Chapter 10
Overall Audit Plan and Audit Program
Review Questions
10-1 The four types of tests used by auditors to determine whether financial
statements are fairly stated are;
1.
2.
3.
4.
procedures to obtain an understanding of internal control
tests of controls
analytical procedures
tests of details of balances
The first two types are performed to assess control risk, and the last two types are
performed to achieve planned detection risk. All audit procedures fall into one or more
of these four categories.
10-2 Tests of controls are audit procedures designed to verify whether the client's
controls are being applied in the manner described in the flowchart and internal control
questionnaire. Examples include:
1.
2.
3.
4.
The examination of vendor invoices for indication that they have been
clerically tested, compared to a receiver and purchase order, and
approved for payment.
Examination of employee time cards for approval of overtime hours
worked.
Examination of journal entries for proper approval.
Examination of approvals for the write-off of bad debts.
Substantive tests are procedures designed to test for dollar errors directly affecting the
fair presentation of financial statement balances. Examples are:
1.
2.
3.
4.
Reconciliation of balances indicated in vendor statements.
Examination of vendor invoices in support of amounts recorded for
purchases of inventories.
Recalculation of payroll amounts.
Recalculation of amounts accrued for various liabilities.
10-3 A reperformance procedure is an audit procedure in which the auditor performs
the same procedure that client personnel did, to make sure that the monetary amounts
are correct. An example is to multiply unit selling prices times quantity on duplicate
sales invoices to make sure the client calculated the amounts correctly.
10-1
10-4 A test of controls audit procedure to test that approved wage rates are used to
calculate employee earnings would be to examine rate authorization forms to determine
the existence of authorized signatures.
A substantive test 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.
10-5 The auditor resolves the problem by making assumptions about the results of the
tests of controls and performing both the tests of controls and substantive procedures
(dual-purpose tests) on the basis of these assumptions. Ordinarily the auditor assumes
effective internal control with few or no deviations planned. If the results of the tests of
controls are as good as or better than the assumptions that were originally made, the
auditor can be satisfied with the substantive procedures, unless the substantive
procedures themselves indicate the existence of misstatements. If the tests of controls
results were not as good as the auditor assumed in designing the original tests,
expanded substantive procedures must be performed.
10-6 When the results of analytical procedures are different from the auditor's
expectations and thereby indicate that there may be a misstatement in the balance in
accounts receivable and sales, the auditor should extend his or her tests until he or she
determines why the ratios are different from his or her expectations. Confirmation of
accounts receivable and cut-off tests for sales are two procedures that can be used to
do this. On the other hand, if the ratios are approximately what the auditor expects, the
other tests can be reduced. This says that the auditor can satisfy the evidence
requirements in different ways and that analytical procedures and confirmation are
complementary when the results of the tests are both good.
10-7 The auditor must gain an understanding of internal control sufficient to plan the
audit under either approach. In a combined audit approach, the auditor plans to assess
control risk below maximum and perform tests of controls to confirm that assessment;
reduced substantive testing will be required because of this reliance on internal control.
In a substantive audit approach, the auditor assesses control risk at maximum and
gains all his or her assurance from substantive procedures.
A combined approach would be appropriate for the acquisitions and payment cycle if
there were internal controls in place and working that provided assurance that all
purchases made by the company were recorded in accounts payable; in this case the
auditor would likely assess control risk below maximum with respect to the
completeness assertion. If, on the other hand, controls over the recording of purchases
were weak or non-existent, controls risk would be assessed at maximum and the
auditor would verify the completeness assertion by substantive procedures.
10-2
10-8
The audit of permanent asset additions normally entails the examination of
invoices in support of the additions and possibly the physical examination of the
additions. These procedures are normally performed on a test basis with a
concentration on the more significant additions. If the individual responsible for
recording new acquisitions were known to have inadequate training and limited
experience in accounting, the sample size of the audit procedures should be expanded
to include a larger sample of the additions for the year. In addition, inquiry as to what
additions were made during the year may be made by the auditor of plant managers,
the controller, or other operating personnel. The auditor should then search the financial
records to determine that these additions were recorded as permanent assets.
Care should also be taken when the repairs and maintenance expense account is
analyzed since lack of training may cause some depreciable assets to be expensed at
the time of purchase.
