PrE 1 – Auditing and Assurance Principles

MODULE 2 - APPLICATION OF THE RISK-BASED AUDIT PROCESS: TEST OF

CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS AND
DETAILS OF BALANCES, AND REPORTING

Welcome to Module 2, this module includes topic related to application of the risk-based
audit process particularly about the test of controls and substantive tests of transactions. . It also
includes topics related to substantive tests of details of balances and procedures necessary to
consider in formulating a report on a particular audit conducted.
At the end of this module, you are expected to know on how to apply the lessons you
learned from this module in reality.

CONSULTATION HOURS:
Cellphone or Messenger: 2 – 5 PM Wednesday/ 2– 5 PM Thursday
Virtual Time: 8 – 11 Monday and Tuesday

MODULE 1 - LEARNING OBJECTIVES

By the end of this module, the students shall be able to:
1. Enumerate and describe the steps involved in auditing the revenue and
collection cycle, expenditure cycle, investing cycle and financing cycle.
2. Apply the risk assessment and risk response phase of the respective audit
process, test of controls and substantive tests of transactions to area involved in
revenue and collection cycle, expenditure cycle, investing cycle and financing
cycle.
3. Describe the auditor’s objective for the substantive audit of balances appearing
on the financial statements.
4. Explain the nature of the appropriate audit procedures to accomplish the
objectives for the substantive audit of balances appearing on the financial
statement.
5. Understand the preparation of audit working papers to document the audit
procedures of balances appearing on the financial statement.
6. Know how to evaluate audit evidence for sufficiency and appropriateness and
understand the need to evaluate audit evidence gathered to support the
conclusion for the auditor’s report.
7. Know the various issues that the auditor considers in completing the audit.
8. Describe the letter of inquiry to client’s legal counsel and discuss the contents

of the representation letter obtained from client management.

9. Describe the independent auditor’s report and know the requirements relative
to forming an opinion on the financial statements.

COURSE CONTENT FOR MODULE 2:

APPLICATION OF THE RISK-BASED AUDIT PROCESS: TEST OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS AND DETAILS OF BALANCES,
AND REPORTING

ACTIVITY DESCRIPTION TIME TO COMPLETE

Audit of the revenue and collection cycle
Lecture Discussion 1 hours
Lecture Discussion Audit of the expenditure cycle 1 hours
Lecture Discussion Audit of the investing and financing 2 hours
cycle
Lecture Discussion Substantive test of details of balances 11 hours
Lecture Discussion Evaluation of audit evidence and 6 hours
formulation of audit report
Review Quick Reviews and Summarizations 2 hours
Quiz Summative Quizzes for Module 1 1 hours

MODULE 2
UNIT 6 - Audit of revenue and collection cycle, expenditure cycle, investing cycle and
financing cycle.

6.A. Audit of Revenue and Collection Cycle

The overall objective of the sales and collection cycle is to evaluate whether the account
balances affected by the cycle are fairly presented in accordance with GAAP.

Nature of the Sales and Collection Cycle

Numerous documents and records are included in the revenue cycle:
Customer order
Sales order–frequently used to show credit approval and authorization for
shipment.
Shipping document–the original is sent to the customer and one or more copies
are retained. Used as a signal to bill the customer. One type of
shipping document is a bill of lading (a written contract between the
carrier and the seller).

Sales invoice–a document indicating the description and quantity of goods sold,
price, freight costs, insurance, terms, etc. Sales invoice information in
the computer is the basis for recording sales transactions and updating
the A/R master file.

Sales journal
 Credit memo–a document indicating a reduction in the amount due from a
customer because of returned goods or an allowance.
Remittance advice–a document that accompanies the sales invoice mailed to the
customer and can be returned to the seller with payment. It is used to
indicate customer name, sales invoice #, and invoice amount.

Cash receipts journal–daily entries in this journal are supported by remittance

advices.

Uncollectible account authorization form

A/R master file–updated from the sales, sales returns and allowances, and cash
receipts computer transactions files.
A/R trial balance

Monthly statement
An understanding of the functions that occur in a client firm for the sales and collection
cycle is useful for understanding how an audit of the cycle is conducted.
1. processing customer orders--starting point for the entire cycle
2. granting credit--before goods are shipped, a properly authorized person must approve
credit for the customer.
3. shipping goods–first critical point where company assets are given up. A shipping
document is essential to the proper billing of shipments to customers.
4. billing customers–the most important aspects of billing are making sure that all
shipments made have been billed, no shipment has been billed more than once, and
each one is billed for the proper amount. In most accounting systems, customer billing
involves simultaneous updating of the sales transaction file and A/R master file.
5. processing and recording cash receipts–the most important concern here is theft. All
cash must be deposited in the bank at the proper amount on a timely basis and recorded
in the cash receipts transaction file.
6. processing and recording sales returns and allowances
7. charging off uncollectible A/R
8. providing for bad debts

Internal Controls and Tests of Transactions for Sales

Tests of transactions are usually performed at an interim date if the IC structure is
effective, but they can also be done after the balance sheet date.

Key Controls
If the internal controls necessary to satisfy any one of the objectives are inadequate the
likelihood of misstatements related to that objective is increased (regardless of controls for the
other objectives).
Tests of Controls
For each internal control there exists a related test of control to verify its effectiveness.
In most audits, it is somewhat easy to determine the nature of the test of the control from the
nature of the control (e.g., if the IC is to initial customer orders after they have been approved for
credit, the test of control is to examine the customer order for a proper initial). The auditor may
evaluate the client’s exception reports and use test data to be sure the client’s programs operate
correctly. For testing sales orders, the auditor can enter test data to evaluate program results.
Another computer audit test is to perform sequence checks to detect a missing or duplicate sales
order.

Substantive Tests of Transactions

Some procedures are used in every audit regardless of circumstances while others depend
on the adequacy of controls and results of tests of controls. The substantive tests of transactions
are related to the objective in the first column of Table 11-1 and are designed to determine
whether any monetary errors of the type relating to that objective exist in the transaction.
The audit procedures used are affected by the ICs and tests of controls for that objective.
Materiality and results of the prior year also affect the procedures used. General objectives are
the same for any class of transactions but specific objectives vary for sales, cash receipts, etc.

A test of control has no meaning unless it tests a particular control. The substantive tests
of transactions are not directly related to the key control or test of control columns, but the extent
of substantive tests of transactions depends, in part, on which controls exist and on results of
tests of controls.

Pre-numbered Documents
Pre-numbered documents are meant to prevent both the failure to bill or record sales and
the occurrence of duplicate billings and recordings. Tests of controls means the auditor focuses
on omitted and duplicate numbers outside the normal sequence.

Proper Authorization
The auditor is concerned about authorization at 3 points:
1- credit must be properly authorized before a sale occurs
2- goods should be shipped only after proper authorization
3- prices must be authorized

The first two controls are meant to prevent the loss of company assets by shipping to
fictitious customers or those who will fail to pay. It is easy to test for the effectiveness of ICs for
authorization by examining documents for proper approval at these three points. Some computer
systems have credit limits in the A/R master file.

Adequate segregation of duties

Anyone responsible for inputting sales and cash receipts transaction information into the
computer should be denied access to cash. It is also desirable to separate credit-granting
functions from the sales function. Credit checks offset the tendency of sales personnel to
optimize volume at the expense of debt writeoffs.
 Personnel responsible for doing internal comparisons should be independent and A/R
master file totals to the general ledger balance should be done by a person different from the one
who inputs sales and cash receipt transactions).

Internal Verification Procedures

The use of independent persons for checking the processing and recording of sales is
critical.

Substantive Tests of Sales Transactions

Recorded sales are valid

For this objective, the auditor is concerned with two types of misstatements: sales being
included in the journals for which no shipment was made and shipments being made to fictitious
customers. Appropriate substantive tests of transactions for invalid transactions depends on
where the auditor believes misstatements are likely to occur.

Sales are properly authorized

It is necessary to test by substantive procedures whether the firm’s general credit,
shipping, and pricing policies are being followed. This is especially true of pricing sales.

Existing sales transactions are recorded

Substantive tests may be necessary here if adequate controls do not exist. This will be the
case if the client does no internal tracing from the shipping documents to the sales journal. An
effective procedure to test for unbilled shipments is to trace selected shipping documents to
related duplicate sales invoices and the sales journal. Tracing from source documents to the
journals is a test for omitted transactions. Auditing from the journals back to the supporting
documents is a test for invalid transactions. Validity objective--starting point is a journal.
Completeness objective--starting point is a shipping document. When designing audit
procedures for validity and completeness, the starting point for tracing the document is critical.
This is referred to as the direction of tests.

Recorded sales are properly valued

This deals with shipping the amount of goods ordered, correctly billing for the amount of
goods shipped, and correctly recording the amount billed. A typical substantive test is to start
with entries in the sales journal and compare the total of selected transactions with A/R master
file entries and duplicate sales invoices. If a control is effective, the sample size for substantive
tests of transactions can be reduced.

Recorded sales are properly classified

Here the auditor examines supporting documents to determine the proper classification of
a transaction and compares this to the actual account to which it is charged.

Sales are recorded on a timely basis

 Transactions could be omitted from the accounting records or sales could be recorded in
the wrong period if they are not recorded on a timely basis. Significant differences between the
dates on shipping invoices and duplicate sales invoices could indicate a cutoff problem.

Sales transactions are properly included in the master file and correctly summarized.
It is necessary to perform some clerical accuracy tests by footing the journals and tracing
the totals and details to the general ledger and the master file to check whether there are
misstatements in the computer program. The distinction between the summarization and other
objectives is that summarization includes footing journals, master file records, and ledgers and
tracing from one to the other among the three.
Control Activities--Cash Receipts Transactions
Common Documents (not already covered)
Prelist–listing of cash receipts received in the mail
Cash count sheet–listing of cash and checks in a cash register
Daily cash summary–report showing total over-the-counter and mail receipts received by
the cashier for deposit

Cash Receipts Functions

1. Receiving cash receipts
2. Depositing cash in the bank
3. Recording the receipts

Controls should ensure that only valid transactions and all actual receipts are entered (e.g.-
restricting access to accounting records) and segregation of counting cash receipts and
journalizing.

Control Activities--Sales Adjustment Transactions

This entails such things as granting cash discounts and sales returns and allowances. It
also includes determining uncollectible accounts. The potential for misstatements resulting
from errors and fraud in processing these transactions is considerable in some firms. A main
concern here is the possibility of fictitious sales adjustments transactions being recorded to hide
fraud.

Substantive Tests of Accounts Receivable

The auditor must first determine the acceptable level of detection risk for each important
assertion to select substantive tests for A/R and uncollectible accounts. Factors relevant to
assessed levels of control risk and inherent risk must be considered in selecting an appropriate
level of detection risk for each assertion. Factors relevant to assessed levels of IR and CR must
be considered in selecting an appropriate level of detection risk for each assertion. Control risk
assessments for A/R assertions are dependent on related control risk assessments for transaction
classes (e.g., credit sales, cash receipts and sales adjustments) that affect the A/R balance.
Assessment for transaction class assertions affect the same account balance assertions for
accounts affected by the transactions except:
1.) CR assessments for the existence or occurrence and completeness assertions for a transaction
class that decreases an account balance affect the assessments for the opposite account balance
assertions (e.g. assessments for existence or occurrence for cash receipts and sales adjustments
affect the combined assessment for the A/R completeness assertion).
2.) Appropriate IR assessments and planned assessed levels of CR for account balance
assertions are used in the audit risk model to arrive at planned DR and the planned level of
substantive tests. Revised levels of DR and substantive tests for an assertion may be necessary if
actual CR differs from planned CR assessments.

Designing Substantive Tests

A listing of possible substantive tests that might be included in an audit program
developed by the auditor appears in Fig. 14-9 of your textbook. This figure does not represent a
formal audit program.

Initial Procedures
The starting point for verifying A/R and the related allowance account is tracing the
current period’s beginning balances to the ending audited balances in the prior year’s working
papers (when applicable). Next, the current period’s activity in the general ledger control account
and related allowance account should be reviewed for any significant entries that are unusual in
nature or amount. A listing of all customer balances, called an A/R trial balance, is obtained.
This listing should be footed and the total compared with the total of the subsidiary ledger or
master file from which it was prepared and the general ledger control account balance. As you
know from some of the cases and AAERs we have studied, when the client furnishes the trial
balance, a sample of the customers and balances shown on the trial balance should be compared
with those in the subsidiary ledger or master file and vice versa t determine that the trial balance
is an accurate and complete representation of the underlying accounting records.

Tests of Details of Transactions

Vouch Recorded Receivables to Supporting Transactions. In doing this test, a sample of
debits to customers’ accounts can be vouched to supporting sales invoices and matching
documents to provide evidence pertaining to the existence or occurrence, rights and obligations,
and valuation or allocation assertions. Credits can be vouched to remittance advices and sales
adjustment authorizations.

Perform Cutoff Tests for Sales and Sales Returns. The sales cutoff test is designed to
obtain reasonable assurance that sales and A/R are recorded in the accounting period in which
the transactions occurred and the corresponding entries for inventories and cost of goods sold are
made in the same period. Sales should be recorded in the period in which legal title to the goods
passes to the buyer. The sales cutoff test is made as of the balance sheet date. For sales of goods
from inventory, the test involves comparison of a sample of recorded sales from the last few days
of the current period and the first few days of the next period with shipping documents to
determine whether the transactions were recorded in the proper period. The sales cutoff test
provides evidence concerning the existence or occurrence and completeness assertions for A/R
and sales. For a calendar year firm, if January sales are recorded in December, there is a
misstatement of the E or O assertion. Conversely, if December sales are not recorded until
January, there is a misstatement of the completeness assertion.

