Determining the Extent of TODBDetermining the Extent of TODB

Risk model factorsRisk model factors• Acceptable audit riskAcceptable audit risk

• Inherent riskInherent risk

• Control riskControl risk

MaterialityMateriality (partially depends on (partially depends on AAR)AAR)

Determining the Extent of TODBDetermining the Extent of TODB

Risk model factorsRisk model factors

MaterialityMateriality

Results of other testsResults of other tests• Tests of controlsTests of controls

• Substantive tests of Substantive tests of transactionstransactions

• Analytical proceduresAnalytical procedures

Analytical ProceduresAnalytical Procedures

2007 Gross 2007 Gross 2006 Gross 2006 Gross Margin Margin Margin Margin

GW INDGW IND GW IND GW IND

HardwoodHardwood 36.3 32.4 36.4 32.5 36.3 32.4 36.4 32.5SoftwoodSoftwood 23.9 22.0 20.3 22.123.9 22.0 20.3 22.1

PlywoodPlywood 40.3 50.1 44.2 54.3 40.3 50.1 44.2 54.3

Analytical ProceduresAnalytical Procedures

Softwood increased 3.9%, industry Softwood increased 3.9%, industry stablestable

Changes Changes usually most informativeusually most informative (also want to understand (also want to understand differences from industry)differences from industry)

Easier to spot errors in Easier to spot errors in disaggregated datadisaggregated data

Analytical Procedure Follow-upAnalytical Procedure Follow-up

Client will be able to suggest likely Client will be able to suggest likely non-error causes, which you will non-error causes, which you will evaluate.evaluate.

Consider error causesConsider error causes

What errors would cause gross What errors would cause gross profit to increase?profit to increase?

Error Causes of Gross Profit IncreaseError Causes of Gross Profit Increase

Sales overstatedSales overstated• Fictitious salesFictitious sales

• Cutoff error - January sale recorded in Cutoff error - January sale recorded in December (COS not matched)December (COS not matched)

Cost of sales understatedCost of sales understated• Inventory overstatedInventory overstated

• Purchases understated or cutoff error - Purchases understated or cutoff error - December purchase recorded in JanuaryDecember purchase recorded in January

Extent of TestsExtent of Tests

Amount of testing for TODB objectives Amount of testing for TODB objectives will depend upon results of TOT for will depend upon results of TOT for related transaction objectives:related transaction objectives:

– see following slide for related see following slide for related objectives (from Ch. 6)objectives (from Ch. 6)

– see table in notes for specific testssee table in notes for specific tests

–main sampling application in main sampling application in TODB for AR is confirmationsTODB for AR is confirmations

Assertion Trans. Obj. Balance Obj.Assertion Trans. Obj. Balance Obj.

ExistenceExistence OccurrenceOccurrence Existence Existence

Completeness Completeness CompletenessCompleteness Completeness Completeness

Accuracy Accuracy AccuracyAccuracy

ValuationValuation Classific. Classific. Classific. Classific.

oror Timing Cutoff Timing Cutoff

AllocationAllocation Post. & Summ. Detail tie-in Post. & Summ. Detail tie-in

None NRVNone NRV

Rights & Obl. N/A Rights & Obl.Rights & Obl. N/A Rights & Obl.

Pres. & Disc. N/A Pres. & DisclPres. & Disc. N/A Pres. & Discl

ConfirmationsConfirmations

Key ObjectivesKey Objectivesexistenceexistence

accuracy (valuation)accuracy (valuation)

Weak evidence for completeness Weak evidence for completeness - why?- why?

Confirmation are required unless Confirmation are required unless (SAS # 67):(SAS # 67):

• Accounts receivable are Accounts receivable are immaterial.immaterial.

• Confirmations are expected to be Confirmations are expected to be ineffective.ineffective.

• Combined IR and CR are lowCombined IR and CR are low, and , and other evidence reduces audit risk to other evidence reduces audit risk to an acceptably low level.an acceptably low level.

ConfirmationsConfirmations

Why would auditors like to Why would auditors like to minimize confirmations?minimize confirmations?

What is the alternative to What is the alternative to confirmations?confirmations?

