Audit
WEEK ONE
Course Administration
Professor Thomas Davis
Email: tomas.davis@hotmail.com
Student course leader
Textbook: Auditing and Assurance Services,
Arens/Elder/Beaseley, 12th edition
Course Assessment
30% midterm exam (5 Oct-22 Oct)
20% project (week 11 case study)
50% final exam (30 Nov-17 Dec)
Course Outline
Introduction (week 1)
Audit overview (week 2)
Financial statement cycles/audit objectives (week 3)
Audit evidence (week 4)
Audit planning (week 5)
Materiality (week 6)
Audit plan/audit program/review for midterm exam (week 7)
Course Outline
Sales cycle: controls and transactions testing (week 8)
Case study (week 9)
Sales cycle: analytical procedures/balances testing (week 10)
Case study (week 11)
Payroll and acquisition cycles (week 12)
Inventory and capital cycles/audit completion (week 13)
Review for final exam (week 14)
Audit
WEEK TWO
Readings
GAAS standards:
http://www.aicpa.org/Research/Standards/AuditAttest/D
ownloadableDocuments/AU-00150.pdf
Audit reports
http://en.wikipedia.org/wiki/Auditor's_report
Legal liability
http://en.wikipedia.org/wiki/Legal_liability_of_certified_p
ublic_accountants
Audit vs. Accounting
Accounting: preparing financial statements
Auditing: verifying financial statements
The CPA Profession
The “Big Four”
Deloitte, EY, PwC, KPMG
Staff levels: Staff, Senior, Manager, Partner
CPA certification
Education
Exam
Experience
Generally Accepted Auditing Standards
(GAAS)
General standards
 Training and proficiency
 Independence
 Professional care
Standards of field work
 Planning and supervision
 Understanding of entity
 Sufficient evidence
Standards of reporting
 Evaluation of GAAP
 Explanation of departures from GAAP
 Adequate disclosure
 Financial statement opinion
Audit Reports – Standard Unqualified
Opinion
All four financial statements included
All three GAAS general standards followed
All three field work standards met
Presentation in accordance with GAAP
No explanation/modification required
Other Audit Reports
Unqualified opinion with explanation/modification
Qualified opinion – “except for”
Scope limitation – client or circumstances
Not in accordance with GAAP but fairly stated
Adverse opinion – financials not fairly stated per GAAP
Disclaimer – lack of information or lack of independence
Materiality and Misstatements
Immaterial – unlikely to affect decision of user:
unqualified opinion
Material but financial statements are fair (one
item/isolated situation): qualified opinion
Material – fairness of financial statements is in
question: disclaimer or adverse opinion
Ethics
Independence
Integrity and objectivity
Confidential client information
Contingent fees
Audit and consulting… conflict of interest
Legal Liability
Business failure vs. audit failure
Audit failure vs. audit risk
Negligence vs. fraud
Third parties vs. clients
Civil (securities law) vs. criminal (federal law) liability
“Joint and several” vs. “separate and proportionate” liability
Audit
WEEK THREE
Readings
Accounting cycles
http://tgg-accounting.com/blog/2012/01/financial-statement-cycles/
Audit objectives (not all objectives are covered here; we will discuss
others during the class)
http://smallbusiness.chron.com/audit-procedures-objectives58836.html
Auditor Responsibilities
Material vs. immaterial misstatements
Reasonable assurance
Errors vs. fraud
Professional skepticism – question everything!
Financial Statement Cycles
Sales and collection cycle
Acquisition and payment cycle (general assets and
expenses)
Payroll and personnel cycle
Inventory and warehousing cycle (inventory and COGS)
Capital acquisition and repayment cycle (debt and equity
transactions)
Financial Statement Cycles
Identify the
transaction cycle for
each account
Identify the main
journal entries for
each cycle
Hillsburg Hardware Co.