Perform Cash Receipts Cutoff Test

 The cash receipts cutoff test is designed to obtain reasonable assurance that cash receipts
are recorded in the accounting period in which received. A proper cutoff at the balance sheet date
is essential to the correct presentation of both cash and A/R. This test relates to the E or O and
completeness assertions for both cash and A/R. Evidence concerning the promptness of the
cutoff can be obtained by personal observation or a review of documentation. An alternative to
personal observation is to review supporting documentation such as the daily cash summary and
validated deposit slip for the last day of the year. The objective of the review is to determine that
the deposit slip total agrees with the receipts shown on the daily cash summary.

Tests of Details of Balances

Confirm A/R
SAS 67–The Confirmation Process states that there is a presumption that the auditor will
request the confirmation of A/R during an audit unless A/R are immaterial to the financial
statements, the use of confirmations would be an ineffective audit procedure, or the auditor’s
combined assessment of inherent risk and control risk is low, and that assessment, together with
the evidence from analytical procedures or other substantive tests, is adequate to reduce audit
risk to an acceptably low level for the relevant financial statement assertions.

There are two forms of confirmation request: the positive form, which requires the debtor
to respond whether or not the balance shown is correct and the negative form, which requires the
debtor to respond only when the amount shown is incorrect. The positive form usually produces
the better evidence, because under the negative form, the failure to receive a response can only
lead to a presumption that the balance is correct, whereas the customer may have overlooked the
request or neglected to return an exception.

The form selection rests with the auditor. In making the decision, the auditor considers
the acceptable level of detection risk and the makeup of the customer balances. The positive
form is used when detection risk is low or individual customer balances are relatively large. The
negative form, according to GAAS, should be used only when all three of the following
conditions are present: (1) the acceptable level of detection risk for the related assertions is
moderate or high; (2) a large number of small balances is involved; and (3) the auditor has no
reason to believe that the recipients of the requests are unlikely to give them consideration.
The extent of requests, or sample size, is inversely related to each of the following factors: (1)
the acceptable level of DR for the assertions t which the confirmation evidence will apply; (2)
the extent to which other substantive tests contribute to achieving that detection risk; and (3)
tolerable misstatement for A/R. If you do not recall the term “tolerable misstatement” from
Chapter 8, then we will review it. Tolerable misstatement is the minimum misstatement that can
exist in an account balance for it to be considered materially misstated. Negative confirmations
require larger sample sizes than positive confirmations.

Given the possibility for fraud, the auditor must control every step in the confirmation
process. This means determining that the amount, name, and address on the confirmation agree
with the corresponding data in the customer’s account, maintaining custody of the confirmations
until they are mailed, using the firm’s own return address envelopes for the confirmations,
personally depositing the requests in the mail, and insisting that the returns be sent directly to the
auditor. When no response has been received after the second or third positive confirmation
request to a customer, the two main alternative procedures that may be used are examining
subsequent collections and vouching open invoices comprising customer balances. The matching
of collections back to open or unpaid invoices comprising the customers’ balances at the
confirmation date establishes the collectibility of the accounts. The confirmation of A/R is the
primary source of evidence in meeting the E or O assertion. The test also provides evidence on
the rights and obligations assertion.

Evaluate Adequacy of Allowance of Uncollectible Accounts

This test of balances involves footing and crossfooting the aged trial balance of A/R and
agreeing that total to the general ledger balance (if different than others used), testing the aging
of the amounts shown in the aging categories, and assessing the reasonableness of the
percentages used to compute the allowance component used for each aging category.

6.B. Audit of Expenditure and Disbursement Cycle

Expenditure cycle–consists of activities related to the acquisition of and payment for
plant assets and goods and services. Two major transaction classes:
1–purchases transactions
2-cash disbursements

For our purposes here, it does not involve payroll transactions, the purchase or sale of
another entity’s securities, or the entity’s own securities.

Audit Objectives
Materiality
Transactions in the expenditure cycle often affect more financial statement accounts than
other cycles combined. The auditor often seeks a low level of risk of material misstatements in
the financial statements due to expenditure cycle transactions. The allocation of materiality to
accounts affected by this cycle will vary according to the likelihood of misstatements in the
account and the probable cost of verifying the account. For example, misstatements are more
likely to exist in inventories than plant assets, and it usually costs more to audit inventories than
plant assets.

Inherent and Control Risks

The auditor must remember inherent limitations of internal control, including the
possibility of management override, collusion, errors due to fatigue or misunderstandings, and
failure to adapt the control structure to changed conditions (e.g., rapid growth).

Audit Strategy
Use of either the lower assessed level of control risk approach or primarily substantive
approach, or a combination of the two, may be appropriate for auditing the expenditure cycle.
For example, the lower assessed level of control risk approach is more efficient for a situation
involving a high volume of transactions.

Consideration of Internal Controls

Let us look at the components of internal control as applied to the expenditure cycle.

1-Control Environment
Integrity and ethics are critical here due to many opportunities for employee fraud in
doing purchase and cash disbursements. Client firm organizational structure and assignment of
authority and responsibility of expenditure cycle activities should be stated clearly.

2-Risk Assessment

3-Information and Communication

4-Monitoring

Initial Assessment of Control Risk

Auditing procedures to obtain an understanding of the 4 IC elements noted above extend
only to the design of policies and procedures. The initial assessment of control risk must be set at
the maximum based on information from understanding of these elements only. Tests of controls
are often done at the same time as procedures to obtain an understanding. Evidence from
concurrent tests of controls may justify a reduction in the initial assessment of control risk for
certain related assertions. It can be reduced to slightly below the maximum.

Control Activities–Purchases Transactions

Various Common Documents and Records

Purchase requisition–written request by an employee to the purchasing department
Receiving report–a report prepared on the receipts of goods showing the kinds and
quantities of goods received from vendors
Voucher–a form indicating the vendor, amount due, and payment date for purchases
received. Usually considered an authorization for recording and paying a
liability.
Purchases transactions files–computer file containing data for approved vouchers for
purchases that have been received. Used to update the A/P, inventory, and
general ledger master file.

Functions
The following functions should be assigned to different individuals or departments:
1-requisitioning goods and services
 Capital expenditures and lease contracts require specific approvals. Purchase
requisition forms should be signed by a supervisor who has budgetary responsibility for
the expenditure category. This represents the start of the transaction trail in support of the
existence or occurrence assertion for purchase transactions.

2–preparing purchase orders

Purchase orders should be pre-numbered and signed by an authorized purchasing
agent. Copies are distributed internally to the receiving department, the vouchers payable
department, and the originating department. Quantity ordered is wiped out on the
receiving department copy.

3-receiving the goods

A pre-numbered receiving report should be prepared for each order received. The
receiving report supports the existence or occurrence assertion for purchase transactions.

4-storing goods received for inventory

Obtaining initials on a copy of the receiving report provides evidence for the
existence or occurrence assertion.

5-preparing the payment voucher

The controls over this function and the assertions to which they relate include:
establishing the agreement of the details of vendors’ invoices with receiving reports and
purchase orders and determining the mathematical accuracy of vendors’ invoices. Copies
of contracts may be required when the voucher relates to leased assets or long-term
suppliers of services or goods. In a computerized system, programmed edit checks are
made for valid vendor numbers and reasonableness of amounts.

6-recording the liability

In computerized systems, the purchases transactions file is used to update the A/P,
inventory, and G/L master files. In any type of system, an accounting supervisor should
check the timeliness of recording by comparing the dates of voucher register entries with
dates on the copies of the vouchers.

Obtaining the Understanding and Assessing Control Risk

Prior experience with the client, inquiry, observation and inspection of documents are the
means by which the auditor obtains an understanding of the control activities component of the
internal control aspect (for purchase transactions). inversely with the auditor’s planned level of
control risk. The direction of testing must be compatible with the specific audit objective to
which the test relates–vouching for existence or occurrence and tracing for completeness. Certain
tests may be done as dual purpose tests (e.g., preparing the payment voucher and recording the
liability). A final assessment of control risk can be made and documented for each assertion
related to purchase transactions based on evidence collected from procedures to obtain an
understanding.

Computer-Assisted Tests of Controls

 Tests of effectiveness must be done for any controls that lead to a control risk assessment
below the maximum. For general controls over changes to programs and master files, the auditor
makes inquiries and inspects documentation. Application controls tests involve the use of test
data to find out whether results produced by the client’s program for unpaid vouchers are as
expected. Generalized audit software may be used to perform sequence checks and print list of
purchase orders, receiving reports, or vouchers with missing numbers.

Control Activities–Cash Disbursement Transactions

Common Documents and Records
Cash disbursements transaction file–information on payments by check to vendors and
others. Used for posting to the A/P and general ledger master files. There are two
cash disbursement functions:

1–paying the liability

In a computerized system, the vouchers payable department submits batches of
vouchers due for payment to EDP or enters the data on vouchers via terminals. Checks
and a check summary are produced. Payment data are entered into a cash disbursements
transaction file. Checks should be physically matched with supporting vouchers. Various
controls over the preparation and signing of checks and related audit objectives include:
–Independent checks of the agreement of the total of the issued checks with a
batch total of the vouchers processed for payment.

–Authorized check signers should ascertain that each check is accompanied by a

properly approved unpaid voucher and that the name of the payee and check
amount agree with the voucher. –The check signer should control the mailing of
the checks.

–Prenumbered checks should be used.

–A voucher and supporting documents should be stamped or canceled to avoid

double payments.

Recording Cash Disbursements

The cash disbursements file created when checks are prepared is used to update the
accounts payable master file and general ledger accounts in computerized systems.

Obtaining the Understanding and Assessing Control Risk

Test data can be used to test edit checks and other programmed controls pertaining to the
preparation and recording of checks. A final assessment of control risk is made based on
collecting the evidence acquired from procedures to obtain an understanding of relevant portions
of all five components of IC and related tests of controls.
Substantive Tests of Accounts Payable Balances
A/P is high volume and therefore susceptible to misstatements. The audit of payables places
more emphasis on collecting evidence about the completeness assertion relative to the E or O
assertion.
Determining Detection Risk
Detection risk for payables assertions is affected by inherent and control risk factors
related to both the purchases transactions and cash disbursements transactions classes. Fig. 15-9
specifies risk levels for IR, AR, DR, and CR and various combinations for the five management
assertions related to payables. The completeness and V or A assertions for payables need more
evidence than the other assertions.

Designing Substantive Tests

Initial Procedures
The starting point for substantive tests is tracing the beginning balance of A/P to the prior
year’s working papers. Other initial activities include reviewing activity in the general ledger for
unusual entries and obtaining a listing of amounts owed at the balance sheet date. Ordinarily, the
listing is prepared by the client from the unpaid voucher file or the accounts payable subsidiary
ledger or master file. The auditor must determine the mathematical accuracy of the listing by
refooting the total and verifying that it agrees with the underlying accounting records and the
general ledger control account balance.

Analytical Procedures
An abnormal increase in the accounts payable turnover ratio, or unexpected decreases in
the percentage of accounts payable to total current liabilities or in one or more expense account
balances, could indicate the possibility of unrecorded accounts payable.

Tests of Details of Transactions

We consider four substantive tests of A/P transactions. The extent of use of each test
varies based on acceptable levels of detection risk. The four tests are:
1. Vouch Recorded Payables to Supporting Documentation
In this test, credit entries to A/P are vouched to supporting documents in the client’s files
such as vouchers, vendor invoices, and purchase orders. Debits are vouched to documentation of
cash disbursements transactions, such as paid checks.

2. Perform Purchases Cutoff Test

This test involves ascertaining that purchases transactions occurring near the balance
sheet date are recorded in the proper period. This is accomplished by tracing dated receiving
reports to voucher register entries and vouching recorded entries to supporting documentation.
The test usually covers a period of 5 to 10 business days before and after the balance sheet date.
The E or O and completeness assertions are the ones addressed by this test.
Do not forget to accord due consideration to goods in transit at the balance sheet date. Goods
shipped FOB shipping point must be included in the inventory and A/P of the buyer. Goods
shipped FOB destination point should remain in the inventory of the seller and be left out of the
buyer’s inventory and A/P (until receipt by the buyer).

3. Perform Cash Disbursements Test

Evidence for the cash disbursements cutoff test may be obtained by personal observation
and review of internal documentation. Tracing of the evidence for the last checks written to the
accounting records is necessary. The auditor should also trace canceled checks dated within a
period of several days before and after the balance sheet date to the dates the checks were
recorded.

4. Perform Search for Unrecorded Payables

A review of subsequent payments consists of examining the documentation for checks
issued or vouchers paid after the balance sheet date. If evidence purports to show payment for an
obligation that existed at the balance sheet date, it should be traced to the A/P listing to ascertain
whether it was included. This is an important test for finding out whether payables have been
understated or left out.
Other auditing procedures that may indicate unrecorded payables include: (1) checking
unmatched purchase orders; (2) inquiring of accounting and purchasing personnel about
unrecorded A/P; and (3) reviewing capital budgets, work orders, and construction contracts.

Tests of Details of Balances

1. Confirm A/P
Confirmation of A/P is optional because a confirmation offers no assurance that
unrecorded payables will be uncovered and external evidence such as invoices and vendor
monthly statements should be available to substantiate the balances. Confirmation of A/P is
recommended when detection risk is low or a firm is having trouble in meeting its obligations.
The positive form of confirmation should be used if this test is used. The test provides evidence
for all A/P assertions.

