LECTURE 1 Logistics & Introduction to Auditing and Assurance Engagements

 Refer to course information distribution during lecture 1  Adhere to the course information closely  Some lecture notes and/or other reading materials will be uploaded to e-learning site  Tutorial arrangements  Assignment arrangements

CAEA 2218 :LECTURE 1 Slide 2

Lecture Program
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Introduction to Auditing Overview of financial statement audits Materiality and audit risks Audit evidence procedures Audit planning and tests Internal control review Auditing the revenue cycle Auditing the purchasing cycle Auditing the inventory cycle Auditing cash Auditing property plant and equipment Auditing long term liabilities, shareholder’s equity & income statement items 13. Auditing payroll cycle
CAEA 2218 LECTURE 1 Slide 3

Definition of an audit
A systematic process of objectively gathering and evaluating evidence in order to ascertain whether assertions about economic actions and events made by individuals or organizations correspond with establish criteria and communicating the results of the examination to users of the reports in which assertions are made (American Accounting
Association, the association of US accounting academics)

CAEA 2218 LECTURE 1 Slide 4

Distinction between accounting and auditing
Accounting: identifies, organises, classifies,
summarises and communicates information about economic events – a creative process

Auditing: gathers and evaluates evidence with
respect to the accounting /economic events – an evaluative process

CAEA 2218 LECTURE 1 Slide 5

though the external auditor may draw upon the results of internal audits. External audit are primarily for the benefit of shareholders and market efficiency. Internal audits: traditionally undertaken by company’s own staff or auditing firms different from main auditor. CAEA 2218 LECTURE 1 Slide 6 .Classification of audit by their beneficiaries External audits: undertaken by professionally qualified and externally accredited auditors who are external to the audited business – Big 4 and many other smaller audit firms. Principally for the benefit of management.

Classification of audit by their objectives : (1) Certification audits: involve the examination of an entity’s financial statement which have been prepared by the entity’s management and directors for the benefit of shareholders and other interested parties (2) Compliance audits: aim to determine whether an individual or an entity has acted in accordance with procedures/regulations set by an autority (eg. parent company ) (3) Operational audits: involve the systematic examination and evaluation of an entity’s operations for the purpose of improving the efficiency and/or effectiveness of the entity. This has become known in the public sector as ‘value for money’ or VFM audits – NKRA – national key results area CAEA 2218 LECTURE 1 Slide 7 . tax authority.

. SysTrust) Other Assurance Services CAEA 2218 LECTURE 1 Slide 8 . Attestation. and Nonassurance Services ASSURANCE SERVICES ATTESTATION SERVICES Audits Reviews Certain Management Consulting Internal Control over Financial Reporting Other Attestation Services (e. WebTrust.Assurance.g.

Attestation.Assurance. and Nonassurance Services NONASSURANCE SERVICES Other Management Consulting Certain Management Consulting Accounting and Bookkeeping Tax Services CAEA 2218 LECTURE 1 Slide 9 .

Types of Auditors  Independent certified public accounting firms  Governmental general accounting office auditors  Internal Revenue agents  Internal auditors CAEA 2218 LECTURE 1 Slide 10 .

massive extension of breadth and coverage of the notion of audit.  From 1990s. Controversy about whether too many people watching rather than doing. particularly affects public sector but is much more general than that CAEA 2218 LECTURE 1 Slide 11 .“The Audit Society” Michael Power  Certification audits or financial statement audit has always been regarded as a low-profile activity  In the public sector. Some connection to the withdrawal of government from production – eg. this activity sat alongside “regularity” (spent according to the authorisation) and “propriety” (proper standards. denationalization of utilities and substitution of regulation for ownership. growth of Value for Money or “performance auditing”. relevant to the use of public money have been met).  From 1980s.

The Role of Auditing CAEA 2218 LECTURE 1 Slide 12 .

and (ii) doubts about auditees’ solvency CAEA 2218 LECTURE 1 Slide 13 .Audit objectives :  Lending credibility to financial and non-financial information provided by management in annual reports  Provision of management advisory services  Increased responsibility for detecting fraud and reporting doubts about “going concern”  Helping to secure responsible corporate governance  Reporting to regulatory authorities on (i) fraud detected during audit.

e-business environment CAEA 2218 LECTURE 1 Slide 14 . its industry and especially its’ risks.Identification of audit risk through analytical review  Adaptation of auditing to the e-commerce. its business.Audit techniques:  Emergence of audit methodologies focusing on clients’ business risk (risk of auditees not meeting their objectives)  Audit based on : .A thorough understanding of the client. and .

Relationships Among Auditors. and External Users Client or audit committee hires auditor Auditor issues report relied upon by users to reduce information risk Auditor Provides capital Client Client provides financial statements to users External Users CAEA 2218 LECTURE 1 Slide 15 . Client.

Overview of the Financial Statement Audit Process CAEA 2218 LECTURE 1 Slide 16 .

A need for theory:  A practical subject. ‘wholly utilitarian’  Practice has developed without theory  Public conception has evolved without theory CAEA 2218 LECTURE 1 Slide 17 .

assumptions : (a) rational utility maximisers.politicians also demand audits for similar reasons. eg.audit serve as an insurance for managers (agents). (b) information asymmetry . to escape criticism in cases of failures CAEA 2218 LECTURE 1 Slide 18 .therefore auditors act as watchdog over the agents (directors) (2) INFORMATION HYPOTHESIS .Can theory explain the existence of financial statement audit: (1) AGENCY THEORY .Agency relationship : a contract under which one or more persons (principal) engage another person (agent) to perform some service on their behalf which involves delegating some decision making authority to the agent .an audit improves the quality of financial information (3) INSURANCE HYPHOTHESIS . managers shift responsibility for reported data to auditors and thus they lower the expected loss from litigation .

changing nature of auditor’s responsibility for detection of fraud .Audit Expectations Gap • A gap between what the public expects or needs and what the auditors can and should reasonably expect to accomplish • Consider both perception of roles and ignorance gap • Sources of expectation gap . going concern debate .Audit assurance: guarantee of accuracy versus a probabilistic statement.Audit reporting: perception of unqualified (clean) audit opinion.Audit independence: the centre of gap CAEA 2218 LECTURE 1 Slide 19 .

Social Role of Auditing • “To add credibility to financial statements” (Mautz. 1975) • Necessary for public to understand exactly what an audit can reasonably be expected to achieve • Necessary that all relevant findings are communicated clearly CAEA 2218 LECTURE 1 Slide 20 .

In the absence of clear evidence to the contrary. There is no conflict of interest between the auditor and management of the enterprise under audit 3. The existence of a satisfactory system of internal control eliminates the probability of irregularities 5. Consistent application of GAAP will results in the fair presentation of the financial position and the results of operations 6. The professional status of the independent auditor imposes commensurate obligations CAEA 2218 LECTURE 1 Slide 21 . When examining financial data for the purpose of expressing an independent opinion.8 postulates about auditing (Mautz & Sharaf) 1. the auditor acts exclusively in the capacity of auditor 8. Financial statements and financial data are verifiable 2. what has held true in the past for the enterprise under examination will hold true in the future 7. The financial statements and other information submitted for verification are free from collusive and other unusual irregularities 4.

Independence 5. Ethical conduct CAEA 2218 LECTURE 1 Slide 22 . Due audit care 3.The 8 postulates led to 5 primary concepts of auditing 1. Evidence 2. Fair presentation 4.


independence .adequate technical training & proficiency .GAAP .adequate planning & supervised assistants .Auditing Standards  serve as guidelines and measures quality of the auditors performance  GAAS – generally accepted auditing standards: (1) General standards .due professional care (2) Fieldwork standards .obtain sufficient appropriate evidential matter (3) Reporting standards .obtain sufficient understanding of internal controls .consistency .disclosure .opinion CAEA 2218 LECTURE2-2Slide 2 2 .

GAAS CAEA 2218 LECTURE2-3Slide 3 2 .

Management asserts that transactions related to inventory actually occurred (2) Account balances .Management asserts that the financial statements properly classify and present the inventory CAEA 2218 LECTURE2-4Slide 4 2 .Management asserts that the entity owns the inventory represented in the inventory account (3) Presentation and disclosures .Management Assertions  Financial statements issued by management contain explicit and implicit assertions (1) Transactions .

Management Assertions CAEA 2218 LECTURE2-5Slide 5 2 .

Evidence Regarding Management Assertions & Sampling  Evidence that assists the auditor in evaluating management’s financial statement assertions consists of the underlying accounting data and any corroborating information available to the auditor:  RELEVANCE.  RELIABILITY  Sampling: inferences based on limited observations  Auditors use (1) their knowledge about the transactions and/or (2) a sampling approach to examine the transactions. CAEA 2218 LECTURE2-6Slide 6 2 .  It would be too costly for the auditor to examine every transaction.

and Illegal Acts  The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. the auditor is able to obtain reasonable. but not absolute. Fraud. that are not material to the financial statements will be detected CAEA 2218 LECTURE2-7Slide 7 2 . assurance that material misstatements are detected  The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements.The Auditor’s Responsibility for Errors. whether caused by errors or fraud. whether caused by error or fraud  Because of the nature of audit evidence and the characteristics of fraud.

and the Code of Professional Conduct  Ethics refers to a system or code of conduct based on moral duties and obligations that indicates how we should behave  Professionalism refers to the conduct.Ethics. or qualities that characterize or mark a profession or professional person. Independence. aims. All professions operate under some type of code of ethics or code of conduct CAEA 2218 LECTURE2-8Slide 8 2 .

business strategies etc)  Audit risk is the risk that the auditor will give an inappropriate audit opinion on financial statements:  Risk of material error occuring  Inherent risk  Internal control risk  Risk of failing to detect material error  Sampling risk  Quality control risk  The auditor’s standard report states that the audit provides only reasonable assurance that the financial statements do not contain material misstatements  Reasonable assurance implies some risk that a material misstatement could be present in the financial statements and the auditor will fail to detect it CAEA 2218 LECTURE2-9Slide 9 2 . operations.Clients’ Evaluation & Audit Risk  In conducting audit. relationships. the auditors need thorough understanding of the entity and its environment ( clients industry. regulations.

Principles of External Auditing. John Wiley & Sons Ltd CAEA 2218 LECTURE2-10 10 2 Slide . 2nd Ed. 2003.3 The Component of audit risk Brenda Porter.Client’s Evaluation & Audit Risk AUDIT RISK (the risk of expressing an unqualified opinion on materially misstated financial statements) risk of material error occuring (non-controllable) risk of failing to detect material error (controllable) Inherent risk Internal control risk Sampling risk Quality control risk Management integrity Account risk Business risk Failure to collect sufficient appropriate audit evidence and/evaluate it properly FIGURE 3. Jon Simon and David Hatherly.

Clients’ Evaluation & Audit Risk  Inherent risk – susceptibility of account balance/class of transactions to material misstatement  Control risk – that a misstatement could occur that could be material. either on its own or together with other misstatements. review the  Control environment  Control procedures  Managing risk and control monitoring  Detection risk – that a misstatement would not be detected which might be material either on its own. that would not be detected or prevented by accounting and internal control procedures. or when aggregated with other misstatements CAEA 2218 LECTURE2-11 11 2 Slide .

in light of surrounding circumstances.Materiality  Materiality is the magnitude of an omission or misstatement of accounting information that. makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement  (material if its omission would reasonably influence decisions)  Not capable of general mathematical definition  Has qualitative and quantitative elements CAEA 2218 LECTURE2-12 12 2 Slide .

Risk-based auditing  Concentrating audit procedures on the areas of the client’s systems/records that are likely to be at most risk of error. misstatement or fraud  Needs some decision criteria to determine the acceptable level of risk CAEA 2218 LECTURE2-13 13 2 Slide .

both about auditee and auditors:  What does a new appointment show?  What does an unexpected ‘exit’ show?  Auditors’ rights  Access to the company’s books and accounts  Explanation from the company’s management CAEA 2218 LECTURE2-14 14 2 Slide . media and stakeholders.Legal and professional rights and duties  Who can be an auditor? • Appointment and remuneration of auditors  in theory  in practice • Removal and resignation of auditors  May resign or be replaced  Disclosure of circumstances  ‘Signals’ that are given to the market.

Auditors rights and responsibilities  Auditors’ rights  Access to the company’s books and accounts  Explanation from the company’s management  Auditors’ responsibility to detect and report fraud. which includes  Misappropriation of corporate assets  Manipulation of accounting information  Deception of a third party CAEA 2218 LECTURE2-15 15 2 Slide .

auditors received all the information/explanation required. COMMON LAW – courts’ cases explain expectation from auditors such as reasonable skill. care. caution in the circumstances 3. compliance with corporate governance requirements CAEA 2218 LECTURE2-16 16 2 Slide . PROFESSIONAL AUDITING STANDARDS AND G’LINES – informing/increasing the quality of audit work – protecting the reputation of auditors – shielding auditing from further government involvement – mandatory compliance: disciplinary action may be taken by the profession (self regulation) 4. F/S are in agreement with the accounting records. REGULATORY REQUIREMENTS – requirements for listed companies. STATUTORY DUTIES – Companies Act • Carry out investigation and form opinion as to whether proper accounting records have been kept. the received explanation/information is consistent with the F/S • Under the Companies Acts. directors are required to prepare F/S which give a true and fair view of the company’s state of affairs 2.Auditors’ duties 1.

care. diligence Courtesy and consideration CAEA 2218 LECTURE2-17 17 2 Slide . Integrity Objectivity Competence Skill. 2. 5.Rules of professional conduct 1. 4. 3.

5. 9. 2. Accountability Integrity Objectivity and independence Competence Rigour Judgement Clear communication Association Providing value CAEA 2218 LECTURE2-18 18 2 Slide . 4. 7. 6.9 Fundamental principles of independent auditing (Auditors’ Code –APB. 8. 1996) 1. 3.

Objectivity and independence INDEPENDENCE: the cornerstone of auditing. an attitude of mind not a set of rules • Auditors need to be independent (in fact) • Possess an objective unbiased attitude of mind. evaluate evidence and express an opinion impartially without being influenced by personal bias • And must also be seen to be independent (in appearance) not to give the impression to others that the auditor is not independent CAEA 2218 LECTURE2-19 19 2 Slide .

Threats to auditors’ independence     Financial involvement with the audit client Personal or business relationship Favorable treatment from an audit client Litigation and other external pressures on the auditor  Undue dependence on the audit client  Provision of non-audit services to an audit client CAEA 2218 LECTURE2-20 20 2 Slide .

Threats to objectivity and independence       Self-interest threat Self review threat Management threat Advocacy threat Familiarity threat Intimidation threat Ethical standards have been issued to promote alertness and define procedures to identify and assess significance of threats CAEA 2218 LECTURE2-21 21 2 Slide .

Appointment of auditors by shareholder/stakeholder panel 4. Mandatory rotation of auditing firm 2. advertising. Appointment of auditors by the government Other professional conduct issues – conflict of interests.Proposal for strengthening independence 1. Mandatory rotation of audit partner 3. money laundering. remuneration. More vigorous Audit Committees 5. publicity. insider dealing. whistle-blowing CAEA 2218 LECTURE2-22 22 2 Slide .

Client acceptance/continuance. and establishing an understanding with the client 2. Establishing materiality and assess risks 4. Evaluate results and issue audit report CAEA 2218 LECTURE2-23 23 2 Slide . Audit business processes and related accounts 7. Preliminary engagement activities 3. Plan the audit 5. Complete the audit 8. Consider and audit company’s internal control 6.Audit phases 1.

although he/she should be aware that other interested parties/stakeholders will use the report  The report communicates the auditor’s conclusion about. and  Their compliance (or otherwise) with the Companies Act CAEA 2218 LECTURE2-24 24 2 Slide . auditor is statutorily required to report to the company’s shareholders.Audit Report  The auditor’s report (audit opinion) is the culmination of audit process  For companies. among other things:  The truth and fairness with which the statements portray the entity’s financial position.

Audit Report  The auditor is also required to communicate with those charged with the company’s governance. and  Ways in which such control weaknesses may be overcome  This communication is often referred to as a management letter (ML)  ML normally focused exclusively on internal control weaknesses and how they might be rectified  Current practices of ML is broader in scope.  Various aspects of the entity’s financial affairs. material weaknesses in entity’s control system uncovered by the audit. but maintain a private communication with the management and contents are not generally revealed to shareholders or other third parties CAEA 2218 LECTURE2-25 25 2 Slide .  Material weaknesses in entity’s financial affairs. Will address:  Various aspects of the audit.

content and notes Audit report usually is the only channel of communication between the auditor and shareholders of the company – the financial statements of which have been subject to audit The report acts as a bridge taking the large volume of information possessed by auditors and conveying it to the shareholders in a much abbreviated form In order to convey information in a succinct form. the directors’ are responsible for preparing financial statements.Audit Report Under the Companies Act 1965. and its requirements indicate the issues auditors must look at to determine the type of audit report they will give. each of which has special significance. and whether they comply with the provisions of the Act as regards form. They are required to form and express an opinion as to whether they give a true and fair view of the company’s state of affairs and its profit or loss for the period of account under consideration. Any deviation from the standard format is regarded by auditors as significant and may provide important extra data CAEA 2218 LECTURE2-26 26 2 Slide . and The auditors have responsibility of examining the financial statements. the audit report has become an extremely formalised group of phrases.

although the opinion is unqualified. it may be relevant to include additional details emphasizing one particular aspect of the financial statements AUDITOR CANNOT ‘GUARANTEE’ OR CERTIFY THAT FINANCIAL STATEMENTS ARE CORRECT. CAEA 2218 LECTURE2-27 27 2 Slide .  The situation where a qualified audit report is needed and how such report should be phrased.Audit Report  Auditors have to understand the following details:  The form of an unqualified report and the meaning of the phrases used.  The situation where.

