Audit Stages

FIRST INTERIM AUDIT STAGE 1: Understand the Business  Understand the business and industry in which it operates. An example of business risk factors evaluation report is shown in Illustration 1. Other aspects of understanding the business: A general understanding may lead to other areas of investigation and planning.
(1) (2) (3) (4)

First time audits require more work than a repeat engagement. Work with company internal auditors. Analyses of the client’s financial statements. Employment of specialists on the audit.

The auditor must have a knowledge and understanding of the client’s business. The understanding aids in planning and developing an audit program, which is a list of procedures necessary to obtain sufficient competent evidence. Methods and sources of information: The auditor obtains an understanding of the client’s business and industry by:  Inquiry and reviews with client management and personnel.  Review of prior year audit work papers.  Observation and tour of company’s physical facilities.  Study and review of published materials, guides, Web sites, and references on industry and client. Financial Statements There are two important points to remember about client financial statements: (1) Management is responsible for preparing them, and they contain management’s assertions about economic actions and events. (2) The financial statement numbers are produced by the company’s accounting system, and summarized in the trial balance. The Financial Statements are mainly Balance Sheet and Income Statement (profit and loss account) and additional statement; cash flow statement, fond flow statement, cost of sales statement, as are identified as being within the scope of the audit opinion.

The Balance Sheet gives a statement of financial position of a company at a particular date. Assets represent the resources owned by the firm, whereas liabilities and shareholders’ equity indicate how those resources are financed. The Income Statement gives a statement of profit or loss of the company for the specified period. An income statement answers the question “how profitable is the business?” For the preparation of the financial statements, every company must keep accounting records and they must be sufficient to show and explain the company 's transactions and financial position. All transactions in the company must show source documents, which are; Invoices, checks, receipts, delivery notes, payrolls... These documents are attached with the cash receipt voucher, cash payment voucher. The source documents are first authorized by senior staff and then entered in accounting records, which are: Daily book, ledger, cashbook, inventory book, check book. According to the Turkish Tax and Commerce Code, Notary public must stamp these books. The company has on the right to keep auxiliary book if necessary (Customers book, Suppliers book, Debtors book...). The balances on the ledger accounts are extracted to form a trial balance to prove that they are arithmetically correct. The financial statements are produced from the trial balance to provide a balance sheet and profit and loss account. Accounting records must be kept for; 5 years according to the Turkish Tax Code, 10 years according to the Commerce Code. STAGE 2: Plan the Audit  Use audit planning tools to guide the audit work.  After these planning tools, plan the audit program.  Record the work in the auditors' working papers. Audit Planning Tools Audit planning tools used to guide and direct audit work are classified as:  Preliminary Risk Assessment  Preliminary Materiality Decisions  Preliminary Analytical Procedures

Detection risk is the probability that audit procedures will fail to produce evidence of material misstatements. However. Audit Programs Preliminary Assessment of Audit Risks Preliminary analytical review can help auditors make broad risk assessments. Substantive procedures include(1) audit of the details of transactions or balances.” Inherent risk is the probability that material misstatements have occurred in transactions entering the accounting system used to prepare financial statements. and (2) analytical procedures. Control risk should not be assessed so low that complete reliance is on controls and no other audit work is performed. Preliminary Assessment of Planning Materiality When planning an audit. . All other risk assessments are estimates based on professional judgement and evidence. except that it should be “acceptably low. Accounting numbers are not perfectly accurate because of the nature of accounting. Audit care attention should be greater where relative and inherent risk are judged to be higher. Relative risk refers to conditions of more or less inherent risk. The auditing profession has no official standard for an acceptable level of overall audit risk. Financial Statement Materiality: Materiality is described in the following way: Information is material and should be disclosed if it is likely to influence the economic decisions of financial statement users. Detection risk is realized when substantive procedures fail to detect material misstatements. Audit risk is the probability that an auditor will give an inappropriate opinion on financial statements. but accountants and auditors want to maintain that financial reports are materially accurate and do not contain material misstatement. Control risk is the probability that the clients internal control system will fail to detect material misstatements. the following technical risks must also be assessed. materiality is considered to be the largest amount of uncorrected dollar misstatement that could exist in published financial statements. Risk Model Audit risk can be expressed in the following model which assumes the elements to be independent: Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR) Auditors want to perform an audit of a balance or disclosure well enough to hold audit risk (AR) to a relatively low level. AR is a quality criterion based on professional judgement.

Absolute size . (2) such that the square root of the sum of the squared tolerable misstatement is equal to overall materiality. (2) Compare to anticipated results (budget and forecasts).Cumulative effects Top-Down Approach for Materiality Assignment: To plan the audit of various accounts. and Top-down approach: Judging an overall material amount for the financial statement and then allocating it to particular accounts.Relative size . and (3) that exactly add up to materiality. and (3) for making decisions about the audit report. (2) to evaluation of the evidence. auditors need to assign part of the planning materiality to each account. The amount assigned is the tolerable misstatement.Materiality Judgement Criteria: Auditors are generally left without definite. Preliminary Analytical Procedures Analytical procedures must be applied in the beginning stages of each audit. then combining them to determine the overall effect. quantitative guidelines to determine materiality. Two methods of assigning overall materiality to tolerable misstatement for accounts are:  Bottoms-up approach: Judging materiality amounts in each account separately. . the amount by which an account may be misstated and yet still not cause the financial statements taken as a whole to be materiality misleading. Five general types of procedures for analysis of current year account balance are as follows: (1) compare to balances for one or more comparable periods. Some of the common factors auditors use in making judgment are: .Nature of the item or issue . Some methods of assigning tolerable misstatement based on overall materiality include assigning amounts: (1) that add up to twice the overall materiality. and anything greater than 10 percent probably is material.Uncertanity .Circumstances . A rule of thumb is that anything less 5 percent is probably not material.  Materiality and Planning: Auditors use the concept of materiality as a guide (1) to planning the audit program.

