical inventory of plant and equipment reveals missing units of
property: units disposed of without a corresponding reduction of the accounts.
9. Examine evidence of legal ownership of property, plant, and equipment.
10. Review rental revenue from land, buildings, and equipment owned by the client but leased to
others.
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Examination of leases will indicate whether tenants are responsible for the cost of electricity,
water, gas, and telephone service. These provisions should be reconciled with utility expense
accounts. Rental revenue accounts should be analyzed in all cases and the amount compared
with lease agreements and cash records.
11. Examine lease agreements on property, plant, and equipment leased to and from
others.
The auditors must be aware that generally accepted accounting principles require differing
accounting treatments, depending up on whether they qualify as an operating or a capital lease.
The auditors should carefully examine lease agreements to determine whether the accounting for
the assets involved is proper. For example, the auditors must determine whether assets leased by
the client should be capitalized.
12. Perform analytical procedures for property, plant, and equipment.
The specific trends and ratios used in judging the overall reasonableness of recorded amounts for
plant and equipment will vary with the nature of the client‘s operations. Among the ratios and
trends often used by auditors for this purpose are the following:
a) Total cost of plant assets divided by annual output in dollars, pounds, or other units.
b) Total cost of plant assets divided by cost of goods sold.
c) Comparison of repairs and maintenance expense on a monthly basis and from year to
year.
d) Comparison of acquisitions for the current year with prior years.
e) Comparison of retirements for the current year with prior years.
13. Evaluate financial statement presentation and disclosure for plant assets and for related
revenue and expenses.
The balance sheet or accompanying notes should disclose balances of major classes of
depreciable assets.
Accumulated depreciation may be shown by major class or in total, and the method or methods
of computing depreciation should be stated.
The total amount of depreciation should be disclosed in the income statement or supporting
notes.
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In addition, adequate financial statement presentation and disclosure will ordinarily reflect the
following principles:
The basis of valuation should be explicitly stated. At present, cost is the generally accepted basis
of valuation for plant and equipment; property not in use should be valued at estimated realizable
value.
Property pledged to secure loans should be clearly identified.
Property not in current use should be segregated in the balance sheet.
Figure 2.7: potential misstatements –investment in property, plant and equipment
Description of misstatement
Example
Misstatement of acquisition of
property, plant and equipment.
Fraud:
.expenditures for repairers and
maintenance expenses
recorded as PPE acquisition
to overstate income
Error:
.purchase of equipment
erroneously reported in
maintenance and repair
expense account
Error:
.an asset that has been
replaced is discarded due to its
lack of value, without an
accounting entity.
Error:
A ―gain‖ recorded on an
exchange of monetary assets
that lacks commercial
substance.
Failure to record retirement of
PPE
Improper reporting of unusual
transactions
Internal control weakness or
factors that increase the risk of
the misstatement
.undue pressure to meet
earnings targets.
.inadequate accounting
manual; incompetent
accounting personnel.
.inadequate accounting
policies e.g. failure to use
retirement work orders.
.inadequate accounting
manuals; incompetent
accounting personnel
Figure: Summary of Substantive Tests of Property, Plant, and Equipment
Substantive procedures
obtain summary analysis of changes in property
owned and reconcile to ledger
Vouch additions during year.
Make physical inspection of major acquisitions.
Analyze repair and maintenance expense account
Investigate the status of property not in current
Primary audit objective
Valuation
Existence, occurrence and rights
Valuation or allocation, Accuracy and
Cutoff
Valuation or allocation
Valuation or allocation
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use.
Test the client‘s provision for depreciation.
Investigate potential impairments.
Investigate retirement of property during the year.
Examine evidence of legal ownership.
Review rental revenue.
Examine lease agreement.
Perform analytical procedures.
Evaluate financial statement presentation and
disclosure
Presentation and disclosure
Valuation and allocation
Existence, occurrence and rights
Existence and rights
Completeness
Valuation or allocation
Presentation and disclosure
Auditor‘s consideration of internal controls for PP&E
There are 4 internal control objectives and associated potential errors or frauds and their
related audit procedures of conversion cycle-fixed assets.
These objectives are:
 Authorization
 Execution
 Recording
 Access to assets
Table 2.10 Authorization: Fixed Assets Objective, Error, Procedure
Objective
Error
Plant additions, disposals,
Assets may be purchased, or sold
retirements should be
without management knowledge,
authorized in accordance with potentially resulting in misapplied cash
management‘s criteria.
and misstated fixed asset records
Assets may be disposed of or sold at
unfavorable prices, potentially resulting
in lost resources.
Procedure
Prepare Written procedures
for all additions, disposals
and retirements
Periodically Compare scrap
prices received with
published prices.
Execution: Fixed Assets Objective, Error, Procedure
Objective
Error
Procedures for operating, using
Unauthorized personnel may
and physically moving fixed assets Circumvent existing procedures
should be established in
,potentially resulting in Stolen, or
accordance with management‘s
misused equipment
authorization.
Equipments may be misplaced,
Procedure
Establish procedures for
operating, using moving and
otherwise controlling fixed
assets;
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potentially resulting in unused
assets.
Restrict access to movable
fixed assets
Recording: Fixed Assets Objectives, Errors, Procedures
Objectives
Errors
Procedures
Fixed asset Additions, disposals, or Fixed assets transactions may go Establish Procedures for
retirements should be recorded at unreported, potentially resulting processing and recording fixed
the correct amounts, proper period in misstated balances.
assets transactions.
and properly classified
Establish Procedures for
identifying fixed assets eligible
for disposal and retirement.
maintain detailed fixed assets
records periodically reconcile
fixed asset records with existing
assets and investigate
differences.
Depreciation and amortization
Depreciation could be
Establish Policies for
should be calculated in accordance miscalculated or recognized on determining depreciation
with management‘s authorization, fixed assets not in service,
methods and for calculating
be recorded in the proper period, potentially resulting in misstated depreciation on all categories of
and be properly classified.
depreciation expense and asset fixed assets.
book value.
Access: Fixed Assets Objectives, Errors, Procedures
Objectives
Errors
Access to fixed assets should be
Fixed Assets could be lost
restricted to personnel authorized by or stolen, potentially
management
resulting in misapplied
assets and misstated
accounts
Access to asset and records should Fixed assets and
be restricted to personnel authorized depreciation records could
by management restricted.
be misused, destroyed, or
lost, potentially resulting in
misstated assets.
Procedures
Establish Physical controls over
unused fixed assets
Maintain adequate insurance
coverage.
Establish physical controls over
unused forms and records;
Perform periodic compliance audits,
reconciling recorded assets with
existing assets.
