Auditing Principles - CH 16 - Auditing Operations & Completing the Audit
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- ØCorporate earnings are considered as an
- extremely important indicator of health and well-being of corporations
- ØMeasurement of income is generally
- regarded as the single most important function of accounting
Conservatism in the Measurement of Income
- ØPowerful influence on revenue and
- ØImportant because of subjectivity
- involved with accounting estimates
- ØAssets – accountants choose lower of two
- or more reasonable alternative values
ØLiabilities – higher amount is chosen
- ØResults in income statement with a low or
- conservative income figure
Relationships Between Balance Sheet and Income Statement Accounts
- Balance Sheet:
- -Uncollectable Accounts
- Balance Sheet:
- -Notes Rec
- -Uncollectable notes
Misc. Revenue (1 of 2)
- ØMixture of minor items, some nonrecurring
- and others received at regular intervals
- ØAuditor should analyze account to look
- for items improperly recorded as miscellaneous:
lCollections on previously written-off accounts or notes receivable
lWrite-offs of old outstanding checks or unclaimed wages
lProceeds from sales of scrap
lRebates or refunds of insurance premiums
lProceeds from sales of plant assets
Misc. Revenue (2 of 2)
lPropose adjusting journal entry to classify items correctly
lPerform analytical procedures and investigate unusual fluctuations
- •Can detect material amounts of unrecorded
- revenue and
- •Significant misclassifications affecting
Substantive Tests for Selling, General and Administrative Expenses (1 of 2)
ØPerform analytical procedures
- lDevelop an expectation of the account
- •Use budgeted amounts, prior-year audited balances, industry averages, relationships
- among financial data and relevant nonfinancial data
- lDetermine the amount of difference from
- the expectation that can be accepted without investigation
•Use estimates of materiality
- lCompare the company’s account balance
- with the expected account balance
- lInvestigate significant deviations from
- the expected account balance
Substantive Tests for Selling, General and Administrative Expenses (2 of 2)
ØObtain or prepare analyses of selected expense accounts
- lExamine accounts based on results of
- analytical procedures
lWhich accounts? AICPA suggests
•Research and development
•Legal expenses and other professional fees
•Maintenance and repairs
•Rents and royalties
ØObtain or prepare analyses of critical expenses in the income tax return
- ØImportance – typically largest operating
- ØPayroll fraud had been common and often
- substantial but now fraud difficult to conceal because of:
lExtensive segregation of duties relating to payroll
lUse of computers with proper controls for preparation of payrolls
lFiling of frequent payroll reports to the government
Segregation of Functions--Payroll
Separate departments should handle:
• Employment (personnel)
• Payroll preparation and record keeping
• Distribution of pay to employees
Internal Control over Payroll Documentation
lAre employees paid by check or direct deposit?
lIs a payroll bank account maintained on an imprest basis?
- lAre the activities of timekeeping, payroll compilation, payroll check signing, and
- paycheck distribution performed by separate departments or employees?
lAre all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed?
lAre employee time reports approved by supervisors?
lIs the payroll bank account reconciled monthly by an employee having no other payroll duties?
Audit Program for Payroll (1 of 2)
Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures:
a. Compare names and wage or salary rates to records maintained by the human resources department.
b. Compare time shown on payroll to time cards and time reports approved by supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by employees.
e. Test extensions and footings of payroll.
Audit Program for Payroll (2 of 2)
Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures (continued):
- f. Compare total of payroll with total of payroll checks issued.
- g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
- h. If wages are paid in cash, compare receipts obtained from employees with payroll records.
- i. If wages are paid by check, compare paid checks with payroll and compare endorsements to signatures on withholding tax exemption certificates.
- j. If wages are paid by direct deposit, compare listing of employee payments with payroll and direct deposit authorizations.
- k. Observe the use of time clocks by employees reporting for work and investigate time cards not used.