10-9
The following shows which types of evidence are applicable for the four types
of tests.
Type of Evidence
Physical examination
Confirmation
Documentation
Observation
Inquiries of the client
Reperformance
Analytical procedures
Types of Tests
Tests of details of balances
Tests of details of balances
All except analytical procedures
Procedures to obtain an understanding of
controls and tests of controls
All four types
Tests of controls, tests of details of balances,
and substantive tests of transactions
Analytical procedures
10-10
Before a reduction in substantive procedures is permitted, internal controls
must be effective and the auditor must have found the results of the tests of controls
satisfactory. Cost effectiveness of reduced assessed level of control risk should be
considered in making the decisions as to whether to test controls. The cost
effectiveness of reduced control risk is an audit efficiency issue.
10-11
The three-step approach to designing tests of transactions is as follows:
1.
Apply the detailed internal control objectives to the class of transactions being
tested.
2.
Identify specific controls that should reduce control risk for each objective.
3.
Develop tests of controls for each key control.
10-3
10-12
The approach to designing tests of transactions (Figure 10-5) emphasizes
satisfying the internal control objectives developed in chapter 9. Recall that these
objectives focus on the proper functioning of the accounting system.
The methodology of designing tests of details of balances (Figure 10-7) emphasizes
satisfying the audit objectives developed in chapter 5. The primary focus of these
objectives is on the fair presentation of account balances in the financial statements.
10-13
It is desirable to design tests of details of balances before performing tests of
controls to enable the auditor to determine if the overall planned evidence is the most
efficient and effective in the circumstances. In order to do that the auditor must make
assumptions about the results of the tests of controls. Ordinarily the auditor will assume
no significant errors or control problems in tests of controls unless there is reason to
believe otherwise. If the auditor determines that the tests of controls results are different
from those expected, the amount of testing of details of balances must be altered.
10-14
If tolerable misstatement is low, and inherent risk and control risk are high,
planned tests of details of balances which the auditor must perform will be high.
An increase in tolerable misstatement or a reduction of either inherent risk or control risk
will lead to a reduction in the planned tests of details of balances.
10-15
Auditors frequently consider it desirable to perform audit tests throughout the
year rather than waiting until year-end because of the public accounting firm's difficulty
of scheduling personnel. Due to the uneven distribution of the year-end dates of their
clients, there is a shortage of personnel during certain periods of the year and excess
available time at other periods.
The procedures that are performed at a date prior to year-end are often dependent
upon adequate internal control and when the client will have the information available.
Procedures which may be performed prior to the end of the year are:
1.
2.
3.
4.
5.
6.
7.
8.
Update permanent asset schedules.
Examine new loan agreements and other legal records.
Vouch certain transactions.
Analyze changes in the client's system.
If the client has strong internal control so that the auditor may assess
control risk at less than maximum, the following procedures may be
performed with minor review and updating at year-end:
Observation of physical inventories;
Confirmation of accounts receivable balances;
Confirmation and reconciliation of accounts payable balances.
10-4
Multiple Choice Questions
10-16
a. (4)
b.
(4)
c.
(3)
10-17
a. (3)
b.
(3)
c.
(4)
d.
(1)
Discussion Questions and Problems
10-18
a.
1.
TD of B
Reperformance
2.
TD of B
Documentation
3.
AP
Analytical procedures
4.
Test of Controls
Inquiry and observation
5.
TD of B
Confirmation
6.
TD of B
Documentation and reperformance
7.
Test of Controls
Documentation
8.
Test of Controls
Documentation
9.
AP
Analytical procedures
10.
TD of B
Documentation
11.
Test of Controls
Documentation
10-19
a.
1
2
b.
b.
c.
d.
e
Acquisition
and payment
Reperformance
Substantive
TD
of B
Posting and
Summarization
Acquisition
and Payment
Documentation
Test of control
or Substantive
10-5
Existence Occurrence
f.