(2) (3) A description of the financial changes and relationships that can be seen in the data.  Auditors look for relationships in accounts as indicators of problems and to plan further audit work. An organized approach. and financing activities. investment. pointing out accounts that may contain errors and frauds and help plan the audit program. (5) Study relationships with relevant non-financial information. Vertical analysis examines financial statement amounts expressed each year as proportions of a base. (4) Asking relevant questions about what would account for the financial results being wrong. . All the planning becomes the basis for preparing an audit program. The analysis can also include: (1) Attention directing. and Preparing a cash flow analysis to see the crucial information from operating. Planning Memorandum Auditors usually prepare a planning memorandum summarizing the preliminary analytical procedures and the materiality assessment with specific directions about the effect on the audit. a specification of procedures that auditors use to guide the work of inherent and control risk assessment and to obtain sufficient competent evidence that serves as basis for the audit report. and at the end of an audit as part if the quality review. Analysis of Unaudited Financial Statements Analytical Procedures Analysis: There are two kinds of analysis of the unaudited financial statements:  Horizontal analysis examines changes of financial statement number and ratios across two or more years.(3) Evaluate relationships to other current-year balances for conformity with predictable patterns. that begins with preliminary analytical procedures that can provide familiarity with the client’s business. (5) Analytical Procedures Requirement: Analytical procedures are required at the beginning of an audit for planning. (4) Compare with similar industry information. or having errors and frauds.

auditing team should develop the audit program. A balance-audit program contains substantive procedures for gathering direct evidence about the five assertions about dollar amounts in the account balances (i. the auditor makes sufficient supervision and review the work done. An internal control program contains procedures to obtain and understanding of the client’s business and management’s control structure. An audit program is a specification of procedures that guide to work for control risk & inherent risk and to obtain sufficient competent evidence that serves as the basis of the audit report. The following includes special technical notes on the existence assertion. confirmations.Audit Programs It has been stated that after those planning tools. The audit procedures are intended to enable auditors to conduct the work in accordance with the three fieldwork standards concerning: planning and supervision of the audit. completeness. the specific accounts affected. in order to simplify the audit plan. existence. they will be based on preliminary risk assessments. Revenue and Collection Cycle: Typical Activities The revenue and collection cycle includes transactions that flow through the following business activities: .Cycles in the Accounting System While developing the audit program. While assessing control risk & inherent risk.e. 1) Revenue and Collection Cycle We will first explain the typical revenue and collection cycle. Developing Audit Program. auditors group the accounts into several cycles (a set of accounts that go together in an accounting system). obtaining an understanding of the central structure and obtaining sufficient competent evidence. These cycles are mainly:  Revenue & Collection Cycle  Acquisition & Expenditure Cycle  Production & Payroll Cycle  Finance & Investment Cycle By grouping the accounts. the audit program should be planned. The exact specification of the objectives and assertions will vary in each cycle. the auditors use cycles approach. rights and obligations. and bank reconciliation auditing. valuation. It is important to recognize that the control objectives and management assertions introduced before should be applied to every cycle. While obtaining sufficient evidence that serves as the basis of the audit report. and the elements of control within the cycle. however. and for assessing the inherent and control risk. presentation and disclosure). There are mainly two types of audit programs.

and sales returns. and discounts. Sales and Accounts Receivable The activities and transactions for the sales and accounts receivable control structure involve the following elements: (1) (2) (3) (4) Authorization: Processing customers orders and granting of credit.  Collecting and depositing cash received from customers.  Reconciling bank statements. recording and reconciliation . Recording: Accountants who record cash receipts and credits to customer accounts should not handle the cash. Cash Receipts and Cash Balances The activities and transactions for the cash receipts and cash balances control structure involve the following elements: (1) (2) (3) Authorization: Approving customers discounts and allowances. timing. bad debt expenses. Custody: Physical custody of goods and accounts receivable records. and extent of substantive audit procedures that will be applied in the audit of the account balances in the revenue and collection cycle. custody. Periodic Reconciliation: Bank accounts should be reconciled carefully. including credit granting. accounts receivable. allowances.  Billing customers and accounting for accounts receivable. Recording: Produces shipping records and sales invoices. Periodic reconciliation: Comparison of the sum of customers unpaid balances with the accounts receivable control account total. Custody: Control and custody of the physical cash. These account balances include cash in bank. Receiving and processing customers orders.  Delivering goods and services to the customers. allowance for doubtful accounts. sales revenue. Proper segregation of responsibilities for authorization. (4) Control Risk Assessment Control risk assessment governs the nature. General Control Considerations 1.

