Auditing Operations

and Completing the

Audit

Chapter 16

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

16-2

Auditing 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

16-3

Conservatism in the

Measurement 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

16-4

Objectives for audit of revenue

and 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.

16-5

Figure 16-1 Comparative Income Statement Analysis

16-6

Relationships Between Balance Sheet

and 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

16-7

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

16-8

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

16-9

Figure 16-2 Professional Fees Analysis

16-10

Substantive Tests for Selling, General

and Administrative Expenses (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

16-11

Substantive Tests for Selling, General

and Administrative Expenses (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

16-12

Payroll

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

16-13

Segregation of Functions--Payroll

Separate departments should handle:

• Employment (personnel)

• Timekeeping

• Payroll preparation and record keeping

• Distribution of pay to employees

16-14

Internal Control over Payroll

Documentation 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?

16-15

Audit Program for Payroll (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.

16-16

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.

16-17

Substantive Procedures for Payroll

16-18

Audit of Statement

of 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

16-19

Audit Procedures Completed

Near 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

16-20

Loss 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

16-21

Litigation

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

16-22

Other Contingencies

Income tax disputes

Accommodation endorsements and other

guarantees of indebtedness

Accounts receivable sold or assigned with

recourse

Environmental issues

Commitments

General risk contingencies

16-23

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.

16-24

Responsibility for Subsequent Events

16-25

Procedures to Identify

Subsequent 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

16-26

Obtain 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

16-27

Misstatements

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

16-28

Qualitative 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.

16-29

Total Likely Misstatement Overstatements (Understatements)

W/P ref.

Current Assets

Noncurrent

Assets

Current

Liabilities

Noncurrent 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)

11,215 4,486

Projected Misstatements

C-5 Overstatement of accounts receivable (confirmation results)

30,000 12,000

30,000 (12,000)

30,000 12,000

Other Estimated Misstatements

C-10

Understatement of allowance for uncollectible accounts

5,000

2,000

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

16-30

Evaluation Materiality: Considering

Previous 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.

16-31

Review 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

16-32

Reporting on Other Information

with the Financial Statements

16-33

Required Communication with

Those 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.

16-34

Post-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

16-35

Subsequent Discovery of

Omitted 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