Auditing Operations and Completing the Audit

Chapter 16

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Auditing OperationsAuditing Operations

Corporate earnings are considered as an extremely important indicator of health and well-being of corporations

Measurement of income is generally regarded as the single most important function of accounting

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Conservatism in the Conservatism in the Measurement of IncomeMeasurement of Income

Powerful influence on revenue and expenses Important because of subjectivity involved

with accounting estimates Assets – accountants choose lower of two or

more reasonable alternative values Liabilities – higher amount is chosen Results in income statement with a low or

conservative income figure

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Objectives for audit of revenue Objectives for audit of revenue and expensesand expenses

1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to revenues and expenses.

2. Consider internal control over revenues and expenses.

3. Assess the risks of material misstatement of revenues and expenses and design further audit procedures that:

a. Establish the occurrence of recorded revenue and expense transactions.

b. Determine the completeness of recorded revenue and expense transactions.

c. Establish the accuracy of revenue and expense transactions.

d. Verify the cutoff of revenue and expense transactions.

e. Determine that the presentation and disclosure of revenue and expense accounts are appropriate, including the proper classification of amounts and the proper presentation of earnings-per-share data.

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Figure 16-1 Comparative Income Statement AnalysisFigure 16-1 Comparative Income Statement Analysis

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Relationships Between Balance Sheet Relationships Between Balance Sheet and Income Statement Accountsand Income Statement Accounts

Balance Sheet Item Revenue Expenses

Accounts receivable

Notes receivable Securities and investments

Sales Interest, Interest, dividends, gains, investee’s income

Uncollectible accounts Uncollectible notes Losses

Inventories Purchases, cost of goods sold, payroll

Property, plant and equip. Intangible assets Prepaid expenses Accrued liabilities

Rent, gains

Royalties

Depreciation; repairs

Amortization Various expenses Various expenses

Interest-bearing debt Interest

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Misc. Revenue (1 of 2)Misc. Revenue (1 of 2) Mixture of minor items, some nonrecurring and others

received at regular intervals Auditor should analyze account to look for items

improperly recorded as miscellaneous: Collections on previously written-off accounts or notes

receivable Write-offs of old outstanding checks or unclaimed

wages Proceeds from sales of scrap Rebates or refunds of insurance premiums Proceeds from sales of plant assets

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Misc. Revenue (2 of 2)Misc. Revenue (2 of 2)

Auditor should Propose adjusting journal entry to classify

items correctly Perform analytical procedures and investigate

unusual fluctuations• Can detect material amounts of unrecorded

revenue and• Significant misclassifications affecting revenue

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Figure 16-2 Professional Fees AnalysisFigure 16-2 Professional Fees Analysis

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Substantive Tests for Selling, General Substantive Tests for Selling, General and Administrative Expenses and Administrative Expenses (1 of 2)(1 of 2)

Perform analytical procedures Develop an expectation of the account balance

• Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data and relevant nonfinancial data

Determine the amount of difference from the expectation that can be accepted without investigation

• Use estimates of materiality Compare the company’s account balance with the

expected account balance Investigate significant deviations from the expected

account balance

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Substantive Tests for Selling, General Substantive Tests for Selling, General and Administrative Expenses and Administrative Expenses (2 of 2)(2 of 2)

Obtain or prepare analyses of selected expense accounts

Examine accounts based on results of analytical procedures

Which accounts? AICPA suggests• Advertising• Research and development• Legal expenses and other professional fees • Maintenance and repairs• Rents and royalties

Obtain or prepare analyses of critical expenses in the income tax return

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PayrollPayroll Importance – typically largest operating cost Payroll fraud had been common and often

substantial but now fraud difficult to conceal because of: Extensive segregation of duties relating to

payroll Use of computers with proper controls for

preparation of payrolls Filing of frequent payroll reports to the

government

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Segregation of Functions--Payroll

Separate departments should handle:

• Employment (personnel)

• Timekeeping

• Payroll preparation and record keeping

• Distribution of pay to employees

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Internal Control over Payroll Internal Control over Payroll DocumentationDocumentation

Typical questions Are employees paid by check or direct deposit? Is a payroll bank account maintained on an imprest basis? Are the activities of timekeeping, payroll compilation, payroll

check signing, and paycheck distribution performed by separate departments or employees?

Are all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed?

Are employee time reports approved by supervisors? Is the payroll bank account reconciled monthly by an employee

having no other payroll duties?

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Audit Program for Payroll Audit Program for Payroll (1 of 2)(1 of 2)

1. 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.

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Audit Program for Payroll (2 of 2)Audit Program for Payroll (2 of 2)

1. 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.