For liability accounts. (5) Examination of Documents (Vouching). and proper period recording) must be related to the revenue cycle activities.” Special Note: The Existence Assertion When considering assertions and obtaining evidence about assets. Auditors may decide not to use confirmations if suitable alternatives procedures are available and applicable in particular circumstances. processing. tracing. completeness.2. and correct accounting errors. (6) Scanning. then substantive audit procedures can be limited in cost-saving ways.” Detail Test of Controls Audit Procedures An organization should have input. (4) verbal inquiry. (3) Confirmation. classification. detect. If it assessed very high. auditors must put emphasis on the existence and rights (ownership) assertions. Special Note: Using Confirmations In general. Justifications for not using confirmations include: (1) receivable are not material. Test of controls audit procedures can be used to audit the accounting transactions in two directions: (1) Completeness: determines whether all transactions that occurred were recorded (none omitted). the emphasis is on completeness and obligations assertions. accounting and posting. and output control procedures in place and operating to prevent. Persons who handle cash should be insured under a fidelity bond 3. The general control objectives (validity. Provide for detail error-checking activities 4. (b) a “walk-through” or a “sample of one. observing. (2) Validity: determines whether recorded transactions actually occurred (were valid). accuracy. authorization. and (2) the action to be taken to produce relevant evidence (the action involves vouching. . Details tests of control procedures can be performed to determine whether controls are being performed properly. The following audit procedures can be used to obtain evidence about the existence and ownership of accounts receivable and other assets: (1) Recalculation. Summary: Control Risk Assessment If control risk is assessed very low. and (3) analytical procedures and other tests provide sufficient competent evidence. scanning. (2) Physical observation. the use of confirmations for cash balances and trade accounts receivable is considered a required generally accepted audit procedure. and recalculation). then substantive procedures will need to be designed to lower the risk of failing to detect material errors in the account balances. Information about the control system can be gathered by (a) an internal control questionnaire. (2) confirmations would be ineffective and unreliable. (7) Analytical procedures. A letter to the client should describe any “reportable conditions. These include: (1) identification of the data population from which a sample will be selected for audit.

” . regardless of correctness of balance. while test of control procedures are designed to obtain evidence about the company’s control activities. and material overstatements or understatements of the account balance. To test for the possibility of stolen receipts. compare deposits slips to the detail of customers credits posted to customers accounts receivable. A dual-purpose procedure can be used for both purposes. A normal procedure is to audit the reconciliation. Check Kitting Check kitting is the practice of building up apparent balances in one bank account based on uncollected checks drawn against similar accounts in other banks. Audit Cases: Substantive Audit Procedures Auditors should not place total reliance on controls to the exclusion of substantive audit procedures. Test for check kitting by preparing a schedule of interbank transfers. bit not necessarily about the collectibility of the accounts. A cutoff bank statement is used by the auditor ro vouch the bank reconciliation items. Substantive procedures are designed to obtain direct evidence about the dollar amounts in account balances. the bank report of cash deposited. followed by an “audit approach. and the bank report of cash paid are all reconciled to the clients general ledger. Accounts Receivable Lapping Lapping is the process whereby an employee takes receipts and attempts to cover up by using later receipts to credit accounts of customers from which receipts were taken. Special Note: Audit of Bank Reconciliations With Attention To Lapping and Kitting The company’s bank reconciliation is the primary means of valuing cash in the financial statements. The case illustrate the approach by first presenting the misstatement. Confirmation of Accounts and Notes Receivable Two types of confirmations are used: (1) Positive confirmation: asks for a response. The objectives in performing substantive procedures is to detect evidence of errors and frauds.Confirmation of Cash and Loans balances Auditors should use a standard bank confirmation form approved by Minister of Finance. (2) Negative confirmation: asks for a response only if something is wrong with the balance. It is often used as a more extensive procedure to find check kitting. Confirmations yield evidence about existence and gross valuation. Bank Transfer schedule and “Proof of Cash” The “proof of cash” is a reconciliation in which the bank balance.

Periodic Reconciliation: Periodic comparison of existing assets to recorded amounts in various accounts. The following includes control risk assessment. accounts and notes payable. (c) Amount: The dollar amount of overstated assets and revenue. the acquisition of property. and payment. selling. we will learn the cycle for the acquisition of goods and services.(1) Case Description: (a) Method: A cause of misstatement by some kind of failure of controls. (2) Paying the bills. and extent of substantive audit procedures that will be applied in the audit of the account balances in the acquisition and expenditure cycle. custody. and reconciliation . 2) Acquisition and Expenditure Cycle In this cycle. Control Risk Assessment Control risk assessment governs the nature. timing. and equipment. order. Custody: Receipt of goods. fixed assets. Acquisition and Expenditure Cycle: Typical Activities The acquisition and expenditure cycle includes transactions that flow through the following business activities: (1) Purchasing goods and services. Proper segregation of responsibilities for authorization. (c) Test of controls: Ordinary and extended procedures designed to test the effectiveness of the controls that should be in operation. recording. (b) Control: Recognition of the control procedures that should be used by an organization to prevent and detect errors and frauds. accumulated depreciation. and the expenditure of cash to pay for the acquisitions. and supporting documents and records. cash disbursements. and various administrative. Recording: Record in accounts payable and cash accounts. (b) Paper trail: A set of telltale signs of erroneous accounting. and special notes on the completeness assertion and physical inventory observation. These accounts include inventory. or understated liabilities and expenses. The activities and transactions of the acquisition and expenditure control system includes the following elements: (1) (2) (3) (4) Authorization: Purchase requisition. (2) Audit Approach: (a) Audit objective: A recognition of a financial statement assertion for which evidence must be obtained. General Control Considerations 1. (d) Audit of balance: Ordinary and extended substantive procedures designed to find errors and frauds in account balances and classes of transactions. depreciation expense. Remember that the same general control objectives and management assertions should be applied to each cycle. plant. and manufacturing expenses.