Trial Balance
December 31, 2013
Cash
Accounts receivable
Allowance for uncollectible accounts
Inventory
Prepaid expenses
Buildings
Accounts payable
Accrued payroll
Notes payable
Capital stock
Retained earnings
Sales
Advertising expense
Rent expense
Salaries expense
Bad debt expense
Income tax expense
Interest expense
Dividends
$
DR
25
90
CR
$
2
135
5
100
40
10
90
190
10
140
$
30
18
40
3
6
25
5
482 $
482
Objectives
Transaction-related
Balance-related
Presentation and disclosure-related
Transaction-Related Objectives
Occurrence – did it really happen?
Completeness – is anything missing?
Accuracy – is the information accurate?
Posting and summarization – are the transactions
included in the journal and ledger?
Classification – is the transaction in the correct account?
Timing – is the transaction in the right period?
Balance-Related Objectives
Existence – does this account really exist?
Completeness – is anything missing?
Accuracy – is the information accurate?
Classification – is the account correctly classified?
Cutoff – are the year-end transactions recorded in the right period?
Detail tie-in – does the balance match the ledger?
Realizable value – does the account reflect accurate value?
Rights and obligations – does account represent true
ownership/liability?
Disclosure-Related Objectives
Occurrence and rights and obligations – did it really
happen, and did it create true ownership/liability?
Completeness – is anything missing?
Valuation and allocation – do all accounts reflect the
appropriate amounts?
Classification and understandability – is the
classification correct and is the meaning clear?
Four Phases of an Audit
Plan the audit
Testing of controls and transactions
Analytical procedures and testing of balances
Audit report
Audit
WEEK FOUR
Readings
Chapter 7 from textbook
Audit Evidence Decisions
Which procedures?
What sample size? (quantity)
Which items to select for testing? (quality)
When?
Persuasiveness of Evidence
Appropriate
Relevant: right test for the right audit objective
Reliable: external information > internal information
Sufficient
Sample size: higher risk = larger sample
Item quality: large amounts and random amounts
Types of Evidence
Physical examination – auditor inspects physical assets
Confirmation – response from third party
Documentation – internal and external documents
Analytical procedures – comparisons and relationships
Inquiries of the client – client responses; may be biased
Recalculation – checking client calculations
Reperformance – checking non-calculation procedures
Observation – watch/listen/touch/smell
Audit Documentation
Sample documents from audit files (attachment)
Activity – notes receivable audit work (attachment)
Audit
WEEK FIVE
Readings
Chapter 8 from textbook
Audit Planning
Initial audit planning – staffing/specialists
Client business and industry (next slide)
Client business risk
Based on understanding business/industry (step 2)
High business risk = high risk of material misstatement
Analytical procedures
Client Business and Industry
Industry
Industry economic environment and risk
Industry accounting requirements
Business operations
Management and governance – philosophy and ethics
Objectives and strategies – financial and legal compliance
Measurement and performance – conservative or aggressive?
Analytical Procedures
Industry data
Prior period data
Client-calculated expected results (budgets)
Auditor-calculated expected results
Expected results using nonfinancial data (units, rates)
Client/Industry Comparison
Inventory turnover
Gross margin %
Client
2013
2012
3.4
3.5
26.3%
26.4%
Industry
2013
2012
3.9
3.4
27.3%
26.2%
Client is stable…. in an improving industry environment…
What happened?
Common Size Financial Statements
Sales
Less returns
Net sales
Cost of goods sold
Gross profit
SGA expenses
Marketing salaries
Adminstrative salaries
Advertising
Rent
Depreciation
Bad debt expense
Total SGA expenses
Earnings from operations
Other income and expense
Interest expense
Gain on sale of assets
Earnings before income taxes
Income taxes
Net income
$
$
$
$
$
$
$
$
$
$
2013
% of Sales
45,800
100.00%
390
0.85%
45,410
99.15%
29,800
65.07%
15,610
34.08%
1,900
3,200
2,000
1,500
900
1,050
10,550
5,060
4.15%
6.99%
4.37%
3.28%
1.97%
2.29%
23.03%
11.05%
525
(300)
4,835
1,290
3,545
1.15%
-0.66%
10.56%
2.82%
7.74%
$
2012
% of Sales
44,100
357
43,743
29,550
14,193
$
$
1,764
3,087
1,896
2,205
882
1,411
11,246
2,948
$
$
$
$
$
529
2,419
1,545
874
Auditor-Calculated Expected Results
Client:
Audit area:
Balance sheet date:
Schedule:
Preparer:
Date:
Northern Star Corp.
