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What kind of procedures are often sufficient audit evidence for prepaid expenses? Why?
- Substantive analytical procedures
- Easy to audit/somewhat predictible
- Not highly material (relative to A/R or Inventory)
- Low inherent risk
- Control risk is assessed through the purchasing process
Typically prepaid expenses are classified as what type of asset?
Short term/current asset
The inherent risk associated with prepaid expenses is generally assessed as what?
How is the control risk for prepaid expenses assessed?
Through the purchasing process.
Prepaid expenses can include:
- Prepaid Insurance
- Prepaid Rent
- Prepaid interest <---relatively immaterial
Do we do a lot of detail testing on prepaid expenses?
No. Normally substantive analytical procedures are considered sufficient evidence.
Intangible assets are normally classified as what type of assets?
PP&E is commonly classified as what type of asset?
What is the common type of prepaid insurance?
- Insurance policy on building or equipment
- Lien on the equipment (equip used as collateral for a loan-insurance policy typically required in a lien agreement.)
What accounts are typically impacted for prepaid insurance?
- Prepaid Insurance XX
- Cash XX
- Insurance Expense XX
- Prepaid Insurance XX
Example of control activities over prepaid insurance:
- New insurance policies are properly authorized and recorded.Insurance register/listing used and reviewed periodically to verify the entity has insurance coverage consistent with its needs.
What types of substantive analytical procedures can be done to test prepaid insurance?
- Compare CY to PY (taking into account changes in operations.)
- Compute CY ratio of insurance expense to assets or sales and compare it with PY ratio (if use assets, make sure assets are audited.)
- Compute estimate using premium amounts and remaining time on policy.(Inputs should agree to contract terms.)
(These are primarily used due to few uncomplicated transactions and typically immaterial.)
When would you typically do tests of details on prepaid insurance?
- When auditor suspects misstatements or when substantive analytical procedures indicate potential misstatement.
- Audit testing begins by obtaining a detailed schedule of the prepaid insurance account.
What assertions are we concerned with for the schedule on prepaid insurance?
**Existence and Completeness - Confirm policy with insurance broker, examine supporting source docs
**Rights and Obligations - Confirm beneficiaries with insurance broker
*****Valuation - Determine unexpired portion of policy and the insurance expense.
**Classification - Determine propriety of distribution between manufacturing overhead and SG&A expense.
What is the most important assertion with intangible assets?
Per the book, what are some other assertions we are concerned with on prepaid insurance?
- Accuracy and completeness--we test it by footing the schedule
- Existence (and completeness) - tested by sending confirmations to the entity's insurance brokers requesting info on each policy's number, coverage, expiration date, and premiums.
- Completeness - by comparing the detailed policies in the current year's insurance register with the policies included in the prior year's register
What is the inherent risk with intangibles?
- High. The nature of the judgments involved in accounting for intangible assets raises serious IR considerations.
- Judgement required to initially value assets
- Valuation and useful lives are difficult to determine --a lo of judgement involved.
What are intangible assets?
Assets that provide economic benefit for longer than a year, but lack physical substance.
What are the five general categories of intangible assets?
- Marketing - trademark, brand name, internet domain names
- Customer - customer lists, order backlogs, customer relationships
- Artistic - copyright
- Contract - licenses, franchises, and broadcast rights
- Technology - patented and unpatented technology
How are intangibles acquired?
Per FASB ASC 350, intangibles are acquired through a purchase or acquisition. Companies cannot record internally generated intangibles on the balance sheet.
How are intangibles expensed?
They are either amortized over time, or they have indefinite lives (licenses, trademarks, goodwill) and can't be amortized.
Which intangibles can't be amortized? What is required instead?
- Those that have an indefinite useful life, such as licenses, trademarks, and goodwill.
- Impairment testing is required annually, or if events/changes indicate impairment.
What is inherent risk set to for intangibles?
Likely set as high due to the judgement and complexity associated with valuation and estimation of intangible assets.