Table 2.11: Summary of financial statement assertions and audit objectives for PPE
Financial statement
assertion
Audit objective
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Existence and
occurrence
Completeness
Rights and obligations
Accuracy, classification and
Valuation
Assertions relating to
presentation and disclosure
– Additions represent assets acquired in
the year and disposal represent assets sold
or scrapped in the year
– Recorded assets represent those in use
at the year-end
– All additions and disposals that occurred in the year have
been recorded
– All assets in use at the year-end are included in balances
– The entity has rights to the assets purchased and those
recorded at the year-end
– Non-current assets are correctly stated at cost less
accumulated depreciation
– Additions and disposals are correctly recorded
– Review any impairment indicators, test or impairment
– Disclosures relating to cost, additions and disposals,
depreciation policies, useful lives and assets held under
finance leases are adequate and in accordance with
accounting standards
Activity 2.4
For each of the following misstatements in property, plants, and equipment accounts, state an internal
control that the client can implement to prevent the misstatement from occurring and a substantive audit
procedure that the auditor can use to discover the misstatement:
1. The asset lives used to depreciate equipment are less than reasonable, expected useful lives.
………………………………………………………………………………………………………………
……………………………………………………….…………………………………………………
2. Capitalizable assets are routinely expensed as repairs and maintenance, perishable tools, or supplies
expense.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
3. Acquisitions of property are recorded at incorrect amounts.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
4. A loan against existing equipment is not recorded in the accounting records. The cash receipts from the
loan never reached the company because they were used for the down payment on a piece of equipment
now being used as an operating asset. The equipment is also not recorded in the records.
………………………………………………………………………………………………………………
……………………………………………………………………………………………………………
5. Computer equipment that is abandoned or traded for replacement equipment is not removed from the
accounting records.
………………………………………………………………………………………………………………
……………………………………………………………………………………………………………
6. Depreciation expense for manufacturing operations is charged to administrative expenses.
………………………………………………………………………………………………………………
……………………………………………………………………………………………………………..
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2.5 SECTION 5: AUDITING OBJECTIVES AND PROCEDURES FOR ACCOUNTS
PAYABLE AND OTHER LIABILITIES
Liabilities are the financial obligations of an enterprise other than owners‘ funds. Liabilities
include loans and borrowings, trade creditors and other current liabilities, deferred payment
credits, installments payable under hire purchase agreements, and provisions. Special
considerations may apply in the case of audit of liabilities of specialized entities like banks,
financial institutions and venture capital funds. Liabilities generally constitute a significant
proportion of the total funds of an entity. The audit of liabilities is primarily directed at ensuring
that all known liabilities have been properly accounted for, since material omission or
misstatement of liabilities vitiates the true and fair view of the financial statements. An important
feature of liabilities which has a significant effect on the related audit procedures is that these are
represented only by documentary evidence which originates mostly from third parties in their
dealings with the entity. In any auditing situation, the auditor employs appropriate procedures to
obtain reasonable assurance about various assertions [see Statement on Standard Auditing
Practices (SAP) 5, Audit Evidence]. In carrying out an audit of liabilities, the auditor is
particularly concerned with obtaining sufficient appropriate audit evidence to satisfy himself that
all known liabilities are recorded and stated at fair and reasonable amounts.
Accounts payable are the major source of unsecured short-term financing for business firms.
They result from transactions in which merchandise is purchased but no formal note is signed to
show the purchaser‘s liability to the seller. The purchaser in effect agrees to pay the supplier the
amount required in accordance with credit terms normally stated on the supplier‘s invoice.
Learning objectives
After studying this section, you should be able to
 Identify the accounts and the classes of transactions in the acquisition and payment cycle.
 Describe the business functions and the related documents and records in the acquisition
and payment cycle.
 Understand internal control, and design and perform tests of controls and substantive
tests of transactions for the acquisition and payment cycle.
 Describe the methodology for designing tests of details of balances for accounts payable
using the audit risk model.
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 Design and perform analytical procedures for accounts payable.
 Design and perform tests of details of balances for accounts payable, including out-ofperiod liability tests.
2.5.1 Sources and nature of accounts payable:
What can you say about the nature of accounts payable? Can you list some of the sources
of accounts payable?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Accounts payable are the major source of unsecured short-term financing for business firms.
They result from transactions in which merchandise is purchased but no formal note is signed to
show the purchaser‘s liability to the seller. The purchaser in effect agrees to pay the supplier the
amount required in accordance with credit terms normally stated on the supplier‘s invoice.
The term accounts payable (often referred to as vouchers payable for a voucher system) is used
to describe short-term obligations arising from the purchase of goods and services in the ordinary
course of business. Typical transactions creating accounts payable include the acquisition on
credit of merchandise, raw materials, plant assets, and office supplies. Other sources of accounts
payable include the receipt of services, such as legal and accounting services, advertising,
repairs, and utilities. Interest–bearing obligations should not be included in accounts payable but
shown separately as bonds, notes, mortgages, or installment contracts.
2.5.2 The auditors’ approach in examination of accounts payable:
What are the main objectives of auditor‘s in the examination of accounts payable?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The auditors‘ objectives in the examination of accounts payable are to determine that:
1. Internal control over accounts payable and the acquisition and payment cycle is adequate.
2. The recorded accounts payable are valid (occurrence and obligations).
3. All accounts payable are recorded (completeness).
4. Accounts payable schedules are mathematically correct and agree with general ledger
accounts (clerical accuracy).
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5. The valuation of accounts payable is proper.
6. The presentation and disclosure of payables is adequate.
The main focus when testing accounts payable is to check for understatement and thus by default
for completeness and Does the creditor list at year and includes:
•
All the major suppliers the client dealt with during the year?
•
All significant suppliers from creditors list of last year?
•
All suppliers revealed by a review of payments after the year end?
•
All suppliers revealed by a review of unpaid invoices at and after the year end+ supplier
statement.
Audit program-(CAVEBOP)
Completeness
– Check balances extracted from purchase ledger balances to list of creditors: check a
sample of balances from purchase ledger to schedule/list of creditors.
–
Last year brought forward is correct: check whether last year‘s closing balances have
been properly brought forward.
–
Last year significant suppliers that are not in current year list: investigate any supplier
names that were shown on last year‘s payables listing but do not have a balance showing
in this year‘s list of balances.
– Cut off before and after year end: select a sample of goods received note just before and
after the year end, trace to invoices and purchases ledger.
–
Post balance sheet payments and invoices accounted: review after date invoices and
payments and ensure they have been provided for at the yearend as appropriate.
Accuracy
– Check balances extracted from purchase ledger balances to list of creditors: check a
sample of balances from the schedule to the purchase ledger.
– Count creditors list to creditors control a/c: check the total of the list to the purchases
control a/c.
– Vouch a sample of recorded creditors‘ transactions to supporting documents: to agree the
amount.
– Perform cut off tests both before and after the year end: to ensure posting made in the
correct period.
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– Reconcile creditors with monthly suppliers‘ statements.
–
Perform analytical procedures
Valuation
– Confirm with creditors through circularization:
– Ensure adequacy of provision for accrual: invoices not yet received.