accuracy. scanning. The general control objectives (validity. auditors must put emphasis on the completeness and obligations assertions. classification. and recalculating. A material error or fraud in inventory has a pervasive effect on the financial statement. substantive audit procedures can be limited in cost-saving ways.” Special Note: The Completeness Assertion When considering assertions and obtaining evidence about accounts payable and other liabilities. Auditors perform detail tests of control audit procedures to determine whether controls are operating. accounting.2. Detail Test of Controls Audit Procedures An organization should have input. If it is assessed very high. and proper period recording) must be related to the acquisition and expenditure cycle. and correct accounting errors. A letter to the client should describe any “reportable conditions. tracing. The search for unrecorded liabilities is designed to yield audit evidence of liabilities that were not recorded in the reporting period. The actions to be taken to produce the relevant evidence include vouching. Persons who have custody of assets and cash disbursement authority should not do accounting. Details Test of Controls for Inventory Records Auditors need to determine whether they can rely on the accuracy of perpetual inventory records. Information about the control structure can be gathered by the use of an internal control questionnaire. detect. A dual direction test of audit samples should be performed. processing. Auditing standards require that the auditor observe the inventory-taking and make test counts. Auditors cannot rely entirely on the management assertion of completeness. 3. Tests of controls over accuracy involve tests of the additions (purchases) and reductions (issues) of the item balances. The emphasis is on completeness because companies tend to be less concerned about recording expenses and liabilities. Special Note: Physical Inventory Observation The audit procedures for inventory and related cost of sales accounts frequently are extensive in an audit engagement. They seldom take or count the entire inventory. completeness. Summary: Control Risk Assessment If the control risk is assessed very low. and output control activities in place and operating to prevent. observing. substantive procedures will need to be designed to lower the risk of failing to detect material misstatement in the account balances. authorization. Many physical inventories are counted at year-end when the auditor is present to observe . Provide for detail control checking activities 4.

inventory additions. . If amounts are not material. Auditors Not Present at Clients Inventory Count The auditor must review the clients plan for the completed count. direct confirmation with the custodian may be sufficient competent evidence. vendors invoices that are always in round numbers. Inventories Located Off the Clients Premises The auditor must determine the amount and location of the inventory off the client premises. Cycle Inventory Counting The auditor must be present during some counting operations to evaluate the counting plans and execution and must evaluate the accuracy of perpetual records. and valuation. Special Note: Finding Fraud Signs in Accounts Payable A company’s accounts payable and cash disbursements systems may be used by fraudsters to generate false payments. completeness. and control risk is low. If amounts are material and controls are not strong. Some test counts of current inventory should be made and traced to current records to determine reliability of perpetual records. and vendors invoices that are always slightly lower than a review threshold. Physical Inventory Not on Year-End Date The inventory on the count date is reconciled to the year-end inventory and auditing procedures are performed on purchases.and perform dual-direction testing to gather evidence for the existence and completeness assertions. the auditor may wish to visit locations and conduct on—site test counts. This may be done by sending false invoices to the company and having an insider manipulate controls or documents to make payment. Examples of the fraud signs auditors should look for include photocopies of invoices. Inventory Existence and Completeness The physical observation procedures are designed to audit for existence. and issues for the intervening period. vendors invoices submitted in numerical order.

test of controls. especially for regular vendors ___7. Purchase order are “open” from the time they are issued until the goods are received. If the control risk is assessed very low additional substantive audit procedures will be required. ___6. and amount. ___4. Normally. ___9. or reconciliation duties. Purchases are requisitioned by a purchasing department that seeks the best prices and quality ___3. The basic acquisition and expenditure activities are (1) purchasing the goods and (2) paying the bills. . Self-Assessment True or False Questions: Indicate in the space provided if the following statements are true or false. ___1. __10. thus making them misleading in financial statements. and audit of balances. followed by the audit approach. Auditors can inspect the “unmatched invoice file” and compare it to the “unmatched receiving report” file to determine whether liabilities are unrecorded. The audit “search for unrecorded liabilities” should emphasize the large balances. control. liabilities should be recorded on the date the goods are received and accepted by the receiving department or by a responsible person. ___5. ___2. Proper segregation involves authorization of purchases by persons who do not have custody. consisting of the audit objective. paper trail. auditors will need to design substantive audit procedures to try to detect whether control failures have produced misleading account balances. Checks are signed by the accounts payable department after assembling the invoice. purchase order and receiving report. ___8. recording. If personnel in the organization are not performing their control procedures very well.Audit Cases: Substantive Audit Procedures The audit of account balances consists of procedural efforts to detect errors and frauds that might exist in the balances. The cases present first the method.

__14.__11. standard costs. __13. materials requisitions. and variances. (3) Cost accounting and cost of goods sold determination. depreciation. The activities and transactions for the production control structure involve the following elements: (1) Authorization: Production authorization based on sales forecasts interacts with production orders. inventory planning and management. The search for unrecorded liabilities should normally be performed up to the report date in the period following the audit clients balance sheet date. (2) (3) (4) Control Risk Assessment Control risk assessment governs the nature. remember that the same general control objectives and management assertions apply. Part I: Production Cycle Typical Activities The production cycle includes transactions that flow through the following business activities: (1) Production planning. and cost accounting records. dealing with inventory valuation. The auditors best opportunity to detect inventory errors and frauds is during the physical observation of the inventory count. equipment and labor. Recordkeeping: Determination of cost-per-unit. __15. (2) producing goods and services. The audit procedures for inventory and related cost of sales accounts frequently are extensive in the audit engagement. The following includes control risk assessment for the production and payroll cycle. bills of materials. timing. Part II covers the audit of payrolls and labor cost accounting. Evidence is much easier to obtain to verify the completeness assertion for liabilities than the existence assertion for assets. As with all of the cycles. 3) Production and Payroll Cycle We will learn the production and payroll cycle in two sections. Auditors emphasize the existence assertion when auditing liabilities because companies typically are less concerned about timely recording of liabilities than of revenues and assets. and cost of goods sold accounting. __12. Part I covers the production cycle. Periodic reconciliation: Periodic reconciliation of physical inventory to recorded amounts. and extent of substantive audit procedures that will be applied in the audit of the account balances in the production . analyses of internal production information. Custody: Physical custody of materials.