Notes payable
30-Nov-13
N-3
1-Feb-13
Interest expense per GL
$
Short term loans, end of month balance
December
$
January
February
March
April
May
June
July
August
September
October
November
Average interest rate:
Estimated short term interest expense
Long term loans
Balance 1 Dec 2012
Balance 30 Nov 2013
550,000
490,000
485,000
492,000
512,000
520,000
488,000
495,000
480,000
478,000
490,000
498,000
9.80%
$ 2,109,000
1,725,000
Average interest rate:
Estimated long term interest expense
Estimated total interest expense
Difference (GL less estimate)
7.90%
215,400
Non-Financial Data
Sales per trial balance
Rooms
Average daily rate
Average occupancy rate
Estimated total revenue
Difference
% difference
$ 10,560,000
$
690
74.25
62%
This percentage difference is significant… we need to find out….
What happened?
Financial Ratios
Current ratio = current assets / current liabilities
Days receivables = 365 / (net sales/average receivables)
Inventory turnover = cost of goods sold/average inventory
Debt to equity = debt / equity
Gross profit margin = gross profit / net sales
Operating margin = operating income / net sales
Profit margin = net income / net sales
Expense item as % of total expenses = expense / total expenses
Return on assets = income before taxes / average assets
Audit
WEEK SIX
Readings
Chapter 9 from textbook, “Materiality and Risk”
Materiality
Set preliminary judgement about materiality
Allocate amounts to segments
Estimate segment misstatement
Estimate combined misstatement
Compare combined estimate with preliminary
judgement
Materiality Judgment
Guidelines (vary from audit to audit):
6% earnings from operations
3% of total assets
Use the smaller result to calculate materiality
Below the amount: no issues
Above the amount: material misstatment; adjustment
required
Materiality Judgment and Allocation
Earnings from operations = $7,370,000
Total assets = $61,367,000
Materiality calculation:
Earnings x 6% = $442,000
Assets x 3% = $1,841,000
The smaller result = $442,000
Additional Auditor Guidelines
Maximum misstatement for one account = 60%
60% * $442,000 = $265,000
To prevent high allocation to one account
Maximum total of all misstatments = 200%
200% * $442,000 = $884,000
To allow for overestimates and over/under offsets
These guidelines vary among audit firms.
Materiality Judgment Allocation Example
Cash
Receivables
Inventories
Other current assets
PPE
Total assets
$
Payables
Notes payable
Accrued payroll
Accrued interest and dividends
Other liabilities
Capital stock
Retained earnings
Total liabilities and equity
$
$
$
Balance
Materiality
(thousands)
(thousands)
828
18,957
29,865
1,377
10,340
61,367
$
6
265
265
60
48
4,720
28,300
1,470
2,050
2,364
8,500
13,963
61,367
$
108
60
72
NA
884
$
%
0.7%
1.4%
0.9%
4.4%
0.5%
Notes
easy to audit, no misstatements expected
large balance, many small transactions, extensive sampling
large balance, many small transactions, extensive sampling
large percentage will allow us to use analytical procedures only
mostly from prior year balances which were audited last year
2.3%
0.0%
4.1%
0.0%
3.0%
0.0%
many small transactions, extensive sampling
easy to audit, no misstatements expected
large percentage will allow us to use analytical procedures only
easy to audit, no misstatements expected
large percentage will allow us to use analytical procedures only
easy to audit, no misstatements expected
Estimate and Evaluate Misstatement
Projection = misstatements/sample size %
Sampling error = risk of non-representative sample
Calculate total estimated misstatement
Compare total to preliminary judgment
Estimate and Evaluate: Receivables
Receivables Information (from slide 7):
Balance
$
Materiality
$
Audit information:
Sample tested
Overstatement
Sampling error
$
$
18,957,000
265,000
1,516,560
17,500
35%
Estimate and Evaluate: Receivables
Receivables balance
Sample amount
Sample tested
Misstatements in sample
Projected misstatement
Sampling error %
Sampling error
Total estimated misstatement
Tolerable misstatement (materiality)
$
$
$
$
$
$
$
18,957,000
1,516,560
8.00%
17,500
218,750
35%
76,563
295,313
265,000
Estimated misstatement exceeds tolerable misstatement…
What do we do?