– Letter of representation from management confirm in all trade payables: have been
included in financial statement.
– Ageing list of creditors.
– Checks if there are set off: between receivable ledger and payable ledger.
– Perform analytical procedures: on payables, com paring age analysis with previous
periods and payables days.
Existence
– Carry out creditors circularization:
–
Vouch a sample of recorded creditors‘ transaction to supporting documents. ( invoices,
goods received etc)
– Check whether last year closing balance has been brought forward: e.g this year‘s
opening balance exists in balance sheet.
–
Review payments to suppliers just after year end.
Beneficial ownership
– Confirm with creditors- circularization.
– Vouch to supporting documentation.
–
Occurrence
– Select a sample of transactions from purchase ledger, trace to invoices, PO and ensure the
goods/services have been received
Presentation and disclosure
– Compliance with accounting standards and companies act.
–
Creditors are properly classified as to type and expected date of realization.
–
Debit balances disclosed under current assets.
–
Related party transactions properly disclosed.
– Note: additional evidence can be obtained from supplier statement reconciliation.
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2.5.3 Internal control over accounts payable:
What internal control mechanisms you experiencing in your company?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------A control is any action taken to mitigate or manage risk and increase the probability that the
organization‘s process will achieve its goal or objectives.
In thinking about internal control for accounts payable, it is important to recognize that the
accounts payable of one company are the accounts receivable of other companies. It follows that
there is little danger of errors being overlooked permanently since the client‘s creditors will
generally maintain complete records of their receivables and will inform the client if payment is
not received. This feature also aids auditors in the discovery of irregularities, since the
perpetrator must be able to obtain and respond to the demands for payment.
Discussion of internal control applicable to accounts payable may logically be extended to the
entire purchase or acquisition cycle. In an effective purchasing system, a stores, or inventory
control department will prepare and approve the issuance of a purchase requisition that will be
sent to the purchasing department. A copy of the purchase requisition will be filed numerically
and matched with the subsequently prepared purchase order and finally with a copy of receiving
report.
The purchasing department, upon receiving the purchase requisition, will
(1) Determine that the item should be ordered and
(2) Select the appropriate vendor, quality, and price. Then, a serially numbered purchase order is
issued to order the goods. Copies of the purchase order should be sent to stores, receiving, and
the accounts payable department. The copy sent to receiving is generally ―blind‖ in that the
quantities are not included so as to encourage receiving department counting of quantities.
The receiving department should be independent of the purchasing department. When goods are
received, they should be counted and inspected. Receiving reports should be prepared for all
goods received. These documents should be serially numbered and prepared in a sufficient
number of copies to permit prompt notification of the receipt of goods to the stores department,
the purchasing department, and the accounts payable department.
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Within the accounts (vouchers) payable department, all forms should be stamped with the date
received. Vouchers and other documents originating within the department can be controlled
through the use of serial numbers. Comparison of the quantities listed on the invoice with those
shown on the receiving report and purchase order will prevent the payment of charges for goods
in excess of those ordered and received. Comparison of the prices, discounts and terms of
shipment as shown on the purchase order and on the vendor‘s invoice provides a safeguard
against the payment of excessive prices.
The separation of the function of invoice verification and approval from the function of cash
disbursement is another step that tends to prevent errors and irregularities. Before invoices are
approved for payment, written evidence must be presented to show that all aspects of the
transaction have been verified. The official who signs checks should stamp or perforate the
voucher and supporting documents so that they cannot be presented to support payment a second
time.
Another control procedure that the auditors may expect to find in a well-managed accounts
payable department is the regular monthly balancing of the detailed records of accounts payable
(or vouchers) to the general ledger controlling account. These trial balances should be preserved
as evidence of the performance of this procedure and as an aid in locating any subsequent errors.
2.5.4 Audit Procedures:
How is accounts payable audited in your company?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------The following procedures are typical of the work required in many engagements for the
verifications of accounts payable.
A. Consider internal control for accounts payable
1. Obtain an understanding of the internal control
One approach used by auditors in becoming familiar with a client‘s system of internal control for
accounts payable is to prepare a flowchart or to use flowcharts prepared by the client. In some
engagements, the auditors may choose to prepare a narrative description covering such matters as
the independence of the accounts payable department and the receiving department from the
purchasing department. The auditors might use a questionnaire to obtain a description of
accounts payable controls. Typical of the questions are the following. Is an accounts payable trial
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balance prepared monthly and reconciled to the general ledger controlling account? Are monthly
statements from vendors reconciled with accounts payable ledgers or unpaid vouchers?
2. Assess control risk and design additional tests of controls
Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost-justified restrictions of
substantive tests.
2. Perform additional tests of controls
A number of tests of controls relating to accounts payable have already been discussed in the
previous sections. In this section we briefly recap several tests.
a) Verify a sample of postings to the accounts payable controlling account.
The validity of the amount in the general ledger controlling account for accounts payable is
established by tracing postings for one or more months to the voucher register and cash
payments journal. Any postings to the controlling account from the general journal during this
test period should also be traced.
b) Vouch to supporting documents a sample of postings in selected accounts of the accounts
payable subsidiary ledger.
Testing the accuracy of the voucher register or the accounts payable ledgers by tracing
specific items back through the cash payments journal, purchases journal, and other journals
to original documents (Such as purchase orders, receiving reports, invoices, and paid checks)
is necessary to determine the adequacy of the internal control.
4. Reassess Control risk and design Substantive tests
Completion of the above audit procedures enables the auditors to perform a final assessment of
control risk for each of the major financial statement assertions about accounts payable. The
internal control assessment provides the basis for selecting the necessary substantive tests for
verification of accounts payable at the balance sheet date.
B. Substantive tests
5. Obtain or prepare a trial balance of accounts payable as of the balance sheet date and
reconcile with the general ledger.
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One purpose of this procedure is to prove that the liability figure appearing in the balance sheet
is in agreement with the individual items comprising the detail records. A second purpose is to
provide a starting point for substantive testing. The auditors will use the list of vouchers or
accounts payable to select a representative group of items for careful examination.
6. Vouch balances Payable to Selected creditors by inspection of supporting documents
Another substantive test of the validity of the client-prepared trial balance of accounts payable is
the vouching of selected creditors‘ balances to supporting vouchers, invoices, purchase orders,
and receiving reports.
7. Reconcile liabilities with monthly statements from creditors
In some companies, it is a regular practice each month to reconcile vendor‘s statements with the
detailed records of payables. If the auditors find that this reconciliation is regularly performed by
the client‘s staff, they may limit their review of vendors‘ statements to determining that the
reconciliation work has been satisfactory. If the client‘s staff has not reconciled vendors‘
statements and accounts payable, the auditors may do so.
8. Confirm accounts Payable by direct correspondence with vendors
Confirmation requests should be mailed to vendors from whom substantial purchases have been
made during the year, regardless of the size of their accounts at the balance sheet date. Even
accounts payable with zero balances at year-end should be confirmed if they represent major
suppliers.