2. Reconcile Unconfirmed Payables to Vendor Statements

In many cases, vendors provide monthly statements that are available in client files. In
such cases, amounts owed to vendors per the client’s listing of payables can be reconciled to
those statements.

6.C. Audit of Investing and Financing Cycle

The Investing Cycle

This pertains to activities relating to ownership of securities issued by other entities. The
types of instruments included are: certificates of deposit, preferred and common stocks, and
bonds. The investing cycle interfaces with cash receipts and disbursements transactions. Let us
consider some definitions.

Investing activities–the purchase and sale of land, buildings, equipment, and other assets
not generally held for resale. These activities also include the purchase and sale of financial
instruments not intended for trading. The auditor must ask what assets are needed to support an
entity’s operations and when assets were acquired during a period.

Financing activities–include transactions and events whereby cash is obtained from or

repaid to creditors or owners. Financing activities would include acquiring debt, capital leases,
issuing bonds or stock. These activities also include retiring debt, buying treasury stock and
payment of dividends.
Materiality, Risk, and Audit Strategy
It is crucial that an auditor obtain an intimate understanding of the client’s business and
industry. There can be a sizable variation between industries in the importance of financing and
investing activities. Industry knowledge is important for developing expectations with regard to
financial statement line items.

The primary criterion in evaluating the allocation of materiality is the determination of

the magnitude of misstatement that will influence the decisions of a reasonable financial
statement user. Usually but not always the auditor will allocate less materiality to fixed assets.
In the case of the investing cycle, inherent risk is influenced by:

Inherent risk may be increased because of the potential that scrapped or retired assets
may not be written off. One key transaction that an auditor should focus on is the initial
accounting for the acquisition of plant assets.

Control risk should be low for the acquisition of fixed assets with regard to the E or O
assertion due to the existence of capital budgets and B of D authorization.

Substantive Tests of Plant Asset Balances

Auditing information on the beginning balances for plant assets is one of the largest risks
in an initial engagement. You may need to look at transactions that happened in years past.

Initial Procedures
As auditor, you must be sure that the starting G/L balance for plant assets agrees with the
prior year’s working papers. Also, you should test the mathematical correctness of client-
prepared schedules of additions and disposals and reconcile the totals with the changes in the
related G/L balances for plant assets. Also, the auditor should vouch items on the schedules to
entries in the G/L and tracing ledger entries to the schedules to determine they are an accurate
representation of the accounting records.

Tests of Details of Transactions

All major additions to plant assets should be supported by documentation in the form of
authorizations in the minutes, vouchers, invoices, contracts, and canceled checks. The vouching
of additions provides evidence about the E or O, R and O, and V or A assertions.

Evidence of sales, retirements, and trade-ins should be available to the auditor in the form
of cash remittance advices, written authorizations, and sales agreements. The following
procedures may also be useful to determine whether all retirements have been recorded:
The auditor should also review entries to repairs and maintenance expense to determine the
propriety and consistency of the charges to repairs expense. The client must make the
appropriate distinction between capital and revenue expenditures. This concerns the
completeness assertion for plant assets.

Tests of Details of Balances

There are various procedures or substantive tests that should be considered. These are:
1. Inspect plant assets
 2. Examine title documents and contracts
3. Tests of accounting estimates for depreciation and asset impairment

The Financing Cycle

The two major transaction classes in the financing cycle are long-term debt transactions
and stockholders’ equity transactions. The financing cycle interfaces with the expenditure cycle
when cash is disbursed for bond interest, the redemption of bonds, cash dividends, and the
purchase of treasury stock.

Materiality, Risk, and Audit Strategy

The importance of long-term debt to the fair presentation of the financial statements
varies considerably. From an inherent risk standpoint, the risk of misstatements in executing and
recording financing cycle transactions is low.

Substantive Tests of Long-Term Debt Balances

Initial Procedures
The schedules associated with long-term debt may include separate schedules on L-T
notes payable, obligation under capital leases, and listings of registered bond holders. These
procedures relate to the mathematical and clerical accuracy component of the V or A assertion.

Tests of Details of Transactions

For bonds, evidence should be obtained on the face value and net proceeds of bonds.
Vouchers and canceled checks can be examined to verify principal payments. Vouching of
entries to long-term debt accounts gives evidence for these assertions: E or O, Completeness, R
and O, and V or A.

Tests of Details of Balances

Review Authorizations and Contracts. These should be found in the B of D meeting
minutes. Reviews of contracts should include details of various covenants and compliance
therewith and obligations under capital leases.

Confirm Debt
The auditor should have direct communication with lenders and bond trustees to confirm
the existence and terms of L-T debt. All confirmations should be compared with the records and
any differences should be investigated.

Recalculate Interest Expense

Interest payments are traced to supporting vouchers, canceled checks, and confirmation
responses.
Substantive Tests of Stockholders’ Equity Balances
The V or A and P and D assertions involve maintaining the distinction between paid-in
capital and retained earnings.
Determining Detection Risk
Inherent and control risk assessments are low for account balance assertions when routine
stock transactions are handled by a registrar and transfer agent.

Designing Substantive Tests

Initial and Analytical Procedures

Tests of Details of Transactions

Vouch Entries to Paid-In Capital Accounts

Each change in a capital stock account should be vouched to supporting documentation.

If consideration for shares was other than cash, the auditor should carefully examine the basis for
the valuation.

Vouch Entries to Retained Earnings

Each entry to retained earnings except the posting of net income should be earnings
appropriations are traced to the minutes book. Vouching enables the auditor to ascertain whether
The auditor should trace dividend payments to canceled checks and other documents. Also, the
auditor should establish the number of shares outstanding on the date of record and verify the
accuracy of the total dividend declaration by recalculation.

Tests of Details of Balances

Review Articles of Incorporation and By-Laws . This review is primarily a concern in
the initial audit. Key matters found in the articles and/or by-laws should be noted in the working
papers. The review is also used to determine whether the B of D has been acting within the scope
of its authority.

Review Authorizations and Terms of Stock Issues . This is a substantive test that relates
to the E or O and R and O assertions.

Confirm Shares Outstanding with Registrar and Transfer Agent . When the client uses a
registrar, the auditor should confirm total shares authorized, issued, and outstanding at the
balance sheet date with the registrar.

Inspect Stock Certificate Book

This test is required when the client serves as its own transfer agent. . Inspect Certificates
of Shares Held in Treasury. This test pertains to the E or O, Completeness, and R and O
assertions.
UNIT 7 - Substantive Test of Details of Balances

7.A. Audit of Cash and Cash Equivalents

Audit procedures are considered integral in facilitating a smoothly conducted audit
process that can deliver the required results. Given the high degree of importance that is tied
with the audit process, it is imperative that planning within the audit function is taken care of in a
serious manner so that planning and execution within the audit process are carried out in a better
manner.

During the audit process, it can be seen that audit procedure are designed so that
sufficient groundwork is obtained so that reasonable assurance can be gathered before making a
statement. As far as cash is concerned, it can be seen that it is regarded as a relatively risky asset
stream because of the reason that it might be used without proper authorization. Given the liquid
nature of the cash assets, it can be seen that there is a need to ensure that this is properly audited,
because of its vulnerability to be under fraud, or malpractice.

Audit Procedures for Cash and Cash Equivalents

Firstly, when deciding upon the audit procedures that are used for cash, there is a need to
ensure that there is proper clarity regarding the existing business model of the client, as well as
internal control policies that are in place in order to ascertain the groundwork that needs to be
covered in this regard. When auditors test for cash and cash equivalents, there is a need to
ensure that they are able to cover the respective assertions for cash, on the following grounds:

Existence: This is to check if the cash balances on the balance sheet exist at the
date of financial statements or not. This is checked by ensuring that the bank statements
that are issued by the bank have the respective balance that is declared on the balance
sheet by the company or not.

Completeness: This measure checks if the cash balances actually include all the
cash transactions that have taken place during the accounting period. In the case of
transactions taking place within the company, all records are duly maintained. For
example, a sales invoice would be proof that the debit transaction in the company’s books
is actually because of sales income.

Rights and Obligations: This is to verify that the company has the legal right to
declare the amount of cash it has declared, on the reporting date. This calls for companies
to have sufficient proof that they own that particular cash, or cash equivalent. For
example, they cannot declare money not yet received from a customer as a cash or cash
equivalent.

Values/ Allocation: This assertion verifies that the recorded balances actually
reflect the true underlying economic value of cash. This amount should not be overstated,
and should be included as per the existing value in the bank accounts, or the equivalents
that the company has.
 Presentation and/or Disclosure: Cash should be properly disclosed in the balance
sheet with adequate and required disclosure made in the notes to the statements. All the
sources of cash should be properly disclosed, with any other information that is relevant
to the shareholders. The cash and cash equivalents should be broken down into cash in
the bank, and other cash that the company might have on the reporting date.

Keeping these assertions in mind, the auditor is then supposed to check for various
different procedures for cash, which include the following.
Bank Confirmation: This process is mainly undertaken in order to ask for
verification or confirmation to the external party, which is primarily cash, as well as the
underlying balances the company actually holds at the bank. In order to verify the
balance at the bank, it is rudimentary for the company to ensure that they are able to
obtain a formal, writer authority by the relevant bank, so that the bank can disclose the
respective information to the client with proper information. Furthermore, once the
authorization process has been covered, it is important to follow up on all the points of
the bank confirmation.

Bank Reconciliation: This tends to be another integral component of the audit

procedure for cash and cash equivalents. This is because after the bank confirmation and
statements have been issued, the auditor is supposed to compare the bank statements sent
by the bank and the cash statement prepared by the bank in order to check for any
discrepancies. In this regard, they are supposed to check and agree with the balances per
bank statement that is shown on the reconciliation to the bank statement as well as
balances that are shown otherwise. This also tests these balances arithmetically, to
ensure that there are no discrepancies in the calculation, whatsoever.

These audit procedures to check for cash and cash equivalents is created in order to
ensure that there are no differences in the actual amount the company owns, and the amount it
has disclosed on the balance sheet. In the same manner, this backward trail also helps to
identify any leakages or potential areas of fraud within the cash system of the company.

Conclusion
As a matter of fact, it can be seen that audit procedures for cash and cash equivalents can
be considered as an integral part of the audit. This is because of the reason that the audit
procedures are conducted in order to ensure that there are no existing discrepancies, and the work
is carried out as per the required standards. In this regard, it is imperative that auditors take their
time in evaluating these procedures so that there is no ambiguity, and any chances of errors or
fraud can be discovered well in time.

7.B. Audit of Receivables, Allowance for Doubtful Accounts and Sales

The overall objective of the audit of accounts receivable and sales is to determine if they
are fairly presented in the context of the financial statements as a whole. The sales account is
closely tied to accounts receivable; therefore, evidence supporting accounts receivable tends to
support sales. For example, having determined that an account receivable is valid, the auditor has
thereby supported the validity of the sale.

Analytical procedures can often be used to test the sales account. An unusual relationship
detected in the audit of receivables and inventory may reflect a problem for the reported sales
figure as well.

Reconciling the Aged Subsidiary Ledger of Individual Accounts to the General Ledger
The first step in auditing accounts receivable is to reconcile the aged subsidiary ledger of
individual accounts to the general ledger control account. This is ordinarily done before any
other tests to assure the auditor that the population being tested agrees with the general ledger. In
addition, the auditor traces a sample of individual balances to supporting documents, such as
duplicate sales invoices, to verify the customer name, balance, and proper aging.

Confirmation of Accounts Receivable

The Confirmation Process states that the confirmation of accounts receivable is a
generally accepted auditing procedure and should be performed in all audit engagements, except
under one or more of the following circumstances:
1. The accounts receivable balance is immaterial to the financial statements.
2. It is expected that the use of confirmations would be ineffective.
3. The auditor's combined assessed level of inherent risk and control risk is low, and the
assessed level, in conjunction with the evidence expected to be provided by analytical
procedures or other substantive tests of details, is sufficient to reduce audit risk to an
acceptably low level for the applicable financial statement assertions.

Although the confirmation of accounts receivable is not necessary when audit risk can
otherwise be reduced to an "acceptably low level, Statements of Auditing Standards points out
that such a situation is unusual by stating that "in many situations, both confirmation of accounts
receivable and other substantive tests of details are necessary to reduce audit risk to an
acceptably low level for the applicable financial statement assertions."

From a practical standpoint, it is rare that a sample of receivables is not circularized for
confirmation where receivables are material, as third-party verification of an entity's records
provides greater audit assurance than evidence from within the entity. When the auditor
concludes that it is not necessary to confirm accounts receivable, that position must be
documented in the workpapers, along with the way the auditor overcame the Statements of
Auditing Standards general requirement to do so. Thus, the workpapers must include a full
explanation based on one or more of the three circumstances listed above.