N/A
3
Inventory
and
Warehousing
Analytical
Procedure
Substantive
AP
N/A
N/A
4
Capital Acquisition and
Repayment
Confirmation Substantive
TD
of B
N/A
Existence
accuracy
Presentation and
Disclosure
5
Acquisition
and Payment
Reperform- Substantive
ance
TD
of B
N/A
Detail
Tie-in
Accuracy
6
Acquisition
and Payment
Documentation
TD
of B
N/A
Cut-off
7
Sales and
Collection
Observation Test of
Controls
N/A
Completeness
N/A
8
Sales and
Collection
Inquiry
TD
of B
N/A
Realizable value
Substantive
Substantive
10-20
a.
1. Accuracy
2. Accuracy
3. Existence
Completeness
4. Timing
b.
Examine vendors'
invoices for
indication of
recalculation
Determine
existence of
approved price lists
for acquisitions
Account for a
numerical sequence
of receiving reports
c.
An error in
calculation of
a vendor's
invoice
Unauthorized
prices could
be paid for
acquisitions
Unrecorded
acquisitions
exist
Examine vendors'
invoices for
indication of
comparison
Cutoff errors
10-6
d.
Recalculation of the
vendor's invoice
Obtain prices from
purchasing department
and compare to vendors'
invoices
Confirm accounts
payable, especially
vendors with small zero
balances
Confirm accounts
payable
5. Posting
Summarization
6. Classification
Examine indication
of reconciliation of
the subsidiary ledge
and control account
Errors in
subsidiary
records or
control
account
Examine vendors'
Account
invoices for
classification
indication of internal errors
verification
7. Existence
Examine cancelled
cheques for
signature
Invalid or
unauthorized
payment
8. Existence
Accuracy
Examine vendors'
invoices for
indication of
comparison
Examine supporting
documents for
indication of
cancellation
Observe cheque
mailing procedures
and inquire about
normal procedures
Invalid or
unauthorized
payment
9. Existence
10. Existence
Duplicate
payment for
an acquisition
Bookkeeper
takes signed
cheques and
changes
payee name
Foot subsidiary records
and compare to control
account
Compare vendors'
invoices to acquisitions
journal for
reasonableness of
account classification
Examine supporting
documents for
appropriateness of
expenditures
Examine supporting
documents for
appropriateness of
expenditures
Examine supporting
documents for every
payment to selected
vendors
Compare payee name on
cancelled cheque to
supporting documents
10-21
a. The performance of interim tests of controls is an effective means of
keeping overtime to a minimum where many clients have the same year-end date.
However, this approach requires additional start-up time each time the auditor enters
the field to perform additional tests during different times of the year. In the case of a
small client, start up costs and training time may require more total time than waiting
until after December 31.
b.
Schaefer may find that it is acceptable to perform no additional tests of controls
work as a part of the year-end audit tests under the following circumstances:
1. The results of the tests of the interim period indicate the accounting system is
reliable.
2. Inquiries concerning the remaining period may indicate there were no significant
changes in internal control and accounting procedures.
10-7
3. The transactions occurring between the completion of the tests of controls and
the end of the year are not unusual compared to the transactions previously
tested and to the normal operations of the company.
4. Other tests performed at the end of the year do not indicate that internal control
is less effective than the auditor has currently assessed.
5. The remaining period is not too long in the circumstances. (Some consensus
exists in the profession requiring the remaining period to be three months or
less, depending upon the circumstances.)
6. Other matters of concern to the auditor indicate that the limitation of tests of
controls is appropriate (i.e., risk of exposure to legal sanction is not too great;
the auditor will probably be familiar with the client's operations and will
determine that a reduced control risk is justified; the auditor has appropriate
confidence in the competence of personnel and the integrity of management).
c.
If Schaefer decides to perform no additional tests of controls, depending upon the
circumstances, she may wish to perform analytical procedures, such as reviewing
interim transactions for reasonableness or tracing them to their source, comparing
balances to previous periods, or other such procedures, for the remaining period
to year end.
10-22
Audit
Tests of
Controls
Analytical
Procedures
Substantive
Tests of
Balances
1
E
E
S
2
N
M
E
3
E
E
S, E*
E = Extensive amount of testing.
M = Medium amount of testing.
S = Small amount of testing.
N = No testing done.
S,E* = Small amount of testing for the gross balance in accounts receivable; extensive
testing done for the collectibility of the accounts.
a.
For audit 1 the recommended strategy is to maximize the testing of internal
controls and minimize the testing of the details of all ending balances in inventory.