4. Detail Tests of Controls Audit Procedures An organization should have input. A letter to the client should describe any “reportable conditions. authorization. substantive audit procedures can be limited in cost-saving ways. classification. completeness. If it is assessed very high. The general control objective (validity. Summary: Control Risk Assessment If the control risk is assessed very low. Cost accounting performed by persons who do not authorize production or have custody of production assets. and recalculating. Proper segregation of responsibilities for authorization. Custody of inventories in hands of persons who do not authorize or account for production.” Computerized production cycle records will require computer audit of balances. Auditors perform detail test of controls audit procedures to determine whether controls are operating. accounting and posting. and output control activities in place and operating to prevent. The actions to be taken to produce the relevant evidence include vouching. processing. accuracy. and proper period recording) must be related to the production cycle. 3. finished goods inventory. custody. Complex computer systems may be used to manage production and materials flow. cost of goods sold.cycle. scanning. detect. depreciation expenses. 2. substantive procedures will need to be designed to lower the risk of failing to detect material errors in inventory and cost of goods sold account balances. tracing. 6. . work-in-process inventory. observing. General Control Considerations 1. Information about the control structure can be gathered by the use of an internal control questionnaire. Direction of the Test of Controls Procedure The test of controls procedures are designed to test the production in the following two directions: (1) Completeness: the recording of all the production that was ordered to be started. and correct accounting errors. Provide for detail control checking procedures 5. These accounts include raw materials inventory. recording and reconciliation. and accumulated depreciation. (2) Validity: proper recording of work in process and finished goods in the general ledger.

followed by the audit approach.” (2) Overpaying for time or production. Part II: Payroll Cycle Typical Activities Personnel management and the payroll accounting cycle include transactions that affect the wage and salary accounts and a number of related accounts. (2) (3) (4) (5) Control Risk Assessment The major risks in the payroll cycle are: (1) Paying fictitious “employees. Custody: Possession of payroll checks. payroll distribution. timekeeping. Recordkeeping: Payroll accounting prepares checks and related state and federal tax reports. test of controls. and audit of balances. paper trail and amount. (3) Incorrect accounting for costs and expenses . (2) Supervision: approval of work time. control. thus making them misleading in financial statements. supervision and timekeeping documents. The activities and transactions of the payroll control system involve the following elements: (1) Authorization: The personnel department. Periodic reconciliation: Payroll records and reports should be reconciled. (4) Payroll accounting: check preparation and related payroll reports.Audit Cases: Substantive Audit Procedures The audit of account balances consist of procedural efforts to detect errors and frauds that might exist in the balances. (3) Timekeeping and cost accounting: payroll preparation and cost accounting. consisting of the audit objective. (5) Payroll Distribution: actual custody of checks and distribution to employees. (1) Personnel and Labor Relations: hiring and firing. The payroll cycle typically would include the following five functional responsibilities performed by separate people or departments. Employees on fixed salary: The control system is simplified by not having to collect timekeeping data. and cost accounting have authorization over their independent functions. The cases present first the method. supervision.

classification. 4. tracing. 3. followed by the audit approach. The actions to be taken to produce the relevant evidence involve vouching. Information about the control structure can be gathered by the use of an internal control questionnaire.General Control Considerations 1. scanning. Direction of the Test of Controls Procedures The test of controls procedures are designed to test the payroll accounting in the following two directions: (1) Completeness: the matching of personnel file content to payroll department files and the payroll register. The general control objectives (validity. completeness. authorization. processing. Custody of payroll distribution by persons who do not authorize employees pay or prepare payroll checks. thus making them misleading in financial statements. and proper period reporting) must be related to the payroll cycle. 2. 6. and output control procedures in place and operating to prevent. Provide for detail control checking activities 5. accuracy. (2) Validity: preparation of the payroll register. Proper segregation of responsibilities for authorization. and recalculating. Audit Cases: Substantive Audit Procedures The audit of account balances consist of procedural efforts to detect errors and frauds that might exist in the balances. and correct accounting errors. consisting of the audit objective. 4) Finance and Investment Cycle . and audit of balances. Recordkeeping is performed by payroll and cost accounting personnel who do not make authorizations or distribute pay. Summary: Control Risk Assessment If the control risk is assessed very low. detect. substantive audit procedures can be limited in cost-saving ways. If it is assessed very high. and reconciliation of payroll functions. test of controls. recording. Auditors perform detail tests of control audit procedures to determine whether controls are operating. Even in complex computer-based payroll systems. Detail Test of Controls Audit Procedures An organization should have input. custody. control. basic management and control functions should be in place. accounting and posting. substantive procedures will need to be designed to lower the risk of failing to detect material errors in financial statements. observing. paper trail and amount. The cases present first the method.