Qualified/modified (‘except for’ opinion.Audit Report  If financial statements are found to meet the necessary regulatory requirements and other requirements. ‘adverse opinion’. CAEA 2218 LECTURE2-28 28 2 Slide . and provide a true and fair view. Unqualified/unmodified (i. or 2. and ‘disclaimer of opinion’). the auditor may not have problem – but if they do not meet the requirements or are in some other respect deemed by their auditors flawed or inadequate.. the extent of that problem must be gauged in terms of the effect it will have on their overall opinion  Auditors opinion on financial statements may be one of two basic types: 1.e. ‘clean’).

and the date of the audit report. a scope paragraph –or basis of CAEA 2218 LECTURE2-29 29 2 Slide .The Audit Report  The title line of the audit report includes the word “Independent. statement of responsibilities of directors and auditors. the report is addressed to the stockholders of the company.” and usually. an explanatory paragraph referring to the audit of internal control. the name of the auditor or audit firm.Refer to auditors’ reports that come together with companies annual reports – you could search annual reports for listed companies in Malaysia via www. auditors signature. introductory paragraph. .  Basic elements of the audit report include title. an opinion paragraph.

indicating that the financial statements are not fairly stated and should not be relied upon. CAEA 2218 LECTURE2-30 30 2 Slide .  Suppose a client’s financial statements contain a misstatement that the auditor considers so material that it pervasively affects the interpretation of the financial statements. Given such a situation.  Suppose a client’s financial statements contain a misstatement that the auditor considers material and the client refuses to correct the misstatement.The Audit Report  The auditor may issue a qualified opinion.  The auditor may issue an adverse opinion. explaining that the financial statements are fairly stated except for the misstatement identified by the auditor. The auditor will likely qualify the report. the auditor will issue an adverse opinion.


Jon Simon and David Hatherly. Principles of External Auditing.3 The Component of audit risk Brenda Porter. John Wiley & Sons Ltd CAEA 2218 . 2003. 2nd Ed.Client’s Evaluation & Audit Risk AUDIT RISK (the risk of expressing an unqualified opinion on materially misstated financial statements) risk of material error occuring (non-controllable) risk of failing to detect material error (controllable) Inherent risk Internal control risk Sampling risk Quality control risk Management integrity Account risk Business risk Failure to collect sufficient appropriate audit evidence and/evaluate it properly FIGURE 3.LECTURE 3 Slide 2 -30 .

non-sampling risk.LECTURE 3 Slide 3 -30 .Engagement Risk  Auditor’s exposure to financial loss and damage to professional reputation.  Client and 3rd party lawsuits  Negative publicity  Audit Risk Model : Audit Risk = IR × CR × DR  Inherent risk and control risk are risks that material misstatements exist  Detection risk is risk that auditor fail to detect misstatements which include sampling risk. inappropriate audit procedures or misinterpreting audit results CAEA 2218 .

AR = IR × CR Auditee risk × DR CAEA 2218 . Assess the risk of material misstatement due to error or fraud.Using the Audit Risk Model Assess the client’s business risks.LECTURE 3 Slide 4 -30 .

Use the audit risk equation to solve for the appropriate level of detection risk: AR = IR × CR × DR  DR = AR / (IR × CR) Auditors will calculate measures of audit risk and use the identified level to design audit procedures that could will reduce audit risk to an acceptable level.Using the Audit Risk Model  Set a planned level of audit risk such that an opinion can be issued on the financial statements. CAEA 2218 .  Assess inherent risk and control risk.LECTURE 3 Slide 5 -30 .

Limitations of the Audit Risk Model  The audit risk model is a planning tool. CAEA 2218 .  There is not way of knowing what the preliminary level of risk actually was.LECTURE 3 Slide 6 -30 .  The desired level of audit risk may not actually be achieved. but it has some limitations that must be considered when the model is used to revise an audit plan or to evaluate audit results.  It does not consider potential auditor error.

analytical procedures.LECTURE 3 Slide 7 -30 . and forces that bear on the entity’s ability to survive and generate profit STEPS  Perform risk assessment to obtain understanding of the entity and its environment. including internal control.  Identify business risks that may result in material misstatements of the financial statements.Business risks include any external or internal factors.  Assess the risk of material misstatement at the assertion level and determine the audit procedures that are necessary based on that risk assessment. observation and inspection CAEA 2218 .  Evaluate the entity’s response to those business risks and obtain evidence of their implementation. pressures.  METHODS to achieve these would include inquiries of management and others.The Auditor’s Risk Assessment Process .Auditors must obtain sufficient understanding of the entity to identify business risks and comprehend the potential misstatements that may result .

Operations in areas with unstable economies..Identifying Business Risks  Examples of conditions or events that indicate the existence of business risks:        Significant changes in the entity (e.g. Significant changes in the IT environment. Significant changes in the industry. New locations.LECTURE 3 Slide 8 -30 . High degree of complex regulation. services. CAEA 2218 . acquisitions and reorganizations). or lines of business. Significant new products.

and by relating these risks to the classes of transactions and account balances in the financial statements. Considers the likelihood that the risks will result in a material misstatement. including controls that relate to the risks. Considers whether the risks are of a magnitude that could result in a material misstatement.Assessing the Risk of Material Misstatement Due to Error or Fraud To assess the risk of material misstatement. CAEA 2218 .LECTURE 3 Slide 9 -30 . Relates the identified risks to what can go wrong at the assertion level. the auditor: – – – – Identifies risks by considering the entity and its environment.

LECTURE 3 Slide 10 -30 .Assessing the Risk of Material Misstatement Due to Error or Fraud Types of misstatements include: A difference between the amount.  The omission of a financial statement element. or item and the amount. or presentation that would have been reported under GAAP. classification. or item.  The omission of information required to be disclosed in accordance with GAAP. or presentation of a reported financial statement element.  CAEA 2218 .  A financial statement disclosure that is not presented in accordance with GAAP. account. account. classification.

manner of presentation. or disclosure. Unreasonable accounting estimates arising from oversight or misinterpretation of facts.Assessing the Risk of Material Misstatement Due to Error or Fraud Errors are unintentional misstatements:  Mistakes in gathering or processing financial data used to prepare financial statements. classification.   CAEA 2218 . Mistakes in the application of accounting principles relating to amount.LECTURE 3 Slide 11 -30 .

Assessing the Risk of Material Misstatement Due to Error or Fraud Fraud involves intentional misstatements. CAEA 2218 -LECTURE 3 Slide 12 -30 . The fraud risk identification process includes:  Sources of information about possible fraud Communications among the audit team  Inquires of management and others  Fraud risk factors  Analytical procedures  Other information   Conditions indicative of fraud Incentives/pressures  Opportunities  Attitudes/rationalization   Auditor identifies risks of material misstatement due to fraud.

Assessing the Risk of Material Misstatement Due to Error or Fraud Three conditions usually exist when fraud occurs.LECTURE 3 Slide 13 -30 . Incentive or pressure to commit fraud Opportunity to commit fraud Attitude or rationalization to justify fraud CAEA 2218 .

Assessing the Risk of Material Misstatement Due to Error or Fraud Fraud involves intentional misstatements. Fraudulent financial reporting Misappropriation of assets CAEA 2218 .LECTURE 3 Slide 14 -30 .

the financial statements of events.Assessing the Risk of Material Misstatement Due to Error or Fraud Fraudulent financial reporting includes acts such as the following: Manipulation. or intentional omission from. manner of presentation. falsification.  CAEA 2218 .  Misrepresentation in. transactions.  Intentional misapplication of accounting principles relating to amount. or significant information. or alteration of accounting records or supporting documents used to prepare financial statements. classification. or disclosure.LECTURE 3 Slide 15 -30 .

LECTURE 3 Slide 16 -30 .Assessing the Risk of Material Misstatement Due to Error or Fraud Fraudulent Financial Reporting Risk Factors Relating to Incentive/Pressure include: Excessive pressure for management to meet third party expectations Excessive pressure for management to meet financial targets Financial stability or profitability is threatened Management’s personal financial situation is threatened CAEA 2218 .

LECTURE 3 Slide 17 -30 .Assessing the Risk of Material Misstatement Due to Error or Fraud Fraudulent Financial Reporting Risk Factors Relating to Opportunities include: Nature of the industry Complex or unstable organizational structure Ineffective monitoring of management Deficient internal control CAEA 2218 .

Risk Factors Relating to Attitudes/Rationalizations Fraudulent Financial Reporting Risk Factors Relating to Attitudes/Rationalizations include: Use of inappropriate accounting based on materiality Poor communication channels for reporting inappropriate behavior Failure to correct known reportable conditions Weak ethical standards for Management behavior CAEA 2218 -LECTURE 3 Slide 18 -30 .

Examples include: Stealing assets Paying for goods and services not received Embezzling cash received CAEA 2218 .LECTURE 3 Slide 19 -30 .Assessing the Risk of Material Misstatement Due to Error or Fraud Misappropriation of assets involves the theft of an entity’s assets to the extent that financial statements are misstated.

LECTURE 3 Slide 20 -30 . valuable inventory items Sudden changes in employee behavior CAEA 2218 .Assessing the Risk of Material Misstatement Due to Error or Fraud Misappropriation of Assets Risk Factors for Misappropriation of Assets include: Access to assets Inadequate separation of duties Lack of inventory control Employee disregard of internal control Adverse employee management relationships No mandatory vacation policy Personal financial pressures Small.

Assess the risk of material misstatement for the nonsignificant risks. Respond to significant risks.Auditor’s Response to the Risk Assessment Assess the risk of material misstatement at the financial statement and assertion levels. CAEA 2218 . Is this a significant risk? Yes Respond to those risks. Yes Do these risks relate pervasively to the financial statements? Determine what can go wrong at the account or assertion level. Financial statement level risks Assertion level risks Develop an overall response.LECTURE 3 Slide 21 -30 .

the auditor should consider whether the accumulated results of audit procedures affect the assessments of the entity’s business risk and the risk of material misstatement. If the management does not do so. If the auditor concludes that the total misstatements cause the financial statements to be materially misstated. the auditor should: CAEA 2218 -LECTURE 3 Slide 22 -30 . The total uncorrected misstatements that were detected should be aggregated to determine if they cause the financial statements to be materially misstated. the auditor should issue a qualified or adverse opinion. the auditor should request management to eliminate the material misstatement. and either has determined that the effect could be material or has been unable to evaluate whether the effect is material.  If the auditor determines that the misstatement is or may be the result of fraud.Evaluation of Audit Test Results  At the completion of the audit.

the auditor should consider withdrawing from the engagement and communicating the reasons for withdrawal to the audit committee or others with equivalent authority and responsibility. If appropriate. Consider the implications for other aspects of the audit. if so. material fraud has occurred and. its effect. CAEA 2218 .LECTURE 3 Slide 23 -30 . in fact. Discuss the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved in committing the fraud and with senior management.  If the results of the audit tests indicate a significant risk of fraud.Evaluation of Audit Test Results     Attempt to obtain audit evidence to determine whether. suggest that the client consult with legal counsel.

the audit committee. Fraud risks or other conditions that result in additional audit procedures. and others.LECTURE 3 Slide 24 -30 . Procedures performed to identify and assess the risks of material misstatement due to fraud. CAEA 2218 . Risks of identified material misstatement due to fraud and a description of the auditor’s response to the risks. The nature of the communications about fraud made to management.Documentation of the Auditor’s Risk Assessment The auditor should document: Discussions among engagement personnel.

that matter should be brought to the attention of an appropriate level of management.  The auditor should reach an understanding with the audit committee regarding the expected nature and extent of communications about misappropriations perpetrated by lower-level employees.Communications about Fraud  Whenever the auditor has found evidence that a fraud may exist.LECTURE 3 Slide 25 -30 . Fraud involving senior management and fraud that causes a material misstatement of the financial statement should be reported directly to the audit committee of the board of directors. CAEA 2218 .

However.Communications about Fraud  The disclosure of fraud to parties other than the client’s senior management and its audit committee ordinarily is not part of the auditor’s responsibility and ordinarily would be precluded by the auditor’s ethical and legal obligations of confidentiality.LECTURE 3 Slide 26 -30 . the auditor may have a duty to make disclosure to others outside the entity when the following conditions exist:  To comply with certain legal and regulatory requirements  To a successor auditor when the successor makes inquiries in accordance with the standards [Communications between Predecessor and Successor Auditors]  In response to a subpoena  To a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance CAEA 2218 .

its determination requires professional judgment.LECTURE 3 Slide 27 -30 . CAEA 2218 .Materiality  The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.  Materiality is not an absolute.

high fraud risk. control weaknesses. total revenues. management turnover. income from continuing operations.Materiality  The quantitative base for materiality is a percentage (typically 3 to 5 percent) of: total assets. high market pressures. three-year average of income before taxes  The quantitative amounts may be adjusted lower for qualitative factors such as: first-year engagement. gross profit.LECTURE 3 Slide 28 -30 . income before taxes. higher than normal risk of bankruptcy CAEA 2218 .

LECTURE 3 Slide 29 -30 .Steps in Applying Materiality on an Audit Step 1: Determine a material level for the overall financial statements (planning materiality) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 3: Evaluate auditing findings (near the end of the audit) CAEA 2218 .

2nd Caliph CAEA 2218 -LECTURE 3 Slide 30 -30 . ‘are those who know equal to those who do not know?’" [The Quran. Verse 9] “only those who have knowledge among His slaves fear Him" [The Quran. Chapter 39(Az-Zumar ). Verse 28] "What I fear most for you is a hypocrite with a knowledgeable tongue. Chapter 35(Faatir).“ Umar bin Al-Khattab.“say.


24 Audit procedures .Relationship of Audit Evidence to the Audit Report Financial statements Audit report Management assertions about components of financial statements Evidence on the fairness of the financial statements CAEA 2218 .LECTURE 4 Slide 2 .

LECTURE 4 Slide 3 . 4. 2.24 . Existence or occurrence Completeness Valuation or allocation Rights and obligations Presentation and disclosure CAEA 2218 .Management Assertions 1. 5. 3.

Transactions related audit objectives
• Existence – recorded transactions exists • Completeness –existing transactions are recorded • Accuracy –recorded transactions are stated at correct amounts • Classification –transactions are properly classified • Timing –transactions are recorded on the correct date • Posting and summarization –transactions are included in the master files and are correctly summarized
CAEA 2218 - LECTURE 4 Slide 4 - 24

Management assertions Transactions related audit objectives
1- Existence or occurence – Existence 2- Completeness – Completeness 3- Valuation or allocation –Accuracy; Classification; Timing; Posting and Summarization 4- Rights and Obligations – na 5- Presentation and disclosure – na

CAEA 2218 - LECTURE 4 Slide 5 - 24

Balance – related audit objectives
1- Existence – amount included exists 2- Completeness – existing amounts are included 3- Accuracy – amounts included are stated at the correct amounts 4- Classification –amounts are properly classified 5- Cutoff –transactions are recorded in the proper period 6- Detail tie in –account balances agree with master file amounts, and with general ledger 7- Realizable value –assets are included at estimated realizable value 8- Rights and obligations –assets must be owned 9- Presentation and disclosure –account balances and disclosures are presented in financial statements
CAEA 2218 - LECTURE 4 Slide 6 - 24

Management assertions – Balance related audit objectives
1- Existence or occurence – Existence 2- Completeness – Completeness 3- Valuation or allocation –Accuracy; Classification; Cut-off; Detail tie-in; Realizable value 4- Rights and Obligations – Rights and obligations 5- Presentation and disclosure – Presentation and disclosure
CAEA 2218 - LECTURE 4 Slide 7 - 24

How audit objectives are met?
• Auditor must obtain sufficient competent audit evidence to support all management assertions in the financial statements • Audit process –a methodology for organizing audit • Audit procedures –specific acts performed by the auditor to gather evidence to determine if specific assertions are being met :  Risk assessment procedures  Test of controls  Substantive procedures
CAEA 2218 - LECTURE 4 Slide 8 - 24

Examine sales invoices immediately before and after year-end for proper cutoff.24 . Evaluate receivables for footnote disclosure. Rights and Obligations Ask if receivables have been sold. Valuation or allocation Trace accounts from aged trial balance to subsidiary accounts. Presentation and disclosure Look for amounts due from related parties. CAEA 2218 . Test the adequacy of the allowance account. Completeness Agree controlling account with total of subsidiary accounts.  Example: Audit Program for Accounts Receivable Management Assertions Audit Procedures Existence Confirm receivables.LECTURE 4 Slide 9 .Audit Procedures  A set of audit procedures prepared to test assertions for a component of the financial statements is referred to as an audit program.