Receivables Misstatement Options
If we increase our sample size, we can decrease the
sampling error % and recalculate the total estimated
misstatement (see next slide); if we still exceed materiality,
we adjust.
Adjusting entry:
Sales
$xx
Accounts receivable
$xx
The adjustment amount will be negotiated between the
client and the auditor.
Receivables: Revised Sampling
Receivables balance
Sample amount
Sample tested
Misstatements in sample
Projected misstatement
Sampling error %
Sampling error
Total estimated misstatement
Tolerable misstatement (materiality)
$
$
$
$
$
$
$
Original
18,957,000
1,516,560
8.00%
17,500
218,750
35%
76,563
295,313
265,000
$
$
$
$
$
$
$
Revised
18,957,000
2,500,000
13.19%
40,000
303,312
20%
60,662
363,974
265,000
If we expand the sample size (from slide 10), we can decrease the sample
error %, and evaluate the new result. In this case, because the amount of
misstatement in the revised sample still exceeds the materiality threshold,
we will propose the adjusting entry.
In Class Activity: Payables Analysis
Payables information (from slide 7):
Balance
Materiality
Audit information:
Sample tested
Understatement
Sampling error
$
$
4,720,000
108,000
$
$
340,000
7,790
25%
Audit Risk Model
PDR = AAR
IR * CR
PDR = planned detection risk (risk of undiscovered misstatement)
auditor risk; lower risk = more evidence
AAR = acceptable audit risk (risk of an incorrect audit opinion);
auditor risk; lower risk = more evidence
IR = inherent risk (account-specific risk);
client risk; lower risk = less evidence
CR = control risk (risk of ineffective control system);
client risk; lower risk = less evidence
Audit
WEEK EIGHT
Readings
Chapter 14, “Audit of the Sales and Collection Cycle”
and Chapter 15, “Audit Sampling for Tests of
Controls” from textbook
Sales and Collection Cycle Accounts
Sales
Cash
Accounts receivable
Sales discounts
Sales returns and allowances
Allowance for uncollectible accounts
Bad debts expense
Sales and Collection Cycle Documents
Customer order
Sales order
Bill of lading (shipping document)
Sales invoice
Additional documentation: cash receipts, sales
returns, bad debt provision, write-offs
Sales and Collection Cycle Controls
Separation of duties
Authorization (credit/shipping/pricing)
Documentation
Prenumbered documents (to prevent missing/duplicate
documents)
Monthly statements
Internal verification
Tests of Controls and Transactions
First, I consider my six transaction objectives:
occurrence, completeness, accuracy, posting,
classification, timing.
Then, I design tests relating to these objectives
based on information I have from client (procedures
manual, client discussions, observation); these tests
are the audit program.
Types of Evidence for Controls and
Transactions
Controls
 Documentation
 Inquiry
 Reperformance
 Observation
Transactions
 Documentation
 Inquiry
 Recalculation
 Reperformance
Audit Program for Controls/Transactions
This is a sample of the audit program on page 464:
Billing and recording sales
12 Account for a sequence of sales invoices in the sales journal
13 Trace selected sales invoice numbers from the sales journal to
a A/R master file and test for amount, date, and invoice number.
b sales invoices and check amount, date, name, footings.
c bill of lading and check name, product, quantity, date
d sales order and test name, product, quantity, date, internal verification
e customer order and test name, product, quantity, date, credit approval
14 Trace recorded sales from the sales journal to the file of supporting documents, which
include a duplicate sales invoice, bill of lading, sales order, and customer order.