Intangibles: Control risk considerations over business acquisitions & policies and procedures for impairment
- Expertise and experience of those determining fair value of the asset
- Controls over the process used to determine FMV (data, seg of duties, etc)
- Extent entity uses valuation specialists
- Mgmt assumptions used in determining fmv
- Integrity of valuation models and info systems and approval process
What general substantive procedures are performed over intangible assets?
- Analytic procedures- generally not useful in gathering sufficient evidence
- Test of details-- primary approach
Test of details of intangible assets
- 1) existence - obtain evidence of intangible assets (acquisition, legal docs).
- 2) Completeness - agree intangibles listing to the balance sheet and ensure all intangibles were subject to impairment testing
- **3) Valuation - most important assertion: Initial valuation (expert typically used) and impairment considerations; assessment of appropriate useful life
- 4) Rights and obligations - examine supporting legal docs and contracts, ready board minutes*, and communicate w/company's legal counsel.
- 5) Classification - ensure types of intangibles are separated appropriately
- IR= high b/c complex and lots of judgement
- IR - Biggest risks are valuation and estimation. How do you determine what fair value truly is?
Auditing PP&E: recurring engagement
The auditor focuses on additions and retirements in the current period because amounts from prior periods have been subject to audit procedures. You auditing prior year, which is the beg bal for this year. Makes it easier.
Auditing PP&E: New engagement
- The auditor has to verify the assets that make up beg balance in pp&e. Harder b/c you didn't verify the assets and bal in PY.
- More detail testing. Sample of all equipment.
PP&E types of transactions
- Acquisition of capital assets for cash or nonmonetary comp.
- Disposition of capital assets through sale, exchange, retirement, or abandonment
- Depreciation of capital assets over their economical useful life.
- Leasing of capital assets
- Interest during construction
PP&E Acquisition of capital assets for cash or nonmonetary comp.
- (exchange - gain/loss consideration, boot, like kind exchanges, etc).
- PPE XX
- Cash/A/P XX
- PPE XX
- PPE XX
PP&E Disposition of capital assets through sale, exchange, retirement, or abandonment
- Or end of useful life.
- (not all at the same time)
- Cash xxx
- Loss xxx
- Accum Depr xxx
- PP&E xxx
- Cash XXX
- A/D XXX
- Gain XXX
- PP&E XXX
PP&E Depreciation of capital assets over their economical useful life
- Depreciation Expense xxx
- Accumulated Depreciation xxx
What are the three inherent risk factors that must be considered by the auditor w/PP&E?
- Complex Accounting Issues: Lease accounting, self-constructed, IDC
- Difficult to audit transactions
- Misstatements detected in prior audits
Does pp&e need to be tested for impairment?
Occurrence and Authorization Control Activites for PP&E
- Control procedures for the occurrence and authorization of PP&E normally are part of the purchasing process.
- BUT, large capital asset transactions may be subject to additional controls
- Companies should have an authorization policy/ table for approving capital asset transactions
- Assets no longer in use
PP&E + Adds - Dispositions = PP&E CY Balance
Recurring auditors test adds and dispositions.
PP&E Completeness control procedures
Control procedures for completeness are normally part of the purchasing process.
- Control activities related to completeness:
- 1) Periodic reconciliation of subledger to GL
- 2)Physical observation of capital assets to subsidiary ledger
More on PP&E completeness:
The detailed PP&E subsidiary ledger usually includes the following info for each capital asset:
- 1. Description, location, and ID#
- 2. Date of acquisition and installed cost
- 3. Depreciation methods for book and tax purposes, salvage value, and estimated useful life
Control Risk Assessment -PP&E:
Key Segregation of Duties and possible errors
- Initiation of purchase seg from final approval--- Error-fictitious or unauthorized purchases can occur. Unnecessary assets, or assets not meeting qual control. Illegal payments to suppliers.
- PP&E Records seg from GL fucntion -- Error - indiv can conceal defalcation that would normally be detected by reconciling subsidiary records w/GL ctrl account
- PP&E Records seg from custodial function -- things can be stolen and theft can be concealed by adjustments of records
- Periodic inventory counter seg from custodial and record keeping - theft of capital assets can be concealed
Substantive analytical procedures PP&E
- 1) compare PY bal of PP&E and depreciation to CY bal
- 2) compute the ratio of deprec expns to related PP&E accounts and compare to PY ratious.