(3) Recordkeeping: Notes. the accounts affected. Confirm bonds held by trustee. (2) Custody: Large companies use registrars and transfer agents for custody of the stock certificate book. (4) Periodic Reconciliation: Inspect and reconcile stock certificate book. Some investments may be in physical custody. production and payroll. others in the form of “management responsibility. Debt and Stockholder Equity Capital Transactions in debt and stockholder equity capital are normally few in number but large in monetary amount. and calculated liabilities are maintained by accounting departments. Small companies keep their own stockholders records. Originals of debt instruments are held by lenders. Authorizations for sale of stock and debt financing is usually at the board of director level. . and revenue and collection cycles. Investments and Intangibles Transactions in investments and intangibles may vary depending on the size and type of company. acquisitions and other investments. and the elements of control within the cycle. The activities and transactions involve the following elements: (1) Authorization: Financial planning includes a cash flow forecast and capital budget.” (3) Recordkeeping: Investment and intangible recordkeeping will vary depending on complexity and nature. The following includes control risk assessment for the financial and investment cycle. We will explain the flow of transactions of both the finance and investment activities. Financing and Investment Cycle: Typical Activities The finance and investment cycle major functions are: (1) Financial planning and raising capital. The activities and transactions involve the following elements: (1) Authorization: Investments approved by the board of directors or investment committee. (2) Interacting with the acquisition and expenditure. bonds payable. (4) Periodic Reconciliation: Inspect and count negotiable security certificates.The finance and investment cycle deals with the major activities of a typical business (1) obtaining funds to finance the operation either from lenders who become creditors or from investors who become owners. and are handled by the highest level of management. (2) Custody: Custody of investments and intangibles depend on the nature of the assets. (3) Entering into mergers. and (2) investing funds not immediately needed to finance operations.

Control over Accounting Estimates A clients management is responsible for making estimates and maintaining the controls designed to reduce the likelihood of material misstatements. test of controls. and (3) investment and intangibles are presented. Summary: Control Risk Assessment The involvement of senior officials in a relatively small number of high-dollar transactions makes control risk assessment a process tailored specifically to the company’s situation. Reliance on control does not normally reduce the extent of substantive audit work on finance and investment cycle accounts. each transaction usually is audited in detail. The number of shares shown as issued is in fact issued. (c) the valuation principles are supported by the underlying documentation. Substantive audit procedures include procedures to determine whether (a) the valuation principles are acceptable under the general accounting principles (b) the valuation principles are consistently applied. followed by an audit approach. A compensating control feature involving two or more persons in each kind of important functional responsibility. General Control Considerations 1. . Owners Equity The typical specific assertions include: 1. and Audit Cases The audit of three sections: (1) owners’ equity. The cases present first the method.Control Risk Assessment Because finance and investment transactions are usually individually material. Responsibilities in the hands of senior management officials 2. thus making them misleading in financial statements. Substantive audit procedures are not limited in extent. (2) long-term liabilities and related accounts. and (d) the method of estimation and the significant assumptions are properly disclosed according to the laws. The audit of the account balance consists of procedural efforts to detect errors and frauds that might exist in the balances. consisting of the audit objective. However. and audit of balances. Difficult to have strict segregation of functional responsibilities when senior management officials are involved 3. Auditors test of controls over estimates amounts to inquiries and observations related to the specific features of estimates. lack of control can lead to significant extended procedures. paper trail and amount. Control deficiencies and unusual or complicated transactions can adjust the nature and timing of the audit procedures. Substantive Procedures. control. Assertions.

When there are no independent agents. All owners equity transactions have been authorized by the board of directors. . and in conformity with accounting principles 5. Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate. Analytical Relationships: Analytical relationships exist for debt. Liabilities are properly classified according to their current or long-term status 3. 5. Confirmation: Capital stock may be confirmed when independent registrars and transfer agents are employed. All material long-term liabilities are recorded 2. Documentation: Owners equity transactions are well documented (e. recorded interest expense and accrued interest accounts. and other stock plans and related disclosures are adequate. auditors usually obtain independent written confirmation for notes and bonds payable. New long-term liabilities and debt payments are properly authorized 4. and restrictions relating to non-current debt are adequately disclosed.2. No other shares have been issued and not recorded or reflected in the accounts and disclosures 3. warrants. 4. Long-Term Liabilities and Related Accounts The primary audit concern is that all liabilities are recorded and that the interest expense is properly paid or accrued.g. All important contingencies are either accrued in the account or disclosed in footnotes. Terms. board of directors minutes.. The auditor can compare audit results with recorded interest to identify unrecorded debt and errors in interest accounts. The typical specific assertions include: 1. 6. most audit evidence is gathered by vouching stock record documents. The accounting is proper for options. Confirmation: When auditing long-term liabilities. The assertion of completeness is paramount. conditions. The valuation of shares issued for non-cash consideration is proper. Off-balance Sheet Financing: Confirmation and inquiry procedures may be used to obtain responses for off-balance sheet information including off-balance sheet commitments. proxy statements) and transactions can be vouched to these documents.

Controlling investments are accounted for by the equity method 4. Amortization Recalculation: Amortization of goodwill and other intangibles should be recalculated.Calculated balances: Several types of deferred credits depend on calculations for their existence and valuation and should be recalculated for accuracy. Documentation Vouching: Investment property may be inspected to determine existence and conditions of the property External Documentation: Market value of securities and related income can be determined from external sources. Investments are properly valued 3. described and disclosed in the balance sheet Confirmation: The practice of obtaining independent written confirmation from outside parties is limited in the investment. Investment income has been received and recorded 9. and legal questions in a specific attorneys letter. depending on the intangible. Investment are adequately classified. intangible. and related accounts Inquires about Intangibles: Company counsel can be queried about knowledge of any lawsuits. Purchased goodwill is properly valued 5. The typical specific assertion includes: 1. auditors need to obtain audited financial statements of the investee company for recalculating the amount of the clients share of income to recognize in the accounts. Investments and Intangibles Companies can have a wide variety of investment and relationship with affiliates. Amortization is properly calculated 8. Income from Intangible: Income from intangibles can be confirmed or vouched. Inspection: Investment property may be inspected to determine existence and conditions of the property. Capitalized intangible costs relate to intangible acquired in exchange transactions 6. Equity method Investment: When equity method accounting is used for investments. Investment securities are on hand or held in safekeeping by a trustee 2.Deferred Credits. Research and development costs are properly classified 7. .