Confirmation of accounts payable is not a mandatory procedure as is the confirmation of
receivables. One reason is that the greatest hazard in the verification of liabilities is the existence
of unrecorded liabilities. To confirm the recorded accounts payable does not prove whether any
unrecorded accounts payable exist. Another factor to be noted in comparing the confirmation of
accounts receivable and accounts payable is that the auditors will find in the client‘s possession
externally created evidence such as vendors‘ invoices and statements that substantiate the
accounts payable. No such external evidence is on hand to support accounts receivable.
9. Perform analytical procedures for accounts Payable and related accounts
To gain assurance as to the overall reasonableness of accounts payable, the auditor may compute
ratios such as accounts payable divided by purchases and accounts payable divided by total
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current liabilities. These ratios are compared with ratios for prior years to disclose trends that
warrant investigation.
10. Search for unrecorded accounts Payable
Throughout the audit the auditors must be alert for any unrecorded payables. For example, the
preceding three steps of this program, reconciliation, confirmation, and analytical procedures,
may disclose unrecorded liabilities.
In addition to the prior audit steps, when searching for unrecorded accounts payable the auditors
will audit transactions that were recorded following year-end. A comparison of cash payments
occurring after the balance sheet date with the accounts payable trial balance is an excellent
means of disclosing unrecorded accounts payable. All liabilities must eventually be paid, and
will, therefore, be reflected in the accounts at least by the time they are paid.
11. Search for accounts payable to related parties
Payables to a corporation‘s officers, directors, stock-holders, or affiliates require particular
attention by the auditors since they are not the result of arm‘s length bargaining by parties of
apposing interests. Here the auditors should consider the possibility that these payables relate to
purchases of inventory or other asset items for which there may be valuation questions. The
independent auditors must search for such payables. All material payables to related parties must
be disclosed in the financial statements.
12. Evaluate proper balance sheet presentation and disclosure of accounts payable
Proper balance sheet presentation of accounts payable requires that any material amounts
payable to related parties (directors, principal stockholders, officers, and employees) be listed
separately from amounts payable to trade creditors.
Other Liabilities
Notes payable is discussed in the next section. In addition to the accounts payable previously
considered, other items classified as current liabilities include.
1. Amounts withheld from employees‘ pay.
2. Sales taxes payable.
3. Unclaimed wages.
4. Customer‘s deposits
5. Accrued liabilities
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Amounts withheld from employees’ pay
Income taxes withheld from employees‘ pay and not remitted as of the balance sheet date
constitute a liability to be verified by the auditors. Accrued employer payroll taxes may be
audited at the same time. This verification usually consists of tracing the amounts withheld to the
payroll summary sheets, testing computations of taxes withheld and accrued and determining
that taxes have been deposited or paid in accordance with the federal and state laws and
regulations.
Sales taxes Payable
In most sections of the country, business concerns are required to collect sales taxes imposed by
state and local governments on retail sales. These taxes do not represent an expense to the
business; the retailer merely acts as a collecting agent. Until the amounts collected from
customers are remitted to the taxing authority, they constitute current liabilities of the business.
The auditors‘ verification of this liability includes a review of the client‘s periodic tax returns.
The reasonableness of the liability also is tested by a computation applying the tax rate to total
taxable sales. In addition, the auditors should examine a number of sales invoices to ascertain
that customers are being charged the correct amount of tax. Debits to the liability account for
remittances to the taxing authority should be traced to copies of the tax returns and should be
vouched to the paid checks.
Unclaimed wages
The auditors will analyze the unclaimed wages account for the purpose of determining that:
1. The credits represent all unclaimed wages after each payroll distribution and
2. The debits represent only authorized payments to employees, remittances to the state
under unclaimed property laws, or transfers back to general cash funds through approved
procedures.
Customers’ deposits
Many companies require that customers make deposits on returnable containers. A review of the
procedures followed in accepting and returning deposits should be made by the auditors with a
view to disclosing any shortcomings in internal control. In some instances, deposits shown by the
records as refunded to customers may in fact have been abstracted by employees.
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As a general rule, the auditors do not attempt to confirm deposits by direct communication with
customers; but this procedure is desirable if the amounts involved are substantial or the internal
control procedures are considered to be deficient.
Accrued liabilities
Most accrued liabilities represent obligations payable sometime during the succeeding period for
services or privileges received before the balance sheet date. Examples include interest payable,
accrued property taxes, accrued payrolls and payroll taxes and income taxes payable.
Because accrued items are based on client estimates of amounts which will subsequently become
payable, subjective factors may make it difficult to establish control over them. As a result, these
estimates may be particularly susceptible to misstatement, especially in circumstances in which
management is under pressure to show increased earnings.
The basic auditing steps for accrued liabilities are:
1. Examine any contracts or other documents on hand that provide the basis for the accrual.
2. Appraise the accuracy of the detailed accounting records maintained for this category of
liability.
3. Identify and evaluate the reasonableness of the assumptions made that underline the
computation of the liability.
4. Test the computations made by the client in setting up the accrual.
5. Determine that accrued liabilities have been treated consistently at the beginning and end
of the period.
6. Consider the need for accrual of other accrued liabilities not presently considered (that is,
test completeness).
Table 2.12: summary of assertions, objectives and procedures for accounts payable and
related accounts
Financial report assertions
Specific audit objective
Existence
Accounts payable and accrued
liabilities are valid obligations
to suppliers at the balance date
Accounts payable and accrued
liabilities include all
Completeness
Common audit procedures
to achieve objectives
.confirmation
.Vouching
.cut off period liability search
.general procedures
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Occurrence
Rights and obligations
Measurement
Valuation
Disclosure

obligations owned to suppliers
at the balance date
Transactions giving right to
accounts payable occurred
during period.
.select transactions from
accounts payable listing and
agree to supporting
documentation (e.g. supplier‘
invoices)
.confirmation
.general procedure
Accounts payable and accrued
liabilities are obligations owed
to by the entity
Accounts payable are recorded .cut-off
in the correct amount and
.check clerical accuracy of
period.
accounts payable listing
.agree dollar value of accounts
payable to supporting
documents (e.g. suppliers‘
invoices)
Accounts payable and accrued .recompilation
liabilities are presented at the
.analytical procedure
appropriate amount.
Accounts payable and accrued .inquiry and scanning
liabilities are properly
.general procedures
described and classified in the
statement of financial position
and related disclosures are
adequate
Activity 2.5
1. Assume that you are an internal auditor in your business enterprise, currently you are working in,
and asked to prepare the audit program for accounts payable at the same time, how do you relate
your audit objectives with different substantive procedures for accounts payable?, discus.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………..