Audit Evidence
“Auditors should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusion on which to base the audit opinion.” SAS 400.1 “the facts presented to the mind of a person for the purpose of enabling him to decide a disputed question.” Mautz (1958) “the information the auditors obtain in arriving at the conclusions in which their report is based- comprises of source documents and accounting records underlying the financial statement assertions and corroborative information from other sources” APB Glossary of Terms
CAEA 2218 -LECTURE 4 Slide 10 - 24

Audit Evidence
 All the information used by the auditor in arriving at the conclusions on which the audit opinion is based.  Nature of audit evidence  records of initial entries and supporting records;  general and subsidiary ledgers;  adjustments to financial statements;  invoices;  worksheets;  contracts;  spreadsheets supporting cost allocations;  other computations, reconciliations and disclosures

CAEA 2218 - LECTURE 4 Slide 11 - 24

Audit Evidence
 Usually is pervasive rather than conclusive, to be sought from different sources or of different nature to support same assertions  Comprises information and impressions accumulated during course of the audit which, taken together, allow the auditor to form an opinion  Audit evidence is influenced by: • Assessment of risk at F/S level and individual account • Nature of accounting and internal control systems • Materiality of the item • Timeliness of information provision • Relevance • Auditors’ knowledge and experience of the business • Findings from audit procedures • Source and reliability of the information (independent? third party expert? Qualifications of provider?
CAEA 2218 - LECTURE 4 Slide 12 - 24

Audit Evidence
 Sufficiency is a measure of the quantity of audit evidence:  Greater risk of misstatement requires higher quantity of audit evidence  Higher quality of audit evidence results in a lower quantity of audit evidence  Appropriateness is a measure of the quality of audit evidence – relevance & reliability:  Independence source of the evidence  Effectiveness of internal control  Auditors direct personal knowledge  Documentary evidence  Original documents
CAEA 2218 - LECTURE 4 Slide 13 - 24

Audit Evidence
 Evaluation of audit evidence requires and understanding of the types and relative reliability of available evidence  Auditor should be thorough in searching for evidence and not biased in its evaluation  Procedures in obtaining evidence includes:
            Inspection of records and documents Calculate and Recalculation Reconciliations Vouch; Read; Trace Examining Inquiry Scanning Confirm; Compare (analytical data) Observation Inspection of tangible assets – physical evidence Analytical procedures Re-perform (of procedures)
CAEA 2218 - LECTURE 4 Slide 14 - 24

not least because audits have to be competitively tendered for and audit firm is profit-seeking Reliability of evidence High . confirmation.Audit Evidence  Mautz and Sharaf (1961) classified evidence into 3 classes: (i) natural evidence.inspection of tangible assets. (ii) created evidence.LECTURE 4 Slide 15 . (iii) rational argumentation  Auditors have to consider the ‘relationship between the cost of obtaining audit evidence and the usefulness of the information obtained’ – because resources at the disposal of auditors are limited. inquiry CAEA 2218 .scanning.24 . recalculation. analytical procedures Low – observation. re-performing. inspection of records and documents Medium .

Combining Evidence Go beyond simple analysis to the implications of what found Look for relationships of cause and effect among variables Analytical tasks Understanding the knowledge of how things hang together Speculate or infer what the differences and similarities mean How things within a topic relate to each other Look for similarities. difference and the implications CAEA 2218 .LECTURE 4 Slide 16 .24 .

24 . CAEA 2218 .Audit Procedures for Obtaining Audit Evidence Vouching (Occurrence) Source Documents Ledger Tracing (Completeness) Inspection of records and documents Evidence obtained from external documents is more reliable than evidence obtained from internal documents.LECTURE 4 Slide 17 .

• Evaluate the response.Audit Procedures for Obtaining Audit Evidence Inspection of records and documents In conducting inquiry. and qualifications of the person to be questioned. responsibility. • Consider the reactions and responses. • Ask clear. • Listen actively and effectively.LECTURE 4 Slide 18 . experience. objectivity.24 Inquiry . CAEA 2218 . then ask follow-up questions. and relevant questions. the auditor should: • Consider the knowledge. concise. • Use open or closed questions appropriately.

24 .LECTURE 4 Slide 19 .Audit Procedures for Obtaining Audit Evidence Inspection of records and documents Inquiry Information Frequently Confirmed by Auditors Cash balance Accounts receivable Inventory on consignment Accounts payable Bonds payable Common stock outstanding Insurance coverage Collateral for loans Source of Confirmation Bank Individual customers Consignee Individual vendors Bondholders/trustee Registrar/transfer agent Insurance company Creditors Confirmation CAEA 2218 .

Physical examination of a tangible asset.LECTURE 4 Slide 20 .Audit Procedures for Obtaining Audit Evidence  Recalculation .Review of accounting data to identify significant or unusual items. CAEA 2218 .Determining the mathematical accuracy of documents or records.  Analytical Procedures .  Inspection of Intangible Assets .  Re-perform .The process of watching a process or procedure being performed by others.Evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data.  Scanning .The auditor’s independent execution of procedures or controls that were originally performed as part of the internal control system.24 .  Observation .

Audit documentation (working papers) have two functions:  To provide support for the audit report.24 .and conclusions reached.  To aid in the conduct and supervision of the audit.Audit Documentation The auditor’s principal record of the audit procedures performed. evidence obtained.LECTURE 4 Slide 21 . CAEA 2218 .

timing.Audit Documentation  Audit documentation should:  Demonstrate how the audit complied with auditing and related professional practice standards. as well as dates of the work and reviews CAEA 2218 . evidence obtained and conclusions reached • Determine who performed and reviewed the work.  Include a written audit program detailing auditing procedures necessary to accomplish audit objectives  Enable knowledgeable and experienced reviewer to: • understand the nature.  Show that the underlying accounting records agreed with financial statements.24 . extent and results of audit procedures.LECTURE 4 Slide 22 .

audit report.Audit plan. client’s year end date • Indexing and cross-referencing – notations that provide a trail from financial statements to audit documents • Tick marks – notations made next to work paper items indicating auditor/reviewer actions CAEA 2218 .LECTURE 4 Slide 23 . Chart of accounts. Audit programs. Working papers supporting accounts  Format: • Heading – client name. Accounting manual.Audit Documentation  Audit documentation is normally maintained in two files: • Permanent files . Reclassification journal entries. Organization chart. Internal control documentation. Terms of stock and bond issues. Current financial statements. Minutes of meetings. Important contracts.24 . Prior years’ analytical procedures • Current files . Adjusting journal entries.Corporate charter. Working trial balance. title of the working paper.

Audit Documentation  Audit documentation should be organized so that audit team members and others can find evidence supporting financial statement accounts  All audit documentation is the property of the auditor including documents prepared by clients at auditor’s request  Regulations requires audit documentation to be retained for seven years from the completion date of the engagement CAEA 2218 .24 .LECTURE 4 Slide 24 .

“Wahai orang-orang yang beriman.Jangan berpuasa tanpa agama. puasa diwajibkan ke atas kamu sebagaimana ia telah diwajibkan ke atas umat sebelummu.24 . Jangan beragama tanpa Tuhan. agar (dengan puasa itu) kamu menjadi insan yang bertaqwa” [Al-Baqarah : 185] CAEA 2218 -LECTURE 4 Slide 25 .


‘audit tests’ and ‘audit techniques’ are often used interchangeably with audit procedures CAEA 2218 .Making an important distinction  ‘Audit objectives’ is the object of the auditor’s investigation – it is what the auditor is trying to find out and the purpose for which the audit procedures are performed  ‘Audit procedures’ are methods used to gather audit evidence.LECTURE 5 Slide 2 .

LECTURE 5 Slide 3 .Hierarchy of audit objectives Overall audit objectives Do the financial statements give a true and fair view of the entity’s financial position and performance General audit objectives Are internal controls complied with? Are sales fairly stated Are contingent liabilities disclosed Do the financial statements comply with applicable accounting standards Specific audit objectives Are sales transactions authorized? Are recorded sales transactions valid? Are recorded sales transactions complete? Are sales transactions correctly classified? Are recorded Are sales sales amount transactions correct? recorded in the correct period Brenda Porter. Jon Simon and David Hatherly. John Wiley and Sons Ltd CAEA 2218 . Principles of External Auditing 2nd Edition. 2003.

(ii) Those charged with governance of the entity 10-Re-appointment at company’s AGM CAEA 2218 -LECTURE 5 Slide 4 .Audit Steps 1-Appointment of auditors at AGM 2-Letter of engagement sent to client 3-Gain understanding of the clients – Activities and circumstances 7-Test transactions and account balances 8-Completion and review 4-Overall analytical review 5-Gain understanding of the clients accounting systems and evaluate internal control 6-Test internal control strength through compliance testing 9-Reporting for: (i)Shareholders and external parties.

LECTURE 5 Slide 5 .How Audit Phases relate to Planning Client acceptance or continuance Establish an understanding with the client Preliminary engagements activities Assess risks and establish materiality Plan the audit CAEA 2218 .

5. 4. 3. Inquire of third parties. Consider unusual business or audit risks. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct. Obtain and review financial information. Determine if the firm is independent.near audit completion or after a significant event o Consider conflict over accounting/auditing issues and dispute over fees if there are CAEA 2218 .Accepting / Continuing a client  Accepting a client: 1. 7. Communicate with the predecessor auditor. 2.  Continuing a client: o Evaluate client retention periodically . 6.LECTURE 5 Slide 6 . Determine if the firm has the necessary skills and knowledge.

Arrangement for use of specialists or internal auditor. The engagement letter. 2.  In establishing the terms of the engagement. 3. CAEA 2218 .Establish Terms of the Engagement  The terms of the engagement.LECTURE 5 Slide 7 . and the limitations of the engagement. The internal auditors. Additional services to be provided and arrangements for these services. The audit committee. 2. engagement letter may also include: 1.  The engagement letter formalizes the agreement reached between the auditor and client. the auditor’s responsibilities. three topics must be discussed: 1. should include the objectives of the engagement. management’s responsibilities. which are documented in the engagement letter. 3. Any limitations of ability of the auditor or client.

Internal Auditors CAEA 2218 .LECTURE 5 Slide 8 .

Internal Auditors CAEA 2218 .LECTURE 5 Slide 9 .

o Must pre-approve all audit and non-audit services provided by its auditors. o Must have authority to engage independent counsel. o Directly responsible for overseeing work of any o registered public accounting firm employed by the o company.The Audit Committee  Is a sub-committee to board of directors  No specific requirements for privately held companies  Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of publicly held companies: o Member of board of directors and independent. CAEA 2218 -LECTURE 5 Slide 10 . o Must establish procedures to follow for complaints.

including independence  Assess risks and establish materiality: o Involve use of audit models o Restricts risk at account balance level o Achieve acceptable level of audit risk CAEA 2218 -LECTURE 5 Slide 11 .Preliminary Engagement Activities  Determine requirements of the audit engagement teams.  Assess compliance with ethical requirements.

• Identify related parties. • Assess the possibility of illegal acts. • Conduct preliminary analytical procedures.LECTURE 5 Slide 12 . the auditor should be guided by the results of the risk assessment procedures performed to gain an understanding of the entity.Planning the Audit  “Auditor should plan the audit work so as to perform the audit in an effective manner” (SAS 200)  Ensure that ‘appropriate’ attention is devoted to the different areas of auditing  Ensure that potential problems are identified  Assists in the proper assignment of work to members of the audit team  Coordination of audit work  Ensures that audit performed in efficient and timely manner  Details the audit strategy for conducting the audit  Helps the auditor determine what resources needed to perform the audit work  When preparing the audit plan.  Additional steps: • Assess the need for specialist. • Document Audit Strategy and Plan and Prepare Audit Programs CAEA 2218 . • Consider additional value-added services.

 The presence of complex information technology may require the use of an IT specialist.LECTURE 5 Slide 13 .  The use of an IT specialist is a significant aspect of most audit engagements. CAEA 2218 .Specialists  A major consideration is planning the audit is the need for specialist (AU 336).

LECTURE 5 Slide 14 .Illegal Acts  Direct and material : Consider laws & regulations as part of audit  Material & Indirect : Be aware of its possibility of occurrence and investigate if brought to attention CAEA 2218 .

Related Parties
 Examples from FASB No. 57: “Related Party Disclosure” :
i- Affiliates of the enterprise; ii- Entities using equity method to account for investments; iii- Trusts for benefit of employees; ivPrincipal owners of enterprise; v- Management; vi- Immediate families of the principal owners & management; vii- Other parties that can have significant influence.

 How to Identify Related Parties o Review board minutes. o Review conflict-of-interest
statements. o Review transactions with major customers, suppliers, borrowers, and lenders. o Review large, unusual, or nonrecurring transactions especially at year end. o Review loan agreements for guarantees.
CAEA 2218 - LECTURE 5 Slide 15

Diagram of Planning Process
Control risk Risk assessment Inherent risk

General strategy

Consider testing strategy

Consider types of tests

Prepare audit programs

CAEA 2218 - LECTURE 5 Slide 16

Preliminary Analytical Procedures
 To understand the client’s business and transactions  To identify financial statement accounts likely to contain errors  By understanding the client’s business and identifying where errors are likely to occur, the auditor can allocate more resources to investigate necessary accounts.

CAEA 2218 - LECTURE 5 Slide 17

Additional Value-Added Services
 Auditors who audit public companies are limited in the types of consulting services that they can offer their audit clients. – Tax Planning – System design and integration – Internal reporting – Risk assessment – Benchmarking – Electronic commerce

CAEA 2218 -LECTURE 5 Slide 18

Document Audit Strategy and Plan
 These involves documenting the decisions about audit tests: – Nature – Timing – Extent  The auditor documents how the client is managing its risk (via internal control processes) and the effects of the risks and controls on the planned audit procedures.  Auditors ensure they have addressed the risks they identified by documenting the linkage from the client’s business, objectives, and strategy to the audit plan.  The auditor’s preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor’s substantive tests of the account balances and transactions.

CAEA 2218 - LECTURE 5 Slide 19

Document Audit Strategy CAEA 2218 .LECTURE 5 Slide 20 .

inspection. account balance. observation.LECTURE 5 Slide 21 . and disclosure component of the financial statements. walk through.tests for errors or fraud in individual transactions (ii) analytical procedure.Types of Audit Tests  Risk assessment procedures: – used to obtain an understanding of the entity and its environment. – Involves inquiry. – Includes (i) test of details.obtains evidential matter about particular assertions related to account balances or classes of transactions CAEA 2218 . reperformance  Substantive procedures: – detect material misstatements in a transaction class.  Test of controls: – directed toward the evaluation of the effectiveness of the design and implementation of internal controls. including internal controls.

Tests of Controls CAEA 2218 .LECTURE 5 Slide 22 .

profit margin.percentage of gross profit.Analytical Procedures  Stages of analytical procedures: 1. return on equity  Coverage ratio. Final analytical procedures . quick ratio. Substantive analytical procedures . 2.  Types of analytical procedures – Trend analysis – Ratio analysis:  Short term liquidity ratio. times interest earned – Reasonableness analysis CAEA 2218 .debt to equity.used as an overall review of the financial information in the final review stage of the audit. days outstanding in AR.LECTURE 5 Slide 23 . 3. obtain evidential matter about particular assertions related to account balances or classes of transactions. inventory turnover.receivables (AR) turnover. Preliminary analytical procedures .current ratio. and extent of audit assist the auditor to better understand the business and to plan the nature. ratios of operating cash flow  Activity ratio. return on assets. days of inventory on hand  Profitability ratio.

LECTURE 5 Slide 24 .Substantive Analytical Procedures Decision Process CAEA 2218 .

competitor information. the desired degree of reliance on the substantive analytical procedures. industry publications. This is the most important step in performing analytical procedures. budgets and forecasts. management’s analyses.Substantive Analytical Procedures Decision Process  Develop an expectation is the first step in the decision process for the amount or account balance. and the precision of the expectation. analyst’s reports. Auditing standards require the auditor to have an expectation whenever analytical procedures are used. An expectation can be developed using a variety of information sources such as financial and operating data. the level of disaggregation in the amount being tested.LECTURE 5 Slide 25 .  Compare the expectation to the recorded amount and investigate any differences greater than the tolerable difference  Preliminary analytical procedures differences – not requires corroborating evidence  Final analytical procedures differences – requires corroborating evidence CAEA 2218 .  Tolerable difference’s size depends on the significance of the account.

Audit Testing Hierarchy CAEA 2218 .LECTURE 5 Slide 26 .

Filling the Assurance Bucket CAEA 2218 .LECTURE 5 Slide 27 .

LECTURE 5 Slide 28 .Example of Filling the Assurance Buckets for Each Assertion (Accounts Payable) CAEA 2218 .