When performing confirmation procedures, the auditor must use judgment to

determine the following:
• Design of confirmation request
• Confirmation date
 • Number of accounts to be confirmed

Design of confirmation request The Confirmation Process states that, when

designing the confirmation request, the auditor should consider the following factors:
• Form of confirmation request
• Auditor's prior experience with the client
• Nature of information being confirmed
• Characteristics of respondents

Form of confirmation request Two common types of confirmations are used for
confirming accounts receivable: positive and negative.
A positive confirmation request is addressed to the customer requesting that it send
directly to the auditor confirmation of whether the balance stated on the confirmation request is
correct or incorrect. A negative confirmation request is addressed to the customer and requests a
response only if the customer disagrees with the stated amount on the confirmation request. A
positive confirmation request is considered more reliable because it requires affirmative action
on the part of the debtor.
The determination of which type of confirmation to use is an auditor's decision and is
based on (1) the strength of the client's internal controls, (2) the nature of the accounts receivable
population, and (3) the facts and circumstances of the individual audit. A more detailed
explanation of positive and negative confirmations follows:

1 Positive confirmation request—A positive confirmation may be designed in two ways.

The information to be confirmed may be indicated in the confirmation request, or the request
may be blank, requiring the respondent to fill in the missing information. There is a trade-off in
the selection of the complete or incomplete request. When an incomplete form is completed and
returned by a respondent, more competent evidence is created than when the respondent is
simply asked to sign a completed confirmation form. However, when the incomplete form is used,
the response rate generally will be lower and it may be necessary to perform alternative audit
procedures to supplement the confirmation process. When a positive confirmation is used and
the request is not returned, no audit evidence is created.

2 Negative confirmation request—A negative confirmation form requires the respondent

to return the confirmation only if there is disagreement with the amount owed. When negative
confirmations are not returned, the evidence generated is different from that generated when
positive confirmations are used. That is, the lack of returned negative confirmations provides
only implicit evidence that the information is correct. The Confirmation Process describes this
limitation as follows:

Unreturned negative confirmations do not provide explicit evidence that the intended
third parties received the confirmation requests and verified that the information contained on
them is correct. Because of this limitation, the negative confirmation form should be used only
under the following conditions:
 The combined assessed level of inherent and control risk is low.
 The audit population contains a large number of relatively small individual balances.
 There is no reason to believe that respondents will not give adequate attention to
 confirmation requests.

Even under the conditions described above, Statements of Auditing Standards expresses a
concern that the use of negative confirmations will not generate sufficient competent evidential
matter and concludes that "the auditor should consider performing other substantive procedures
to supplement the use of negative confirmations." For example, if the auditor uses negative
confirmations to test the existence of accounts receivable, it may also be advisable to use
additional tests, such as reviewing subsequent cash collections and vouching, to determine with
reasonable assurance that accounts receivable do exist.

When a response is received from a negative confirmation indicating disagreement with

the amount owed, the auditor should investigate the reason for the disagreement. If there are a
number of disagreements or the disagreements appear to be significant, the auditor should
reconsider the original assessment of the level of inherent and control risk. This reassessment
may lead to the conclusion that the combined assessed level of inherent and control risk is not
low, in which case the auditor should modify the originally planned audit approach
appropriately.

Auditor's prior experience with the client When designing confirmation requests, the
auditor should consider information from prior experience with the client and with similar
clients. This information includes response rates, knowledge of misstatements identified during
prior years' audits, and any knowledge of inaccurate information on returned confirmations. Prior
experience may suggest, for example, that a confirmation form was improperly designed or
previous response rates were so low that audit procedures other than confirmation should be
considered.

Nature of information being confirmed The auditor should consider the capabilities of the
respondents when determining what to include in the confirmation request. Respondents can
confirm only what they are capable of confirming, and there is a tendency to confirm only
what is relatively easy to confirm. For example, when designing an accounts receivable
confirmation, the auditor should consider whether respondents are more capable of verifying an
individual account balance or transactions that make up a single account receivable balance.
Information to be confirmed with respondents should not be limited to dollar amounts. For
example, in complex transactions it may be appropriate to confirm addition, it may be
appropriate to confirm information that is based on oral modifications and, therefore, not part of
the formal documentation. Statements of Auditing Standards provides the following guidance
with respect to oral modifications:

When the auditor believes there is a moderate or high degree of risk that there may be
significant oral modifications, he or she should inquire about the existence and details of any
such modifications to written agreements. If the client responds to the auditor's inquiry by
stating that there are no oral modifications to an agreement, the auditor should consider
confirming with the other party to the agreement that no oral modifications exist.
 Characteristics of respondents Confirmation requests should be addressed to respondents
who will generate meaningful and competent evidential matter. Factors to be considered in this
regard include the following:
 Competence of the recipient—Recipients may be apathetic about the
confirmation process, and management may have assigned responsibility to an
individual who will sign and return the confirmation without adequate concern
for its accuracy.
 Knowledge of the respondent—Confirmations may be signed by persons who
have no knowledge of the account and no authority to respond.
 Objectivity of the respondent—For example, the reliability of confirmations
from related parties may be questionable.

If information concerning the above factors, as well as other relevant factors, comes to
the auditor's attention, and that information suggests that meaningful and competent evidential
matter will not result from the confirmation process, the auditor should consider using other
audit procedures to test financial statement assertions. Statements of Auditing Standards
specifically warns that under some circumstances the level of professional skepticism should be
increased, resulting in a closer scrutiny of the respondent. Two examples presented in The
Confirmation Process are: (1) significant, unusual year- end transactions that are material or (2)
where the respondent is the custodian of a material amount of the client's assets.

Confirmation date
The confirmation date relates to the timing of the confirmation procedures. Whether
confirmations are requested as of year end or as of some other date will depend on the overall
design of the audit approach, with the aim of making the examination more efficient or meeting
client deadlines. A confirmation date other than year end can be justified when internal controls
are sufficiently reliable to produce reasonably accurate revenue and collection data between the
confirmation date and year end. Otherwise, confirmation must be performed at or very near to
the balance-sheet date. Other factors the auditor should consider when deciding on a
confirmation date include (1) the materiality of the accounts receivable balance and (2) the
auditor's exposure to lawsuits because of the possibility of client bankruptcy and similar risks.
If the auditor makes the decision to confirm accounts receivable prior to year end, the auditor
may find it necessary to test the transactions occurring between the confirmation date and the
balance-sheet date by examining such internal documents as duplicate sales invoices, shipping
documents, and evidence of cash receipts in addition to performing analytical procedures of the
intervening period.

Number of accounts to be confirmed

The auditor also must decide how many confirmations to send and to which customers.
The auditor may determine the extent of confirmations to send by using statistical analyses or by
judgmentally determining the sample size. The primary considerations affecting the decision on
the number of confirmations to send are:
 The materiality of total accounts receivable (i.e., if the accounts receivable balance is
highly material relative to the other asset balances, a larger number of accounts would
 be necessary than when the balance is immaterial)
 The number of accounts receivable
 The distribution in the size of the accounts
 The results of obtaining an understanding of the client's internal control and tests of
transactions
 The results of the confirmation tests in previous years
 The type of confirmation being used (more confirmations usually are required for
negative than for positive confirmations)
 The results of related analytical procedures

In most audits, the auditor's emphasis should be on confirming accounts with the
following characteristics:
 Accounts with larger balances
 Accounts with older balances
 Accounts in dispute
 Accounts with credit balances
 Accounts with related parties

Usually, the auditor selects all accounts above a certain dollar amount and selects a
sample from the remainder. During selection of the accounts for confirmation, it is important that
the auditor have complete discretion and independence in choosing the accounts to be confirmed.
However, clients sometimes request that certain accounts not be confirmed. In these cases, the
auditor should determine (1) the client's reasons for the request and whether they are valid, (2)
whether the amounts involved are material, and (3) whether it is possible to verify the balances
in the accounts by other means (e.g., testing subsequent collections). If the client dictates which
accounts to select or refuses to grant permission to confirm certain accounts and the auditor
cannot confirm the validity of the accounts by other means, the auditor should evaluate the effect
of this scope limitation on the overall audit and whether an unqualified opinion can still be issued
on the financial statements.

Occasionally, the client may ask the auditor to perform procedures that go beyond the
minimum scope requirements of the audit. For example, the client may ask the auditor to confirm
certain customer accounts receivable that are below the cutoff amount determined by the auditor
or to confirm all customer accounts receivable. While it is permissible for the auditor to
accommodate the client's wishes, the auditor should indicate clearly in the working papers which
tests are being performed to be responsive to the client's expectations.

Performance of confirmation procedures

For confirmation procedures to be effective, the auditor must maintain control of the
confirmations from the time they are prepared and mailed until they are returned by the
customer. The confirmation process should be executed so that the client does not have an
opportunity to intercept requests when they are mailed or when they are returned from
respondents.
 The confirmation process ideally involves the auditor mailing a confirmation request
directly to a respondent and receiving the returned confirmation directly from the respondent.
When positive confirmations are used and there is no response, the auditor should consider
sending second and, possibly, third requests. Statements of Auditing Standards recognizes that
other means of confirmation may be used but notes that the auditor must consider using
additional audit procedures to reasonably ensure that a response is authentic and relevant.
Specifically, The Confirmation Process discusses the use of facsimile and oral responses. When
a fax is received from a respondent as part of the confirmation process, some degree of
uncertainty arises concerning the source of the information. Problems may arise if auditors rely
on faxes as audit evidence without performing corroborating audit procedures. For example, it is
possible to preprogram a fax machine with an incorrect transmitting number and name, which
leaves the recipient with no other information about the source of the document. Another
problem is that information contained in the faxed document itself can be easily manipulated. If a
fax can be intercepted, a dishonest party can remove and replace key information. While
Standards of Auditing Standards recognizes that fax confirmations may be used, it notes that the
auditor must consider using additional procedures to reasonably ensure that a response is
authentic and relevant. When a fax is received from a respondent as part of the confirmation
process, some degree of uncertainty arises concerning the source of the information. To reduce
that risk, procedures such as the following may be used:
 Verify the source and content of the fax by telephoning the respondent.
 Request that the respondent mail the original confirmation directly to the auditor.

When information is confirmed orally, the content of, and circumstances surrounding, the
confirmation should be documented in the working papers. If the information confirmed orally is
significant, The Confirmation Process requires that the auditor request the respondent to confirm
the information in writing. Auditors sometimes are able to directly access online information
held by a third party concerning a client's account balance or other information.

Alternative procedures—nonresponses
For negative confirmations, no problem exists for nonresponses because the customer was not
requested to respond if the balance or information was correct. Once an account is selected for
positive confirmation, on the other hand, the account usually must be supported. Nevertheless,
the auditor often is unable to obtain a 100% response rate when positive confirmations are used.
When information has not been confirmed, alternative audit procedures must frequently be
employed. Statements of Auditing Standards concludes that it may be acceptable to omit the use
of alternative procedures when the auditor has not received replies to positive confirmation
requests if both of the following conditions are met:

 The auditor has not identified unusual qualitative factors or systematic characteristics
related to the nonresponses, such as that all nonresponses pertain to year-end transactions.
 When testing for overstatement of amounts, the nonresponses in the aggregate, when
projected as 100% misstatements to the population and added to the sum of all other unadjusted
differences, would not affect the auditor's decision about whether the financial statements are
materially misstated.

When information has not been confirmed for positive requests and the auditor has
decided to use alternative audit procedures, the specific nature of the alternative procedures
depends on the account balance and the client's internal control. Common alternative procedures
include examining subsequent cash collections and reviewing documentation.

 Examining subsequent cash collections—The auditor may examine cash receipts subsequent to
the confirmation date to determine if the receivable has, in fact, been collected. Evidence of the
receipt of cash subsequent to the confirmation date includes examining remittance advices and
related bank deposit tickets, entries in the cash receipts records, and subsequent credits in
the accounts receivable subsidiary records. This verification, along with shipping documents that
indicate that the goods were shipped prior to the confirmation date (or documentation that
services were delivered), provides good evidence that the receivable was owed as of the
confirmation date. Additional care should be taken to match subsequent payments with specific
invoices outstanding as of the confirmation date. One particular fraud another customer to the
wrong account to conceal a misappropriation. Careful examination of subsequent remittances to
determine if they were applied to the correct account would uncover this scheme. Because
review of subsequent cash collections involves an examination of evidence outside the entity, it
is usually considered to provide more reliable audit evidence than a review of internal
documentation.

 Reviewing documentation—The auditor may review the documentation that gave rise to the
receivable. For example, a sales invoice should be issued on the date the receivable was created
and there should be shipping documents related to the sale. By examining the sales invoices and
shipping documents, the auditor can verify the actual date of the billing and the shipping date.

Alternative procedures—responses with differences

Confirmation responses sometimes contain differences noted by the customer. The auditor must
determine the reasons for the differences and clear them satisfactorily. In many cases, differences
are caused by timing differences between the client's and the customer's records. It is important
to distinguish between these differences and exceptions, which represent misstatements of the
accounts receivable balance. The most commonly reported types of differences in confirmations
are as follows:
 Payment has already been made—Reported differences typically arise when the customer has
made a payment prior to the confirmation date, but the client has not received the payment in
time to record it before the confirmation date. The auditor should carefully investigate these
instances to determine the possibility of a cash receipts cutoff error, lapping, or cash theft.

 Merchandise has not been received—Differences typically arise because the client records the
sale at the date of shipment and the customer records the purchase when the goods are received.
The time the goods are in transit is frequently the cause of differences reported on confirmations.
These should be investigated to determine the possibility that the customer did not receive the
goods at all or that a cutoff error in the client's records exists.
 The goods have been returned—The client's failure to record a credit memo could result from
timing differences or from the improper recording of sales returns and allowances. Again, these
differences should be investigated.

 Clerical errors and disputed amounts exist—Differences typically arise because the customer
states that there is an error in the price charged for the goods, the goods are damaged, the proper
quantity of goods was not received, or there is other customer dissatisfaction. These differences
should be investigated to determine whether the client is in error and, if so, the amount of the
error. The auditor should investigate all differences between the client's records and the
information provided by respondents. If such differences cannot be resolved or if the auditor
determines that they represent misstatements, the auditor should:

 Determine the cause of the misstatement.