Direction
FROM invoices TO journal
FROM sales journal TO
a/r ledger
sales invoice
bill of lading
sales order
customer order
FROM sales journal TO file
Four Audit Evidence Decisions
We have decided our procedures (Ch. 14)
Audit evidence decisions (Ch. 15):
What sample size? (quantity)
Which items to select for testing? (quality)
When? (timing)
Sampling for Controls and Transactions
We sample and test for controls based on attributes,
not dollar amounts.
Our assessment is based on number of errors.
Dollar amount does not matter.
Chapter 15 covers sampling procedures; we will not
study this information, rather I will provide you with
sampling instructions.
Perform the Audit Procedures
We set an estimated population exception rate based on our
understanding of client controls.
We set a tolerable exception rate (generally from 3%-10%)
based on what we consider acceptable.
We determine a sample size based on relationship between the
estimated and tolerable amounts (big difference = smaller
sample).
We perform our testing based on the audit program.
What Do We Do with the Results?
I compare my sample exception rate to my tolerable
exception rate.
If TER>SER, I can rely on this control procedure.
If TER<SER, I either 1) increase testing or 2) revise control risk
(I don’t rely on this control)
This evaluation of controls and transactions is the basis for
the design of my audit program for balances (Chs. 16-17).
Case Study Documentation Package
Auditor documents
 Audit program
 Attributes defined
 Sampling sheet
 Sales invoice sequence
Company accounting documents
 Sales journal
 A/R ledger
Company operations documents
 Customer order
 Sales order
 Bill of lading
 Sales invoice
Audit
WEEK TEN
Readings
Chapter 16, “Completing the Tests in the Sales and
Collection Cycle” and Chapter 17, “Audit Sampling for
Tests of Details of Balances” from textbook
Sales and Collection Cycle Accounts
Sales
Cash
Accounts receivable
Sales discounts
Sales returns and allowances
Allowance for uncollectible accounts
Bad debts expense
Analytical Procedures
2yr Change
Gross margin
Sales returns as % of sales
Bad debt expense as % of sales
Allowance as % of receivables
Days receivables
-0.30%
-0.30%
31-Dec-12
27.9%
0.90%
2.30%
6.10%
48.1
31-Dec-11
27.7%
0.90%
2.60%
7.50%
48.0
31-Dec-10
27.7%
0.90%
2.60%
6.40%
49.3
Analytical Procedures – Potential
Misstatement
($ in thousands)
Bad debts expense
($ in thousands)
Allowance for uncollectible accounts
Sales
143,086
2yr Change
Potential
% of Sales Misstatement
-0.30% $
(429)
Receivables
$
20,197
2yr Change
Potential
% of AR Misstatement
-0.30% $
(61)
$
These results indicate a potential misstatement relating to
the objective of “realizable value” which will affect our
balance testing for this objective.
Tests of Balances
First, we consider the eight balance objectives: existence,
completeness, accuracy, classification, cutoff, detail tie-in,
realizable value, rights/obligations.
Then, we design tests relating to these objectives based on:
The tolerable misstatement calculated in phase I
The controls/transaction testing completed in phase II
Analytical procedures just completed (this, along with
tests of balances, is phase III)
Types of Evidence for Balances
Physical examination
Confirmation
Documentation
Client inquiry
Recalculation
Reperformance
Test of Balances for Accounts Receivable
Aged trial balance (classification, tie-in, realizable value)
Confirmation (existence, accuracy)
Sales cutoff (cutoff)
Obtain last bill of lading number for year
Test recorded sales to confirm no subsequent BOLs
Document review/client inquiry (rights)
Pledging/factoring
Assignment/sale
Aged Trial Balance
List of all receivable balances
Customer name
Amount outstanding
Age of receivables balance
Audit procedures
Tie account balance to general ledger
Review customer names for any related parties
Analysis of allowance for uncollectible accounts
Aged Trial Balance
Customer
A
B
C
D
E
…
…
…
Balance
$ 140,000 $
31,000
80,000
60,000
15,000
0-30
90,000 $
31,000
70,000
Aging, Days
31-60
61-90
50,000
$
91-120
over 120
10,000
$
60,000
$
15,000
$ 20,196,800 $ 14,217,156 $ 2,869,366 $ 1,408,642 $ 1,038,926 $
662,710
Analysis of Analysis for Uncollectible
Accounts
Category
0-30
31-60
61-90
91-120
over 120
Total
Balance per trial balance
Difference
Balance Allowance %
Amount
$ 14,217,156
3% $ 426,515
2,869,366
6%
172,162
1,408,642
15%
211,296
1,038,926
25%
259,732
662,710
40%
265,084
$ 20,196,800
$ 1,334,788
1,240,000
$
94,788
Analysis of Analysis for Uncollectible
Accounts
Since the calculation is greater than the trial balance amount,
this is an OVERstatement. If the difference exceeds materiality, I
will make the following adjusting entry for the excess amount:
Bad debts expense
xx
Allowance for doubtful accounts
xx
I will include this difference in the “Summary of Possible
Misstatements” schedule in the audit file.