End of lecture 5 Translation of Sahih Bukhari: Volume 1. 1) Volume 1." It was asked." (Fateh-al-Bari page 177 Vol. O Allah's Apostle?" He replied by beckoning with his hand indicating "killing. Book 3. and Harj will increase." (Fateh-al-Bari Page 192. (the second is) the one whom Allah has given wisdom (the Holy Qur'an) and he acts according to it and teaches it to others. "(Religious) knowledge will be taken away (by the death of religious scholars) ignorance (in religion) and afflictions will appear. 1) 4-29 . whom Allah has given wealth and he spends it righteously. Number 73: Narrated 'Abdullah bin Mas'ud: The Prophet said. "What is Harj. (The first is) A person. Vol. "Do not wish to be like anyone except in two cases. Book 3. Number 85: Narrated Abu Huraira: The Prophet said.


creating a stronger internal control system. protecting sensitive information relating to customers and business operations and limiting the ability of employees and managers to conduct fraud or embezzlement. CAEA 2218 . management should consult an outside public accounting firm about designing and implementing internal controls.LECTURE 6 Slide 2 . An outside look into company operations will usually find more areas needing internal controls. two of the largest corporate bankruptcies in the history of U.  A major risk with internal controls is who sets up the controls and reviews how the controls work in the daily operations of business operations. although that is not always the case.Internal Control  Internal controls is a company's policy for conducting business in a consistent manner.S. this mindset leads to few or highly ineffective internal controls. Companies that use internal managers or accountants to set up their internal controls process may not take an objective look at the company prior to designing the internal controls.  Public companies are held to a higher scrutiny regarding their internal controls since the passage of the Sarbanes-Oxley Act of 2002. business.  When reviewing company processes and designing internal controls. This results in poor internal controls because internal employees may not believe their company has that many problems. Internal controls should be designed to limit the amount of internal business risk. This legislation was passed after the major accounting frauds found in Enron and WorldCom.

Internal Control  Once internal controls are in place. Companies may set up a system that only reviews business operations as they currently exist.  Once internal controls are in place and management reviews the internal controls for effectiveness. spreading the workload around the company. Inflexible internal controls will require managers to completely rework the internal controls systems for new operations. Companies normally use several managers and supervisors to review the internal control process.  Using multiple levels of company management can also strengthen the review process. they should also review the flexibility of internal controls for gathering and reviewing new information. creating higher operating costs and increasing the time spent on business expansion. leaving internal control reviews at a standstill when assessing their effectiveness. management must be responsible for reviewing the information produced by these controls to ensure the company is operating according to its internal guidelines. not planning for a possible expansion or for growth. allowing several individuals to provide input for eliminating internal control risk.  Managers may not be willing to take on the extra paperwork.  Internal controls may limit a company's ability to take on new operations or expand existing operations if the controls create too many barriers for reviewing new information. CAEA 2218 .LECTURE 6 Slide 3 .

ascertain factors that affect the risk of material misstatement.Internal Control  Internal control plays an important role in how management meets its stewardship or agency responsibilities.LECTURE 6 Slide 4 . and design tests of controls and substantive procedures.  The auditor uses risk assessment procedures to obtain an understanding of the entity’s internal control and uses this understanding to identify the types of potential misstatements.  The auditor needs assurance about the reliability of the data generated by the information system in terms of how it affects the fairness of the financial statements and how well the assets and records of the entity are safeguarded. CAEA 2218 . Management also needs a control system that generates reliable information for decision making.  Proper internal control not only ensures that assets and records are safeguarded but also creates an environment in which efficiency and effectiveness are encouraged and monitored.  Management has the responsibility to maintain controls that provides reasonable assurance that adequate control exists over the entity’s assets and records.

Compliance with laws and regulations  Internal controls pertaining to the preparation of financial statements for external purposes are relevant to an audit. Efficiency and effectiveness of operations 3.Pinpoint the factors that affect the risk of material misstatement CAEA 2218 .Design tests of controls and substantive procedures 3. Reliability of financial reporting 2.  The auditor should obtain an understanding of each of the five components of internal control in order to plan the audit. The auditor’s responsibilities for internal control are discussed under two major topics: (1) obtaining an understanding of internal control and (2) assessing control risk.  Controls relating to operations and compliance objectives may be relevant when they relate to data the auditor uses to apply auditing procedures.LECTURE 6 Slide 5 .Internal Control  The auditor’s understanding of the internal control is a major factor in determining the overall audit strategy. This knowledge is used to: 1.  Objectives of internal control: 1.Identify types of potential misstatements 2.

http://www.htm CAEA 2218 .24 of the KLSE Listing Requirements. auditors are required to review the Directors’ Statement on Internal Control with regard to the state of internal control of the listed issuer and report the results thereof to the Board of Directors of the listed issuer (MIA Recommended Practice Guide 5)  Objective of the review by auditors is to assess whether the Statement on Internal Control appropriately reflects processes the Directors (or its committees) have adopted in reviewing the sufficiency and integrity of the internal control system. Auditors will usually perform procedures to obtain appropriate evidence for this review.  The auditors are not expected to actively search for misstatements or Auditors’ responsibility  Pursuant to paragraph 15.mia.LECTURE 6 Slide 6 . however if found/aware –discussion with Directors is necessary to seek to establish the significance of the lack of proper disclosure –auditors should consider implications on their reporting responsibilities and may need to take legal advice should the Directors cannot be persuaded to amend the disclosure to auditors’

Components of Internal Control CAEA 2218 .LECTURE 6 Slide 7 .

Components of Internal Control CAEA 2218 .LECTURE 6 Slide 8 .

Management philosophy and operating style 5.LECTURE 6 Slide 9 . Communication and enforcement of integrity and ethical values 2. A commitment to competence 3. Participation of those charged with governance (board of directors or audit committee) 4. Organizational structure 6. Human resources policy and practices CAEA 2218 . Assignment of authority and responsibility 7.Internal Control Environment  Factors Affecting the control environment: 1.

LECTURE 6 Slide 10 .Planning an Audit Strategy Audit Risk Model AR = IR × CR × DR CAEA 2218 .

LECTURE 6 Slide 11 . have been recorded  Authorization –all transactions and events are properly classified  Accuracy –amounts and other data relating to recorded transactions and events have been recorded appropriately  Cutoff –transactions and events have been recorded in the correct accounting period  Classification –transactions and events have been recorded in the proper accounts CAEA 2218 .Assertions and control activities  Occurrence –transactions and events that have been recorded have ocured and pertain to the entity  Completeness –all transactions and events that should have been recorded.

Assertions and control activities CAEA 2218 .LECTURE 6 Slide 12 .

Control Risk
 After obtaining an understanding of internal control, an auditor may choose to follow a (i) substantive strategy and set control risk at the maximum for some or all assertions because of one or all of the following factors:  Controls do not pertain to an assertion Audit Risk Model  Controls are assessed as ineffective  Testing the effectiveness of controls is inefficient AR = IR × CR × DR (ii) reliance strategy if the auditors assess control risk below maximum and decided to rely on the internal control  The risk assessment process should consider external and internal events and circumstances that may arise and adversely affect the entity’s ability to initiate, record, process and report financial data consistent with the assertions of management in the financial statements.  Client business risk can arise or change due to the following circumstances:
 changes in the operating environment; changing personnel; rapid growth; new or revamped information systems; new business models, products, or activities; new accounting pronouncements; new technology; expanded international growth; corporate restructuring
CAEA 2218 - LECTURE 6 Slide 13

Control Risk
 Auditors should consider client accounting system when assessing control procedures/risk - an effective accounting system gives appropriate consideration to establishing methods and records that will :
1.Identify and record all valid transactions. 2.Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting. 3.Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements. 4.Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period. 5.Properly present the transactions and related disclosures in the financial statements.

CAEA 2218 - LECTURE 6 Slide 14

Controlprocedures that help ensure that Risk Control activities are the policies and
management’s directives are carried out. Those control procedures that are relevant to the audit include 1. Performance reviews 2. Information processing 3. Segregation of duties 4. Physical controls

 Monitoring of controls is a process that assesses the quality of internal control performance over time.  Internal Auditors – internal auditors evaluates internal control to ensure effective functionality of the organization. An effective internal audit function has clear lines of authority and reporting, qualified personnel, and adequate resources to enable these personnel to carry out their assigned duties.  While the basic concepts of the five components should be present in all entities, they are likely to be less formal in a small or midsize entity than in a large entity.  There are limitations to internal control, due to various factors, such as:  management override of internal control;  human error or mistakes;  collusion

CAEA 2218 - LECTURE 6 Slide 15

Factors contributing to fraud

CAEA 2218 - LECTURE 6 Slide 16

Assessing Control Risk
 Assessment of control risk involve a few steps:  Identify specific controls that will be relied upon  Perform tests controls  Conclude on the achieved level of control risk
 How to document the understanding of internal control? 1. Procedure manuals and organizational charts 2. Structured working paper 3. Internal control questionnaires/memorandum 4. Narrative description 5. Flowcharts

CAEA 2218 - LECTURE 6 Slide 17

Documenting the Assessed Level of Control Risk CAEA 2218 .LECTURE 6 Slide 18 .

LECTURE 6 Slide 19 .Substantive procedures CAEA 2218 .

Timing of Audit Procedures  Audit procedures are performed at interim as well as at year end.LECTURE 6 Slide 20 . example: CAEA 2218 .

 Goes further by testing whether the controls provide reasonable assurance that the related control objectives were achieved during the period.  An auditor may reduce control risk below the maximum only on the basis of a service auditor’s report that includes tests of the controls.  Auditor may issue report (s) on the service organization’s operations:  Describes the service organization’s controls and assesses whether they are suitably designed to achieve specified internal control objectives.LECTURE 6 Slide 21 . CAEA 2218 .  Auditor will have to review the service provided as it involves accounting .Auditing Accounting Applications Processed by Service Organizations  An audit client may have some or all of its accounting transactions processed by an outside service organization.

LECTURE 6 Slide 22 . and report financial data consistent with management’s assertions.Communication of Internal ControlRelated Matters  Reportable conditions  Significant deficiencies in the design or operation of internal control that could adversely affect the organization’s ability to initiate. or combination of significant deficiency that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. process.  Material weakness  A material weakness is a significant deficiency. record. CAEA 2218 .

LECTURE 6 Slide 23 .Reportable conditions CAEA 2218 .

LECTURE 6 Slide 24 .The Effect of Information Technology on Internal Control CAEA 2218 .

access security. system software acquisition. processing controls. data validation controls.Types of Controls in an IT Environment  General control –data center & network operations. error controls CAEA 2218 . and maintenance  Application controls –data capture controls. output controls.LECTURE 6 Slide 25 . development. change and maintenance. application system acquisition.

Types of Controls in an IT Environment CAEA 2218 .LECTURE 6 Slide 26 .

LECTURE 6 Slide 27 .Flowcharting symbols CAEA 2218 .

death will catch up with you.End of lecture 6 “Mankind’s Reckoning has drawn very close to them. yet they heedlessly turn away. from which you are fleeing.LECTURE 6 Slide 28 . even if you are in impregnable fortresses. Then you will be returned to the Knower of the Unseen and the Visible and He will inform you about what you did.” (Al-Anbiyaa’ 21:1) “Say: “Death. will certainly catch up with you. (An-Nisaa’ 4:78) CAEA 2218 .”” (Al-Jumu`ah 62:8) Wherever you are.


rendering services. cash discounts – Sales return and allowance transactions: sales returns. Receipt of cash from the customer in payment for goods or services. or other activities that constitute the entity’s major or central operations. sales. 3. Sale of goods or rendering of a service for cash or credit.  Numerous accounts are affected – significant ones are: – Sales transactions: trade receivables.  Three types of transactions are typically processed through the revenue cycle: 1. bad-debt expense – Cash receipts transactions: cash. trade receivables CAEA 2218 . allowance for uncollectible.Revenue Recognition  Revenue is an inflows/enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivery or producing goods.LECTURE 7 Slide 2 . sales allowances. Return of goods by the customer for credit or cash. 2. trade receivables.

LECTURE 7 Slide 3 .Overview of the Revenue Process Cash Sale Credit Sale Cash collection Purchases Purchases Cash sales Account receivable Inventory Inventory Credit sales CAEA 2218 .

Revenue Process – EarthWear Clothiers Order Entry Department By mail or fax Customer sales order A By phone or internet Input To the IT Department Error Correction A If a new customer. credit is checked by IT CAEA 2218 .LECTURE 7 Slide 4 . Otherwise. a credit check is run by the Credit Department.

Revenue Process – EarthWear Clothiers IT Department Customer Price Inventory Inventory Open orders Open orders From order entry department Data validation Batched program nightly Shipping program To order entry department Error Report To shipping department CAEA 2218 .LECTURE 7 Slide 5 .

Ship goods Approved shipping ticket Input to the billing program To customer with goods A CAEA 2218 .LECTURE 7 Slide 6 .Revenue Process – EarthWear Clothiers Shipping Department From shipping department Approved shipping ticket The shipping ticket forwarded to the customer contains quantity and price of each item purchased.

Revenue Process – EarthWear Clothiers IT Department Open orders Shipping transactions A weekly open order report is prepared and reviewed by billing department. Inventory A Billing program Sales Invoice Customer Accounts receivable update For receivables processing B CAEA 2218 .LECTURE 7 Slide 7 . Outstanding orders are investigated.

LECTURE 7 Slide 8 .Revenue Process – EarthWear Clothiers IT Department Accounts receivable Shipping transactions Remittance transactions Sales B Accounts receivable Weekly or Accounts receivable reporting update Monthly D Daily shipping listing Daily sales report Daily remittance report To cash receipts department To sales department C CAEA 2218 .

LECTURE 7 Slide 9 .Revenue Process – EarthWear Clothiers IT Department Accounts receivable Remittance transactions Shipping transactions General ledger Reports •Sales journal •Cash receipts journal •Aged trial balance •Sales summary •Remittance summary •Journal entry summary D Accounts receivable reporting Weekly or Monthly Customer statements Customer CAEA 2218 .

LECTURE 7 Slide 10 .Revenue Process – EarthWear Clothiers Cash Receipts Department IT Department From bank Remittance advice transactions Error correction Remittance advice transactions Accounts receivable C From bank Daily remittance report Reconciled by cash receipts clerks Cash remittance update Error report B Remittance advice listing CAEA 2218 .

contains information on the type of product or authorization is generally received from the treasurer  Order entry –initial function in the revenue process when new sales order is received CAEA 2218 . the client must have a formal procedure for investigating the creditworthiness of the customer  Open order report – a report of all customer orders for which processing has not completed yet  Shipping document – a document serves as bill of lading and contains information on the type of product shipped. the sales need to be recorded in the accounting records which is the sales journal to begin with  Customer statement – is mailed to the customer and contains details of all sales. price and terms of trade  Sales journal – once sales invoice has been issued.Documents and Records  Customer sales order – contains the details of the type and quantity of products or services ordered by customer(s)  Credit approval form – for credit sales. will be classified as current of placed into one of several past due categories  Remittance advice –usually the portion of customer’s bill that should be return with payment  Cash receipts journal – to record the cash receipts of the entity  Credit memorandum –to record credits for the return of goods by a customer  Write off authorization –authorizes the write off of an uncollectible account receivable. quantity. cash receipt. and credit memorandum transactions  Accounts receivable subsidiary ledger – contains an account and the details of transactions for each customer  Aged trial balance of accounts receivable –summarizes all customer balances in the AR subsidiary ledger.LECTURE 7 Slide 11 . quantity and other relevant information  Sales invoices – used to bill the customer.

and summarization of revenues. collections. and receivables are properly recorded and classified  Order entry– acceptance of customer orders for goods and services into the system in accordance with management criteria CAEA 2218 .Major Functions  Credit authorization– appropriate approval of customer orders for creditworthiness. and receivables in the financial statement accounts . this process determines that the customer is able to pay for the goods or services purchased – failure in authorization could lead to extensive bad debts for the entity  Shipping – shipping of goods that has been authorized. a proper billing system ensures that all goods shipped/ services rendered are billed to customers  Cash receipts –processing of the receipts of cash from customers. collections and credit memoranda in individual customer accounts -all billings. classification. all cash receipts must be properly identified and promptly deposited intact at the bank  Accounts receivable –recording of all sales invoices. and cash collections must be properly recorded in the customers’accounts receivable records  General ledger –proper accumulation. nor should services be provided without proper authorization –the main control is payment or proper credit authorization  Billing –issuance of sales invoices to customers and processing of adjustments for allowances. goods should not be shipped. the general ledger function must ensure that all revenues.LECTURE 7 Slide 12 .as related to the revenue process. adjustments. collections. discounts and returns.

Key Segregation of Duties Department Order Accounts Cash Revenue and Accounts Receivable Entry Credit Shipping Receivable Receipts Receiving and preparing customer order X Approving credit X Shipping goods to customer X Preparing customer invoice X Updating accounts receivable records for sales X Receiving customer's remittance X Updating accounts receivable for remittance X Preparing accounts receivable aged trial balance X IT X X X X Information Systems and Communication Process by which sales. and credit memoranda are initiated. cash receipts.LECTURE 7 Slide 13 . The process used to prepare estimates for bad debts and sales returns. and sales returns. Accounting records. cash receipts. supporting documents. and accounts that are involved in sales. Auditor’s knowledge The flow of each transaction from initiation to inclusion in the financial statements. CAEA 2218 .

Setting and documenting the control risk for the revenue process CAEA 2218 -LECTURE 7 Slide 14 . Complexity and contentiousness of revenue recognition issues 3. Difficulty of auditing transactions and account balances 4. (ii) narrative descriptions.  Understanding & documenting internal control –the auditor identifies what controls ensure that the assertions for transactions and events are being met. (iv) flowcharts  Control risk assessment: 1. The auditor should estimate the significance of the risk and assess the likelihood of occurrence. Planning and performing tests of controls on revenue transactions. (iii) internal control q’aires. Industry related factors 2. Understanding and documenting the revenue process based on a reliance approach. 3. The auditor must understand how management assesses the design and operation of controls in the revenue process. This understanding should include how supervisory personnel review the personnel who perform the controls and evaluate the performance of the entity’s IT function.Risk Assessment  Risk assessment process –the auditor must understand how management considers risks that are relevant to the revenue process. Misstatements detected in prior audits  Control Environment –understanding of control environment is generally completed on an overall entity basis. 2. documentation of the auditor’s understanding can be accomplished by using (i) procedures manual.  Inherent risk prevalent to the revenue cycle: 1.