- 3) Compute ratio of repairs and maintenance expense to the related PP&E accounts and compare to PY
- 4) Compute the ratio of insurance expense to related PP&E accounts and compare to PY
- 5) Review capital budgets and compare the amounts spent with the amounts budgeted
PP&E tests of details of transactions and disclosures
- Completeness & accuracy
- Classification (right bucket? in svc assets sep from works in process?)
- Rights and obligations
- Valuation and allocation
- Disclosure issues
PP&E repairs and maintenance
Should the expense be capitalized? Should it be expensed? Is it in the right bucket? if testing PP&E for this, we are testing completeness. If we were auditing expenses for this, it would be existence.
T or F : Substantive analytical procedures are not commonly used to test prepaid accounts.
T or F: Prepaid expenses provide economic benefit for longer than a year
T or F : Inherent risk for prepaid expenses would generally be assessed as low because these accounts do not usually include complex transactions.
T or F : The property, plant, and equipment records function should be segregated from the custodial function.
T or F : If the auditor has detected misstatements in prior audits, the assessment of inherent risk for the property management process will usually be set higher.
T or F : Generally, dividends paid will not be audited.
T or F : When auditing stockholders' equity, auditors primarily focus on, stock transactions, dividends, and retained earnings
T or F : When auditing long-term debt, there are typically a large number of small transactions that would best be tested through analytical procedures.
T or F : Substantive analytical procedures can be used extensively to test revenue and expense accounts.
T or F : The auditor typically begins an audit of retained earnings by obtaining a schedule of account activity for the period.
T or F : A cutoff bank statement is used to verify the appropriateness of the reconciling items shown on the bank reconciliation.
T or F : The general cash account is normally the principal account used to disburse payroll.
T or F : In auditing the valuation of investments, Level 1 inputs are more risky and difficult to audit than Level 3 inputs.
T or F : Kiting is an audit procedure used to test the accuracy of the cash receipts.
T or F : The auditor's use of analytical procedures for auditing cash is limited.
_______ and _______ are the major sources of financing for most entities.
LT Debt and equity
LT Debt and equity usually involve a ______ number of _______ transactions.
LT Debt and equity usually involve a small number of large (and therefore material) transactions -- Substantive approach is typically appropriate.
Income statement accounts are typically assessed through _________ and ______ _______ _________.
- Income statement accounts are typically assessed through control and substantive analytical procedures.
- High level. Cost effective. Patterns are predictable and have direct relationships that we are able to predict.
Income statement accounts are (for the most part) audited when:
Their related balance sheet accounts are audited.
Types of LT debt financing transactions:
- 1) Notes
- 2) Bonds
- 3) Mortgages
- 4) Capitalized lease obligations
- 5) Other financial instruments (collateralized mortgage obligations, repurchase agreements, interest-rate swaps, derivatives, etc.)
1-4 are typically low risk. 5 is high risk. Also, debt that has special features, like convertible, callable, etc is more complicated and therefore higher inherent risk. Features MUST be in the disclosures.
What is they typical inherent risk of long term debt?
Normally assessed as low to moderate because the volume of transactions are low, the accounting is not complex, and the client often receives 3rd party statements or amortization tables. (Strong evidence, easily obtainable.)
(However the amts are usually large and there are types that have complex accounting.)
Control Risk assessment for long term debt-
Must at least understand the controls even if substantive procedures are used. And, if reliance strategy is used...
Primary assertions over control activities for LT debt are:
- **Completeness - main concern. Like off balance sheet financing. Fraud risk. Enron.
- *Disclosure - classification - LT vs ST
[When the entity has proper controls for issuing debt transactions, it is generally easy for the auditor to test those transactions for occurrence and authorization at the end of the period.]
LT Debt Assertions and related control activities: Occurrence and Authorization
1) Adequate documentation must verify that a note or bond was properly authorized
2) Any significant debt commitments should be approved
by the board of directors or by executives who have been delegated this authority.
- Where to get evidence to test this?