The most important objective would be to minimize the number of locations that
need to be visited. The justification for doing this is the quality of internal control
and the results of prior year audits. Assuming that some of the locations have a
large portion of the ending inventory balance and others smaller portions, the
auditor can likely completely eliminate tests of physical counts of some locations
and emphasize the locations with larger dollar balances. The entire strategy is
oriented to minimizing the need to visit locations.
10-8
b.
Audit risk for this audit should be low (that is, assurance because of the plans to
sell the business, severe under-financing and a first year audit.) The lack of
controls over accounts payable and the large number of adjusting entries in
accounts payable indicate the auditor cannot consider internal control effective.
Therefore the plan should be to do extensive tests of details of balances, probably
through accounts payable confirmation and other end of year procedures. No tests
of controls are recommended because of the impracticality of reduced assessed
control risk. Some analytical procedures are recommended to verify the
correctness of acquisitions and to obtain information about the reasonableness of
the balances.
c.
The most serious concern in this audit is the evaluation of the allowance for
uncollectible accounts. Given the adverse economic conditions, significant
increase of loans receivable, the auditor must be greatly concerned about the
adequacy of allowance for uncollectible accounts and the possibility of
uncollectible accounts being included in loans receivable. Given internal control,
the auditor is not likely to be greatly concerned about the gross accounts
receivable, except for accounts that need to be written off. Therefore, for the audit
of gross accounts receivable there will be a greatly reduced assessed control risk
and relatively minor confirmation of accounts receivable. In evaluation of the
allowance for uncollectible accounts the auditor should test the controls over
granting loans and follow up on collections, however given the changes in the
economy it will be necessary to do significant additional testing of the allowance
for uncollectible accounts. Therefore an S is included as a test of details of
balances for gross accounts receivable and an E for the tests of net realizable
value.
10-23
a. The balances in the accounts included in the income statement and
statement of changes in financial position result from the transactions during the period
which affect the asset and liability accounts. If the beginning balances are not audited,
the auditor cannot be sure that the intervening transactions are correct. A qualified
opinion on the income statement and statement of changes in financial position will be
required, though an unqualified opinion for the balance sheet is possible.
b.
To verify the beginning balance in accounts receivable, Jackson could:
1.
2.
c.
Confirm the balance directly with customers (although most customers
may not have sufficient records to reply).
Examine supporting documents for the beginning balances. These would
include verifying shipments by examining bills of lading and payments by
tracing to the cash receipts journal and bank statement showing deposits.
Beginning balances on continuing audit engagements have been verified as
ending balances during the previous audit.
10-9
10-24
a. Factors which could explain the difference in the amount of evidence
accumulated in different parts as well as the total time spent on the engagement are:
a.
Internal control;
b.
Materiality of the account balance;
c.
Size of the populations;
d.
Make-up of populations;
e.
Initial vs. repeat engagement;
f.
Results of the current and previous audits;
g.
Existence of unusual transactions;
h.
Motivation of the client to misstate the financial statements;
i.
Degree of client integrity.
For an example, in the first audit, the auditor has apparently made the decision to
emphasize tests of controls and minimize substantive procedures. That implies effective
internal control and a low expectation of misstatement (low inherent and control risk.) In
the third audit, the auditor apparently has a high expectation of misstatements, and
therefore believes it is necessary to do both extensive tests of controls and substantive
procedures. Audit two is somewhere between.
b.
The audit partners could have spent time discussing the audit approach and
scope with Bryan prior to the beginning of the field work.
c.
The nature of these three engagements and the different circumstances
appear to be excellent examples of the tailoring of audit procedures to
appropriate levels considering the circumstances.
10-25
a. The following is a time line for the audit procedures, showing the
sequence of the parts of an audit in a typical audit.
July 31
Audit Report Date
______________________________________________________________________
5, 9, 7, 2
8
1
3
4
6
Parts 5, 9, and 7 are all a part of planning and are therefore done early. These are in
the sequence shown in chapter 5.
As part of planning the audit, the auditor obtains an understanding of internal control
and initially assesses control risk. The auditor then tests the internal controls and
confirms or disconfirms his or her assessment of control risk.
Ideally most analytical procedures are performed after the client has prepared financial
statements, but before tests of details of balances are performed. Therefore, they
should be done before confirmation of accounts payable, to provide information about
the expectation of misstatement.