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2.6 SECTION 6: AUDITING OBJECTIVES AND PROCEDURES FOR DEBT AND
EQUITY CAPITAL INCLUDING LOSS CONTINGENCIES
Business corporations obtain substantial amounts of their financial resources by incurring
interest-bearing debt and by issuing capital stock. The acquisition and repayment of capital is
sometimes referred to as the financing cycle. This transaction cycle includes the sequence of
procedures for authorizing, executing, and recording transactions that involve bank loans,
mortgages, bonds payable, and capital stock as well as the payment of interest and dividends. In
this section we present material on the auditors‘ approach to both debt and equity capital
accounts.
In addition, there is an important difference in the audit of owners‘ equity between a publicly
held corporation and a closely held corporation. In most closely held corporations, which
typically have few shareholders, occasional, if any, transactions occur during the year for capital
stock accounts. The only transactions entered in the owners‘ equity section are likely to be the
change in owners‘ equity for the annual earnings or loss and the declaration of dividends, if any.
Closely held corporations rarely pay dividends, and auditors spend little time verifying owners‘
equity, even though they must test the corporate records.
For publicly held corporations, however, the verification of owners‘ equity is more complex
because of the larger numbers of shareholders and frequent changes in the individuals holding
the stock.
Learning objectives
Dear learner! After reading this chapter you should be able to:
 Internalize the Audit procedure for interest-bearing debt
 Be aware of the auditor‘s objective in the examination of debt and owner‘s equity
 Look the effectiveness of internal control over interest bearing debt
 Contrast the audit procedures for loss contingencies with the practical achievements in
your organization
 Distinguish internal control and substantive procedure for debt and equity audit
 Prepare audit programs for debt and capital stock
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2.6.1 Interest Bearing Debt, Notes Payable, and Contingent Liabilities:
What are auditors‘ objectives in the examination of interest-bearing debt?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Source and nature of debt
Long-term debt-Substantial in amount and often extend for periods of 20 years or more (i.e.
Debentures, secured bonds and notes payable), Formal document creating bond indebtedness is
indenture or trust indenture and May contain restrictive covenants
A business with an excellent credit reputation may find it possible to borrow from a bank on a
simple unsecured note. A business of lesser financial standing may find that obtaining bank
credit requires the pledging of specific assets as collateral or that it must agree to certain
restrictive covenants, such as the suspension of dividends.
The auditors‘ objectives in the examination of interest-bearing debt are to determine that:
 Adequate internal control exists for interest bearing debt transactions (Control)
 Items recorded as liabilities are bona fide obligations (Obligations)
 All liabilities are properly recorded (Completeness)
 Interest expense and/or amortization was properly computed and recorded
(Completeness, Obligation)
 Client is not in violation of restrictions or requirements imposed on it by terms of
loan agreement (Presentation & Disclosure)
 Authority is given to enter into long-term agreement (Valuation, Completeness)
 Assets pledged as security are adequately disclosed (Presentation and Disclosure)
Internal control over interest-bearing debt
 Interest bearing obligations should be authorized by the board of directors
 Banks from which loans are obtainable should be specified by the board of directors
 An independent trustee should be employed to account for all bond issuances,
cancellations, and interest payments
 When independent trustee is not employed
 Unsigned bonds and notes should be in custody of an officer
 Note and note certificates should be pre numbered
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 Surrendered certificates and interest coupons should be canceled and preserved
 Detail records of interest-bearing debt should be maintained and reconciled to periodic
statements of trustee and to the control account
 Records of collateral pledged for debt should be maintained
 Paid notes should be canceled and retained
2.6.2 Audit procedure for interest-bearing debt:
How is interest bearing debt audited in your community? Mention the main audit
procedures?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Audit procedures appropriate for the verification of interest-bearing debt include the following:
A. Review and evaluate internal control over interest bearing debt
Obtain a description of controls regarding authorization, execution, and recording of interest
bearing debt transactions and evaluate internal control weaknesses. This includes:
i.
Obtain an understanding of internal control for interest bearing debt.
ii.
Assess control risks for assertions about interest bearing debt.
iii.
Perform additional tests of controls for those controls on which auditor plans to rely
to reduce assessed level of control risks.
iv.
Reassess control risk and design substantive tests.
A. Substantive Tests
1. Obtain or prepare analysis of interest bearing debt accounts
Obtain analyses of interest-bearing debt and related accounts

Payment or other disposition of notes listed as outstanding in the previous year‘s audit
can be verified

Propriety of individual debits and credits can be established

Amount of year-end balance of the account is proved through the step-by-step
examination of all changes in the account during the year

Misstatements may be due to improper reporting of debt, incomplete recording of debt or
improper amortization.
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A notes payable analysis shows the beginning balance, if any, of each individual note,
additional notes issued and payments on notes during the year, and the ending balance of
each note. In addition, the beginning balances of interest payable or prepaid interest, interest
expense, interest paid, and ending balances of interest payable or prepaid interest may be
presented in the analysis working paper.
In the first audit of a client, the auditors will analyze the ledger accounts for Bonds
payable, Bond Issue costs, and Bond Discount (or Bond premium) for the years since the
bonds were issued. The working paper is placed in the auditors‘ permanent file, in later
audits, any further entries in these accounts may be added to the analysis.
2. Examine copies of notes, mortgages, or trust deed payable
The auditors should examine the client‘s copies of notes payable and supporting documents such
as mortgages and trust deeds. The original documents will be in the possession of the payees, but
the auditors should make certain that the client has retained copies of the debt instruments.
3. Obtain and review a copy of indenture for bonds payable
4. Trace authority to issue long-term debt to the corporate minutes
The authority to issue interest-bearing debt generally lies with the board of directors. To
determine that the bonds outstanding were properly authorized, the auditors should read the
passages in the minutes of directors‘ (and stockholders‘) meetings concerning the issuance of
debt.
5. Vouch interest bearing debt transactions to supporting documents

Trace cash received from issuance of notes or bonds to validated copy of bank deposit
slip and to bank statement

Examine payments and agree to repayment schedule

Examine canceled notes for retired notes

Trace disposition of any collateral used to secure canceled notes. The auditors must
obtain evidence that transactions in interest-bearing debt accounts were valid.

To accomplish this objective, the auditors trace the cash received form the issuance of
notes, bonds, or mortgages to the validated copy of the bank deposit slip and to the bank
statement. Any remittance advices supporting these cash receipts are also examined.
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Debits to a Note payable or a mortgages payable account generally represent payments in full or
in installments. The auditors should examine paid checks for these payments; in so doing, they
also will account for payments of accrued interest. The propriety of installment payments should
be verified by reference to the repayment schedule set forth in the note or mortgage copy in the
client‘s possession.
6. Confirm interest bearing debt with appropriate third parties
Payees should be requested to confirm dates of origin, due dates, unpaid balances of
notes, interest rates, dates to which interest has been paid, and collateral for the notes.