Planning and Performing Tests of Controls  The auditor systematically examines the client’s revenue process to identify relevant controls that help to prevent. the auditor conducts the planned level of substantive procedures for the account balances. or detect and correct material misstatements. example of the tests:  Inquiry of client personnel  Inspection of documents and records  Observations of the operation of the control  Walkthrough  Reperformance of the control procedures  If the results of the tests of controls support the planned level of control risk. or ‘high’ CAEA 2218 .LECTURE 7 Slide 15 .  In order to properly set control risk. the auditor must test controls over the revenue process.  The level of control risk for the revenue process can be set using either quantitative amounts or qualitative terms such as ‘low’. ‘medium’.

All revenue and cash receipt transactions and events that should have been recorded have been recorded. Completeness All revenue and cash receipt transactions and events have been recorded in the correct accounting period.Revenue Transactions Assertions about Classes of Transactions and Events for the Period under Audit All revenue and cash receipt transactions and events Occurrence that have been recorded have occurred and pertain to the entity. All revenue and cash receipt transactions and events Classification have been recorded in the proper accounts. Amounts and other data relating to recorded revenue Accuracy and cash receipt transactions and events have been recorded appropriately. All revenue and cash receipts transactions and events Authorization are properly authorized. Cutoff Control procedures and test of controls – next pages CAEA 2218 .LECTURE 7 Slide 16 .

the sales invoice should also be verified for mathematical accuracy before being sent to the customer.LECTURE 7 Slide 17 . (ii) recording revenue when goods have not been shipped or services have not been performed. Controls concerning completeness include (i) accounting for numerical sequence of shipping documents and sales invoices.  Accuracy of revenues – the presence of an authorized price list and terms of trade reduces the risk of inaccuracies. Test policies and procedures relating to authorization of revenue transactions. (iii) reconciling sales invoices to daily sales reports  Authorization of revenues – possible misstatements due to improper authorization include shipping goods to or performing services for customers who are bad credit risks and making sales at unauthorized prices or terms.Revenue Transactions  Occurrence of revenues – the auditor is concerned about two major types of material misstatements (i) sales to fictitious customer. All shipping documents should be forwarded to the billing department daily  Classification of revenues – the use of chart of accounts and proper codes for recording transactions should provide adequate assurance about the proper classification of revenue transactions CAEA 2218 .  Cutoff of revenues – sales may be recorded in the wrong accounting period unless proper controls are in place. (ii) matching shipping documents with sales invoices.  Completeness of revenues – the major misstatement that concerns both management and the auditor is that goods are shipped or services are performed and no revenue is recognized. The auditor needs assurance that all recorded revenue transactions are valid.

As a result. credit memoranda that are used to process sales returns can also be used to cover an unauthorized shipment of goods or conceal a misappropriation of cash. CAEA 2218 .Cash Receipts Transactions  Occurrence of cash receipts – the possible misstatement that concerns the auditor is that cash receipts are recorded but not deposited in the client’s bank accounts.  Completeness of cash receipts –major misstatements is that cash/checks are stolen/missing/lost before being recorded in the cash receipts records. proper segregation of duties and a lockbox system are strong control relating to completeness  Authorization of cash receipts – terms of trade generally include discounts for payment within a specified period as a way of encouraging customers to pay on time/earlier  Accuracy of cash receipts –the wrong amount of cash could be recorded from the remittance advice or receipt could n accuracies. there is a small possibility of cash being recorded in the wrong accounting period  Classification of cash receipts – the auditor seldom has major concerns about cash receipts being recorded in the wrong financial statement account Control Procedures and Tests of Controls – Sales Returns and Allowances: Sales returns and allowances is usually not a material amount in the financial statements. the sales invoice should also be verified for mathematical accuracy before being sent to the customer. However. all credit memoranda should be properly authorized.  Cutoff of cash receipts – if client uses a lockbox system or if cash is deposited daily in the bank.LECTURE 7 Slide 18 .

Allowance for uncollectible accounts as a percent of accounts receivable or credit sales. 2. 5. 4.Relating the Assessed Level of Control Risk to Substantive Procedures  The auditor’s testing of control for revenue processing impacts the detection risk and therefore the level of substantive procedures impacted by the controls  Auditing accounts receivable and related controls: 1.  Substantive Analytical Procedures: (ratios are used for comparative reasons) 1. Large account balances compared to last period. CAEA 2218 . Receivables turnover and days outstanding in accounts receivable. 3. Substantive analytical procedures are used to examine plausible relationships among accounts receivable and related accounts.LECTURE 7 Slide 19 . Bad-debts expense as a percent of revenue. Aging categories on aged trial balance of accounts receivable. Tests of details concentrate on the ending balance for accounts receivable and related accounts as well as related disclosures. or disclosures. Tests of details focus on transactions. 2. account balances.

determine that each is properly classified in the revenue accounts CAEA 2218 .LECTURE 7 Slide 20 . allowance for doubtful accounts and bad-debt expense:  Occurrence –a sample of transactions from sales journal should be traced to the sales invoice. compare date of sales invoices with date of shipment and date sale was recorded  Classification –for a sample of sales invoices.Relating the Assessed Level of Control Risk to Substantive Procedures  For accounts receivables. customer order and shipping document  Completeness –a sample of shipping documents should be traced to related sales invoice and customer’s account  Authorization and accuracy –compare prices and terms for sample of sales invoices with authorized price list  Cutoff –from a sample.

a comparison with last year’s results should be examined. Next.Relating the Assessed Level of Control Risk to Substantive Procedures – Accounts Receivables tests  Completeness –auditors primary concern is whether all AR have been included in the AR subsidiary ledger and the general ledger (GL) AR account.LECTURE 7 Slide 21 . in some cases AR may be sold with/without recourse  Valuation and allocation –AR should be shown on the balance sheet at net realizable value (gross minus allowance) The auditor must verify the adequacy of the allowance for uncollectible accounts. however. CAEA 2218 . this is usually not a problem.  Classification & Understandability –major issues for presentation and disclosure classification are: (i) Identifying and reclassifying any material credits contained in accounts receivable. (iii)Ensuring that different types of receivables are properly classified. The first step is to prepare an aged trial balance and discuss results with the credit manager. Test a few shipping documents just prior to year end – and test another few just after the year end – determine whether all transactions tested were recorded in the proper period  Rights and obligation –the auditor must determine that all AR are owned by the entity. (ii) Segregating short-term and long-term receivables. Reconciliation of the aged trial balance to the GL account should detect an omission of receivables from either the subsidiary or GL  Cutoff –attempts to determine whether all revenue transactions and related AR are recorded in the proper period.

The Confirmation Process – Accounts Receivables  Confirmation is the process of obtaining information from third parties about the account receivable balance. some cases may need 2nd request. 2. the confirmation request should be sent soon after the end of the accounting period in order to maximize response rate  Procedures –the auditor should mail the confirmation request outside the client facilities – a record should be maintained of the confirmations mailed and those returned.Positive Confirmation –requests that customers indicate whether they agree with the amount due to the client. Negative confirmations are used when the client has many small account balances and control risk is assessed as low. Confirmation is a good source of evidence about the existence of the account receivable. For each exception received. The confirmation process should be controlled by the auditor.Negative Confirmation –requests that the customer respond only when they disagree with the amount due to the client. A response is expected whether the customer agrees or disagrees with the balance indicated. 1. CAEA 2218 -LECTURE 7 Slide 22 . the auditor should examine the reasons for the difference between the balance on the client’s books and the balance indicated by the customer.  Timing –AR may be confirmed at an interim date or year-end.

” Notes receivable would also be confirmed and examined for repayment terms and whether interest income has been properly recognized. CAEA 2218 . and (3) notes receivables. alternative audit procedures are used. Each of these types of receivables is confirmed and evaluated for collectability.  Other types of receivables that are reported on the balance sheet may include (1) receivables from officers and employees.Alternative Procedures  When the auditor does not receive responses to positive confirmations. and duplicate sales invoices. The auditor’s concern with satisfying the assertions for these receivables is similar to that for trade accounts receivable. shipping documents.LECTURE 7 Slide 23 . The transactions that result in receivables from related parties are examined to determine if they were at “arm’s length. (2) receivables from related parties.  Examination of customer orders.  Examination of other client documentation. These alternative procedures include:  Examination of subsequent cash receipts.

Evaluating the Audit Findings When the auditor has completed the planned substantive procedures. the likely misstatement (projected misstatement plus an allowance for sampling risk) for accounts receivable is determined. CAEA 2218 .LECTURE 7 Slide 24 . Likely misstatement less than tolerable misstatement Likely misstatement greater than tolerable misstatement Accept the account as fairly presented Account is not fairly presented.

akan dimasukkan nya ke dalam syurga yang mengalir di bawahnya beberapa sungai. Adapun tanaman di syurga. setelah benihnya disebar. mereka kekal di dalamnya. dan buahbuahannya pula dapat dipetik dengan semudahnya’Al-Insan: 14 Rasulullah pbuh have said: ‘sesungguhnya orang beriman ditempatkan di syurga dalam istana dari mutiara berongga. di dalamnya terdapat pelayan-pelayan’ ‘buah-buahan di syurga seperti anggur. lebih lembut dari tepung dan tidak berbiji.’Ar-Rahman: 68 ‘sedang naungan pohon-pohon syurga itu dekat kepada mereka. maka ia tumbuh dalam sekejap dan sedia dimakan pada waktu itu juga’ (Hadis riwayat oleh Muslim) CAEA 2218 .” Ar-Rahman:48 ‘pada keduanya juga terdapat buah-buahan. lebih manis dari madu. dan itulah kejayaan yang amat besar.LECTURE 7 Slide 25 .” An-Nisa’: 13 ‘(dua syurga) yang ada berjenis-jenis pohon dan buah-buahan.A dream … ‘… dan sesiapa yang taatkan Allah dan Rasulnya. serta pohon-pohon kurma dan delima. panjangnya adalah 60 batu. ia lebih putih dari susu.


LECTURE 8 Slide 2 . CAEA 2218 .Expense and Liability Recognition  Expenses are outflows or other using up of assets or incurrences of liabilities from delivering or producing goods. rendering services or carrying out other activities that constitute the entity’s ongoing major or central operations.  Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

The purchasing department prepares a purchase order that is sent to the vendor. a liability is recorded. the entity pays the vendor.Overview of the Purchasing Process A purchase transaction usually begins with a purchase requisition generated by the user department.LECTURE 8 Slide 3 . Purchase requisition Purchase order Receiving report and liability recorded Vendor CAEA 2218 . When the goods are received or the services rendered. Finally.

2.Types of Transactions and Financial Statement Accounts Affected  Three types of transactions are processed through the purchasing process: 1.LECTURE 8 Slide 4 . Return of goods to suppliers for cash or credit. 3. Purchase of goods and services for cash or credit. Type of Transaction Purchase Transaction Account Affected Accounts payable Inventory Purchases or cost of goods sold Various asset and expense accounts Cash disbursement transaction Cash Accounts payable Cash discounts Various asset and expense accounts Purchase return transaction Purchase returns Purchase allowances Accounts payable Various asset and expense accounts CAEA 2218 . Payment of the liabilities arising from such purchases.

Flowchart of the Purchasing Process – EarthWear Clothiers Department Requesting Purchase requisition Purchasing Approved purchase requisition received IT Accounts Purchase payable order file master file Input Purchase order program Vendor Purchase order (4 part) Error corrections PO #2 Filed Numerically Error report A/P Receiving Purchasing CAEA 2218 .LECTURE 8 Slide 5 .

quantity.Flowchart of the Purchasing Process – EarthWear Clothiers Department PO #3 Receiving PO #1 Accounts Payable (A/P) Compare invoice to PO and RR Review account distribution Voucher packet Input Error correction To IT Goods received. and inspected Receiving report (RR) Enter vendor. counted. and PO # Daily receiving log Receiving report Vendor invoice From IT CAEA 2218 .LECTURE 8 Slide 6 .

LECTURE 8 Slide 7 .Flowchart of the Purchasing Process – EarthWear Clothiers Department PO #3 Receiving PO #1 Accounts Payable (A/P) Compare invoice to PO and RR Review account distribution Voucher packet Input Error correction To IT Goods received. counted. quantity. and PO # Daily receiving log Receiving report Vendor invoice From IT CAEA 2218 . and inspected Receiving report (RR) Enter vendor.

LECTURE 8 Slide 8 .Flowchart of the Purchasing Process – EarthWear Clothiers Department IT Purchase order file A/P master file General ledger file Open PO report Input from A/P Accounts payable update Weekly Monthly Daily A/P reporting A/P listing Cash disbursement report Monthly reports A/P expense distribution report Voucher register Cash disbursements journal Report to A/P Error report Daily General ledger CAEA 2218 .

LECTURE 8 Slide 9 .Flowchart of the Purchasing Process – EarthWear Clothiers Department IT A/P master file Accounts Payable (A/P) Cash disbursement report Cashier Checks Review documents and authorize payment Cash disbursement program Review checks and mail to vendors Cash disbursement report Checks Checks Input To Vendors CAEA 2218 .

Purchase Order – includes description. Voucher Register – used to record vouchers for goods and services. Voucher – serves as the basis for recording a vendor’s invoice. Accounts Payable Subsidiary Ledger – includes amount owed to individual vendors. Check – pays for goods or services.Check Register – contains columns to record credits to cash and debits to accounts payable and cash discounts. Purchase Requisition – request to purchase goods or services. 2. Vendor Statement – represents the purchase activity with vendor. 8. 4. 5.LECTURE 8 Slide 10 . 10. Receiving Report – records the receipt of goods. 6. Vendor Invoice – the bill from the vendor.Types of Documents and Records 1. quality. 3. 9. 7. CAEA 2218 . and quantity or goods or services being purchased.

CAEA 2218 . cash disbursements.The Major Functions Functions of the Purchasing Process Initiation and approval of requests for goods and services Requisitioning by authorized individuals consistent with management criteria. and vendor. cash disbursements. and returns. Recording of all vendor invoices. discounts. Receiving Receipt of properly authorized goods and services. quality.LECTURE 8 Slide 11 . processing of adjustments for allowances. also. Approval of purchase orders and proper execution as to Purchasing price. Disbursements Processing of payment to vendors. and Accounts payable adjustments in individual vendor accounts. Processing of vendor invoices for goods and services Invoice processing received. classification. and payables in the general ledger. and summarization of General ledger purchases. quantity. Proper accumulation.

that individual should be segregated from the can conceal any defalcation that would normally be general ledger function.Key Functions and Duties Segregation of Duties Possible Errors or Fraud The purchasing function should be If one individual is responsible for the requisition. possibly payment for unauthorized purchases. This can result in theft of the entity's cash. This can result in the theft of goods and and receiving functions. purchase The invoice-processing function transactions can be processed at the wrong price or should be segregated from the terms. unauthorized checks supported by fictitious segregated from the accounts documents can be issued. and unauthorized payable function. or a cash disbursement can be processed for accounts payable function. transactions can be recorded. If one individual isresponsible for the accounts payable The accounts payable function records and also for the general ledger. If one individual is responsible for the invoiceprocessing and accounts payable function. goods not received. This can result in overpayment of goods or the theft of cash. fictitious purchases can be made.LECTURE 8 Slide 12 . and receiving functions. If one individual is responsible for the disbursement function and also has access to the accounts payable The disbursement function should be records. segregated from the requisitioning purchasing. detected by reconciling subsidiary records with the general ledger control account. CAEA 2218 .

and inspection of purchased materials Receipt of vendor invoices/matching to supporting documents Coding of account distributions Updating of accounts payable records Preparation of vendor checks Signing and mailing of vendor checks Preparation of the voucher register Reconciliation of voucher register to general ledger Department Accounts Purchasing Receiving Payable Cashier's X X IT X X X X X X X X CAEA 2218 .The Key Segregation of Duties Purchasing and Accounts Payable Preparation and approval of purchase order Receipt. counting.LECTURE 8 Slide 13 .

the auditor sets the level of control risk. cash disbursements. 2.Inherent & Control Risk Assessment  Industry-Related Factors – adequacy of the raw material supply?. The flow of each type of transaction from initiation to inclusion in the financial statements.  For each major class of transactions in the purchasing process. 3. the auditor must obtain the following information: 1. Setting and documenting the control risk for the purchasing process. and purchase return transactions are initiated. Planning and performing tests of controls of purchase transactions. 3. Understanding and documenting the purchasing process based on a reliance strategy. 2. The auditor may proceed with the substantive procedures as planned. The accounting records.LECTURE 8 Slide 14 . supporting documents. cash disbursements. how volatile are raw material prices?  Misstatements detected in prior audit  Assessing control risk for purchasing process: 1. no modifications are necessary to detection risk. How purchase. and purchase returns. The process used to estimate accrued liabilities  After testing controls. 4. and accounts involved in processing purchases. CAEA 2218 . including computer processing. When tests of controls support the planned level of control risk.