 Extrapolate the misstatement (together with other misstatements included in the same
sampling application, if applicable) over the population to determine whether additional audit
evidence is required to reduce the risk of material misstatement to an appropriately low level.

 Consider the possibility that fraud may have occurred.

 Determine whether additional audit procedures are necessary to achieve the desired
confirmation audit objectives.

 Report all unreconciled misstatements to a client personnel not directly involved in the area
subject to confirmation.

 Consider whether responses indicate matters that should be reported to the audit committee.
Errors noted while performing additional tests of accounts receivable balances at the client's
request may receive different consideration.

Evaluating the results of confirmation procedures

When all differences have been resolved, including those discovered when performing
alternative procedures, the auditor should determine whether the related assertions have been
sufficiently tested. Statements of Auditing Standards concludes that the following factors should
be considered:
 The reliability of evidence obtained through the confirmation process and alternative
procedures
 The nature and implications of exceptions discovered
 The evidence obtained by the auditor through the use of procedures other than confirmation
and alternative procedures
 Whether additional evidence is needed. If the auditor concludes that evidential matter
obtained through the confirmation process, alternative audit procedures, and other audit
procedures is not sufficient to substantiate relevant assertions in the financial statements,
additional evidence must be obtained. The additional evidence may be acquired by applying
whatever procedures the auditor deems appropriate, including additional confirmations, tests of
details, and analytical procedures. It will be necessary for the auditor to generalize from the
sample to the entire population of accounts receivable. Even though the sum of the errors in the
sample may not significantly affect the financial statements, the auditor must consider whether
the population is likely to be materially misstated.

7.C. Audit of Inventories, Cost of Sales and Accounts Payables

Observation of inventory is a generally accepted auditing procedure, where an
independent auditor issues an opinion on whether the financial records of inventory accurately
represent the physical inventory being carried.

Auditing inventory is an important aspect of gathering evidence, especially for

manufacturing or retail-based businesses. It can represent a large balance of assets or capital.
Auditing inventory must verify not only the amount of inventory but also its quality and
condition to see whether the value of the inventory is fairly represented in financial records and
statements.

Inventory Audit Procedures

Some common inventory audit procedures are:

1. ABC analysis
An ABC analysis includes grouping different value and volume inventory. For example, high-
value inventory, mid-value, and low-value products can be grouped separately. The items can be
tracked and stored in their separate value groups as well.

2. Analytical procedures
Analytical procedures include analyzing inventory based on financial metrics such as gross
margins, days inventory on hand, inventory turnover ratio, and costs of inventory historically.

3. Cut-off analysis
The cut-off analysis includes pausing operations such as receiving and shipping of inventory
while making a physical count to avoid mistakes.

4. Finished goods cost analysis

Finished goods cost analysis applies to manufacturers and includes valuing finished inventory
during an accounting period.

5. Freight cost analysis

Freight cost analysis includes determining the shipping or freight costs for transporting inventory
to different locations. Generally, freight costs are included in the value of inventory, so it is
important to track the freight costs as well.

6. Matching
Matching involves matching the number of items and the cost of inventory shipped with
financial records. Auditors may conduct matching to verify that the right amounts were charged
at the right time.
7. Overhead analysis
Overhead analysis includes analyzing the indirect costs of the business and overhead costs that
may be included in the costs of inventory. Rent, utilities, and other costs can be recorded as part
of inventory costs in some cases.

8. Reconciliation
Reconciliation includes solving discrepancies that are found in an inventory audit. Errors may be
re-checked and reconciled on financial records.

7.E. Audit of Investments

Investments are assets held by an entity for earning income by way of dividends, interest
and rentals, for capital appreciation, or for other benefits to the investing entity. Investments are
classified as 'current investments' and 'long term investments'. A current investment is an
investment that is by its nature readily realisable and is intended to be held for not more than one
year from the date on which such investment is made. A long term investment is an investment
other than a current investment.

The following features of investments have an impact on the related auditing procedures:
(a) Investments constitute a significant portion of the total assets of certain entities
like banks, insurance companies, investment companies, trusts, etc. In other
cases, the nature, quantum and type of investments may vary from case to
case.
(b) Documentary evidence is generally available for audit verification. A detailed
record of acquisition, disposal, etc., of the investments is usually maintained.
(c) The market values of investments may keep on fluctuating. While in the case
of some investments, such fluctuations may not be wide, in the case of others,
they may be significant.
(d) Physical location of documents of title to investments may be different from
the one where the acquisition, disposal and recording thereof take place.
(e) Many investments are readily marketable or can be converted into cash.

Internal Control Evaluation

The auditor should study and evaluate the system of internal control relating to investments to
determine the nature, timing and extent of his other audit procedures. He should particularly
review the following aspects of internal control relating to investments.
(a) Control over acquisition, accretion and disposal of investments: There should be proper
authority for sanction, acquisition and disposal of investments (including renunciation of rights).
It should also be ensured that investments are made in accordance with the legal requirements
governing the entity as also with its internal regulations, e.g., the provisions of the articles of
association, rules and regulations, trust deed, etc.

(b) Safeguarding of investments: The investments should be in the name of the entity as far as
possible. The legal requirements in this behalf, if any, should be complied with. There should
exist a proper system for the safe custody of all scrips or other documents of title to the
investments belonging to the entity.

(c) Controls relating to title to investments: It should be ensured that in cases where the title does
not pass on to the entity immediately on acquisition, the same is transferred to the entity in due
course of time, along with the benefits that might have accrued since the acquisition of the
investments. It should be ensured that there is no undue time-lag in the execution of various
stages of the transactions.

(d) Information controls: These controls should ensure that reliable information is available for
recording acquisitions (including by way of conversion of securities, right issues or other
entitlements, under schemes of amalgamation, acquisition, etc.), accretions and disposals,
and for ascertaining the market values etc. Detailed records regarding acquisition, disposal etc. of
the investments should be maintained along with proper documentation.

Verification
The auditor's primary objective in audit of investments is to satisfy himself as to their
existence and valuation. Verification of investments may be carried out by employing the
following procedures:
(a) verification of transactions;
(b) physical inspection;
(c) examination of valuation and disclosure; and
(d) analytical review procedures.
The nature, timing and extent of audit procedures to be performed is, however, a matter of
professional judgment of the auditor.

The investments of an entity may take various forms, e.g., they may be in the form of
Government securities, shares and debentures, immovable properties, etc. The following
paragraphs discuss the audit steps for verifying investments, with special reference to
investments in the form of shares, debentures and other securities.

Verification of Transactions
The auditor should ascertain whether the investments made by the entity are within its
authority. In this regard, the auditor should examine whether the legal requirements governing
the entity, insofar as they relate to investments, have been complied with and the investments
made by the entity are not ultra vires the entity. Apart from the above, the auditor should also
ensure that any other covenants or conditions which restrict, qualify or abridge the right of
ownership and/or disposal of investments, have been complied with by the entity.

The auditor should satisfy himself that the transactions for the purchase/sale of
investments are supported by due authority and documentation. The acquisition/disposal of
investments should be verified with reference to the broker's contract note, bill of costs, receipts
and other similar evidence. The auditor should pay special attention to ascertaining whether the
investments have been purchased or sold cum-dividend/exdividend, cum-interest/ex-interest,
cum-right/ex-right or cum-bonus/ex-bonus. He should check whether proper adjustments in this
regard have been made in the cost/sales value of securities purchased or sold.

In the case of a rights issue, the offer to the entity contained in the letter of rights should
be examined. Where the rights have been renounced or otherwise disposed of or not exercised,
the auditor should examine the relevant decision of the appropriate authority in this behalf, as
also that the sale proceeds, if any, have been duly accounted for.

As regards bonus shares, the intimation to the entity regarding such issue should be
examined with a view to ascertaining the receipt and recording of the requisite number of shares
by the entity.

Where the amounts of purchases or sales of investments are substantial, the auditor may
check the prices paid/received with reference to the stock exchange quotations, where available,
on or about the date of purchase or sale.

Physical Inspection
The auditor should carry out a physical inspection of investments in the form of shares,
debentures and other securities. In the case of certain entities (e.g., insurance companies),
physical inspection of investments is a statutory requirement.

The depository services and scripless trading are becoming increasingly popular in India.
Depository services involve custody of documents of title to investments such as certificates,
scrips and deeds and thus avoid their physical handling by the investor. The Public Debt Office
of the Reserve Bank of India offers such services to facilitate trading in Government Securities.
Authorised institutions such as banks, financial institutions etc., which have individual ledger
accounts with the Public Debt Office can trade in government securities between themselves by
issuing and accepting Bankers' Receipts. In case of such transactions, the auditor should verify
the periodic reconciliation of balances as per the records of the entity and those as per the Public
Debt Office.

Apart from the Public Debt Office, there are now a number of other custodial
organisations whose services are being utilised by banks, large investors, institutional investors,
mutual funds etc. The concept of the National Depository System (NDS) is also under
development. This system is aimed at eliminating physical movement of securities for purchases
and sales. Wherever the services of any of these custodial or depository organisations are being
used by the entity under audit, the auditor should redesign his audit procedures to ensure that
there is an effective system of periodic reconciliation of balances as per the records of the entity
and those as per the records of the custodial or depository organisation. The auditor should also
examine the certificates issued by such organisations confirming the holdings of the entity. The
concept of scripless trading being introduced by the National Stock Exchange and the OTC
Exchange of India also envisage elimination of movement of title deeds of securities. In such
cases, the auditor should verify the interim and other acknowledgments issued by dealers as well
as the year-end confirmation certificates of the depository organisations.

The investments held by the entity in its own custody should normally be
examined at the close of business on the last day of the year. In case this is not possible, the
auditor should carry out the inspection on a date as near to the balance sheet date as possible. In
such a case, he should take into consideration any adjustments for subsequent transactions of
purchase, sale, etc. Where a substantial number of investments are kept by the entity in its
custody, the auditor should carry out a surprise inspection of the investments on hand at least
once in the year in addition to his year-end examination. He should take particular care to see
that only the investments belonging to the entity are produced to him. This aspect assumes
special importance in the case of entities like banks which hold investments on their own
account, in the form of securities lodged by the customers against loans and advances, and on
behalf of the PMS clients.

Where investments are held by any other person on behalf of the entity, e.g., by banks,
the auditor should examine the certificates received from them. Such certificates should
preferably be received directly by the auditor.

In case investments are held by persons other than banks, the auditor should ensure that
there is justification for it, e.g., securities in the custody of brokers or with the company
concerned for transfer, consolidation, splitting up conversion, etc. Evidence of securities held
with others should be examined and, in appropriate cases, physical inspection of the relevant
documents may be made, to the extent possible, in the course of audit. Where the investments
are recorded at an office other than the one where the documents of title thereto are physically
located, the local auditor may be requested to verify the same.

If the investments are held otherwise than in the name of the entity (e.g., in the name of
nominees/trustees), the auditor should ascertain the reasons for the same and examine the
relevant documentary evidence (e.g., written confirmations from the nominees, trustees, etc.)
supporting the real/beneficial interest of the entity in the investments.

The auditor should also examine any other aspects required to be examined or reported
upon by the relevant statute. For example, in the case of a company, the auditor should also carry
out the procedures outlined in paragraphs below.
 Where shares are held not in the name of the company but in the name of a director,
officer, etc., the auditor should examine whether the declaration referred to in section 187-C of
the Companies Act, 1956 has been properly made.

The auditor should keep in mind the provisions which requires that the auditor of a
company, not being an investment company or a banking company, should enquire whether so
much of the assets of the company as consist of shares, debentures and other securities have been
sold at a price less than that at which they are purchased by the company.

In case the entity is a finance, investment, chit fund, nidhi or mutual benefit company and
is dealing or trading in shares, securities, debentures or another investments, the auditor has to
state in his report whether proper records have been maintained of the transactions and
contracts and whether timely entries have been made therein as also whether the shares,
securities, debentures and other investments have been held by the company in its own name
except to the extent of exemptions.

Immovable Properties
Where immovable properties are held as investments, the auditor should verify them in
the same manner as in the case of immovable properties held as fixed assets.

Examination of Valuation and Disclosure

The auditor should satisfy himself that the investments have been valued and disclosed in
the financial statements in accordance with recognized accounting policies and practices and
relevant statutory requirements, the auditor should also examine whether the method of valuation
followed by the entity is consistently applied.

The auditor should examine whether, in computing the cost of investments, the
expenditure incurred on account of transfer fees, stamp duty, brokerage, etc., is included in the
cost of investments.

The auditor may ascertain the market value of the quoted securities from official
quotations of the stock exchange. In case of unquoted securities, the auditor should ascertain the
method adopted by the entity for determining the market value of such securities. He should
examine whether the method adopted by the entity is one of the recognised methods of valuation
of securities such as break-up value method, capitalisation of yield method, yield to maturity
method, etc. In the case of investments other than in the form of securities (e.g., rare paintings),
the auditor should examine that the market value has been ascertained on the basis of authentic
market reports.

Analytical Review Procedures

As a measure of judging the overall reasonableness of the amounts attributed to
investments, the auditor may relate the amount of income received from investments with the
corresponding figures of investments and compare this ratio with the similar ratio for the
previous years. For this purpose, investments may be classified into appropriate categories. Thus,
in the case of fixed interest-bearing securities, the auditor may relate the amount of interest
earned with the face value of the related securities. In the case of other securities, the auditor
may review the schedule of dividend and other returns and the schedule of investments prepared
by the entity and judge their reasonableness.