Confirmation of Accounts Receivable
Types of confirmation
Positive confirmation
Negative confirmation
Analysis of differences and potential accounting issues
Payment made – cash receipts cutoff error, theft?
Goods not received – shipping cutoff error?
Goods returned – sales returns recording error?
Clerical errors – client miscalculation?
For non-response – audit subsequent receipt of cash
Audit Program for Tests of Balances
1
2
3
4
5
6
7
8
9
Review accounts receivable balance for large and unusual receivables.
Calculate analytical procedures from carry-forward schedules and follow up on significant
changes from prior years.
Review the aged trial balance for notes and related party receivables.
Inquire of management regarding related party notes or long-term receivables.
Review corporate minutes and inquire of management regarding pledged/factored
receivables.
Trace 10 accounts from trial balance to A/R master file.
Foot two pages of the trial balance, total all pages, cross-foot the aging.
Trace balance to general ledger.
Trace five accounts from A/R master file to aged trial balance.
Audit Program for Tests of Balances
10 Confirmations (positive) using stratified sampling; >$100,000, $25,000-$100,000, <$25,000.
11 Perform alternative procedures for unreturned confirmations after two requests.
12 Analyze amounts 90+ days outstanding (credit file, cash receipts, client inquiry) and
evaluate collectability.
13 Evaluate whether allowance is adequate after performing other audit procedures for
collectability of receivables.
14 Select from sales journal last 20 sales this year and first 20 sales next year and trace to
shipping documents to test shipment date and recording date.
15 Review large sales returns and allowances close to balance sheet date to evaluate date of
recording.
Four Audit Evidence Decisions
We have decided our procedures (Ch. 16)
Audit evidence decisions (Ch. 17):
What sample size? (quantity)
Which items to select for testing? (quality)
When? (timing; for testing of balances, most testing
will be after year-end)
Sampling for Balances
We sample and test for balances based on dollar
amounts.
Chapter 17 covers sampling procedures; we will not
study this information, rather I will provide you with
sampling instructions.
Perform the Audit Procedures
We set the tolerable misstatement during phase I.
We determine a sample size and sample items using
sampling procedures and considering the results of
our controls and transactions testing (strong controls
= less balance testing).
We perform our testing based on the audit program.
What Do We Do with the Results?
I analyze sample misstatements to calculate total
projected misstatement.
I compare projected misstatement to tolerable
misstatement
If projected misstatement < tolerable misstatement,
account balance is presented fairly.
If projected misstatement > tolerable misstatement, I either
1) perform additional testing or 2) propose adjusting entry.
Analysis of Receivables Confirmation –
Estimated Misstatement (from lecture 6)
Receivables balance
Sample amount
Sample tested
Misstatements in sample
Projected misstatement
Sampling error %
Sampling error
Total estimated misstatement
Materiality
Proposed adjustment to receivables
$
$
$
$
$
$
$
$
20,196,800
1,615,744
8.00%
17,500
218,750
35%
76,563
295,313
265,000
(30,313)
Now let’s look at the same analysis using stratified sampling…
Analysis of Receivables Confirmation
Using Stratified Sampling
Stratified sampling – test higher percentage of large amounts and
smaller percentage of small amounts.