Control Activities and Tests of Controls – Purchase Transactions Assertions about Classes of Transactions and Events for the Period under Audit All purchases and cash disbursements have been Occurrence recorded and have occurred and pertain to the entity. All purchases and cash disbursements that should Completeness have been recorded have been recorded.LECTURE 8 Slide 15 . CAEA 2218 . Amounts relating to recorded purchases and cash Accuracy disbursements have been recorded properly. All purchase and cash disbursements are properly Authorization authorized. Purchases and cash disbursements have been Classification recorded in the proper account. Purchases and cash disbursements have been Cutoff recorded in the correct accounting period.

and Accuracy price. Examine purchase requisitions or purchase orders for proper Authorization approval. Recompute the mathematical accuracy of vendor invoice. Review procedures for accounting for numerical sequence of purchase orders. Review purchases journal and general ledger for reasonableness. Trace a sample of vouchers to the purchases journal.LECTURE 8 Slide 16 . CAEA 2218 . Examine reconciliation of vouchers to daily accounts payable report. Examine paid vouchers and supporting documents for indication of cancellation.Control Activities and Tests of Controls – Purchase Transactions Assertions Substantive Tests of Controls Observe and evaluate proper segregation of duties. Review client's competitive bidding process. Trace a sample Completeness of receiving reports to their vendor invoices and vouchers. Compare the dates on receiving reports with the dates on the Cutoff relevant vouchers. quantity. Compare the dates of vouchers with the dates they were recorded in the purchases journal. Classification Examine a sample of vouchers for proper classification. Agree information in the sample of vouchers for product. Test a sample of vouchers for the presence of an authorized purchase order Occurrence and receiving report. receiving reports and vouchers.

independent reconciliation and review of vendor statements.  Completeness – the major audit concern is that a cash disbursement is made but not recorded in the records. and monthly bank reconciliations. The primary control procedures to prevent such misstatements include proper segregation of duties. The individual who approves a purchase should not have direct access to the cash disbursement. CAEA 2218 . The auditor should account for the numerical sequence of checks and reconcile the daily cash disbursements with posting to the accounts payable subsidiary records.Control Activities and Tests of Controls – Cash Disbursement Transactions  Occurrence – the auditor is concerned with a misstatement caused by a cash disbursement being recorded in the client’s record when no payment was made.LECTURE 8 Slide 17 .  Authorization – proper segregation of duties reduces the likelihood that unauthorized cash disbursements are made.

The use of a chart of accounts. CAEA 2218 .  Classification – The auditor is concerned that a cash disbursement may be charged to the wrong general ledger account.Control Activities and Tests of Controls – Cash Disbursement Transactions  Accuracy – One of the major audit concerns is that the payment amount is recorded incorrectly. as well as independent approval and review of the account code on the voucher should provide adequate control. To detect such an error. client personnel should reconcile the total of the checks issued each day with the daily cash disbursements report. The auditor also tests cash disbursements before and after year-end to ensure that transactions are recorded in the proper period.LECTURE 8 Slide 18 .  Cutoff – The auditor’s tests of controls include reviewing the reconciliation of checks with postings to the cash disbursements journal and accounts payable subsidiary records.

The auditor normally does not test controls relating to purchase returns. CAEA 2218 .  Relating the Assessed Level of Control Risk to Substantive Procedures: If the results of the tests of controls support the achieved level of control risk.LECTURE 8 Slide 19 . the auditor reduces the detection risk. which will increase substantive procedures. the number and magnitude of purchase return transactions are not material.Control Activities and Tests of Controls –  Purchase Return Transactions: Generally. If the results do not support the achieved level of control risk. the auditor conducts substantive procedures at the planned level. Substantive testing is used to test the reasonableness of the amount.

and any resulting valuation or allocation adjustments are appropriately recorded CAEA 2218 .Auditing Accounts Payable & Accrued Expenses  Existence – accounts payable and accrued expenses are valid liabilities  Rights and obligation – AP and accrued expenses are obligations of the entity  Completeness – All AP and accrued expenses have been recorded  Valuation and allocation – AP and accrued expenses are included in the financial statements at appropriate amounts.LECTURE 8 Slide 20 .

LECTURE 8 Slide 21 .Auditing Accounts Payable & Accrued Expenses Assertion about presentation and disclosure  Occurrence and rights and obligations. All disclosed events. All disclosures relating to accounts payable and accrued expenses that should have been included in the financial statements have been included. Financial information relating to accounts payable and accrued expenses is appropriately presented and described. and other matters relating to accounts payable and accrued expenses have occurred and pertain to the entity.  Classification and understandability.  Completeness. Financial and other information relating to accounts payable and accrued expenses are disclosed fairly and at appropriate amounts. transactions.  Accuracy and valuation. CAEA 2218 . and disclosures are clearly expressed.

Under.Auditing Accounts Payable & Accrued Expenses Substantive Analytical Procedures Substantive Analytical Procedure Possible Misstatement Detected Compare payables turnover and days outstanding in accounts payable to previous years' and industry data. Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior Under. CAEA 2218 . Under.or overstatment of liabilities and expenses.or overstatment of liabilities and expenses.or overstatment of liabilities and expenses. Compare current-year balances in accounts payable and accruals with prior years' balances. data. Compare purchase returns and allowances as a percentage of revenue or Under.LECTURE 8 Slide 22 .or overstatement of purchase cost of sales to prior years' and industry returns.

The auditor should vouch a sample of items on the listing of accounts payable to other supporting documents. 5. 3. and Disclosures  Completeness – Obtain a listing of accounts payable. and agree it to the general ledger control account. Obtain copies of vendors’ monthly statements and reconcile the amounts to the client’s accounts payable records. Examine the files of unmatched purchase orders. Account Balances. Confirm vendor accounts. and vendor invoices for any unrecorded liabilities.  Existence – The auditor’s major concern is whether the recorded liabilities are valid obligations of the entity. Ask management about control procedures used to identify unrecorded liabilities at the end of the period. Vouch large-dollar items from the purchases journal and cash disbursements journal for a limited time after year-end. receiving reports. 1. 2. Selected vouchers or vendor accounts should be traced to the supporting documents or subsidiary accounts payable records to verify the accuracy of the details. including accounts with small or zero balances. CAEA 2218 .Tests of Details of Transactions.LECTURE 8 Slide 23 . 4. foot the listing.

The valuation of accruals depends upon the type and nature of the accrued expense. and Disclosure – Major classification issues include .LECTURE 8 Slide 24 .  Valuation – Accounts payable are recorded at either the gross amount of the invoice or net of cash discount amount. Identifying and reclassifying any material debits contained in accounts payable.  Rights and obligation – There is little risk related to this assertion because clients seldom have an incentive to record liabilities that are not obligations of the entity. Segregating short-term and long-term payables. Proper cutoff should also be determined for purchase return transactions. CAEA 2218 . . Presentation. 1. 3. Account Balances. . 2. and Disclosures  Cutoff – The auditor attempts to determine if all purchase transactions are recorded in the proper period.  Classification. Ensuring that different types of payables are properly classified. the purchase cutoff is coordinated with the client’s physical inventory count.Tests of Details of Transactions. On most audits. Most accruals are relatively easy to value.

 Other Presentation DisclosureAssertion  The auditor must ensure that all related party transactions have been identified. • Purchases from and payables to related parties. • Long-term purchase contracts. The vendor is asked to supply the balance owed by the client. • Dependence on a single vendor or a small number of vendors. CAEA 2218 . and Disclosures  Disclosure Items for the Purchasing Process: • Payables by type (trade. When the client has entered into formal long-term purchase contracts.LECTURE 8 Slide 25 . Account Balances. employees. including any unusual purchase commitments.).Tests of Details of Transactions. • Short. When confirmations are used they are usually positive and referred to as blank confirmations. etc. The auditor is able to examine externally created source documents relating to accounts payable.  Accounts payable confirmations are used less often than accounts receivable confirmations. • Costs by reportable segment of the business.and long-term payables. adequate disclosure of the terms must be made.

Conversely. the auditor should conclude that the account is not fairly presented. If the likely misstatement is less than the tolerable misstatement. The likely misstatement is then compared to tolerable misstatement.LECTURE 8 Slide 26 . if the likely misstatement exceeds the tolerable.Evaluating the Audit Findings All identified misstatements should be aggregated. the auditor has evidence that the account is fairly presented. CAEA 2218 .


Overview of the Inventory Management Process Purchasing process Inventory management process Revenue process • Purchase of raw materials • Payment of manufacturing overhead Human resource management process • Assignment of direct and indirect labor costs • Sale of goods CAEA 2218 2010/2011. LECTURE 9 Slide 2 .

Production Data Information – Contains information about the transfer of goods and related cost accumulation at each stage of production. The variance report compares actual costs to standard or budgeted costs. Receiving Report – Records the receipt of goods from vendors. 4. 3. 8. including the perpetual inventory records. Cost Accumulation and Variance Report – Material. Inventory Master File – Contains all the important information related to the entity’s inventory. Materials Requisition – Used to track materials during the production process. CAEA 2218 2010/2011. and overhead costs are charged to inventory as part of the manufacturing process.Type of Documents and Records demand for the entity’s 1. Production Schedule – Based on the expected 2. labor. LECTURE 9 Slide 3 . 6. Shipping Order – Used to remove goods from the perpetual inventory records. 5. Production Schedule Inventory Master File 7. products. Inventory Status Report – Shows the type and amount of products on hand.

LECTURE 9 Slide 4 .The Major Functions Functions in the Inventory Management Process Authorization of production activity and maintenance of Inventory management inventory at appropriate levels. Cost accounting General ledger Maintenance of the costs of manufacturing and inventory in cost records. issuance of purchase requisitions to the purchasing department. Proper accumulation. classification. Custody of finished goods and issuance of goods to the Finished goods stores shipping department. Manufacturing Production of goods. and summarization of inventory and related costs in the general ledger. Custody of raw materials and issuance of raw materials to Raw materials stores manufacturing departments. CAEA 2218 2010/2011.

leading to an overstatement of inventory. CAEA 2218 2010/2011. production and inventory costs can be manipulated. The responsibility for supervising physical inventory should be separated from the inventory management and inventory stores functions. unauthorized shipments can be made or theft of goods can be covered up. This may lead to an over. The inventory stores function should be segregated from the costaccounting function. resulting in an overstatement of inventory. it is possible that inventory records to the physical inventory. LECTURE 9 Slide 5 . The cost-accounting function should be segregated from the general ledger function. it is possible for that individual to conceal unauthorized shipments. If the individual responsible for production management or inventory stores functions is also responsible for the physical inventory. This can result in the theft of goods. If one individual is responsible for both controlling and accounting for inventory. Possible Errors or Fraud If the individual responsible for inventory management also has access to the cost-accounting records.or understatement of inventory and net income. If one individual is responsible for the inventory records and also for the general ledger.Key Segregation of Duties Segregation of Duties The inventory management function should be segregated from the costaccounting function.

 Products that are small and of high value are more susceptible to theft. there may be problems with the proper valuation of inventory. 2. Plan and perform tests of controls on inventory transactions. Prior-year misstatements are good indicators of potential misstatements in the current year. Set and document the control risk for the inventory management process.Risk Assessment INHERENT RISK  If industry competition is intense. Understand and document the inventory management process based on a reliance strategy. CONTROL RISK Steps: 1. CAEA 2218 2010/2011. 3. Technology changes in certain industries may also promote material misstatement due to obsolescence. The auditor must be alert to related-party transactions for acquiring raw materials and selling finished products. LECTURE 9 Slide 6 .

Review and test cost accumulation and variance reports. Observe the physical safeguards over inventory. Review authorized production schedules. and excess quantities. Review and test client procedures for account for numerical sequence of materials requisitions. Review and test procedures for taking physical inventory. Classification Review the procedures and forms used to classify inventory. Review and test procedures for developing Authorization inventory levels and procedures used to control them.Control Activities and Tests of Controls – Inventory Transactions Assertion Test of Controls Observe and evaluate proper segregation of duties. LECTURE 9 Slide 7 . Review and test procedures used to develop standard costs. Review the reconciliation of perpetual inventory to general ledger control account. slow-moving. Review and test procedures for issuing materials to manufacturing Occurrence departments. Review and test procedures for transfer of inventory. Review Accuracy and test procedures for identifying obsolete. Review and test procedures for processing inventory included on receiving reports into the Cutoff perpetual records. CAEA 2218 2010/2011. Review and test procedures for removing inventory from perpetual records based on shipments of goods. Review and tests client's procedures for Completeness consignment goods.

LECTURE 9 Slide 8 .  Authorization of Inventory Transactions – the auditor’s concern with authorization in the inventory system is with unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods. the auditor is able to classify it by type.  Accuracy of Inventory Transactions – inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements. Inventory purchases must be recorded at the correct price and actual quantity received. Inventory shipped must be properly recorded in cost of goods sold and the related revenue recognized. By knowing which manufacturing department holds the inventory. The auditor should also be concerned that goods may be stolen. or finished goods.Control Activities and Tests of Controls – Inventory Transactions  Occurrence of Inventory Transactions – the auditor’s main concern is that all recorded inventory exists.  Completeness of Inventory Transactions – the primary control procedure for completeness relates to recording inventory that has been received. work in process.  Classification of Inventory Transactions – the client must have control procedures to ensure that inventory is properly classified as raw materials. CAEA 2218 2010/2011. Controls are closely related to the purchasing process. Review and observation are the main tests of controls used by the auditor to test the control procedures.

 Authorization . Inventory transactions and events are valid. Inventory receipts and shipments are recorded in the correct accounting period.All inventory transactions and events have been recorded. All inventory transactions and events are properly authorized. LECTURE 9 Slide 9 . transactions.Control Risk relation to Substantive Procedures Assertions about Classes of Transactions and Events:  Occurrence.  Cutoff. Inventory is recorded in the proper accounts. and other matters relating to inventory have occurred and pertain to the entity  Completeness –all disclosures relating to inventory that should have been included in the financial statements have been included  Classification and understandability – financial information relating to inventory is appropriately presented and described.  Accuracy.  Completeness. and related revenue and cost of goods sold have been properly accumulated from journals and ledgers. Assertions about Account Balances at the Period End:  Existence – inventory recorded on the books and records actually exists  Rights and obligations – the entity has the legal rights of the recorded inventory  Completeness – all inventory is recorded  Valuation and allocation – inventory is properly recorded in accordance with GAAP Assertions about Presentation and disclosure:  Occurrence & Rights and obligations –all disclosed events. and disclosures are clearly expressed  Accuracy and valuation –financial and other information relating to inventory are disclosed fairly and at appropriate amounts CAEA 2218 2010/2011.  Classification. Inventory transactions have been properly computed and ending inventory.

Compare gross profit percentage by product line with Unrecorded or fictitious inventory previous years' and industry data. finished goods. or excess inventory and industry average. CAEA 2218 2010/2011. or excess inventory turnover to previous years' and industry averages. Compare actual cost of goods sold to budgeted amounts. Compare actual manufacturing overhead costs with Inclusion or exclusion of overhead costs budgeted or standard overhead costs. Over. LECTURE 9 Slide 10 . Compare days outstanding in inventory to previous years' Obsolete. slow-moving. and total inventory Obsolete. slow-moving.Auditing Inventory – Substantive Analytical Procedures Substantive Analytical Procedure Possible Misstatement Detected Compare raw material.or understated inventory Compare current-year standard costs with prior years' after Over.or understated inventory considering current conditions.

Overhead Review the client’s method of overhead allocation for reasonableness. LECTURE 9 Slide 11 . compliance with GAAP. and consistency. CAEA 2218 2010/2011. Labor Gather evidence about the type and amount of labor needed for production and the labor rate.Auditing Inventory Auditing Standard Costs Material Test the quantity and type of materials included in the product and the price of the materials.

9. Inquire about goods held on consignment for others or held on a “bill-andhold” basis. including the number of the last shipping and receiving documents issued. 2. slow moving. 4. Ensure that there is no movement of goods during the inventory count. 8.Auditing Inventory Observing Physical Inventory 1. 5. If production is scheduled proper controls must be established for movement between departments in order to prevent double counting. or carried in excess quantities. Obtain tag control information for testing the client’s inventory compilation. 3. 6. LECTURE 9 Slide 12 . Ensure that inventory tags are issued sequentially to individual departments. Ensure that no production is scheduled. Observe the condition of the inventory for items that may be obsolete. Make sure that the client’s count teams are following the inventory count instructions. 7. Perform test counts and record a sample of counts in the working papers. CAEA 2218 2010/2011. Obtain cutoff information.

Review book to physical adjustments for possible misstatements CAEA 2218 2010/2011. LECTURE 9 Slide 13 . Test mathematical accuracy of extensions and foot the inventory compilation. audit standard costs or other methods used to price inventory  Cutoff – trace a sample of time cards before and after period and to the appropriate weekly inventory report  Classification –examine a sample of inventory checks for proper classification into expense accounts Test of details of account balances:  Existence – observe count of physical inventory  Rights and obligations – verify that inventory held on consignment for others or ‘billand-hold’ goods are not included in inventory  Completeness – trace tests counts and tag control information to inventory compilation  Valuation and allocation – obtain a copy of the inventory compilation and agree totals to general ledger. Inquire management on obsolete. excess inventory. & Disclosures Substantive tests of transactions:  Occurrence –vouch a sample of inventory additions to receiving reports and purchase requisition  Completeness – trace a sample of receiving reports to the inventory records  Authorization –test a sample of inventory shipments to ensure there is an approved shipping ticket and customer sales  Accuracy – re-compute mathematical accuracy of a sample of inventory transactions. slow-moving. Account Balances.Tests of Details of Transactions.