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Substantive Procedures for PayrollSubstantive Procedures for Payroll

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Audit of Statement Audit of Statement of Cash Flowsof Cash Flows

Amounts are audited in conjunction with the audit of balance sheet and income statement accounts

Presentation and disclosure important audit objective is important Operating Investing Financing

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Audit Procedures Completed Audit Procedures Completed Near the End of Field WorkNear the End of Field Work

Search for unrecorded liabilities Review the minutes of meetings Perform final analytical procedures Perform procedures to identify loss

contingencies Perform the review for subsequent

events Obtain the representation letter

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Loss ContingenciesLoss Contingencies

Loss contingencies should be reflected in the financial statement amounts when:

It is probable that a loss had been sustained before the balance sheet date

The amount of the loss can be reasonably estimated

Loss contingencies should be disclosed in the notes to the financial statements when it is at least reasonably possible that a loss has been sustained

Loss contingencies need not be disclosed when the possibility of loss is remote

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LitigationLitigation

Most common loss contingency – pending or threatened litigation Letter of inquiry to client’s legal counsel

• Evidence of pending and threatened litigation• Unasserted claims - need to be disclosed if

probable and reasonably possible SAS 12

• Auditors should obtain from management a list describing and evaluating threatened or pending litigation

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Other ContingenciesOther Contingencies

Income tax disputes Accommodation endorsements and other

guarantees of indebtedness Accounts receivable sold or assigned with

recourse Environmental issues Commitments General risk contingencies

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Audit Procedures for Loss Audit Procedures for Loss ContingenciesContingencies

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.

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Responsibility for Subsequent Events

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Procedures to Identify Procedures to Identify Subsequent EventsSubsequent Events

Review latest available financial statements and minutes of the board and selected committees

Inquiry about matters dealt with at meetings for which minutes are not available

Inquiry of management Obtain lawyer’s letter Obtain representations from management

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Obtain Representation LetterObtain Representation Letter

Purpose is to have the client’s principal officers acknowledge that they are primarily responsible for the fairness of the financial statements

Dated as of the date of the audit report Not a substitute for application of

necessary audit procedures

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MisstatementsMisstatements

Known misstatements Specific misstatements identified during the

course of the audit Likely misstatements

Due to extrapolation from audit evidence or differences in accounting estimates

Evaluation Material misstatements must be corrected

• Quantitative and qualitative factors

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Qualitative Materiality FactorsQualitative Materiality Factors

Likely to be material when: Arise 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).

Mask a change in earnings or other trends. Hide a failure to meet analysts’ consensus expectations for the company. Change a loss into income, or vice versa. Concern a particularly important segment or other portion of the registrant’s

business. Affect compliance with regulatory requirements, loan covenants, or other

contractual requirements. Increase management’s compensation. Involve concealment of an unlawful transaction. Are of an amount that management or the auditors believe would affect the

stock’s price.

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Total Likely MisstatementOverstatements

(Understatements)W/P ref. Current

AssetsNoncurrent

AssetsCurrent

LiabilitiesNoncurrent Liabilities

Owners’ Equity

Income before Taxes

Tax Expenses

Uncorrected Known Misstatements

D-8 Overstatement of prepaid expenses

$6,500$2,600

$6,500 (2,600)

$6,500$2,600

F-6 Overstatement of prior years’ depreciation

($10,000)(4,000)

(10,000)4,000

M-4 Unrecorded liabilities (11,215)4,486

11,215(4,486)

11,2154,486

Projected Misstatements

C-5 Overstatement of accounts receivable (confirmation results)

30,00012,000

30,000(12,000)

30,00012,000

Other Estimated Misstatements

C-10

Understatement of allowance for uncollectible accounts

5,0002,000

5,000(2,000)

5,000________ 2,000

Total Likely Misstatements

$41,500 ($10,000) $5,871 $25,629 $52,715 $21,086

Amount considered material

$100,000 $125,000 $100,000 $125,000 $200,000 $150,000

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Evaluation Materiality: Considering Evaluation Materiality: Considering

Previous Year Uncorrected MisstatementsPrevious Year Uncorrected Misstatements SEC SAB 108 Situation:

$70,000 current year misstatement $60,000 balance sheet carryover from preceding year

If either the $70,000 or the $130,000 total ($70,000 + 60,000) is material to this year, an adjustment must be made.

The current year’s income is decreased by at least $70,000

If the $60,000 is immaterial this year, it will also decrease current year income

• If the $60,000 is material this year, prior year financial statements should be adjusted.

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Review the EngagementReview the Engagement

Review of work of audit staff accomplished through review of audit working papers

Typically performed by seniors Review of working papers not completed until

near (of after) completion of fieldwork Partner and manager devote attention to

accounts with higher risk of material misstatement

Second partner review prior to issuance of audit report

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Reporting on Other Information Reporting on Other Information with the Financial Statementswith the Financial Statements

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Required Communication with Required Communication with Those Charged with GovernanceThose Charged with Governance

Auditor responsibility under generally accepted auditing standards (e.g., to form and express an opinion, and management’s responsibilities)

An overview of the planned scope and timing of the audit

Significant findings from the audit Qualitative aspects of accounting practices Audit difficulties encountered Uncorrected misstatements Disagreements with management Management consultations with other accountants Auditor independence issues Other issues.

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Post-Audit ResponsibilitiesPost-Audit Responsibilities

Auditor subsequent discovery of facts existing at date of report Advise client to make appropriate disclosure

of the facts to anyone actually or likely to be relying upon the audit report and financial statements

If client refuses to make disclosure, CPA should inform each member of board and notify regulatory agencies

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Subsequent Discovery of Subsequent Discovery of Omitted Audit ProceduresOmitted Audit Procedures

Discovered during peer review or other subsequent review of working papers

Assess importance of omitted procedures to their previously issued opinion If omission impairs ability to support issued

opinion and report being relied upon by third parties, attempt to perform omitted procedure or appropriate alternative procedure