Management Representations
The auditor should obtain from the management of the entity a written statement
regarding classification and valuation of investments for Balance Sheet purposes. While such a
representation letter serves as a formal acknowledgment of the management's responsibilities
with regard to investments, it does not relieve the auditor of his responsibility for performing
audit procedures to obtain sufficient appropriate audit evidence to form the basis for the
expression of his opinion on the financial information. It may be mentioned that the
representations made in the letter can alternatively be included in the composite representation
letter usually issued by the management to the auditor.

Documentation
The auditor should maintain adequate working papers regarding audit of investments.
Among others, he should maintain on his audit file, the management representation letter
concerning investments.

7.E. Audit of Property, Plant and Equipment, and the Related Depreciation and Depletion
Property plant and equipment or PPE are usually material items on the balance sheet;
hence to audit PPE, it is very important to perform proper audit procedures in order to obtain
sufficient appropriate audit evidence for making a proper conclusion on PPE accounts.

In the audit of PPE, the inherent risk of PPE involves more on the existence and valuation
of their balances. This is due to the risk of overstatement of PPE is higher than the risk of an
understatement.

The inherent risk of PPE is that the client may over overstate the balance by including
fictitious assets or capitalize the costs, such as repair and maintenance costs, which should be the
expense. Meanwhile, the valuation issue is usually related to the estimate of the useful life of the
PPE which may result in an understatement of depreciation expense.

Audit Assertions for PPE

In the audit of PPE, we usually test the audit assertions included in the table below:
 Audit assertions for PPE
Existence PPE reported on the balance sheet really exists at the reporting date.
PPE balances truly reflect their actual economic value as at
Valuation
reporting date.
All PPE transactions that should have been recorded have been
Completeness
recorded.
Rights and obligations The client has ownership rights for PPE as of the reporting date.

Existence and valuation assertions are the most relevant assertions in the audit of PPE.
This is because the client tends to overstate the value of PPE rather than understate. Hence, we
usually pay more attention to the areas related to these two audit assertions.

Audit Procedures for PPE

In the audit procedures for PPE, we need to test various audit assertions, including
existence, valuation, completeness and rights and obligations. This is so that we can make sure
PPE balances reported in the financial statements actually exist and reflect their actual economic
value. Additionally, we need to evaluate whether all PPE items are included and if they really
belong to the client.

Completeness
For the PPE audit, we test completeness assertion to ensure that all PPE transactions that
occurred during the year have been recorded. Lack of completeness would result in the
understatement of PPE.

Example: tests of completeness in PPE audit include:

Reconcile and compare the PPE register with the general ledger
Select a sample of PPE items that physically exist
Trace the selected items to the PPE register
We need to obtain proper explanations if there are any differences between the
PPE register and the general ledger.

Existence
When we perform the PPE audit, we test the existence assertion to ensure that the PPE
balances shown on the balance sheet really exist at the reporting date.
Example: tests of existence on PPE audit include:
Select a sample of items in PPE register
Perform physical inspection on the selected items
When performing the physical inspection of PPE, we need to make sure not only that the
selected items really exist, but they also need to be in a working condition.

Valuation
In the audit of PPE, we test the valuation assertion to ensure that the PPE balances are
mathematically correct and proper valuation method has been made. The valuation assertion
usually relates to the deprecation of PPE. Hence, we usually perform the test of PPE
depreciation in this section.
Example: tests of depreciation in the audit of PPE:
Review the client’s depreciation method to evaluate whether it is in accordance
with the applicable accounting standards
Examine the useful life of PPE to evaluate whether the client’s estimate is
reasonable, e.g. by comparing with industry standard. Professional
judgment is required and very important here.
Perform recalculation on the depreciation of PPE
Compare the result of recalculation to the client’s figures.

Rights and obligations

Right and obligation assertion tests whether the client has the right and ownership of all
PPE shown on the financial statements as at reporting date.

Example: tests of rights and obligations in the PPE audit include:

Select a sample of PPE items in the register
Examine the title documents or title deeds of the selected items to ensure they
really belong to the client

Summary
All in all, existence and valuation assertions are the primary concerns in the audit of PPE.
The existence of PPE itself is the high-risk area as the misstatement in this area could be due to
the intentional act of cooking the books.

On the other hand, misstatement occurred in the area of valuation tends to be an

understatement of depreciation. In this case, they impact both the balance sheet and income
statement; and it may result in an overstatement of both PPE and net profit.

7.F. Audit of Intangible Assets

Tests for the existence of intangible assets are usually conducted through the examination
of documentation. Common intangible assets include patents, trademarks and goodwill. Most of
these items arise from contractual interactions, legal filings and business combinations. As such,
companies should have substantial documentation related to their ownership. Auditors will
request supporting documentation and cross-validate the information with other audited
accounting information.

The analytical procedure Intangible assets is intended for the comprehensive analysis and
data check in a continuous way, includes the following segments:

 accuracy of the classification as intangible assets;

 useful live;
 depreciation;
 land tax.

Audit Documentation software (analysis) is used for a continuous analysis. This program is
registered by the employee of our company in the National center of intellectual property of the
Republic of Belarus. In accordance with the contract is intellectual property of the auditing
company AuditComService LLC.

The conducted analysis consists of the following audit procedures:

- analytical audit procedures on the verification of base data of intangible assets

 audit of the appropriation of long-term assets according to the characteristics of intangible

assets;
 positive residual value at the end of the audit period;
 check of the fact of charge depreciation for the last month of the calendar year;
 search for other variances according to auditors.

- analytical auditing procedure for the reconciliation of depreciation of intangible assets with
estimated data

 search for deviations of the estimated monthly and final depreciations for the audited period;
 audit of the availability of depreciation for accounting in the case of disposal of intangible
assets;
 analysis of the absence of accrual of depreciation for accounting in the case of non-disposal of
intangible assets;
 audit and analysis of the facts of change account of depreciation for the audited period.

- audit procedure for data analysis of the land tax calculation on intangible assets

 analysis of the correctness of t inclusion / non-inclusion of the objects into the tax base;
 verification of the applied coefficients of land-tax and rightness of calculations on them;
 analysis of the application of land tax privileges.

The results of the conducted audit procedures are documented in a detailed description of
analysis procedure, the list of deviations for intangible assets with the recommendations for their
recovery, as well as the conclusions of the auditors by the results of analysis.

7.G. Audit of Prepaid Expenses, Deferred Charges and Other Current Liabilities

As an auditor you have to pay attention to all of a company’s assets. Prepaid expenses
and deferred charges appear on a company’s balance sheet as other assets. Both categories apply
to a situation where a client pays in advance for a good or service.
 When you see the words expense and charge, you may wonder how the heck these items
belong in an asset account. Expenses belong on the income statement, right? Well, GAAP dictate
that expenses that are paid before they’re due belong on the balance sheet. Whenever your audit
client pays expenses in the current period that won’t be matched with revenue until subsequent
periods, it’s a prepaid expense or deferred charge.

If a company prepays its expenses, it usually has the next 12 months to use up that asset.
Businesses prepay their expenses all the time. For example, they often pay a year’s worth of
business insurance at once. They may also pay rent and interest expense in advance.

Auditing prepaids is usually a simple task. The prepaid expense originates in the
purchases process, so good controls in that business process carry over to the prepaid process.
Misstatements are normally immaterial and easily fixed with a journal entry.

Your client may have deferred charges, which are transactions that take place and are
recorded on the financial statements in the present and are carried forward into the future until
they’re actually used. Two examples are relocation expenses and debt issuance costs:
Relocation costs: Your client pays these costs when it packs up and moves shop.
Depending on the size of the operation and the distance of the move, the costs can be
considerable. Because the benefits of a move presumably will last for many years, the costs
involved in the move can be expensed over time (instead of when they’re actually paid). If you
see relocation costs on your client’s financial statements, query the client as to the circumstances
to see if any necessary cost was appropriately moved to the income statement.

Debt issuance (bond) costs: If your client issues bonds to raise money, the costs
associated with the bonds are debt issuance costs. For example, your client has to pay an
investment bank to market the bonds to investors and pay legal fees to have attorneys prepare the
bond documents. The idea is that the bonds will generate revenue for many years, so the costs
associated with issuing the bonds can be expensed over the same time frame.

Corporations raise money either by selling stock (which is classified as equity and
doesn’t have to be paid back) or by selling bonds (which are debts and do have to be paid back).
If your client sells bonds, it definitely needs to provide adequate disclosure in its financial
statements, including the reason for and amount of the bond issuance, the time in which the
bonds need to be paid back, and the interest rate.

7.H. Audit of Long-term Liabilities, Equity Accounts and Other Accounts in the Statement
of Operation and Comprehensive Income
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. This assurance extends to the recognition of
interest expense. For the vast majority of entities, it is more efficient to follow a strategy of
conducting substantive testing.
 The inherent risk for notes and bonds would normally be assessed as low to moderate
because the volume of transactions are low, the accounting is not complex, and the client often
receives third-party statements or amortization tables.

However, the amounts are usually large and the financial markets have developed
sophisticated instruments that have characteristics of both debt and equity. The inherent risk
associated with these instruments is normally high.

When a substantive strategy is followed, the auditor still needs a sufficient understanding
of the entity’s internal control system over debt.

Assertions and Related Control Activities

Occurrence and Authorization
Completeness
Valuation
Disclosure – Classification

Substantive Procedures of Long-Term Debt

Assertions Substantive Tests of Transactions
Occurrence Examine copies of new note or bond agreements. Examine board of
directors' minutes for approval of new lending agreements.

Completeness Trace large cash receipts and payments to source documents and the
general ledger. Review interest expense for payments to debt holders
not listed on the debt analysis schedule. Review notes paid or renewed
after the balance sheet date to determine if there are unrecorded
liabilities at year-end. Evaluate lease contracts to determine if leases are
properly accounted for as an operating or capital lease.

Authorization Examine board minutes for evidence of proper authorization of notes or

bonds.

Accuracy Test a sample of receipts and payments.

Cutoff Review debt activity for a few days before and after year-end to
determine if the transactions are included in the proper period.

Classification Examine the due dates on notes or bonds for proper classification
between current and long-term debt.

Substantive Procedures of Long-Term Debt

Auditing Stockholders’ Equity
The following three types of transactions are of importance to the auditor:
1. Issuance of stock including transactions such as sale of stock for cash; the exchange of
stock for assets, services, or convertible debt; and issuance of stock for stock splits.

2. Repurchase of stock including both the reacquisition of stock and retirement of stock.

3. Payment of dividends including cash and stock dividends.

Control Risk Assessment – Stockholders’ Equity

A substantive strategy is often used to audit stockholders’ equity because the number of
transactions is usually small. The auditor must still understand the types of controls that are in
place to prevent the misstatement of equity transactions.

Large, publicly traded companies use an independent registrar, transfer agent, and
dividend-disbursing agent to process and record equity transaction. Relevant information about
equity transactions may be confirmed with those parties.

Assertions and Related Control Activities

Occurrence Verify that stock and dividend transactions comply with corporate charter.

Accuracy Verify that stock and dividend transactions have been properly posted and
summarized in the accounting records.

Authorization Verify that stock and dividend transactions have been properly approved.

Valuation Verify that stock and dividend transactions have been properly valued.

Segregation of Duties
When possible, the following duties should be segregated:
 1. The individuals responsible for issuing, transferring, and canceling stock
certificates should not have any accounting responsibilities.

2. The individual responsible for maintaining the detailed stockholders’ records

should be independent of the maintenance of the general ledger control
accounts.

3. The individual responsible for maintaining the detailed stockholders’ records

should not also process cash receipts or disbursements.

4. Appropriate segregation of duties should be established among the preparation,

recording, signing, and mailing of dividend checks.

Auditing Capital-Stock Accounts

Occurrence and Completeness
Valuation
Completeness of Disclosure

Auditing Dividends
All dividends declared and paid will be audited because of concerns of violations of
corporate bylaws or debt covenants

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.

When an independent agent is not used, the auditor can recomputed the amount of the
dividend authorized by the board of directors and trace the amount to cash disbursements or
dividends payable.

Auditing Retained Earnings

Under normal circumstances, retained earnings are affected by the current year’s income
or loss and the dividends declared and or paid.

The major exceptions are the existence of prior period adjustments, correction of errors,
stock retirements, and changes in appropriations of retained earnings.

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. Substantive procedures on selected
income statement accounts include:
o The results of testing controls for the various business processes.
o The results of the detailed tests of balance sheet accounts and the related income
statement accounts.
o Performance of substantive analytical procedures on income statement accounts.
o Detailed tests of selected income statement accounts.

UNIT 8. Evaluation of Audit Evidence and Formulation of Audit Report

Audit evidence documents give you the substantiation for your professional audit opinion.
When performing an audit, you must assess the nature, competence, sufficiency, and evaluation of the
audit evidence to determine its accuracy. After all your audit depends on the veracity of the evidence.

This standard establishes requirements regarding the auditor's evaluation of audit results
and determination of whether he or she has obtained sufficient appropriate audit evidence.
Objective

The objective of the auditor is to evaluate the results of the audit to determine whether the
audit evidence obtained is sufficient and appropriate to support the opinion to be expressed in the
auditor's report.

Evaluating the Results of the Audit of Financial Statements

In forming an opinion on whether the financial statements are presented fairly, in all
material respects, in conformity with the applicable financial reporting framework, the auditor
should take into account all relevant audit evidence, regardless of whether it appears to
corroborate or to contradict the assertions in the financial statements.