 Accuracy and valuation –Determine if the cost method is accurately disclosed. & Disclosures Assertions about Presentation and disclosure:  Occurrence & Rights and obligations – Inquire of management and review any loan agreements and board of directors' minutes for any indication that inventory has been pledged or assigned. Inquire of management abut issues related to LIFO liquidations. work in process. Read footnotes and other information to ensure that the information is accurate and properly presented at the appropriate amounts. Read footnotes to ensure that required disclosures are understandable.Tests of Details of Transactions. CAEA 2218 2010/2011. (v) Purchases from related parties. retail method). (2) Unreported scrap or spoilage. (vii) Pledged or assigned inventory (viii) Disclosure of unusual losses from write-downs (ix) Warranty obligations. LIFO. Possible causes of book-to-physical differences: (1) Inventory cutoff errors. Account Balances. and finished goods. LECTURE 9 Slide 14 . Inquire of management about issues related to warranty obligations. (iv) Consigned inventory. Examples of Disclosure Items: (i) Cost method (FIFO.  Completeness –Complete financial reporting checklist to ensure that all financial statement disclosures related to inventory are made.  Classification and understandability – Review inventory compilation for proper classification among raw materials. (vi) LIFO liquidations.. (3) Pilferage or theft. (iii) Long-term purchase contracts. (ii) Components of inventory.

Inventory At the conclusion of testing. (Qur'an. whoever rejects taghut (evil) and believes in Allah has grasped the most trust worthy hand-hold that never breaks. the auditor should aggregate all identified misstatements. Likely misstatement > Tolerable misstatement The auditor may conclude the inventory is not fairly presented. LECTURE 9 Slide 15 . verily. the right path has become distinct from the wrong path. and Allah hear and know all things". 2:256) CAEA 2218 2010/2011. Likely misstatement < Tolerable misstatement The auditor may accept the inventory account as fairly presented. End of lEcturE 9 "Let there be no compulsion in religion.Evaluating the Audit Findings . The likely misstatement is compared to the tolerable misstatement allocated to the inventory account.


an entity implements procedures for accelerating the collection of cash receipts and properly delaying the payment of cash disbursements. Examples: Treasury bills.Cash and Other Business Processes  “Cash” reported in the financial statements represents currency on hand and cash on deposit in bank accounts. time deposits. including certificates of deposit. LECTURE 10 Slide 2 . highly liquid investments that are readily convertible to cash or so near their maturity that there is little risk of change in their value. CAEA 2218 2010/2011. commercial paper. and money market funds. (iii) Branch Accounts In order to maximize its cash position. (ii) Imprest cash accounts. and savings accounts.  Types of banking accounts : (i) General cash accounts. Definition: Short-term.  “Cash equivalents” are frequently combined with cash for presentation in the financial statements.

LECTURE 10 Slide 3 .Cash and Other Business Processes CAEA 2218 2010/2011.

 This limited use of substantive analytical procedures is normally offset by (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and disbursements or (2) extensive tests of the entity’s bank reconciliations. the auditor’s use of substantive analytical procedures for auditing cash is limited to:  comparisons with prior years’ cash balances. CAEA 2218 2010/2011. LECTURE 10 Slide 4 .Substantive Analytical Procedures—Cash  Because of the residual nature of the cash account.  The reliability of the client’s controls over cash (controls over cash receipts and control over cash disbursements as well as bank reconciliations) affects the nature and extent of the auditor’s tests of details.  comparisons with budgeted amounts.

Substantive Tests of Details of Transactions & Account Balances CAEA 2218 2010/2011. LECTURE 10 Slide 5 .

LECTURE 10 Slide 6 .Balance-Related Assertions CAEA 2218 2010/2011.

(ii) standard bank confirmation and (iii) cutoff bank statement CAEA 2218 2010/2011.Auditing the General Cash Account  The auditor should first obtain (i) copies of bank reconciliation. LECTURE 10 Slide 7 .

LECTURE 10 Slide 8 .Auditing the General Cash Account CAEA 2218 2010/2011.

LECTURE 10 Slide 9 .Auditing the General Cash Account Date of Last Bank Reconciliation 7 to 10 Days A cutoff bank statement normally covers the 10-day period after the date on which the bank account is 10-day period. Any reconciling item should have cleared the client’s bank account during the 7. CAEA 2218 2010/2011.

 The audit of any imprest cash account such as payroll or a branch account follows the same basic audit steps for general cash accounts  Petty cash are seldom material in organisation. amount and endorsement. 5. Agree the adjusted book balance to the cash account lead schedule. 4. Trace the deposits in transit on the bank reconciliation to the cutoff bank statement. Agree any charges included on the bank statement to the bank reconciliation. 3. LECTURE 10 Slide 10 . Agree the bank balance on the reconciliation with the balance shown on the standard bank confirmation. 6.Auditing the General Cash Account  The auditor uses the following audit procedures to test the bank reconciliation: 1. Compare the outstanding checks on the bank reconciliation with the canceled checks in the cutoff bank statement for proper payee. 2. Test the mathematical accuracy and agree the balance per the books to the general ledger. however it has potential for defalcation – substantive tests are rarely performed for petty cash. auditing the controlling documents surrounding petty cash should be sufficient CAEA 2218 2010/2011.

Any restrictions on cash such as a sinking fund requirement for funds allocated by the entity’s board of directors for special purposes. Contractual obligations to maintain compensation balances. 4. the year-end bank reconciliation can be used to cover cash defalcations. CAEA 2218 2010/2011. The employee could “hide” the $5. LECTURE 10 Slide 11 .000 from the client. 5. 3.  Proof of cash  In some instances. suppose a client employee was able to steal $5. For example. The client’s cash balance at the bank would then be $5. Letters of credit  A letter might be sent to banks to confirm the compensating balance disclosures  Audit procedures related to fraud includes:  Extended bank reconciliation.000 less than reported on the client’s books. This is usually accomplished by manipulating the reconciling items in the bank reconciliation. Cash balances restricted by foreign exchange controls. Accounting policies for defining cash and cash equivalents.Auditing the General Cash Account  Some disclosure issues over cash are: 1.000 shortage in the bank reconciliation by including a fictitious deposit in transit.  Tests for kiting. 2.

Auditing the General Cash Account CAEA 2218 2010/2011. LECTURE 10 Slide 12 .

LECTURE 10 Slide 13 .Auditing the General Cash Account – Test for Kiting CAEA 2218 2010/2011.

(ii) completeness.Auditing for Investments  Investments items includes – common stock. and (iii) accuracy and classification  Key segregation of duties and possible errors avoided: CAEA 2218 2010/2011. debt securities and hybrid securities  Control risk assessments for investments focuses on assertion in terms of (i) occurrence and authorization. preferred stock. LECTURE 10 Slide 14 .

Auditing for Investments . LECTURE 10 Slide 15 .Substantive Procedures CAEA 2218 2010/2011.

Auditing for Investments . (iv) Confirmation of unsettled transactions with the broker-dealer. • A debt security has been downgraded by a rating agency. (v) Confirmation with the counterparty. LECTURE 10 Slide 16 . Auditing and accounting standards provide guidance for determining whether a decline in value below amortized cost is other than temporary. Held-to-maturity securities and individual available-for-sale securities should be classified as current or non-current assets based on whether management expects to convert them to cash within 12 months. Here are some factors that may indicate a non-temporary impairment of investment value: • Fair value is significantly below cost . trading. (iii) Confirmation with the custodian. • Management does not possess both the intent and ability to hold the investment long enough to allow for recovery in fair value. (vi) Reading executed agreements. • Decline in fair value is attributable to specific adverse conditions.  Valuation and Allocation: The auditor must also determine if there has been any permanent decline in the value of an investment security. • The financial condition of the issuer has deteriorated Permanently Impaired = Write down to new carrying amount  Disclosure Assertions : Marketable securities need to be properly classified as held-to-maturity. and available-for-sale. (ii) Confirmation with the issuer.Tests of Details  Existence: Auditing Standards state that the auditor should perform one of the following procedures when gathering evidence for existence: (i) Physical examination. All trading securities should be classified as current assets CAEA 2218 2010/2011.

DEPARTMENT OF FINANCIAL ACCOUNTING AND AUDITING CAEA 2218 AUDITING PRINCIPLES –SESSION 1 2010/2011 DR HASLIDA ABU HASAN LECTURE 11 Auditing for Prepaid Expenses. Intangible Assets and Tangible Assets of Property. LECTURE 11 Slide 1 4-1 . Plant and Equipment CAEA 2218 2010/2011.

 The inherent risk associated with prepaid expenses is generally assessed as low because the accounts do not involve any complex or contentious accounting issues.  Rights and Obligations – confirm policy beneficiary with the insurance broker.  Because prepaid expenses are normally processed through the purchasing process. examine supporting source documents. Examples include: (i) Prepaid insurance. (iii) Prepaid interest. (ii) Prepaid rent. control procedures in purchasing should ensure that each item is properly authorized and recorded. CAEA 2218 2010/2011.  Classification –determine propriety of distribution between manufacturing overhead and SG&Aexpense.  Tests of Details of the Prepaid Insurance Account – audit testing begins by obtaining a detail schedule of the prepaid insurance account.  Existence and Completeness –confirm policy with insurance broker.Auditing Prepaid Expenses  Other assets that provide economic benefit for less than a year are classified as current assets and are called prepaid expenses. LECTURE 11 Slide 2 4-2 .  Valuation – determine unexpired portion of policy and insurance expense.

3. Examples of five general categories of intangible assets: 1. including approval processes (AU 328). brand name.  The inherent risk associated with intangible assets raises serious risk considerations. 2. LECTURE 11 Slide 3 4-3 . The significant management assumptions used in determining fair value. 5. 4. franchises and broadcast rights. The expertise and experience of those determining the fair value of the assets. order backlogs. The extent to which the entity engages or employs valuation specialists. including controls over data and segregation of duties between those committing the client to the purchase and those undertaking the valuation. Customer – customer lists. and customer relationships. 2. Controls over the process used to determine fair value measurements. 3. Technology – patented and unpatented technology. but lack physical substance. With the judgment and complexity association with valuation and estimation of intangible assets. 4. The accounting rules are complex and the transactions are difficult to audit. the auditor would likely assess the inherent risk as high.  Factors considered in Control Risks assessments: 1. Contract – licenses. 5. CAEA 2218 2010/2011.Auditing Intangible Assets  Intangible assets are assets that provide economic benefit for longer than a year. Marketing – trademark. Accounting standards require different asset impairment tests for different classes of intangible assets (FAS 142). and Internet domain names. The integrity of change controls and security procedures for valuation models and relevant information systems. Artistic – items protected by copyright.

substantive analytical procedures are not likely to provide sufficient. as noted above. 4. and. CAEA 2218 2010/2011.Auditing Intangible Assets  Tests of Details – associated with valuation and impairment of intangible assets are often necessary because the complexity and degree of judgment increase the risk of material misstatement. Rights and obligations. Some substantive evidence is required for all significant accounts. 2. Four assertions are normally considered for tests of details of intangible assets: 1. Existence and completeness. 3. LECTURE 11 Slide 4 4-4 . Classification. Valuation. appropriate evidence for significant transactions involving intangible assets.

Auditing the Property Management Process  Property. However. Difficult-to-audit transactions (donated assets.  Control procedures for the occurrence and authorization of property. plant. 3. selfconstructed assets). (ii) date of acquisition and installed costs. Acquisition of capital assets for cash or other nonmonetary considerations. or abandonment. location and ID number. and equipment are normally part of the purchasing process.  Four types of PP&E transactions may occur: 1. Misstatements detected in prior audit. New Engagement – the auditor has to verify the assets that make up the beginning balance in property. non-monetary exchange. large capital asset transactions may be subject to additional controls. Complex accounting issues. Recurring Engagement – the auditor is able to focus on additions and retirements in the current period because amounts from prior periods have been subject to audit procedures. Depreciation of capital assets over their useful economic life. LECTURE 11 Slide 5 4-5 . 2. retirement. Leasing of capital assets. 3. plant and equipment usually represents a material amount in the financial statements. plant. 4. exchange. Disposition of capital assets through sale. (iii) depreciation methods for book and tax purpose – salvage value. Companies should have an authorization table for approving capital asset transactions. Completeness – detailed PPE subsidiary ledgers usually includes information about (i) description. estimated useful life etc CAEA 2218 2010/2011. and equipment. 2.  There are three inherent risk factors that must be considered by the auditor: 1.

Auditing the Property Management Process Physical Plant IT Department From purchasing process PP&E transaction file Specialized PP&E transactions Review for proper recording Input PP&E program PP&E transaction report Reconcile to Monthly PP&E general ledger subledger CAEA 2218 2010/2011. LECTURE 11 Slide 6 4-6 General ledger PP&E master file master file General ledger program General ledger report .

normally be detected by reconciling subsidiary records with the general ledger control account. The initiation function should be segregated from the final approval function. If one individual is responsible for the PP&E records The PP&E records function should be and also has custodial responsibility for the related segregated from the custodial function. If one individual is responsible for the PP&E records The PP&E records function should be and also for the general ledger functions. and the theft can be concealed by adjustment of the accounting records. or illegal payments to suppliers. items may be stolen.Auditing the Property Management Process Segregation of Duties Possible Errors or Fraud If one individual is responsible for initiating a capital asset transaction and also has final approval. fictitious or unauthorized purchases of assets can occur. If a periodic physical inventory of PP&E If one individual who is responsible for the periodic is taken. assets that do not meet the company's quality control standards. This can result it purchases of unnecessary assets. LECTURE 11 Slide 7 4-7 . theft or the the custodial and record-keeping entity's capital assets can be concealed. functions. that segregated from the general ledger individual can conceal any defalcation that would function. assets. CAEA 2218 2010/2011. the individual responsible for physical inventory of PP&E is also responsible for the the inventory should be independent of custodial and record-keeping functions.

3. 2. each material lease agreement should be reviewed for proper classification as operating or capital lease.  Test of details of transactions. the repairs and maintenance account should be reviewed to determine if any capital assets have been incorrectly recorded in these accounts. the auditor must determine that the capital asset is recorded in the proper account. 4.Auditing the Property Management Process  Substantive Analytical Procedures: 1. 5.  Cutoff – Cutoff is normally part of the accounts payable and accrued expenses work. These schedules are footed and agreed to the general ledger.  Classification – First. Compare prior-year balances in PP&E and depreciation expense with current-year balances. Review capital budgets and compare the amounts spent with amounts budgeted. Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior years’ ratios. CAEA 2218 2010/2011. Finally. Compute the ratio of depreciation expense to the related PP&E accounts and compare to prior years’ ratios. Compute the ratio of insurance expense to related PP&E accounts and compare to prior years’ ratio. account balances and disclosures:  Completeness – The auditor begins the process by obtaining a lead schedule and detailed schedules of additions and dispositions of assets. LECTURE 11 Slide 8 4-8 . Vendor’s invoices from a few days before and after year-end are examined to determine if the assets is recorded in the proper accounting period. Second.

 Rights and obligations – In most cases. account balances and disclosures (continued):  Existence – A list of all major additions should be obtained and each addition should be vouched to supporting documentation.Auditing the Property Management Process  Test of details of transactions. CAEA 2218 2010/2011. For major acquisitions. The auditor tests the recorded cost of major new additions to PP&E. this process can be quite difficult. LECTURE 11 Slide 9 4-9 . either manually or with the aid of a computer. the auditor may wish to confirm property deeds or title documentation. rights or ownership can be determined by examining vendor’s invoices and other supporting documents. The auditor may recompute. In some cases. Major dispositions should be vouched to supporting documentation and examined for proper authorization. The auditor must test for permanent impairment of long-lived assets. This is often done during the inventory observation.  Valuation and allocation – Capital assets are valued at acquisition cost plus any costs necessary to make the asset operational. Auditors may look to other sources of information to learn about impairments. the auditor may physically examine the capital asset. the proper depreciation expense for the period. While GAAP requires the comparison of future cash inflows to the asset’s carrying amount.

Acquisition or disposal of major operating facilities. 5. the evidence indicates that the PP&E accounts are fairly stated. account balances and disclosures (continued):  Examples of disclosure items: 1. CAEA 2218 2010/2011. Depreciation methods and useful lives for financial reporting and tax purposes. 4. If the likely misstatement is greater than the tolerable misstatement.Auditing the Property Management Process  Test of details of transactions. 3. Liens and mortgages. 2. Construction or purchase commitments. Capitalized and other lease arrangements. the auditor would either require adjustment of the accounts or issue a qualified audit report. Classes of capital assets and valuation bases. LECTURE 11 Slide 10 4-10 . Evaluating the audit findings for PPE: If the likely misstatement is less than the tolerable misstatement. Nonoperating assets. 7. 6.