Audit of Statement of Cash Flows
- ØAmounts are audited in conjunction with
- the audit of balance sheet and income statement accounts
- ØPresentation and disclosure important
- audit objective is important
Audit Procedures Completed Near the End of Field Work
ØSearch for unrecorded liabilities
ØReview the minutes of meetings
ØPerform final analytical procedures
- ØPerform procedures to identify loss
ØPerform the review for subsequent events
ØObtain the representation letter
- ØLoss contingencies should be reflected in
- the financial statement amounts when:
lIt is probable that a loss had been sustained before the balance sheet date
lThe amount of the loss can be reasonably estimated
- ØLoss contingencies should be disclosed in
- the notes to the financial statements when it is at least reasonably possible
- that a loss has been sustained
- ØLoss contingencies need not be disclosed
- when the possibility of loss is remote
- ØMost common loss contingency – pending or
- threatened litigation
lLetter of inquiry to client’s legal counsel
- •Evidence of pending and threatened
- •Unasserted claims
- - need to be disclosed if probable and reasonably possible
- •Auditors should obtain from management a
- list describing and evaluating threatened or pending litigation
ØIncome tax disputes
- ØAccommodation endorsements and other
- guarantees of indebtedness
- ØAccounts receivable sold or assigned with
ØGeneral risk contingencies
Audit Procedures for Loss Contingencies
1. Review the minutes of directors’ meetings to the date of completion of fieldwork.
2. Send letter of inquiry to client’s lawyer
3. Send confirmation letters to financial institutions to request information on contingent liabilities of the company.
4. Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts receivable.
5. Review reports and correspondence from regulatory agencies to identify potential assessments or fines.
6. Obtain a representation letter from the client indicating that all liabilities known to officers are recorded or disclosed.
Procedures to Identify Subsequent Events
- ØReview latest available financial
- statements and minutes of the board and selected committees
- ØInquiry about matters dealt with at
- meetings for which minutes are not available
ØInquiry of management
ØObtain lawyer’s letter
ØObtain representations from management
Obtain Representation Letter
- ØPurpose is to have the client’s principal
- officers acknowledge that they are primarily responsible for the fairness of
- the financial statements
ØDated as of the date of the audit report
- ØNot a substitute for application of
- necessary audit procedures
lSpecific misstatements identified during the course of the audit
lDue to extrapolation from audit evidence or differences in accounting estimates
lMaterial misstatements must be corrected
•Quantitative and qualitative factors
Qualitative Materiality Factors
Likely to be material when:
- ØArise from an item capable of precise
- measurement (e.g., the amount of a sale) rather than from an estimate (e.g.,
- the amount in the allowance for doubtful accounts).
- ØMask a change in earnings or other
- ØHide a failure to meet analysts’
- consensus expectations for the company.
ØChange a loss into income, or vice versa.
- ØConcern a particularly important segment
- or other portion of the registrant’s business.
- ØAffect compliance with regulatory
- requirements, loan covenants, or other contractual requirements.
ØIncrease management’s compensation.
- ØInvolve concealment of an unlawful
- ØAre of an amount that management or the
- auditors believe would affect the stock’s price.
Review the Engagement
- ØReview of work of audit staff
- accomplished through review of audit working papers
ØTypically performed by seniors
- ØReview of working papers not completed
- until near (of after) completion of fieldwork
- ØPartner and manager devote attention to
- accounts with higher risk of material misstatement
- ØSecond partner review prior to issuance
- of audit report
Required Communication with Those Charged with Governance
- ØAuditor responsibility under generally accepted auditing standards (e.g., to form and
- express an opinion, and management’s responsibilities)
ØAn overview of the planned scope and timing of the audit
- ØSignificant findings from the audit
- lQualitative aspects of accounting
lAudit difficulties encountered
lDisagreements with management
- lManagement consultations with other
lAuditor independence issues
- ØAuditor subsequent discovery of facts
- existing at date of report
- lAdvise client to make appropriate disclosure of the facts to anyone actually or likely
- to be relying upon the audit report and financial statements
lIf client refuses to make disclosure, CPA should inform each member of board and notify regulatory agencies
Subsequent Discovery of Omitted Audit Procedures
- ØDiscovered during peer review or other
- subsequent review of working papers
- ØAssess importance of omitted procedures
- to their previously issued opinion
- lIf omission impairs ability to support issued opinion and report being relied upon
- by third parties, attempt to perform omitted procedure or appropriate alternative procedure
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