__11. Self-Assessment True or False Questions: Indicate in the space provided if the following statements are true or false. when fixed assets are acquired during the year under audit. the segregation of functional responsibilities is relatively easy for the finance and investment cycle ___9. The primary audit concern with the verification of long-term liabilities is that all liabilities are recorded and that the interest expense is properly paid or accrued. __14. Ownership of bonds can be handled by a trustee having duties and responsibilities similar to those of registrars and transfer agents ___5. auditors should inquire about the source of funds for financing the new asset. when there are no independent agents. __15. the most significant reconciliation opportunity in the investment and intangible accounts is the inspection and count of negotiable securities certificates. In large companies. reliance on controls normally reduces the extent of substantive audit work on finance and investment cycle accounts. ___6. All investment policies should be approved by the board of directors or its investment committee. ___7. auditors test of controls over the production of estimates amounts to inquiries and observations __10. ___1.Inquiries about Management Intentions: Inquiries should be held with management to determine the nature of investments and reasons for holding them. Sales of capital stock and debt financing transactions usually are authorized by the board of directors ___3. custody of stock certificate books is a significant management problem. Confirmation requests should be sent only to lenders with a liability balance at the audit date . it is very common for auditors to perform substantive audit procedures on 100 percent of the details in finance and investment accounts. ___8. most audit evidence about capital stock is gathered by confirmation directly with the holders __12. owners equity transactions usually are not well documented __13. Financial planning starts with the chief financial officers capital budget ___2. ___4.

indicating observance of the first standard of fieldwork. Auditors Working Papers An audit must document the audit procedures performed to support the understanding. text. __20. Listed below are general guidelines as to what working papers should include: i. The work has been adequately planned and supervised. ii. and the testing of performed has provided sufficient component evidential matter to afford a reasonable basis for an opinion. This evidence is accumulated in files of audit working papers. the balance sheet classification of investment by management should be confirmed with outside parties. tests. The audit evidence obtained. __17. and evaluation of risks and the substantive tests performed directly on the amounts and disclosures shown in the financial statements. the tests performed. and the pertinent conclusions reached in the engagement. timing. Even confirmation letters from outside parties can be electronically scanned into the audit files.__16. __18. Reasons for audit working papers I. The term working papers is used here to include all audit documentation. Purchase-method consolidations usually create problems of accounting for the fair value of acquired assets and related goodwill. __19. Confirmation and inquiry procedures are not required for a class of items loosely termed off-balance sheet information. Working papers are records kept by the auditor of the procedures applied. much audit evidence now exists only in electronic files. both electronic and paper. A number of accounting firms are now developing paperless auditing systems. Although the term working papers suggests paper documents. indicating observance of the third standard of fieldwork. iii. The practice of obtaining independent written confirmation from outside parties is fairly limited in areas of investments and intangibles. the information obtained. Interest expense generally is audited primarily by analytical procedures. and other evidence are prepared and saved in an electronic format. . A sufficient understanding of the internal controls has been obtained to plan the audit and to determine the nature. Spreadsheets. Reporting partner needs to be able to satisfy himself that work delegated by him has been properly performed. and extent of tests to be performed. the auditing procedures applied. Working papers should be sufficient to show that the financial statements or other information on which the auditor is reporting were in agreement with the client’s records. checklists. indicating observance of the second standard of fieldwork.

They should contain sufficient. properly prepared working papers are necessary for an auditor to demonstrate compliance with the standards of fieldwork. as well as restrictions on payment of dividends. the auditor places one copy in the permanent file. schedules and other data that will be of continuing significance to several years’ audits. and number of authorized shares of stock that the company may issue. or other matters requiring disclosure in the financial statements. Evidence with the staff review. To use working papers in the following years. f. A summary of significant points effects the financial statements and audit report preparations. purchase of treasury stock. The auditor assessment of the company's accounting system.g. IV. the use of audit programs) and the extent of supervision of assistants (indication of reviews made by the auditor). other financial information including analyses and summaries of the financial statements. notes of errors. In summary. which is . g. Types of Working Papers Auditors normally maintain two types of working paper files. Working papers provide. and the other often is called the current-year audit file. e. Records of balances. bank reconciliations) on which to base an opinion.II. The preparation of working papers encourages the auditor to adopt a methodical approach. Rather than obtaining a copy of the same document each year. details of problems together with evidence of audit and conclusions in arriving at the audit opinion. an auditor must obtain a copy of a client’s articles of incorporation as evidence of the types (common and preferred). action taken together with the opinion of the staff. For example. One is referred to as a permanent or continuing audit file. confirmations from creditors. c. competent evidence (e. III. Audit planning information including the audit program. They should show how the work was planned (e. Details of audit work. Information of continuing importance of audit b. control risk checklists. his review and evaluation of internal control. par values. d. Contents of working papers a. Permanent Audit Files The permanent audit file is composed of documents. for future reference.g.