Distinguish auditor’s and management’s objectives. Describe the relevant statutory and regulatory requirements in the Malaysian auditing environment. Explain the nature and fundamental concepts of auditing with emphasis on external auditors. 5. 3. Apply code of ethics and professional standards (MIA By-Laws) in auditing 4-11 . Apply relevant audit procedures and practical aspects of audit to transaction cycles and items of balance sheet and income statement. responsibilities on audit of financial statements. 2. 4.1.

LECTURE 12 Slide 1 .DEPARTMENT OF FINANCIAL ACCOUNTING AND AUDITING CAEA 2218 AUDITING PRINCIPLES –SESSION 1 2010/2011 DR HASLIDA ABU HASAN LECTURE 12 Auditing for Long Term Liabilities. Stockholders’ Equity. and Income Statement Accounts CAEA 2218 2010/2011.

The inherent risk associated with these instruments is normally high.  The inherent risk for notes and bonds would normally be assessed as low to moderate because the volume of transactions are low. However.  The control risk : when a substantive strategy is followed. LECTURE 12 Slide 2 . CAEA 2218 2010/2011. the auditor still needs a sufficient understanding of the entity’s internal control system over debt. it is more efficient to follow a strategy of conducting substantive testing. and the client often receives third-party statements or amortization tables.Auditing Long Term Debt  The auditor must be assured that the amounts shown on the balance sheet for the various types of long-term debt are not materially misstated. the accounting is not complex. the amounts are usually large and the financial markets have developed sophisticated instruments that have characteristics of both debt and equity. For the vast majority of entities. This assurance extends to the recognition of interest expense.

(ii) any significant debt commitments should be approved by the board of directors or by executives who have been delegated this authority. CAEA 2218 2010/2011. When the entity has proper controls for issuing debt transactions. 2.Auditing Long Term Debt  Assertion and Related Control Ativities – 1. it is generally easy for the auditor to test those transactions for occurrence and authorization at the end of the period. The debt amount recorded in the subsidiary ledger should be reconciled to the general ledger control account regularly. 3. 4. Disclosure-Classification – Controls should ensure that notes and bonds are properly classified in the financial statements. Occurrence and authorization – (i) adequate documentation must verify that a note or bond was properly authorized. The major issue is to properly classify as a shortterm liability the portion of long-term debt that is due in the next year. Valuation – Notes and bonds are recorded at their face value less any unamortized discount or plus any unamortized premium. Completeness – The client should maintain a subsidiary ledger that contains information about all the long-term debt owed by the entity. The effective interest method should be used to amortize discounts and premiums (the straight-line method may be used if the results are not materially different from the effective interest amounts). LECTURE 12 Slide 3 .

Accuracy Test a sample of receipts and payments. Review debt activity for a few days before and after year-end to Cutoff determine if the transactions are included in the proper period. and confirm balances and other relevant information with outside parties. LECTURE 12 Slide 4 . CAEA 2218 2010/2011. Review notes paid or renewed after the balance sheet date to determine if there are unrecorded liabilities at year-end. determine the status of prior debt agreements. Review interest expense for payments to debt holders Completeness not listed on the debt analysis schedule. Trace large cash receipts and payments to source documents and the general ledger. Evaluate lease contracts to determine if leases are properly accounted for as an operating or capital lease. Assertions Occurrence Substantive Tests of Transaction Examine copies of new note or bond agreements. Analytical procedures are useful because of the direct relationship between interest expense and the amount of long-term debt. Examine board of directors' minutes for approval of new lending agreements. Examine board minutes for evidence of proper authorization of notes or Authorization bonds.Auditing Long Term Debt  Substantive Procedures – the auditor should examine any new debt agreements. Examine the due dates on notes or bonds for proper classification Classification between current and long-term debt.

allocation Recompute accrued interest. Rights and obligations Examine copies of note and bond agreements. Confirm the outstanding balance for notes or Valuation and bonds and the last date on which interest has been paid. CAEA 2218 2010/2011. Confirm notes or bonds with creditors. foot schedule and agree totals to the general ledger. Obtain a standard bank confirmation requesting specific Completeness information on notes from banks. Inquire or management about "off-balance sheet" activities. LECTURE 12 Slide 5 . Review board meeting minutes for debt-related activities. Verify computation of the amortization of premium or discount. Examine new debt agreements to ensure that they were recorded at the proper value.Auditing Long Term Debt Year-End Balances Tests of Details of Account Balances Existence Confirm notes or bonds directly with creditors. and accrued interest. Obtain an analysis of notes and bonds payable.

Relevant information about equity transactions may be confirmed with the register and transfer agent. LECTURE 12 Slide 6 . Large. and issuance of stock for stock splits. (i) issuance of stock including transactions such as sale of stock for cash.Auditing Stockholders’ Equity  The following three types of transactions are of importance to the auditor. (iii) payment of dividends including cash and stock dividends. publicly traded companies use a registrar and transfer agent to process and record equity transaction. (ii) repurchase of stock including both the reacquisition of stock and retirement of stock.  The control risk : A substantive strategy is often used to audit stockholders’ equity because the number of transactions is usually small. The auditor must still be aware of the types of controls that are in place to prevent the misstatement of equity transactions. the exchange of stock for assets. CAEA 2218 2010/2011.

The individual responsible for maintaining the detailed stockholders’ records should be independent of the maintenance of the general ledger control accounts. 4. transferring. 2. The individuals responsible for issuing. 3. CAEA 2218 2010/2011. 3. Accuracy – Verify that stock and dividend transactions have been properly posted and summarized in the accounting records. LECTURE 12 Slide 7 . recording. Authorization – Verify that stock and dividend transactions have been properly approved. Occurrence – Verify that stock and dividend transactions comply with corporate charter. signing. and canceling stock certificates should not have any accounting responsibilities. 4. the following duties should be segregated: 1. The individual responsible for maintaining the detailed stockholders’ records should not also process cash receipts or disbursements. Valuation – Verify that stock and dividend transactions have been properly valued.  When possible. 2. and mailing of dividend checks.Auditing Stockholders’ Equity  Assertion and control activities: 1. Appropriate segregation of duties should be established among the preparation.

The auditor must recompute the dividend and trace the entries to the general ledger.Auditing Capital-Stock Accounts  Assertion and control activities: 1. (iv) stock option or purchase plans. The proceeds from the sale are normally traced to the cash receipts records. 2. Valuation – (i) when stock is issued for cash the valuation is straightforward. (ii) when stock is exchanged for property. and dates of preferred stock. issued. (vi) any completed or pending transactions that may affect stockholders’equity. (iii) stock dividends may also create complex auditing issues. Occurrence and completeness – when outside agents are not used the auditor must (i) trace the transfers of shares between stockholders to the stock register and/or stock certificate book. prices. or services. (ii) call privileges. (iii) preferredstock sinking funds. Generally. 3. (iv) account for and inspect any unissued stock certificates in the stock certificate book. goods. fair market value is an issue and the accounting may involve a gain or loss. Completeness of disclosure – examples of disclosure items include (i) number of shares authorized. (iii) examine any canceled stock certificates. the valuation issue is more complex. LECTURE 12 Slide 8 . and outstanding for each class of stock. (v) restrictions on retained earnings and dividends. (ii) foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares outstanding in the general ledger. CAEA 2218 2010/2011.

 When an independent dividend-disbursing agent is used. the auditor can confirm the amount disbursed with the agent. This amount is agreed with the amount authorized by the board of directors.Auditing Dividends  All dividends declared and paid will be audited because of concerns of violations of corporate bylaws or debt covenants.  When an independent agent is not used. LECTURE 12 Slide 9 . the auditor can recompute the amount of the dividend authorized by the board of directors and trace the amount to cash disbursements or dividends payable. CAEA 2218 2010/2011.

CAEA 2218 2010/2011. The major exception is the existence of prior period adjustments.Auditing Retained Earnings  Under normal circumstances. valuation accounts for certain marketable securities and foreign currency translation. retained earnings are affected by the current year’s income or loss and the dividends declared and or paid. LECTURE 12 Slide 10 .

3.Auditing Income Statement Accounts  The audit of revenue and expense accounts depends on the extent of work conducted on the entity’s control system and balance sheet accounts. gain/losses on sales or assets retirement  Prepaid insurance – insurance expense  Long term debt / accrued interest payable – interest expense CAEA 2218 2010/2011. If controls are operating effectively – the auditor may reduce control risk below the maximum. The results of the detailed tests of balance sheet accounts and the related income statement accounts. LECTURE 12 Slide 11 . Substantive procedures on selected income statement accounts include: 1. Performance of substantive analytical procedures on income statement accounts. Instead extensive substantive procedures are used.  Income statement accounts are normally audited in the course of auditing the related balance sheet accounts.  Balance sheet accounts link to income statement accounts  AR / Allowance for doubtful debt – bad debt expense  NR / Investments / Accrued interest receivable – Interest expense  PPE / Accumulated depreciation / Depreciation expense. 4. Detailed tests of selected income statement accounts.  If control risk is set at the maximum – the auditor does not rely on controls. If a reliance strategy is followed – the auditor determines if controls may be relied upon. 2. The results of testing controls for the various business processes.

charitable contributions.Auditing Income Statement Accounts  Substantive analytical procedures – extensive use of analytical procedures in the audit of revenue and expense accounts. page 522 CAEA 2218 2010/2011. trend and ratio analysis. Usually. the auditor verifies the transactions in the account by examining the supporting documentation. and other income and expense. LECTURE 12 Slide 12 . travel and entertainment. Accounts audited in this manner may be related to income tax reporting and include legal and audit expense. example – common size statement comparing current to previous years. TUTORIAL QUESTIONS Problem 15-21.  Tests of selected account balances – The auditor may wish to examine key revenue and expense accounts in some detail. page 521 Problem 15-23.


deduction authorization forms. periodic payroll reports. pension schemes. payroll master file. training. evaluating. (iii) payroll.  Departments involve includes (i) operating.Auditing the HRM  The human resource process starts with the establishment of sound policies for hiring. unemployment taxes etc – cash and various accruals . and taking remedial actions for employees. payroll check/direct deposit records. direct/indirect labor expense account . payroll master file changes report. accrual and payment of payroll-related liabilities arising from employees’ services such as social securities. payroll register. (ii) HRM. various tax reports and forms. compensating. LECTURE 13 Slide 2 . (iv) IT  Transactions and accounts involve are the: 1. counseling. CAEA 2218 2010/2011. 2. including wagerate or salary authorizations. promoting. time card. payments to employees –cash.  Documents and records relevant are – personnel records.  The main concern of the auditor involves payroll transactions once an employee has been hired.

and General ledger summarization of payroll in the general ledger. deductions. wage-rate and salary adjustments. Processing of employees' attendance and time information and coding of account distribution. Payment of employees' compensation and benefits. CAEA 2218 2010/2011. firing. recording and summarization of payments and verification of account distribution. LECTURE 13 Slide 3 .Major HRM functions Personnel Authorization of hiring. classification. salaries. and payroll cost variances. monitoring of employee scheduling. Review and approval of employees' attendance and time information. Supervision Timekeeping Payroll processing Disbursement Proper accumulation. Computation of gross pay. and payroll deductions. productivity. and net pay.

LECTURE 13 Slide 4 .Segregation of duties Payroll Function Initiation of wage or salary changes Initiation of employee hiring and firing Approval of wage and salary changes Updating of personnel records Updating of payroll records Approval of time cards and job classification Review of time data and payroll distribution Preparation of payroll Preparation and signing of payroll checks Distribution of payroll checks Undating of general ledger for payroll Comparison of payroll expense to budget Calculation and recording of payroll taxes Human TimeOperating Resource keeping Payroll X X X X X X X X IT Treasurer X X X X X X CAEA 2218 2010/2011.

LECTURE 13 Slide 5 .Segregation of duties Payroll Function Initiation of wage or salary changes Initiation of employee hiring and firing Approval of wage and salary changes Updating of personnel records Updating of payroll records Approval of time cards and job classification Review of time data and payroll distribution Preparation of payroll Preparation and signing of payroll checks Distribution of payroll checks Undating of general ledger for payroll Comparison of payroll expense to budget Calculation and recording of payroll taxes Human TimeOperating Resource keeping Payroll X X X X X X X X IT Treasurer X X X X X X CAEA 2218 2010/2011.

 Control risk assessments steps follow similar procedures of understanding and document the HRM process. LECTURE 13 Slide 6 .  The inherent risk associated with officers of the company may not be considered low because of the ability to take advantage of their high position. CAEA 2218 2010/2011. perform tests of control and set and document control risk.Risk assessments  In assessing inherent risk the auditor may want to consider the effect of economic conditions on payroll costs.  The inherent risk associated with non-officers of the company is generally considered low. The auditor should be familiar with any existing labor contracts and the impact of regulation on the company. the supply of skilled workers. and the frequency of employee turnover.

awarding benefits. the nature and extent of substantive testing will be increased. If the results of the tests of controls for the payroll system support the planned level of control risk.Risk assessments  Control activities and test of controls:  Occurrence – the auditor want assurance that payments for payroll-related services are being made to valid employees for time actually worked. and issuing payroll checks. making withholdings. the financial statement may be misstated. CAEA 2218 2010/2011.  Authorization – the client must have controls for hiring and terminating employees. awarding benefits. If the tests do not support the level of control risk. the auditor conducts substantive procedures of payroll-related accounts at the assessed level. and issuing payroll checks. If payroll expense is not properly classified between direct and indirect labor. making withholdings. setting pay rates.  Classification – If payroll expense is charged to the wrong accounts.  Accuracy – The client must have controls for hiring and terminating employees. LECTURE 13 Slide 7 . inventory and cost of goods sold may not be valued properly. setting pay rates. Controls must be in place to ensure that no payments are made to fictitious employees and payments to valid employees are stopped once the employee is terminated.

Auditing payroll related accounts Substantive analytical procedures: 1. Payroll Expense Accounts:  Compare current year with prior years' payroll expense accounts  Compare current and prior years' payroll costs as percent of sales and industry data  Compare labor utilization rates and statistics with industry data  Compare budgeted payroll expenses with actual payroll expenses  Estimate sales commissions with formula and recorded sales 2. Payroll-Related Accrual Accounts:  Compare current and prior years' balances in payroll related accounts  Test reasonableness of accrual balance CAEA 2218 2010/2011. LECTURE 13 Slide 8 .

deductions. LECTURE 13 Slide 9 . Trace a sample of time cards before and after period end to the appropriate payroll report. Trace a sample of time cards to the payroll register. Examine a sample of payroll checks for proper classification into expense accounts. and Disclosures Assertions about Transactions Occurrence Completeness Authorization Accuracy Cutoff Classification Substantive Tests of Transaction Trace a sample of payroll checks to the master employee list to verify validity. and net pay. Recompute a sample of payroll checks for gross pay.Auditing payroll related accounts Tests of Detail of Transactions. Test a sample of payroll checks for proper authorization. CAEA 2218 2010/2011. Account Balances.

foot schedules for accrued payroll Valuation and Allocation liabilities. LECTURE 13 Slide 10 . Completeness Search for unrecorded liabilities. etc. Obtain an account analysis schedule for accrued payroll liabilites. such as payroll tax returns. Compare amounts accrued to supporting documentation.Auditing payroll related accounts Tests of Detail of Transactions. Review supporting documentation to determne that Rights and obligations the entity is legally obligated to pay the liability. CAEA 2218 2010/2011. Account Balances. and Disclosures Assertions about Account Balances at Period End Tests of Details of Account Balances Vouch selected amounts from account schedules for Existence accruals to supporting documents (payroll tax returns. corporate benefit policies..

CAEA 2218 2010/2011. Account Balances. LECTURE 13 Slide 11 . and rights and Inquire about accruals to ensure that they are properly obligations disclosed. and Disclosures Assertions about Presentation and Disclosure Tests of Details of Disclosures Occurrence.Auditing payroll related accounts Tests of Detail of Transactions. Read footnotes Accuracy and valuation and other information to ensure that the information is accurate and properly presented at the appropriate amounts. Review benefit contracts for proper disclosure of pension and postretirement benefits. Complete financial reporting checklist to ensure that Completeness all financial statement disclosures related to payroll expense have been made.

and other miscellaneous deductions. medical and life insurance premiums.  Existence and valuation – To verify the existence and valuation of an accrued payroll liability. TUTORIAL QUESTIONS (1) Problem 12-25 . sales salaries. LECTURE 13 Slide 12 . pension. Additional testing is necessary only when control weaknesses exist. and payroll tax expenses. the auditor does not need to conduct detailed tests of all these payroll expense accounts. including direct and indirect manufacturing expense. If the entity’s internal control is reliable. commissions. accrued wages.Auditing payroll related accounts Payroll transactions affect many expense accounts. (2) Problem 12-26 CAEA 2218 2010/2011.  Completeness – The auditor must be aware of the normal payroll-related taxes that are paid by the entity and therefore should be able to determine if accruals have been made for payroll taxes such as Social Security taxes and unemployment insurance. bonuses. general and administrative salaries. The entity incurs a number of liabilities including payroll taxes withheld (federal and state income. the auditor can trace the amounts included on the account analysis working paper to supporting documentation such as payroll tax reports. commissions etc. Audit objectives and procedures:  Cutoff – An examination of supporting documentation for the accruals provides evidence on the proper period for recording the expense or liability.

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