In the audit of financial statements, 1 the auditor's evaluation of audit results should
include evaluation of the following:

The results of analytical procedures performed in the overall review of the

financial statements ("overall review");

Misstatements accumulated during the audit, including, in particular,

uncorrected misstatements;

The qualitative aspects of the company's accounting practices;

Conditions identified during the audit that relate to the assessment of the risk of
material misstatement due to fraud ("fraud risk");

The presentation of the financial statements, including the disclosures; and

The sufficiency and appropriateness of the audit evidence obtained.

Performing Analytical Procedures in the Overall Review
In the overall review, the auditor should read the financial statements and disclosures and
perform analytical procedures to (a) evaluate the auditor's conclusions formed regarding
significant accounts and disclosures and (b) assist in forming an opinion on whether the financial
statements as a whole are free of material misstatement.

As part of the overall review, the auditor should evaluate whether:

The evidence gathered in response to unusual or unexpected transactions, events,
amounts, or relationships previously identified during the audit is sufficient; and

Unusual or unexpected transactions, events, amounts, or relationships indicate

risks of material misstatement that were not identified previously, including, in
particular, fraud risks.

Note: If the auditor discovers a previously unidentified risk of material misstatement or

concludes that the evidence gathered is not adequate, he or she should modify his or her audit
procedures or perform additional procedures as necessary.

The nature and extent of the analytical procedures performed during the overall review
may be similar to the analytical procedures performed as risk assessment procedures. The auditor
should perform analytical procedures relating to revenue through the end of the reporting period.

The auditor should obtain corroboration for management's explanations regarding

significant unusual or unexpected transactions, events, amounts, or relationships. If
management's responses to the auditor's inquiries appear to be implausible, inconsistent with
other audit evidence, imprecise, or not at a sufficient level of detail to be useful, the auditor
should perform procedures to address the matter.

Evaluating Whether Analytical Procedures Indicate a Previously Unrecognized Fraud Risk.

Whether an unusual or unexpected transaction, event, amount, or relationship indicates a
fraud risk, as discussed in paragraph .06b, depends on the relevant facts and circumstances,
including the nature of the account or relationship among the data used in the analytical
procedures. For example, certain unusual or unexpected transactions, events, amounts, or
relationships could indicate a fraud risk if a component of the relationship involves accounts and
disclosures that management has incentives or pressures to manipulate, e.g., significant unusual
or unexpected relationships involving revenue and income.

Accumulating and Evaluating Identified Misstatements

Accumulating Identified Misstatements. The auditor should accumulate misstatements
identified during the audit, other than those that are clearly trivial.

The auditor may designate an amount below which misstatements are clearly trivial and
do not need to be accumulated. In such cases, the amount should be set so that any misstatements
below that amount would not be material to the financial statements, individually or in
combination with other misstatements, considering the possibility of undetected misstatement.
 The auditor's accumulation of misstatements should include the auditor's best estimate of
the total misstatement in the accounts and disclosures that he or she has tested, not just the
amount of misstatements specifically identified. This includes misstatements related to
accounting estimates, and projected misstatements from substantive procedures that involve
audit sampling.

Misstatements Relating to Accounting Estimates. If the auditor concludes that the amount
of an accounting estimate included in the financial statements is unreasonable or was not
determined in conformity with the relevant requirements of the applicable financial reporting
framework, he or she should treat the difference between that estimate and a reasonable estimate
determined in conformity with the applicable accounting principles as a misstatement. If a range
of reasonable estimates is supported by sufficient appropriate audit evidence and the recorded
estimate is outside of the range of reasonable estimates, the auditor should treat the difference
between the recorded accounting estimate and the closest reasonable estimate as a misstatement.
Note: If an accounting estimate is determined in conformity with the relevant requirements of the
applicable financial reporting framework and the amount of the estimate is reasonable, a
difference between an estimated amount best supported by the audit evidence and the recorded
amount of the accounting estimate ordinarily would not be considered to be a misstatement.

Considerations as the Audit Progresses. The auditor should determine whether the
overall audit strategy and audit plan need to be modified if:
The nature of accumulated misstatements and the circumstances of their
occurrence indicate that other misstatements might exist that, in combination
with accumulated misstatements, could be material; or

The aggregate of misstatements accumulated during the audit approaches the

materiality level or levels used in planning and performing the audit.

Note: When the aggregate of accumulated misstatements approaches the materiality level or
levels used in planning and performing the audit, there likely will be greater than an
appropriately low level of risk that possible undetected misstatements, when combined with the
aggregate of misstatements accumulated during the audit that remain uncorrected, could be
material to the financial statements. If the auditor's assessment of this risk is unacceptably high,
he or she should perform additional audit procedures or determine that management has adjusted
the financial statements so that the risk that the financial statements are materially misstated has
been reduced to an appropriately low level.

The auditor should communicate accumulated misstatements to management on a timely

basis to provide management with an opportunity to correct them.

If management has examined an account or a disclosure in response to misstatements

detected by the auditor and has made corrections to the account or disclosure, the auditor should
evaluate management's work to determine whether the corrections have been recorded properly
and whether uncorrected misstatements remain.
 Evaluation of the Effect of Uncorrected Misstatements. The auditor should evaluate
whether uncorrected misstatements are material, individually or in combination with other
misstatements. In making this evaluation, the auditor should evaluate the misstatements in
relation to the specific accounts and disclosures involved and to the financial statements as a
whole, taking into account relevant quantitative and qualitative factors.

Note: As a result of the interaction of quantitative and qualitative considerations in materiality

judgments, uncorrected misstatements of relatively small amounts could have a material effect
on the financial statements. For example, an illegal payment of an otherwise immaterial amount
could be material if there is a reasonable possibility that it could lead to a material contingent
liability or a material loss of revenue. Also, a misstatement made intentionally could be material
for qualitative reasons, even if relatively small in amount.

Note: If the reevaluation of the established materiality level or levels, results in a lower amount
for the materiality level or levels, the auditor should take into account that lower materiality level
or levels in the evaluation of uncorrected misstatements.

The auditor's evaluation of uncorrected misstatements, should include evaluation of the

effects of uncorrected misstatements detected in prior years and misstatements detected in the
current year that relate to prior years.

The auditor cannot assume that an instance of error or fraud is an isolated occurrence.
Therefore, the auditor should evaluate the nature and effects of the individual misstatements
accumulated during the audit on the assessed risks of material misstatement. This evaluation is
important in determining whether the risk assessments remain appropriate.

Evaluating Whether Misstatements Might Be Indicative of Fraud. The auditor should

evaluate whether identified misstatements might be indicative of fraud and, in turn, how they
affect the auditor's evaluation of materiality and the related audit responses. Fraud is an
intentional act that results in material misstatement of the financial statements.

If the auditor believes that a misstatement is or might be intentional, and if the effect on
the financial statements could be material or cannot be readily determined, the auditor should
perform procedures to obtain additional audit evidence to determine whether fraud has occurred
or is likely to have occurred and, if so, its effect on the financial statements and the auditor's
report thereon.

For misstatements that the auditor believes are or might be intentional, the auditor should
evaluate the implications on the integrity of management or employees and the possible effect on
other aspects of the audit. If the misstatement involves higher-level management, it might be
indicative of a more pervasive problem, such as an issue with the integrity of management, even
if the amount of the misstatement is small. In such circumstances, the auditor should reevaluate
the assessment of fraud risk and the effect of that assessment on (a) the nature, timing, and extent
of the necessary tests of accounts or disclosures and (b) the assessment of the effectiveness of
controls. The auditor also should evaluate whether the circumstances or conditions indicate
possible collusion involving employees, management, or external parties and, if so, the effect of
the collusion on the reliability of evidence obtained.

If the auditor becomes aware of information indicating that fraud or another illegal act
has occurred or might have occurred, he or she also must determine his or her responsibilities.

Evaluating the Qualitative Aspects of the Company's Accounting Practices

When evaluating whether the financial statements as a whole are free of material
misstatement, the auditor should evaluate the qualitative aspects of the company's accounting
practices, including potential bias in management's judgments about the amounts and disclosures
in the financial statements.
The following are examples of forms of management bias:
1. The selective correction of misstatements brought to management's attention
during the audit (e.g., correcting misstatements that have the effect of increasing reported
earnings but not correcting misstatements that have the effect of decreasing reported
earnings).
Note: To evaluate the potential effect of selective correction of
misstatements, the auditor should obtain an understanding of the reasons that
management decided not to correct misstatements communicated by the auditor.

2. The identification by management of additional adjusting entries that offset

misstatements accumulated by the auditor. If such adjusting entries are identified, the
auditor should perform procedures to determine why the underlying misstatements were
not identified previously and evaluate the implications on the integrity of management
and the auditor's risk assessments, including fraud risk assessments. The auditor also
should perform additional procedures as necessary to address the risk of further
undetected misstatement.

3. Bias in the selection and application of accounting principles.

4. Bias in accounting estimates.

If the auditor identifies bias in management's judgments about the amounts and
disclosures in the financial statements, the auditor should evaluate whether the effect of that bias,
together with the effect of uncorrected misstatements, results in material misstatement of the
financial statements. Also, the auditor should evaluate whether the auditor's risk assessments,
including, in particular, the assessment of fraud risks, and the related audit responses remain
appropriate.

Evaluating Bias in Accounting Estimates. The auditor should evaluate whether the
difference between estimates best supported by the audit evidence and estimates included in the
financial statements, which are individually reasonable, indicate a possible bias on the part of the
company's management. If each accounting estimate included in the financial statements was
individually reasonable but the effect of the difference between each estimate and the estimate
best supported by the audit evidence was to increase earnings or loss, the auditor should evaluate
whether these circumstances indicate potential management bias in the estimates. Bias also can
result from the cumulative effect of changes in multiple accounting estimates. If the estimates in
the financial statements are grouped at one end of the range of reasonable estimates in the prior
year and are grouped at the other end of the range of reasonable estimates in the current year, the
auditor should evaluate whether management is using swings in estimates to achieve an expected
or desired outcome, e.g., to offset higher or lower than expected earnings.

Evaluating Conditions Relating to the Assessment of Fraud Risks

When evaluating the results of the audit, the auditor should evaluate whether the
accumulated results of auditing procedures and other observations affect the assessment of the
fraud risks made throughout the audit and whether the audit procedures need to be modified to
respond to those risks.

As part of this evaluation, the engagement partner should determine whether there has
been appropriate communication with the other engagement team members throughout the audit
regarding information or conditions that are indicative of fraud risks.

Note: To accomplish this communication, the engagement partner might arrange another
discussion among the engagement team members about fraud risks.

Evaluating the Presentation of the Financial Statements, Including the Disclosures

The auditor must evaluate whether the financial statements are presented fairly, in all
material respects, in conformity with the applicable financial reporting framework.

Note: The auditor should look to the requirements of the Securities and Exchange Commission
for the company under audit with respect to the accounting principles applicable to that
company.

As part of the evaluation of the presentation of the financial statements, the auditor
should evaluate whether the financial statements contain the information essential for a fair
presentation of the financial statements in conformity with the applicable financial reporting
framework. Evaluation of the information disclosed in the financial statements includes
consideration of the form, arrangement, and content of the financial statements (including the
accompanying notes), encompassing matters such as the terminology used, the amount of detail
given, the classification of items in the statements, and the bases of amounts set forth.

Note: If the financial statements, including the accompanying notes, fail to disclose information
that is required by the applicable financial reporting framework, the auditor should express a
qualified or adverse opinion and should provide the information in the report, if practicable,
unless its omission from the report is recognized as appropriate by a specific auditing standard.

Evaluating the Sufficiency and Appropriateness of Audit Evidence

 Audit Risk, states: To form an appropriate basis for expressing an opinion on the
financial statements, the auditor must plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement due to error or fraud.
Reasonable assurance is obtained by reducing audit risk to an appropriately low level through
applying due professional care, including obtaining sufficient appropriate audit evidence.

As part of evaluating audit results, the auditor must conclude on whether sufficient
appropriate audit evidence has been obtained to support his or her opinion on the financial
statements.

Factors that are relevant to the conclusion on whether sufficient appropriate audit
evidence has been obtained include the following:
1. The significance of uncorrected misstatements and the likelihood of their
having a material effect, individually or in combination, on the financial statements,
considering the possibility of further undetected misstatement.

2. The results of audit procedures performed in the audit of financial statements,

including whether the evidence obtained supports or contradicts management's assertions
and whether such audit procedures identified specific instances of fraud.

3. The auditor's risk assessments.

4. The results of audit procedures performed in the audit of internal control over
financial reporting, if the audit is an integrated audit.

5. The appropriateness (i.e., the relevance and reliability) of the audit evidence
obtained.

If the auditor has not obtained sufficient appropriate audit evidence about a relevant
assertion or has substantial doubt about a relevant assertion, the auditor should perform
procedures to obtain further audit evidence to address the matter. If the auditor is unable to
obtain sufficient appropriate audit evidence to have a reasonable basis to conclude about whether
the financial statements as a whole are free of material misstatement, the standard indicates that
the auditor should express a qualified opinion or a disclaimer of opinion.

Evaluating the Appropriateness of Risk Assessments. As part of the evaluation of whether

sufficient appropriate audit evidence has been obtained, the auditor should evaluate whether the
assessments of the risks of material misstatement at the assertion level remain appropriate and
whether the audit procedures need to be modified or additional procedures need to be performed
as a result of any changes in the risk assessments. For example, the re-evaluation of the auditor's
risk assessments could result in the identification of relevant assertions or significant risks that
were not identified previously and for which the auditor should perform additional audit
procedures.