- -Look at contracts
- -Send confirmations
- -Check board minutes
LT Debt Assertions and related control activities: Completeness
- The client should maintain a subsidiary ledger that has info about all the LT Debt owed by entity. Should be tied to GL regularly.
- How to test this assertion?
- -Check to see if they are tying subsidiary to GL regularly. You tie it too?
- -Confirmation - is balance being understated?
- -Review board minutes
- - Inquire w/mgmt about special entities/related parties/off bal sheet financing. (probably will be in rep letter too.)
LT Debt Assertions and related control activities: Valuation
- *To test_
- *Recompute interest payable/interest expense. And, recompute discounts/premiums
- *Confirm balances
- *Read Contracts
- *Recorded at face value plus or minus unamortized premium or discount
- *Effective intrst method s/b used to amortize discounts and premiums
- *Issuance costs are recorded as deferred charges and amortized over the life of the debt
- *Valuation for sophisticated financial instruments are more complex
LT Debt Assertions and related control activities: Disclosure - Classification
- ST vs LT
- (a common adjustment needed to be recommended by auditor).
Controls should ensure that notes and bonds are properly classified in the financial statements. The major issue is to properly classify as ST vs LT portions.
Also: other disclosures- related party transactions, restrictive debt covenants, and revolving lines of credit
Substantive procedures: LT Debt Occurrence
Occurrence - Examine copies of new note or bond agreements. Examine board of directors minutes for approval of new lending agreements.
Substantive procedures: LT Debt Completeness
- Completeness -
- Trace large cash receipts and pmts to source docs and GL
- Review intrst expense for pmts to debt holders not listed on the debt analysis schedule
- Review notes paid or renewed after the bal sheet date to determine if there are unrecorded liabilities @ YE
- Evaluate lease contracts to determine if leases are properly accounted for as an operating or capital lease.
Substantive procedures: LT Debt (general)
The auditor should examine any new debt agreements, determine the status of prior debt agreements, and confirm balances and other relevant info w/outside parties.
Analytical procedures are useful b/c of the direct relationship between interest expense and the amount of LT Debt
Substantive procedures: LT Debt Authorization
Authorization - Examine board minutes for evidence of proper authorization of notes or bonds.
Substantive procedures: LT Debt Cutoff
Cutoff - Review debt activity for a few days before and after year-end to determine if the transactions are included in the proper period.
Substantive procedures: LT Debt Classification
Classification - Examine the due dates on notes or bonds for proper classification between st and lt
Substantive procedures: LT Debt Existence
Existence - Confirm notes or bonds directly with creditors
Substantive procedures: LT Debt Rights and Obligations
Rights and Obligations - Examine copies of note and bond agreements
Substantive procedures: LT Debt Completeness
- Completeness -
- Get an analysis of notes and bonds payable, and accrued interest.
- Foot schedule and agree totals to GL
- Get a standard bank confirmation requesting specific info on notes from banks
- Confirm notes or bonds w/creditors
- Inquire of mgmt about off bal sheet financing
- Review board minutes for debt related activities.
Substantive procedures: LT Debt Valuation and allocation
- Valuation and allocation - Examine new debt agreements to ensure that they were recorded at the proper value.
- Confirm the outstanding balance for notes or bonds and the last day on which interest has been paid
- Recompute accrued interest payable
- Verify computation of the amortization of premium or discount
On a LT debt schedule, what kinds of procedures are performed?
- Confirm debt and intrst
- examine due dates to ensure appropriate st vs lt classification
- read debt agreements for any restrictive covenants
- make sure ending balance ties to GL, etc
What are three types of transactions (for Stock) that are of importance to auditors?
- 1) Issuance of stock
- 2) Repurch of stock
- 3) Payment of dividends
Control Risk Assessment: Stockholder's equity
What kind of strategy is often used to audit stockholder's equity, and why?
- Substantive strategy. Because the number of transactions is usually very small.
- Auditor must still understand types of controls that are in place
Control Risk Assessment: Stockholder's equity Occurrence
Verify that stock and dividend transactions comply with the corporate charter
Control Risk Assessment: Stockholder's equity Accuracy
Verify that stock and dividend transactions have been properly posted and summarized in the accounting records
Control Risk Assessment: Stockholder's equity Valuation
Verify that stock and dividend transactions have been properly valued (especially if involving debt for stock or svc exchange).