The auditors may also substantive the existence and amount of a mortgage liability
outstanding by direct confirmation with the mortgagee. The information received should
be compared with the client‘s records and the audit working papers.
7. Examine treasury bonds and reconcile to the general ledger
8. Verify computation of interest expense, interest payable, and amortization of discount or
premium
Interest expense is of special significance to auditors because it indicates the amount of
outstanding liabilities. In other words, close study of interest payments is a means of bringing to
light any unrecorded interest bearing liabilities.
The auditors test the accuracy of the client‘s interest expense and interest payable computations.
In addition, the auditors should examine paid checks supporting interest payments and review the
confirmations received from the payees to verify the dates when interest on each or mortgage has
been paid.
The total bond interest expense for the period usually reflects not only the interest actually paid
and accrued but also amortization of bond premium or discount. The auditors will verify the
amounts amortized by independent computations.
9. Obtain letter of representation
Written representations are an important source of audit evidence. If management modifies or
does not provide the requested written representations, it may alert the auditor to the possibility
that one or more significant issues may exist. Further, a request for written, rather than oral,
representations in many cases may prompt management to consider such matters more
rigorously, thereby enhancing the quality of the representations.
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10. Determine proper balance presentation
Internal control over notes payable: Major controls over notes payable
1. Board of directors or specific officers approve issuance of notes
2. Board of directors has specified sources of borrowing and loan limits
3. Dual signatures should be required to issue notes – at least one of which is that of
a senior executive
4. Numerical controls of unissued and outstanding notes is maintained
5. Notes payable register should be maintained and balanced with control account
periodically
6. Records should be maintained of collateral pledged as security for notes payable
7. Paid notes should be canceled and placed in a paid file
8. Renewal of notes should be subjected to same control procedures as new notes
9. Vouchers for interest payment should be approved in writing by to executives not
associated with the borrowing operation
Audit procedures – notes payable (substantive tests)
1. Prepare or obtain schedule of notes payable
2. Compare schedule with notes payable register
3. Compare total of schedule with total per control account and subsidiary
4. Confirm selected notes payable
5. Analyze notes payable account by using schedule. Tie in interest expense and
accrued interest to respective account balances
6. Examine notes paid during audit period and trace payment to disbursement journal
7. Review payments after B.S. date
8. Obtain letter of representation
Search for contingent liabilities
 Inquire of client officers. Obtain letter of representation
 Inquire of clients‘ banks
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 Inquire of clients‘ lawyers
 Inquire of clients‘ suppliers and creditors
 Review minutes
 Review purchase orders
 Examine correspondence with financial institutions
2.6.3 Sources and nature of owners’ equity:-Equity Capital:
Can you cite some sources of equity capital?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Most of this section is concerned with the audit of stockholders‘ equity account of corporate
clients. Owners‘ equity for corporate clients consists of capital stock accounts (preferred and
common) and retained earnings. Balances in the capital stock accounts change when the
corporation issues or repurchases stock. The account balances are not affected by transfer of
ownership of shares from one shareholder to another. Retained earnings are normally increased
by earnings and decreased by dividend payments. Additionally, a few journal entries (e.g., prior
period adjustments) may directly affect retained earnings. Transactions in the owners‘ equity
accounts are generally few in number, but material in amount. Often no change will occur during
the year in the capital stock accounts, and perhaps only one or two entries will be made to the
retained earnings account.
2.6.4 The auditors’ approach in examination of owners’ equity:
Dear learner! Would you please try to list down some of the audit objectives to examine
equity capital?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Audit objectives – Determine that
1) Control: - Adequate internal controls exists over owner‘s equity
2) Presentation and Disclosure, Valuation: - Amounts shown in balance sheet as capital
stock, retained earnings and paid in capital are properly classified, described, and
stated in accordance with generally accepted accounting principles and are not in
conflict with requirements of the corporate charter (also rights and obligation)
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3) Completeness: - Transactions in the owner‘s equity accounts are properly authorized
and approved
4) Presentation and Disclosure: - Adequate disclosure had been made of restrictions on
retained earnings, stock subscription rights, stock reservations, stock options, etc.
which may be imposed by various authorizations or agreements or by legal
requirements
In conjunction with the audit of owners‘ equity accounts, the auditors will also obtain evidences
about the related accounts of dividends payable and capital stock discounts and premiums.
Evidence is also gathered regarding the proper cutoff cash receipts and disbursements relating to
the equity accounts.
2.6.5 Internal control for Owners’ equity:
Dear learner! In what way your company controls over owner‘s equity? If any
---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------a. Company should utilize the services of an independent stock register and transfer
agent to handle capital stock transactions
b. When independent agents are not employeri.
Should maintain numerical control of unissued certificates
ii.
Should retain canceled certificates
iii.
Officer should maintain custody of unissued certificates
c. Stockholders ledgers and transfer journals should be maintained
d. Subsidiary records and stock certificate book should be balanced to control
account periodically
e. Issues and retirements should be authorized by board of directors
f. Treasury stock should b maintained in name of company
g. Entries in owner‘s equity accounts should be approved by controller
h. Separate bank account should be maintained for dividend payments
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2.6.6 Audit Procedures-Capital Stock:
What are the common audit procedures typical to capital stock?
--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------A. Review and evaluate internal control for owner’s equity transactions
Obtain description of controls and document, test transactions for proper authorization, execution
and recording, note proper segregation of duties, and evaluate internal control weaknesses.
1. Obtain and understanding of internal control of owner‘s equity.
2. Assess control risks for assertions about owner‘s equity.
3. Perform additional tests of controls for those controls on which auditor plans
to rely to reduce assessed level of control risk.
4. Reassess control risk and design substantive tests.
B. Substantive tests
1. Review articles of incorporation, bylaws, and minutes for provision relating to
capital stock
In a first audit, copies of the articles of incorporation, bylaws, and minutes of the meetings of
directors and stockholders obtained for the permanent file should be read carefully. The
information required by the auditors for each issue of capital stock includes the number of shares
authorized and issued, the par or stated value if any, dividend rates, call and conversion
provisions, stock splits and stock options. By gathering evidence on these points, the auditors
will have some assurance that capital stock transactions and dividend payments have been in
accordance with legal requirements and specific authorization by stockholders and directors.
Also, they will be able to judge whether the balance sheet contains all necessary information to
describe adequately the various stock issues and other elements of corporate capital.
2.
Obtain analysis of owner’s equity accounts
In an initial audit engagement, capital stock accounts should be analyzed from the beginning of
the corporation to provide the auditors with a complete historical picture of corporate capital.
Analysis of capital stock includes an appraisal of the nature of all changes and the Vouching of
these changes to the supporting documents and records. All changes in capital stock should bear
the authorization of the board of directions.
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After the initial audit, if the analyses are kept in the auditors‘ permanent file, all that will be
necessary is to record the current period‘s increases and decreases and to Vouch these
transactions. The auditors then will have working papers showing all changes in capital stock
from the inception of the corporation.