10-10
Confirmation of accounts payable should be done as early after the balance sheet date
as possible to facilitate getting responses back, performing alternative procedures for
non- responses and reconciling differences before the audit is completed.
Tests for review of subsequent events is normally the last thing done on the
engagement before the auditor's report date. The audit report is issued after the
auditor's report date.
b.
The time line shows that 5, 9, 7 and 2 are frequently done before the balance
sheet date.
Cases
10-26
a.
Further information required:
1. The names and relationships of related parties, either individuals or corporations, in
order to:
!
Identify any intercompany transactions and balances that should be
eliminated on consolidation
!
Identify related party transaction so that the disclosure requirements
related to the transaction, balances and other matters may be considered
!
Enable Fairly, Small & Co to report on its independence to Giant and Co.
2. Additional information regarding the accounting policies and other matters that
would affect YPL. To identify differences, if any, and adjust the financial statements.
3. General information regarding the business philosophy and other business matters
that would affect YPL. This would gain an insight into the operations and its overall
philosophy. General business information would provide data on product lines and
transfer prices.
4. Information regarding the requirements for nine month statements. This would be
necessary for consolidation purposes.
5. Information on Many Conglomerate Limited’s income tax classification to verify if
YPL has lost its small business deduction and is therefore required to pay Part VI
income tax on previous small business deduction credits.
10-11
6. Whether Giant and Co. require any particular information, such as a special
presentation of fixed assets, the salaries of executives or analyses of certain
accounts.
b.
Memorandum to audit senior
General matters
1.
An introduction outlining the change in control including the date of change,
name of and general information about the acquiring company and an indication
of how this change in control will specifically affect the audit as to related party
transactions.
2.
The new reporting package with which YPL must now comply.
Internal control
1.
The early reporting deadline for the financial statements, and the earlier
attendance at inventory. The audit senior will have to evaluate the new internal
control system to determine whether it is possible to rely upon it.
2.
The early inventory attendance will necessitate reliance on the new inventory
system and on the accounts receivable and accounts payable systems as well.
3.
The review procedures for the evaluation of internal control and the compliance
procedures of the system should include tests to examine:
•
•
•
•
•
•
Payroll and purchase entries to inventory accounts
Cost of goods sold entries
Transfers between inventory accounts
Physical controls that safeguard the inventories
The recording of sales, including shipping and billing procedures
Control over cash receipts and deposits
Cut-off
Because the inventory count date has been moved forward, certain cut-off procedures
must now be completed.
1.
Verify that the client has instituted effective procedures with his staff for this early
cut-off.
2.
To ensure an effective cut-off, the interrelated accounts of inventory, receivables
and payables will have to be verified.
10-12
3.
The sending of accounts receivable and accounts payable confirmations should
be completed at the time of attendance at the inventory count.
Post cut-off
1.
For transactions between November and December it will be necessary to carry
out analytical review and substantive tests to ensure that accounts receivable,
accounts payable and inventories are properly recorded.
2.
For November and December procedures should include:
•
•
A comparison of results with budgets and with previous years’ results
Testing of entries to the various related accounts.
Other important matters
1.
Certain aspects of the year-end audit involving prepaid expenses, fixed assets,
capital stock and goodwill can be carried out in October.
2.
Other confirmation letters, such as lawyers’ letters and long-term debts, should
be prepared in January.
3.
The reporting package for YPL should be reviewed as soon as possible and
problem areas highlighted.
The reporting package should be reconciled to the statutory financial statements as
soon as the statements are prepared.
10-27
Memo to:
From:
Subject:
Partners in charge
CA
Audit planning for Canadian Chocolate Company (CCC)
Inherent audit risk is high and is affected by the following factors:
• Both auditors are new to this client and therefore have no previous experience to
rely on.
• CCC has a number of locations, some of them foreign, with their own accounting
system and has intercompany transactions among locations.
• CCC has had some financial problems such as a shrinking market and
unsuccessful new product launching. It is also facing major lawsuits, from the
extortion attempt. These increase the risk of manipulation by management of the
financial results.
10-13
•
Inventory prices are volatile, and the nature of the inventory makes its existence
difficult to audit. CCC relies on perpetual records and does not perform a physical
count.