Control Risk Assessment: Stockholder's equity Authorization
Verify that stock and dividend transactions have been properly approved. Usually they are authorized by the board of directors
Control Risk Assessment: Stockholder's equity Segregation of duties
- 1) Issuing, transferring, and cancelling (auth) seg from accounting responsibilities (records)
- 2)Maintaining detailed sh records seg from GL function
- 3) Detailed sh records seg from cash receipts or disbursements (custody)
- 4) Seg among prep, recording, signing, and mailing of dividend checks
Control Risk Assessment: Stockholder's equity OCCURRENCE & COMPLETENESS
- Outside agents used:
- Outside agents not used:
- Trace the transfers of shares between sh to the stock register and or stock certificate book (accuracy and completeness)
- Foot the shares outstanding in the stock register and/or stock certificate book and agree them to total shares outstanding in GL (completeness)
- Examine any cancelled stock certificates (occurrence)
- Account for and inspect any unissued stock certificates in the stock certificate book. (completeness)
Auditing capital stock accounts: Valuation
- Straightforward when stock is issued for cash. Proceeds from sale traced to cash receipts records
- When stock is exchanged for property, goods, or svcs, valuation more complex
- Stock dividends might be complex- Auditor should recompute the stock divident and trace the entries to the GL
Auditing capital stock accounts: Completeness of Disclosures
- Examples of disclosure items:
- # shares authorized, issued, and outstanding for each class of stock
- Call privileges, prices, and dates of preferred stock
- Preferred stock sinking funds
- Stock option or purchase plans
- Restrictions on retained earnings and dividends (read contracts/debt agreements, board minutes.Inquire.)
- Any completed or pending transactions that may affect stockholder's equity
Why will all dividends paid and declared be audited?
Because of concerns of violations of corporate bylaws or debt covenants
Auditing Dividends w/or w/o 3rd party dividend disbursing agent.
With 3rd party: Auditor can confirm the amount disbursed w/the agent. Amount is agreed w/amt authorized by board of directors
W/O 3rd party: Auditor can recompute amt of dividend authorized by board of directors and trace the amounts to cash disbursements or dividends payable
How do you arrive at retained earnings?
- Beg bal RE
- + Net Income (less: net loss)
- Less: Dividends declared and/or paid
- =Ending balance RE
- Under normal circumstances, RE is affected by CY income/loss and dividends
- *Major exceptions: prior period adjustments, correction of errors, stock retirements, and changes in appropriations of RE.
Auditing Income stmt accounts
- Depends on the extent of work conducted on the entity's control system and balance sheet accounts.
- A lot comes through what we've already audited on bal sheet
- We also get comfort from test of ctrls
- We perform substantive analytical procedures - high level of coverage over accounts w/easily predictable movement
- -still do detail testing
Income Statement accounts: Substantive procedures:
- Results from ctrl tests of the business processes
- Results from detailed tests of bal sheet accounts and related income stmt accounts
- Performance of substantive analytical procedures on income stmt accounts
- Detailed tests of selected income stmt accounts
What bal sheet accounts are related to Income Statement accounts?
- A/R and allowance for doubtful ----- Bad Debt Exp
- Notes receivable/invstmnts/accrued intrst receivable -------- Interest income
- PPE/accumulated depreciation ---------- Depreciation expense, gain/loss on sales/retirement
- Prepaid Ins ------------------ Insurance expense
- LT Debt/accrued intrst payable ---- Interest expense
What should an auditor do in testing reasonableness?
- 1) set expectations/make your estimate
- 2) What amt matters to us? Tolerable misstatement
- 3) Calculate the difference. Compare
- 4) If > than threshold, more testing is needed
What type of procedures are mainly used to audit income stmt accounts?
- Extensive use may be made of analytical procedures in the audit of revenue and expense accounts
- (Important to look at % diff and dollar diff)
- 1) compare CY to PY
- 2) Trend and ratio analysis
- 3) % of expense accounts to net sales for CY and PY