was formed in 19X0 by Mr. The company acquires most of its raw materials (crude oil) in the open market and is subject to the regulations of the Department of Energy (a copy of the DOE regulations is filled behind this memo). Company Operation and Audit Administration Memo X Co. Illustration 2: X Co. at the intersection of Highways 65 and 71. major plants and manufacturing processes. Arkansas (also the location of its administrative offices). operates a 40. The client is saved the task of acquainting different members of the auditing firm with basic information about the company. This type of information is particularly important to auditors assigned to a client for the first time. what some of the important reporting and timing requirements . Johnson. both of who remain 50% stockholders. an auditor who had never worked on the X Company engagement would know where the company is located and what it does. Although the organization of permanent files varies. and important customers. Fitzgerald and Mr. so we must be sure to mail the confirmation at the earliest possible date and include sufficient details to …………. which is sold to a chain of independent gasoline stations. By regarding the memorandum. Amendments normally would be detected by the auditor during his or her review of minutes of stockholders’ and directors’ meetings. is Ms. such as timing deadlines and reporting requirements. and products. X Co.a part of each year’s audit evidence. with whom we arrange the timing of our work. Hamilton. The company reports on a December 31 fiscal year. The crude oil is refined into premium and regular gasoline. The President and Plant Manager is Mr. It allows them to learn something about the operations of the company in a brief period of time and makes them aware of any unusual matters concerning the audit. Of course. most would contain the following sections: 1) Historical information regarding the client: This section usually includes a memorandum describing the company and its operations. An organization chart listing the names and positions of key officers and employees and any recurring audit administrative matters are also shown. Foote and the Treasurer. distribution facilities. it is necessary to check each year for any amendment to the articles of incorporation and to indicate any changes on the document in the permanent file. because approval is generally required by one or both of these parties. Out audit report is to be delivered to the shareholders by February 10. In the past we have experienced difficulty and delay in obtaining confirmation of a significant accounts receivable from the chain of independent gasoline stations.000-barrel per day refinery near Granville. A partial example of such a memorandum is shown in Illustration 2. whom to contact at the company.

decision tables. All refinery property and equipment is pledged to these bonds. and other documents. Procedures for Notes Payable and Long-Term Debt X Co. the auditor must have evidence of the provisions of these documents and his or her reviews thereof. labor contracts. checklists for compliance with loan agreements. All borrowings are authorized by the Board of Directors. Because all of these documents could significantly affect the company’s operations and its financial statements. note. 4) Continuing analyses of certain accounts: It is often more efficient to maintain cumulative schedules in the permanent files for certain accounts with little activity. has outstanding a $5 million issue of 8% bonds due in installments of $500. accounting and control procedures. bond indentures. The bond indenture restricts payment of dividends of $200. the permanent file normally contains copies of loan agreements.000 per year. and interest payments………. Continuing analysis might be used for capital stock. 2) A description of the entity’s internal controls: This material might consist of narrative descriptions of the client’s control environment. A chart of accounts and samples of any records that would aid in understanding company procedures may also be included.are. The company also borrows on short-term notes for working capital purposes. stock option plans. A brief example of a description of accounting procedures to notes payable and long-term debt is shown in Illustration 3. Both the President and the Treasurer must sign any notes that are issued. or any combination of these items. and the banks or other creditors are specifically mentioned. equity in earnings of subsidiaries. 3) Legal Documents: In addition to the articles of incorporation. An illustration of such an analysis is shown in Illustration 4. flowcharts. longterm debt.000 per year beginning in 20X2. and that he or she would need a knowledge of regulations in the auditing about the company. internal control questionnaires. Illustration 3: X Co. . pension plans. or for which comparisons with several prior years are helpful. important long-term operating agreements or contracts. than to prepare such schedules each year in the current files. The Treasurer maintains a schedule showing the due dates of all bond. and gross profit ratios by major product class.

365.000 67.000 Total $405.000 16.000 19X8 $5.7 $501.000 Over 60 days 2.00 0 68.837.000 57.000 $639.000 $35.0 33.928.000 $15.1% 2.3 39.1% 6.4% 15.000 19. that his or .000 54.5% 2.000 $571.000 54.000 19X7 $5.000 $35.2 36.1% 1.000 91.000 1. after being satisfied as to inventory.3 Allowance for doubtful accounts $30.1% 6.000 $498.000 63. bins and other containers (an auditor would be embarrassed to discover.000 19X9 $5. 5) Audit planning: This section would include a master copy of the audit program (often on computer diskettes) that could be revised and copied each year than completely written.679.9 This analysis should alert the auditor that there has been deterioration in accounts receivable during the year.000 30-60 days 31.00 0 63. schedules of plant capacity and volumes of tanks.000 1.00 0 54.Illustration 4: X Co.000 $570.2% 7.000 RatiosBad debt charge-offs to sales Allowance to total accounts receivable Allowance to accounts receivable over 60 days Days’ sales in accounts receivable 1.000 52.6 $530.000 1.8 35.000 Accounts receivable balance 1231 Current $372. Analyses of Uncollectible Accounts 19X6 Sales Bad debt provision Bad debt charge-offs $4.3% 0. and it should raise a question as to the adequacy of the allowance for doubtful accounts.000 71.000 53.

memoranda of audit work performed and audit problems considered and resolved.) or locations (branch offices. an audit will neglect to review and update the permanent file. etc. a record of the accounts (cost centers. etc. The material in the current files includes schedules and analyses of accounts. correspondence with third parties (banks. . At that point. subsidiaries. bank accounts.her client didn’t have the physical capacity to store the amount of inventory shown in the accounting records). When this happens. the file becomes less useful and less used each succeeding year. it becomes a threat because it is evidence of negligent and inadequate work. an audit program. until it becomes a file of obsolete data. legal counsel. creditors.) confirming balances. it becomes less than useless to the auditor. Current Audit Files The current audit files for each year contain the evidence gathered and the conclusions reached in the audit for that year. Occasionally. The permanent audit file can be very useful tool of the auditor if it is kept current and used. etc. in his or her haste of complete the current-year audit. and other documents. customers. transactions and other data. and if certain procedures are performed on a rotating basis.) tested each year to ensure that nothing is overlooked.

Sign up to vote on this title
UsefulNot useful