New product line
The introduction of the new product lines has several audit implications, as follows:
1. Product 4 will not recover all development costs until at least the seventh year.
There are two alternative accounting treatments that may be considered.
a. In Canada and on consolidation of the U.S. subsidiary, it may be appropriate to
defer only the amount of development costs considered recoverable in a
reasonable period. (5 years)
b. If the four new items are considered collectively as a single new product, all
development costs can be recovered in a shorter period.
2. Outstanding contracts for advertising the new products should be properly accrued
and disclosed.
3. The costs associated with obtaining the market research data can be deferred, as
party of the development costs, but advertising costs cannot.
4. The development costs will have to be examined in detail to ensure that they are
costs that qualify for capitalization.
5. In the U.S. development costs must be expensed. For consolidation purposes, the
information from the U.S. auditors is needed to adjust development costs to
Canadian GAAP.
6. The coupon campaign will create a liability and CCC should accrue these liabilities
as it makes sales to retailers.
7. The capitalization of development costs and the accrual of the coupon liability will
result in deferred taxes, as the tax treatment of these items is not the same as the
accounting treatment.
Extortion loss
The net book value of the equipment taken out of service, the cost of the destroyed
products, and the public relations cost do not represent future benefits so they should
not be capitalized. CCC should recognize them as extraordinary losses.
It is necessary to review the insurance claim for reasonableness and confirm with the
insurance company the amounts paid and due to the company.
10-14
A letter is required from CCC’s lawyers concerning the outstanding lawsuit, to decide
whether CCC should accrue a liability or merely disclose the fact that liability may exist.
CCC’s insurance coverage should be checked to se if any of the costs of this lawsuit will
be covered by insurance.
Product discontinuance costs
Ensure that any capital items or inventory supplies that will no longer be used are
valued at no more than net realizable value. Any related deferred costs should be
written off and adequate provision made for any other related disposition costs that may
be incurred.
Inventories
The potential inventory problems can be segregated under physical existence and
valuation.
1. Physical existence
A physical count of the main raw materials, cocoa beans and sugar, stored at each
subsidiary should be conducted. It will be necessary to ascertain the degree of accuracy
of the perpetual records because they are the basis on which the year-end balances will
be determined.
The only significant audit problem posed by work in process might be obtaining
satisfaction about semi-process chocolate in transit between subsidiaries. Finished
goods do not appear to present any problems.
If a specialist is required to aid in the audit, the provisions of Handbook Section 5360
must be followed.
2. Valuation
Valuation of sugar and cocoa beans could be difficult; they are valued at the lower of
cost and replacement cost. Any valuation problem with regard to semi-processed
chocolate transferred from another company should be eliminated on consolidation, as
any intercompany profits must be eliminated.
Purchase contract losses
Review all outstanding purchase contracts at year-end for disclosure in the notes to the
financial statements. Ascertain whether any contract might lead to a loss that should be
accrued at the year-end in accordance with Section 3290 of the Handbook.
10-15
Segment information
CCC only operates in one industry segment (chocolate); the company cannot present
information on an industry-segment basis. Disclosure of the fact that dominant segment
exists will be required.
The major audit problems will be in obtaining satisfaction that all inter-segment transfers
have been appropriately priced and that such transfers reflect any consolidated profit
eliminations. Ensure that all common costs have been allocated on a reasonable basis.
Reliance on other auditors
Use the Handbook Section 6930 to determine if the auditing procedures performed by
the foreign auditors is acceptable.
Reliance on internal auditors
Use CCC’s internal audit team when doing the annual audit. Their participation should
result in a more effective and efficient audit.
Transfer pricing
CCC does not have a formal policy for transfer pricing. A formal policy should be issued
using either a cost or a market-based approach to eliminate the problem of determining
a price for each shipment.
Research and Development cost allocation
Research, development and other common costs are being allocated among the
subsidiaries on the basis of asset values. This basis is not reasonable, especially in
cases where the subsidiary is not manufacturing or marketing the bar. For the new
product line, costs should be shared between the two subsidiaries that have been
created to manufacture the line.
Taxation issues
Ensure that cross-border transfer-pricing is at fair market value to satisfy Canada
Customs and Revenue Agency.
10-16