3.
Confirm shares outstanding with independent registrar and stock transfer
agent
The number of shares issued and outstanding on the balance sheet date may be confirmed by
direct communication with the independent registrar and stock transfer agent. The confirmation
request should be written by the client‘s letterhead, but it should be mailed by the auditors.
Confirmation replies should be sent directly to the auditors, not to the client. All information
contained in these replies should be traced to the corporate records.
1. Trace proceeds from stock issues to cash receipts journal
2. Examine canceled certificates
3. Reconcile stockholders records and stock certificate numbers
4. Inspect treasury shares and reconcile balance to control account
2.6.7 Retained Earnings and Dividends:
Can you list the two measure steps in the audit of retained earnings and dividends?
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Audit work on retained earnings and dividends includes two major steps:
(1) The analysis of retained earnings and any appropriations of retained earnings, and
(2) The review of dividend procedures for both cash and stock dividends.
The analysis of retained earnings and any appropriations of retained earnings should cover the
entire history of these accounts. Credits to the retained earnings account ordinarily represent
amounts of net income transferred from the income summary account. Debits to the retained
earnings account may include entries for net losses, cash and stock dividends, and for the
creation or enlargement of appropriated reserves. Appropriations of retained earnings require
specific authorization by the board of directors. The only verification necessary for these entries
is to ascertain that the dates and amounts correspond to the actions of the board.
In the verification of cash dividends, the auditors usually will perform the following steps:
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1. determine the dates and amounts of dividends authorized
2. Verify the amounts paid
3. Determine the amount of any preferred dividends in arrears.
4. Review the treatment of unclaimed dividend checks.
When reviewing minutes of the directors‘ meetings, the auditors should note the date and amount
of each dividend declaration. This serves to establish the authority for dividend disbursements.
The dividend payment may then be verified by multiplying the total number of shares as shown
by the general ledger controlling accounts by the dividend per share.
In the verification of stock dividends, there is as additional responsibility of determining that the
proper amounts have been transferred from retained earnings to capital stock and paid-in capital
accounts for both large and small stock dividends.
2.6.8 Audit procedures for loss contingencies:
Dear learner! So far you are aware of the different audit procedure across different audit
engagements, what do you think unique for audit procedures of loss contingencies?
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Although audit procedures vary with the individual type of loss contingency, the following steps
are taken in most audits as means of discovering these conditions:
1. Review the minutes of directors‘ meetings to the date of completion of field work.
Important contracts, lawsuits, and dealing with subsidiaries are typical of matters
discussed in board meetings that may involve loss contingencies.
2. send a letter of inquiry to the client‘s legal counsel requesting:
a) A description (or evaluation of management‘s description) of the nature of
pending and threatened litigation and of tax disputes.
b) An evaluation of the likelihood of an unfavorable outcome in the matters
described.
c) An estimate of the probable loss or range of loss, or a statement that an estimate
cannot be made.
d) An evaluation of management‘s description of any unasserted claims that, if
asserted, have a reasonable possibility of an adverse outcome.
e) A statement of the amount of any unbilled legal fees.
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3. Send a standard bank confirmation request to each bank with which the client has done
business during the year. This standard form includes a request for information on any
indirect or contingent liabilities of the client.
4. Review correspondence with financial institutions for evidence of assignments of
accounts receivable.
5. Obtain a representations letter from the client indicating that all liabilities known to
officers are recorded or disclosed.

Activity 2.6
A. The following are frequently performed audit procedures for the verification of bonds payable
issued in previous years:
1. Analyze the general ledger account for bonds payable, interest expense, and unamortized bond
discount or premium.
2. Obtain a confirmation from the bondholder.
3. Obtain a copy of the bond indenture agreement and review its important provisions.
4. Determine that each of the bond indenture provisions has been met.
5. Test the client‘s calculations of interest expense, unamortized bond discount or premium,
accrued interest, and bonds payable.
Required:
i. State the purpose of each of the five audit procedures listed.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
……………………………………………………………………………
ii. List the provisions for which the auditor should be alert in examining the
bond indenture (contract) agreement.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………
iii. For each provision listed in part b, explain how the auditor can determine
whether its terms have been met.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
……………………………………………………………………………
iv. Explain how the auditor should verify the unamortized bond discount or
premium.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
……………………………………………………………………
v. List the information that should be requested in the confirmation of bonds
payable with the bondholder.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
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
Activity 2.6
B. The following audit procedures are commonly performed by auditors in the verification of owners‘
equity:
1. Review the articles of incorporation and bylaws for provisions about owners‘ equity.
2. Analyze all owners‘ equity accounts for the year and document the nature of any recorded change in
each account.
3. Account for all certificate numbers in the capital stock book for all shares outstanding.
4. Examine the stock certificate book for any stock that was cancelled.
5. Review the minutes of the board of directors‘ meetings for the year for approvals related to owners‘
equity.
6. Re compute earnings per share.
7. Review debt provisions and senior securities with respect to liquidation preferences, dividends in
arrears, and restrictions on the payment of dividends or the issue of stock.
Required:
i. State the purpose of each of these seven audit procedures.
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
ii. List the type of misstatements the auditors can uncover by the use of each audit
procedure.
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………..
Model examination questions
I. multiple choices
1. Which of the following are examples of substantive tests of controls in the audit of financial
investment?
A. Trace several transactions for sales and purchases of investments through the accounting
system.
B. Review and test reports of investments activity prepared for the investment committee.
C. Test the valuations of financial investments
D. Make independent computations of revenue from securities.
E. A&B
F. C&D
2. Which of the following are examples of substantive procedure for investment transactions and
year-end balances in the audit of financial investment?
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A. Trace several transactions for sales and purchases of investments through the accounting
system.
B. Review and test reports of investments activity prepared for the investment committee.
C. Test the valuations of financial
investments
E. A&B
F. C&D
D. Make independent computations of
revenue from securities.
3. The auditor‘s primary objectives in obtaining analysis of investments and related accounts and
reconcile to ledger are:
A. Existence, rights and occurrence
D. Valuation and presentation
B. Completeness
E. None
C. Valuation and posting
4. The auditor‘s primary objectives in obtaining analysis of cash balance and reconcile them to
general ledger are:
A. Existence, rights and occurrence
D. Valuation and presentation
B. Completeness
E. None
C. Existence and accuracy
5. Why auditors need to understand their client and its environment?
A. To consider inherent risk including fraud risk relate to cash or other items
B. To check whether the client‘s records reflect all cash transactions that took place during
the fiscal year
C. To check whether all cash payments are properly authorized
D. All
E. None
6. Which of the following are examples of substantive tests of controls in the audit of cash?
A. Test the accounting records and reconciliations by re performance
B. Compare the details of a sample of cash receipts listings to the cash receipt journal
C. Count and list cash on hand
D. Obtain analysis of cash balance and reconcile the to the general ledger
E. A&B
F. C&D
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7. ___refers to manipulations that utilizes temporarily overstated bank balances to conceal a cash
shortage or meet short term cash needs.