Positive ConfirmationsPositive Confirmations

• Emphasis in testing is usually larger, and Emphasis in testing is usually larger, and older accountsolder accounts• Testing may be balance or individual Testing may be balance or individual

invoiceinvoice– Invoice may increase response rateInvoice may increase response rate

–Reduces extent of reconciling itemsReduces extent of reconciling items

–However, provides less assuranceHowever, provides less assurance

Negative ConfirmationsNegative Confirmations

Used whenUsed when

• Internal control effectiveInternal control effective

• Many small balancesMany small balances

• Customers expected to give Customers expected to give adequate considerationadequate consideration

Alternative ProceduresAlternative Procedures

1. Subsequent cash receipts1. Subsequent cash receipts

2. Shipping document2. Shipping document

Any untested portion should be Any untested portion should be treated as an error for projection treated as an error for projection purposes.purposes.

95% of returned confirmations indicated 95% of returned confirmations indicated the customer owed a smaller balance. the customer owed a smaller balance. This may be explained by:This may be explained by:

a. a. Cash receipts journal was held open after Cash receipts journal was held open after year-end.year-end.

b. There are a large number of unrecordedb. There are a large number of unrecorded liabilities.liabilities.

c. Sales journal was closed prior to y/e.c. Sales journal was closed prior to y/e.

d. Sales journal was held open after year-d. Sales journal was held open after year- end.end.

FIGURE 16 - 3FIGURE 16 - 3FIGURE 16 - 3FIGURE 16 - 3Aged Trial Balance forAged Trial Balance for

Hillsburg Hardware Co.Hillsburg Hardware Co.Aged Trial Balance forAged Trial Balance for

Hillsburg Hardware Co.Hillsburg Hardware Co.

FIGURE 16 -4FIGURE 16 -4FIGURE 16 -4FIGURE 16 -4

AnalysisAnalysisof Allowanceof Allowance

for Uncollectiblefor UncollectibleAccounts forAccounts for

Hillsburg Hardware Hillsburg Hardware Co.Co.

AnalysisAnalysisof Allowanceof Allowance

for Uncollectiblefor UncollectibleAccounts forAccounts for

Hillsburg Hardware Hillsburg Hardware Co.Co.

Estimated EstimatedEstimated EstimatedAgeAge Percentage Percentage

PercentagePercentage(days)(days) Amount Amount Uncollectible Uncollectible Uncollectible Uncollectible

Less thanLess than

3030 14,217,15614,217,156 3 3 426,515 426,515

31-6031-60 2,869,366 2,869,366 6 6 172,162 172,162

61-9061-90 1,408,642 1,408,642 1515 211,296 211,296

91-12091-120 1,038,926 1,038,926 2525 259,732 259,732

> than> than

120120 662,710 662,710 4040 265,084 265,084

TotalsTotals 20,196,80020,196,800 1,334,789 1,334,789

Auditing AllowanceAuditing Allowance

Beginning BalanceBeginning Balance from prior yearfrom prior year

Less: write-offsLess: write-offs tested tested

Plus: current provisionPlus: current provision

(bad debt expense)(bad debt expense) residualresidual

Ending balanceEnding balance tested TODBtested TODB

Cutoff TestingCutoff Testing

Sales Cutoff - Sales Cutoff - Primary focus is on sales Primary focus is on sales recorded just recorded just beforebefore year-endyear-end

Cash receipts cutoff -Cash receipts cutoff - Primary focus is Primary focus is on receipts recorded on receipts recorded beforebefore year-endyear-end

Purchases Cutoff -Purchases Cutoff - Primary focus is on Primary focus is on purchases recorded purchases recorded afterafter year-endyear-end

( does not affect A/R)( does not affect A/R)

Sales Cutoff ErrorsSales Cutoff Errors

Key issue is whether COS is matched. Key issue is whether COS is matched. Determining factor is whether good Determining factor is whether good are included or excluded from are included or excluded from inventory.inventory.

Y/E physicalY/E physical - inventory normally - inventory normally correctcorrect

Sales Cutoff ErrorsSales Cutoff Errors

Shipped 1/2Shipped 1/2 Sale - $10,000Sale - $10,000

Recorded 12/31Recorded 12/31 COS - $7,000COS - $7,000

Counted inCounted in Income Effect Income Effect

inventory?inventory? of Error of Error___ ___

YesYes $10,000$10,000

No $3,000No $3,000

Cutoff AdjustmentsCutoff Adjustments

Error 1 - inventory correctError 1 - inventory correct

Sales 10,000Sales 10,000 Accounts receivable 10,000Accounts receivable 10,000

Error 2 - inventory not correctError 2 - inventory not correct

Sales 10,000Sales 10,000Inventory 7,000Inventory 7,000 Accounts receivable 10,000Accounts receivable 10,000 Cost of sales 7,000Cost of sales 7,000