1 (>$15,000)
Receivables balance
Sample amount
Sample tested
Misstatements in sample
Projected misstatement
Sampling error %
Sampling error
Total estimated misstatement
Materiality
Proposed adjustment to receivables
$
$
$
$
$
$
3,409,282
933,888
27.39%
9,500
34,681
5%
1,734
36,415
2 ($5k-$15k)
$
$
$
$
$
$
7,564,345
532,700
7.04%
6,521
92,594
30%
27,778
120,372
$
$
Total
20,196,800
1,615,744
8.00%
17,500
218,750
$
$
$
$
76,563
295,313
265,000
(30,313)
3 (<$5,000)
$
$
$
$
$
$
9,223,173
149,156
1.62%
1,479
91,475
51%
47,051
138,526
$
$
Adjustments to Financial Statements
We are performing multiple tests to evaluate the sales
cycle; once we complete our testing for this cycle, we will
evaluate the need for adjusting entries.
The confirmations testing analysis on slide 19 is only one
of these tests; other tests might indicate the need for a
larger or smaller adjustment to accounts receivable.
Accounts receivables is only one account in the sales
cycle; other tests might indicate the need to make
adjustments to other accounts in the sales cycle.
Audit
WEEK TWELVE
Readings
Chapter 18, “Audit of the Payroll and Personnel
Cycle”
Chapter 19, “Audit of the Acquisition and Payment
Cycle”
Chapter 20, “Completing the Tests in the Acquisition
and Payment Cycle”
Payroll Accounts
Cash
Accrued payroll
Direct labor
Tax withholdings
Accrued payroll tax expense
Payroll tax expense
Payroll Controls/Transactions Testing
Verify payroll records - work and employees (occurrence)
Payroll is recorded in accounting system (completeness)
Hours and rates in payroll records are correct (accuracy)
Payroll master file ties to general ledger (posting)
Payroll is correctly classified (classification)
Payroll is recorded on correct date (timing)
Payroll Analytical Procedures
Sales
Payroll expense
Commission expense
Payroll tax expense
Accrued payroll
Accrued payroll taxes
Payroll expense/sales
Commissions expense/sales
Payroll tax expense/payroll expense
Accrued payroll/payroll expense
Accrued payroll taxes/payroll tax expense
$
$
$
$
$
$
2013
521,000
32,900
10,680
2,996
669
62
6.31%
2.05%
9.11%
2.03%
2.08%
$
$
$
$
$
$
2012
492,500
30,800
9,870
2,818
655
59
6.25%
2.00%
9.15%
2.13%
2.09%
Payroll Balance Testing
Accrued payroll expense is correct (accuracy); main
test is recalculation.
Payroll transactions are in correct period (cutoff);
main test is reviewing payroll payments after yearend.
Acquisition and Payments Accounts
Cash
Accounts payable
Inventory
Purchase returns, allowances, discounts
Property, plant, and equipment
Prepaid expenses
Operating expenses
Acquisitions Controls/Transactions
Testing
Verify acquisitions records - goods/services received
(occurrence)
Acquisitions are recorded in accounting system
(completeness)
Acquisitions transactions are accurate (accuracy)
Acquisitions accounts tie to general ledger (posting)
Acquisitions are correctly classified (classification)
Acquisitions are recorded on correct date (timing)
Payments Controls/Transactions Testing
Verify payments are for legitimate goods/services
(occurrence)
Payments are recorded in accounting system
(completeness)
Payments are accurate (accuracy)
Cash and accounts payable tie to general ledger (posting)
Payments are correctly classified (classification)
Payments are recorded on correct date (timing)
Acquisitions and Payments Analytical
Procedures
Sales
COGS
Non-payroll operating expenses
Income before taxes
Income tax expense
Accounts payable
Operating expenses/sales
Income tax as % of pretax income
Days payables
$
$
$
$
$
$
2013
521,000
180,200
121,890
42,900
15,990
23,400
23.40%
37.27%
47
$
$
$
$
$
$
2012
492,500
169,800
116,590
41,780
14,980
21,090
23.67%
35.85%
45
Accounts Payable Balance Testing
All accounts payable are included in AP ledger
(completeness); review subsequent cash
disbursements and year-end receiving reports
Payables are correctly classified (classification)
Acquisition transactions are in correct period (cutoff)
Other Acquisition/Payment Cycle
Accounts
Property, plant, and equipment – examine documentation of
current year acquisitions to confirm existence and
classification.