Evaluating the Results of the Audit of Internal Control Over Financial Reporting
 An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit
of Financial Statements, indicates that the auditor should form an opinion on the effectiveness of
internal control over financial reporting by evaluating evidence obtained from all sources,
including the auditor's testing of controls, misstatements detected during the financial statement
audit, and any identified control deficiencies. The standard describes the auditor's responsibilities
regarding evaluating the results of the audit, including evaluating the identified control
deficiencies.

Qualitative Factors Related to the Evaluation of the Materiality of Uncorrected

Misstatements
The auditor should evaluate whether uncorrected misstatements are material, individually
or in combination with other misstatements. In making this evaluation, the auditor should
evaluate the misstatements in relation to the specific accounts and disclosures involved and to the
financial statements as a whole, taking into account relevant quantitative and qualitative factors.

Qualitative factors to consider in the auditor's evaluation of the materiality of uncorrected

misstatements, if relevant, include the following:
1. The potential effect of the misstatement on trends, especially trends in profitability.

2. A misstatement that changes a loss into income or vice versa.

3. The effect of the misstatement on segment information, for example, the significance
of the matter to a particular segment important to the future profitability of the
company, the pervasiveness of the matter on the segment information, and the impact
of the matter on trends in segment information, all in relation to the financial
statements taken as a whole.

4. The potential effect of the misstatement on the company's compliance with loan
covenants, other contractual agreements, and regulatory provisions.

5. The existence of statutory or regulatory reporting requirements that affect materiality

thresholds.

6. A misstatement that has the effect of increasing management's compensation, for

example, by satisfying the requirements for the award of bonuses or other forms of
incentive compensation.

7. The sensitivity of the circumstances surrounding the misstatement, for example, the
implications of misstatements involving fraud and possible illegal acts, violations of
contractual provisions, and conflicts of interest.

8. The significance of the financial statement element affected by the misstatement, for
example, a misstatement affecting recurring earnings as contrasted to one involving a
non-recurring charge or credit, such as an extraordinary item.
 9. The effects of misclassifications, for example, misclassification between operating and
non-operating income or recurring and non-recurring income items.

10. The significance of the misstatement or disclosures relative to known user needs, for
example:
a. The significance of earnings and earnings per share to public company
investors.

b. The magnifying effects of a misstatement on the calculation of purchase price

in a transfer of interests (buy/sell agreement).

c. The effect of misstatements of earnings when contrasted with expectations.

11. The definitive character of the misstatement, for example, the precision of an error
that is objectively determinable as contrasted with a misstatement that unavoidably
involves a degree of subjectivity through estimation, allocation, or uncertainty.

12. The motivation of management with respect to the misstatement, for example, (i) an
indication of a possible pattern of bias by management when developing and
accumulating accounting estimates or (ii) a misstatement precipitated by
management's continued unwillingness to correct weaknesses in the financial
reporting process.

13. The existence of offsetting effects of individually significant but different

misstatements.

14. The likelihood that a misstatement that is currently immaterial may have a material
effect in future periods because of a cumulative effect, for example, that builds over
several periods.

15. The cost of making the correction—it may not be cost-beneficial for the client to
develop a system to calculate a basis to record the effect of an immaterial
misstatement. On the other hand, if management appears to have developed a system
to calculate an amount that represents an immaterial misstatement, it may reflect a
motivation of management.

16. The risk that possible additional undetected misstatements would affect the auditor's
evaluation.

Matters That Might Affect the Assessment of Fraud Risks

 If the following matters are identified during the audit, the auditor should take into
account these matters in the evaluation of the assessment of fraud risks:
a. Discrepancies in the accounting records, including:
1. Transactions that are not recorded in a complete or timely manner or
are improperly recorded as to amount, accounting period,
classification, or company policy.

2. Unsupported or unauthorized balances or transactions.

3. Last-minute adjustments that significantly affect financial results.

4. Evidence of employees' access to systems and records that is

inconsistent with the access that is necessary to perform their authorized
duties.

5. Tips or complaints to the auditor about alleged fraud.

b. Conflicting or missing evidence, including:

1. Missing documents.

2. Documents that appear to have been altered.

3. Unavailability of other than photocopied or electronically transmitted

documents when documents in original form are expected to exist.

4. Significant unexplained items in reconciliations.

5. Inconsistent, vague, or implausible responses from management or

employees arising from inquiries or analytical procedures.

6. Unusual discrepancies between the company's records and confirmation

responses.

7. Missing inventory or physical assets of significant magnitude.

8. Unavailable or missing electronic evidence that is inconsistent with the

company's record retention practices or policies.

9. Inability to produce evidence of key systems development and program

change testing and implementation activities for current year system
changes and deployments.

10. Unusual balance sheet changes or changes in trends or important

financial statement ratios or relationships, e.g., receivables growing
 faster than revenues.
`
11. Large numbers of credit entries and other adjustments made to
accounts receivable records.

12. Unexplained or inadequately explained differences between the

accounts receivable subsidiary ledger and the general ledger control
account, or between the customer statement and the accounts
receivable subsidiary ledger.

11. Missing or nonexistent cancelled checks in circumstances in which

cancelled checks are ordinarily returned to the company with the bank
statement.

12. Fewer responses to confirmation requests than anticipated or a greater

number of responses than anticipated.

Problematic or unusual relationships between the auditor and management, including:

1. Denial of access to records, facilities, certain employees, customers, vendors, or others
from whom audit evidence might be sought, including:
a. Unwillingness to facilitate auditor access to key electronic files for testing
through the use of computer-assisted audit techniques.

b. Denial of access to key information technology operations staff and facilities,

including security, operations, and systems development.

c. Undue time pressures imposed by management to resolve complex or

contentious issues.

d. Management pressure on engagement team members, particularly in

connection with the auditor's critical assessment of audit evidence or in the
resolution of potential disagreements with management.

e. Unusual delays by management in providing requested information.

f. Management's unwillingness to add or revise disclosures in the financial

statements to make them more complete and transparent.

g. Management's unwillingness to appropriately address significant deficiencies

in internal control on a timely basis.

Other matters, including:

a. Objections by management to the auditor meeting privately with the audit
committee.

b. Accounting policies that appear inconsistent with industry practices that are
widely recognized and prevalent.

c. Frequent changes in accounting estimates that do not appear to result from

changing circumstances.

d. Tolerance of violations of the company's code of conduct.

UNIT 9. Completion of the Audit and Forming an Opinion in the Independent Auditor’s
Report
The completion stage of the audit is of crucial importance. It is during the completion stage that
the auditor reviews the evidence obtained during the audit together with the final version of the
financial statements with the objective of forming the auditor's opinion.

Review for Contingent Liabilities

Contingent liability—a potential future obligation to an outside party for an unknown
amount resulting from activities that have already taken place. Three conditions are required for
a contingent liability to exist: 1) there is a potential future payment to an outside party that
resulted from an existing condition; 2) there is uncertainty about the amount of the future
payment and 3) the outcome will be resolved by some future event or events.

SFAS No. 5 discusses three levels of likelihood:

Probable—the future event or events are likely to occur

Reasonably possible—the chance that the future event or events will occur
is more than remote but less than probable

Remote—the chance that the event will occur is slight

If a potential loss is probable and the amount can be reasonably estimated the loss
should be accrued and indicated in the body of the financial statements.

Disclosure in footnotes but no accrual is required if the amount of a probable loss cannot
be reasonably estimated of if the loss is only reasonably possible. The footnote should describe
the nature of the contingency to the extent it is known and the opinion of legal counsel or
management as to the expected outcome.

Certain contingent liabilities are of considerable concern to the auditor:

--pending litigation
 --income tax disputes

--product warranties

--notes receivable discounted

--guarantees

--standby L/Cs

The following are some audit procedures commonly used to search for contingent liabilities:
--inquire of management regarding the possibility of unrecorded contingencies

--review current and previous years’ internal revenue agent reports for income tax
settlements

--review minutes of stockholder and B of D meetings

--analyze legal expenses and review invoices and statements from legal counsel for
indications of contingent liabilities

--obtain a confirmation from all major attorneys performing legal services as to the status
of pending litigation information that may indicate a contingency

--review L/Cs in force as of the balance sheet date

The standard letter of confirmation from the client’s attorney, which should be prepared on the
client’s letterhead and signed by one of the company’s officers, should include the following:
--a list, prepared by management, of likely material unasserted litigation, claims, or
assessments

--a list, prepared by management, of likely material unasserted claims and assessments

--a request that the attorney furnish information or comment about the progress of each
listed claim or assessment, the legal action the client intends to take, the likelihood of
an unfavorable outcome and an estimate of the range of loss

--a request for the identification of any unlisted pending or threatened legal action or a
statement that the client’s list was complete

Review for Subsequent Events

 Two types of subsequent events require consideration by management and evaluation by
the auditor:
1—those that have a direct effect on the financial statements and require
adjustment (Type I) such as the following when material:
--the declaration of bankruptcy due to deteriorating financial condition of
a customer with outstanding A/R recorded cost
2—those that have no direct effect on the financial statements but for which
disclosure is advisable (Type II)

Events of this type provide evidence of conditions that did not exist at the balance sheet
date but are so significant they require disclosure even though they require no adjustment.
--e.g., decline in the market value of securities held for temporary investment or
resale or an uninsured loss of inventories as a result of fire

Final Evidence Accumulation

1—Final Analytical Procedures
Analytical procedures done during the completion of the audit are useful as a final review
for material misstatements. It is common for a partner to do the analytical procedures during the
final review.

2—Client Representation Letter

There are two purposes of the client letter of representation:
1—to impress upon management its responsibility for the assertions in the
financial statements. It should be sufficiently detailed to serve as a reminder
for management.

2—to document the responses from management to inquiries about various

aspects of the audit

SAS 85 suggests many specific matters that should be included, when applicable, in a client
representation letter. A few of these are:
--management’s acknowledgment of its responsibility for the fair presentation of the
financial statements in conformity with GAAP

--availability of all financial records and data

--information concerning related-party transactions

--completeness and availability of all minutes of stockholder and B of D meetings

--disclosure of compensating balances or other arrangements involving restrictions on

cash balances and disclosure of line-of-credit or similar arrangements

Evaluate Results
 An important part of evaluating whether the financial statements are presented fairly is
summarizing the errors uncovered in the audit. The trial balance should be adjusted for material
errors.

Often there are a large number of immaterial errors discovered that are not adjusted at the
time they are found. It is necessary to combine individually immaterial errors to evaluate
whether the combined total is material.

If the auditor has sufficient evidence but it does not warrant a conclusion of fairly
presented statements, the auditor has two choices:
1—statements must be revised
2—a qualified or adverse opinion must be issued

This includes a complete review of all footnotes. The auditor must be

constantly alert for disclosure problems not just at the completion of the audit.

Many CPAs use a financial statement disclosure checklist. However, one

cannot rely on a checklist to replace one’s knowledge of GAAP.

3—Working Paper Review

There are three main reasons why it is essential that the working papers be
thoroughly reviewed by another member of the audit firm at the completion of the
audit:
1—to evaluate the performance of inexperienced personnel
2—to make sure that the audit meets the CPA firm’s standard of
performance
3—to counteract the bias that may enter into the auditor’s judgment

Forming an Opinion in the Independent Audit Report

An audit report is an appraisal of a small business’s complete financial status. Completed
by an independent accounting professional, this document covers a company’s assets and
liabilities, and presents the auditor’s educated assessment of the firm’s financial position and
future. Audit reports are required by law if a company is publicly traded or in an industry
regulated by the Securities and Exchange Commission (SEC). Companies seeking funding, as
well as those looking to improve internal controls, also find this information valuable.
There are four types of audit reports: and unqualified opinion, a qualified opinion, and adverse
opinion, and a disclaimer of opinion. An unqualified or "clean" opinion is the best type of report
a business can get.
Unqualified Opinion
Often called a clean opinion, an unqualified opinion is an audit report that is issued when an
auditor determines that each of the financial records provided by the small business is free of
any misrepresentations. In addition, an unqualified opinion indicates that the financial records
have been maintained in accordance with the standards known as Generally Accepted
Accounting Principles (GAAP). This is the best type of report a business can receive.

Typically, an unqualified report consists of a title that includes the word “independent.”
This is done to illustrate that it was prepared by an unbiased third party. The title is followed by
the main body. Made up of three paragraphs, the main body highlights the responsibilities of the
auditor, the purpose of the audit and the auditor’s findings. The auditor signs and dates the
document, including his address.

Qualified Opinion
In situations when a company’s financial records have not been maintained in
accordance with GAAP but no misrepresentations are identified, an auditor will issue a
qualified opinion. The writing of a qualified opinion is extremely similar to that of an unqualified
opinion. A qualified opinion, however, will include an additional paragraph that highlights the
reason why the audit report is not unqualified.

Adverse Opinion
The worst type of financial report that can be issued to a business is an adverse opinion.
This indicates that the firm’s financial records do not conform to GAAP. In addition, the
financial records provided by the business have been grossly misrepresented. Although this
may occur by error, it is often an indication of fraud. When this type of report is issued, a
company must correct its financial statement and have it re-audited, as investors, lenders and
other requesting parties will generally not accept it.

Disclaimer of Opinion
On some occasions, an auditor is unable to complete an accurate audit report. This may
occur for a variety of reasons, such as an absence of appropriate financial records. When this
happens, the auditor issues a disclaimer of opinion, stating that an opinion of the firm’s financial
status could not be determined.

END OF MODULE 2