A. Lapping
D. Fraud
B. Kiting
E. None of the above
C. Window dressing
8. Which of the following are examples of substantive procedure for cash transactions and
balances in the audit of cash?
A. Test the accounting records and reconciliations by re performance
B. Compare the details of a sample of cash receipts listings to the cash receipt journal
C. Count and list cash on hand
D. Obtain analysis of cash balance and reconcile the to the general ledger
E. A&B
F. C&D
9. Which of the following will be the possible internal control weakness for recording fictitious
cash receipts?
A. Lack of segregation of duties of the functions of access to cash and record keeping and no
effective review of bank reconciliation.
B. Inadequate supervision of cashier
D. All
C. Failure to encourage customers to
E. None
obtain cash receipts
10. _____is the concealment of a cash shortage by delaying the recording of cash receipts
A. Lapping
D. Fraud
B. Kiting
E. None of the above
C. Window dressing
11. Which of the following is not a balance-related audit objective evaluated in the audit of
accounts receivable?
A. Timing
C. Completeness
B. Realizable value
D. Accuracy
12. The two primary classes of transactions in the sales and collection cycle are:
A. Sales and sales discounts.
C. Sales and sales returns.
B. Sales and cash receipts.
D. Sales and accounts receivable.
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13. Tests of which balance-related audit objective are normally performed first in an audit of the
sales and collection?
A. Accuracy
C. Rights
B. Completeness
D. Detail tie-in
14. When positive confirmations are used, auditing standards require follow-up procedures for
confirmations not returned by the customer. In such a situation, which of the following would
not be classified as an alternative procedure?
A. Send a second confirmation request.
B. Examine subsequent cash receipts to determine if the receivable has been paid.
C. Examine shipping documents to verify that the merchandise was shipped.
D. Examine customer‘s purchase order and the duplicate sales invoice to determine that the
merchandise was ordered.
15. The test of details of balances procedure that requires the auditor to foot the outstanding
check list and deposits in transit is an attempt to satisfy which audit objective?
A. Cutoff.
C. Detail tie-in.
B. Presentation and disclosure.
D. Completeness.
16. The test details of balances procedure that requires the auditor to trace the book balance on
the reconciliation to the general ledger is an attempt to satisfy the audit objective of:
A. Detail tie-in.
C. Completeness.
B. Existence.
D. Accuracy.
17. Which of the following statements is correct?
A. Auditors must obtain bank confirmations on every audit.
B. Auditors obtain bank confirmations at their discretion.
C. Auditing standards do not address specific requirements regarding bank confirmations.
D. Auditing standards do not require bank confirmations except when there is an unusually
large number of inactive bank accounts.
The following questions concern analytical procedures in the sales and collection cycle.
Choose the best response.
18. As a result of analytical procedures, the auditor determines that the gross profit percentage
has declined from 30% in the preceding year to 20% in the current year. The auditor should
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A. Express a qualified opinion due to inability of the client company to continue as a going
concern.
B. Evaluate management‘s performance in causing this decline.
C. Require footnote disclosure.
D. Consider the possibility of a misstatement in the financial statements.
19. After a CPA has determined that accounts receivable have increased as a result of slow
collections in a ―tight money‖ environment, the CPA will be likely to
A. Increase the balance in the allowance for bad debt account.
B. Review the going concern ramifications.
C. Review the credit and collection policy.
D. Expand tests of collectability.
20. In connection with his review of key ratios, the CPA notes that ABC had accounts receivable
equal to 30 days‘ sales at December 31, 2010, and to 45 days‘ sales at December 31, 2011.
Assuming that there have been no changes in economic conditions, clientele, or sales mix, this
change most likely will indicate
A. A steady increase in sales in 2011.
B. An easing of credit policies in 2011.
C. A decrease in accounts receivable relative to sales in 2011.
D. A steady decrease in sales in 201
II. Matching
From the following mach errors with potential assertions (Control assertion associations)
1
2
3
4
5
6
7
Error
Sales recorded, goods not shipped
Goods shipped, sales not recorded
Goods shipped to a bad credit risk customer
Sales billed at the wrong price or wrong quantity
Product A sales recorded as Product line B
Failure to post charges to customers for sales
January sales recorded in December
Assertions
?
?
?
?
?
?
?
Discussion questions
1. The following are analytical procedures for the sales and collection cycle. Discus the
potential misstatements uncovered by each procedure.
145
a) Gross margin by product line
b) Sales returns and allowances as a percentage of gross sales by product line or segment
c) Trade discounts taken as a percentage of net sales
d) Bad debts as a percentage of gross sales
e) Days sales in receivables outstanding.
f) Aging categories as a percentage of accounts receivable
g) Allowance for uncollectible accounts as a percentage of accounts receivable
h) Comparison of the balances in individual customer‘ accounts over a stated amount with
their balances in the previous year
2. Explain what is meant by a cutoff bank statement, and discuss the purpose of the cutoff bank
statement in the audit of cash.
3. Explain the purpose of testing the client‘s bank reconciliation, and discuss the major audit
procedures involved.
4. Discus the transaction and balance related audit objective for plants, property and equipment?
5. Explain the substantive tests that apply to the existence or occurrence and completeness
assertions for stockholders' equity balance
Answers to Model Examination Questions:
Unit one:
B. Multiple Choices
1. C
5. C
2. A
6. E
3. C
7. E
4. C
8. D
Unit two:
I. Multiple Choices
1. E
8. F
2. F
9. A
3. A
10. A
4. C
11. A
5. D
12. B
6. E
13. D
7. B
14. A
II. Matching
1. Occurrence
2. Completeness
3. Accuracy
4. Accuracy
9. A
10. E
11. B
12. A
13. B
15. C
16. A
17. D
18. D
19. D
20. B
5. Classification
6. Completeness
7. Cutoff
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R References:
Auditing and assurance services: an integrated approach/ Alvin A. Arens, Randal J. Elder, Mark
S. Beasley.—14th ed. p. cm.
Fundamentals of Auditing –ACC 311: Virtual University of Pakistan
Guidance on sampling methods for audit authorities: European commission directorate-general
regional and urban policy (2013).
Guide to internal audit: frequently asked questions about developing and maintaining an
effective internal audit function, 2nd edition
Internal audit training module based on the internal audit procedure manual: ministry of finance
& economic development November 2005
Guidance note on audit of liabilities: Published in December, 1995 issue of ‗The Chartered
Accountant‘.
Audit Risk and Materiality in Conducting an Audit AU Section 312: Effective for audits of
financial statements for periods beginning on or after December 15, 2006.
Ray Whittington, Kurt Pany: Principles of auditing and other assurance services
The previous module by letenah Ejigu (PhD)