Prepaid assets – examine documentation to confirm existence
and cutoff.
Accrued liabilities – ensure that normal accruals (taxes and
payroll) are included in financials and are correctly calculated.
Income and expense accounts – ensure that normal expenses
are included in financials and are correctly calculated.
Audit
WEEK THIRTEEN
Readings
Chapter 21-24 (Inventory, Capital, Cash, Audit
completion) from textbook
Inventory and Warehousing Accounts
Raw materials
Direct labor
Manufacturing overhead
Work in process
Finished goods
Cost of goods sold
Inventory Controls/Transactions Testing
Materials and overhead – tested in acquisitions cycle
Labor – tested in payroll cycle
Shipping of inventory – tested in sales cycle
Inventory Analytical Procedures
Sales
COGS
Gross Profit
Inventory
Gross profit margin
Inventory turnover
$
$
$
$
2013
521,000
180,200
340,800
18,202
65.41%
9.9
$
$
$
$
2012
492,500
169,800
322,700
17,558
65.52%
9.7
Inventory Balance Testing - Observation
Verify inventory items are present (existence)
Verify all inventory is counted (completeness)
Verify counting and pricing is accurate (accuracy)
Verify inventory/COGS is recorded in correct period
(cutoff)
Obsolete/damaged inventory value is correct (value)
Client has rights to counted inventory (rights)
Capital Acquisition and Repayment Cycle
Notes payable and interest expense
Capital stock and dividends
Infrequent transactions; often 100% tested (no sampling )
Key audit considerations
Interest expense is accurate – recalculation
Debt balance is complete – bank confirmation
Capital issuance is not disguised debt – board meeting minutes
Dividends are not disguised expenses – board meeting minutes
Audit of Cash Balances
Controls testing is generally completed in other cycles
Bank reconciliation
Bank confirmation for year-end balance
Next month bank statement to confirm outstanding
checks and deposits at year-end
Presentation and Disclosure Testing
Occurrence and rights and obligations
Completeness
Classification and understandability
Accuracy and valuation
Completing the Audit
Contingent liabilities – client inquiry, attorney inquiry letter
Subsequent events – from year end to audit report date
Management representation letter
Evaluate possible misstatements for adjustment (slide 11)
Audit documentation review
Issue the audit report
Summary of Possible Misstatements
Possible Overstatement / (Understatement)
Noncurrent
Current Noncurrent
Assets
Liabilities
Liabilities
Equity
Current
Assets
Bad debts expense
$ 95,000
Allowance for uncollectible accounts
$
To adjust for understated allowance (aged A/R analysis)
Accounts receivable
$ 60,000
Sales
$
COGS
$ 35,000
Inventory
$
To adjust for understated sales and COGS (cutoff testing)
95,000
$
95,000
$
(60,000)
60,000
35,000
COGS
$ 120,000
Inventory
$ 120,000
To adjust for overstated inventory (inventory observation)
Inventory
$ 100,000
Equipment
$ 85,000
Utilities expenses
$ 100,000
Accounts payable
$ 285,000
To adjust for unrecorded expenditures at year end (bank reconciliation)
Totals
Materiality threshold
Adjustment
$
Income
before Tax
$
95,000
$
$
(60,000)
35,000
$
120,000
$
100,000
$
700,000 $
No
290,000
500,000
No
35,000
$
120,000
$
(100,000)
$
(85,000)
$
(285,000)
$
90,000 $ (85,000) $ (285,000) $
$ 1,500,000 $ 1,000,000 $ 1,000,000 $
No
No
No
800,000 $
No