AUD - Notes Chapter 4

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Transaction Cycles
TIP PIE ACDO – whole chapter 4

Revenue cycle – includes sales revenues, receivables and cash receipts

Sales (serially number documents are PAID TIP)
1. Preparation of sales order – a serially numbered sales order is prepared and sent to the credit department
for approval
2. Credit approval – valuation assertion, credit department determines (ARC)
3. Shipment – Shipping department prepares a serially numbered bill of lading (ARC)
4. Billing – Billing dept. prepares serially numbered sales invoice. Shipping documents, sales orders, and
invoices are compared to ensure that all shipments were based on customer orders and properly billed.
The invoice is then sent to the customer and A/R dept. (ARC)
5. Accounting – the sale is entered into the sales journal and a receivable is recorded (ARC)

Accounts receivable
1. Sales
2. Collection of cash receipts
3. Uncollectible receivables – an aging schedule is prepared and sent to the credit department for use in
carrying out its collection program. Auditor observes the preparation of aging schedule to support
assessing control risk below maximum
4. Sales returns – a serially numbered receiving report may be used as a sales return slip. Once the return
is approved, the related receivable is eliminated

Cash receipts
1. Collection – incoming mail must be opened by a person who does not have access to the A/R ledger.
One receipt copy should be sent to cashier (or treasury) for bank deposit. Another copy sent to A/R
dept. for entry into the A/R subsidiary ledger. A third copy should be sent to acctg dept. for entry into
the general ledger

Testing controls for Sales

• Inquire about credit procedures for new customers (valuation) (ARC)
• Compare sales journal to subsidiary ledgers
• Inspect a sample of prenumbered shipping documents and
- agree to sales order (existence)
- account for prenumbered (completeness)
• Vouch a sample of sales invoices, trace a sample of shipping documents
• Inspect customer exception file and disposition (existence, completeness, rights and valuation)
• Send confirmations – follow up on error reports (rights and obligations)
• Test cutoff
• Test adequacy of uncollectible accounts

Expenditure cycle
Purchases
1. Purchase requisition – the dept. needing an asset or services sends an approved serially numbered
requisition to the purchasing dept
2. Purchase orders – obtain competitive bids from various suppliers to make sure that the best price is
obtained. Use prenumbered purchase orders
3. Receipt of goods or services- it is preferable that the copy not indicate the quantity ordered (blind copy),
thus the receiving dept is forced to count the goods upon arrival

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Accounts payable
1. record the payable
2. approve the bill – when the invoice arrives, the accounting department approves it by matching the
invoice, purchase order, receiving report, and (sometimes) the requisition

Cash disbursements
1. best for internal controls to pay invoices by check
2. best for internal control to segregate approving payment and writing checks
3. Treasurer pays the bills

The accounting department has three functions

1. to record the payable
2. to approve the invoice for payment
3. to record the payment after its paid by the treasurer

The auditor should review bills in January to determine is they were incurred in Nov or Dec (search for
unrecorded liabilities.

Audit procedures related to cash

• Internal controls over the handling of cash is one the most critical areas of an audit; proper segregation of
duties
• The auditor should obtain cutoff bank statements used to test for lapping and kiting
• Vouch postings to ledger accounts, reconcile bank statements, and verify cash transactions

Simultaneously verify internal and external evidence

Internal evidence – includes counting cash on hand and reconciling it with the journals
External evidence – includes confirming accounts on deposit with banks, all securities on deposit and
obtaining bank cut-off statements

Lapping – theft of cash is often concealed by failing to account for cash receipts (today’s cash receipts cover
yesterday’s theft)
• Best way to guard against lapping is to use a lock box system. Inspect checks when deposited/cashed and
compare to when accts receivable was booked

Kiting – when a check drawn on one bank is deposited in another bank and no record is made (cash is recorded
in 2 places at once (Dec 31))
• A bank transfer schedule compares the dates checks are drawn to the dates checks are deposited

A standard bank confirmation should be sent to all banks that the client has done business with during the year,
regardless of whether there is a year end balance to confirm.

Potential misstatements
• Recording fictitious sales (existence assertion)
• Holding open the sales journal to include next year’s sales (improper cutoff)
• Shipping unordered goods near year end which can be returned (bill and hold)
• Failure to record payments
• Sales adjustments may be used to conceal thefts of cash collections

Reduce risk by ARC

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Audit Documentation
Audit documentation (workpapers) belong to the CPA (not the clients acctg records) and are meant to support
the auditors opinion and record audit procedures performed and evidence obtained

Audit documentation should:

• Indicate that the accounting records support/reconcile to the F/S
• Contain enough detail so an auditor with no prior knowledge can understand the whole audit
• Support that the audit was conducted in accordance with GAAS

Report release date – date on which the auditor grants the client permission to use the report (usually date
report is delivered to the client)

For private companies, auditing standards require audit documentation be completed 60 days from report
release date and held for 5 years from that date

For private companies, the PCAOB requires audit documentation be completed 45 days from report release
date and held for 7 years from that date

The specific quantity, type and content of audit documentation are based on the auditors judgement

Permanent (continuous) file – audit documentation that has continuing interest from year to year
- contracts, pension plans, leases, stock options, bylaws

Current file – all audit documentation applicable to the year under the audit

Audit documentation should include significant audit findings, actions taken, and conclusions reached, such as:
• Selection and application of accounting principles
• Possible material misstatements
• Need to revise the auditors previous risk assessment
• Significant difficulty in applying necessary audit procedures
• Modification to the auditors standard report

You can provide audit documentation to another party without the clients permission:
• If it’s subpoenaed in court
• To your defense team: lawyers, insurance company, expert witnesses
• AICPA for an investigation or quality review

Audit Evidence
Audit evidence – all the information an auditor uses to arrive at the opinion

The auditor should have access to all pertinent accounting data and corroborating evidential matter (otherwise
it’s a scope limit)

Types of audit evidence

• Underlying accounting records – test through analytical procedures and substantive tests, such as retracing,
recalculation and reconciliation
• Corroborating evidence – provides additional support for the acctg data; observation, inquiry and inspection
• Electronic evidence – consider the time during which information exists or is available in determining the
nature, extent and timing of audit procedures.

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The third standard of fieldwork – “The auditor must obtain sufficient appropriate evidence by performing audit
procedures to afford a reasonable basis for an opinion regarding the F/S under audit”

Evidential matter must persuade the auditor that the ending balance in the F/S are fairly presented (persuasive
rather than conclusive)

Cost/benefit relationship may be a valid reason for performing only certain procedures, cost alone or difficulty
in obtaining evidence is not a valid basis for omitting a procedure

Evidential matter should be valid and relevant

The greater the risk of material misstatement the more evidence will be required
The higher the quality of audit evidence the less audit evidence needed

Evidence must relate to the financial statement assertion under consideration

The evaluation of evidential matter must take into consideration the achievement of audit objectives

Substantive procedures are performed to evaluate mgmt’s assertions which help detect material misstatement

Substantive procedures consist of:

1. Test of details (applied to transactions balances and disclosures)
2. Substantive analytical procedures

Analytical Procedures
• Comparison of financial data – review current and prior year’s F/S and the current years budget, industry
norms, and nonfinancial information
• Most effective and efficient for assertions in which potential misstatements are not apparent from detailed
evidence or is not available

The I/S has more predictable relationships than the B/S

Accts with mgmt discretion are less predictable\

Analytical procedures for planning phase and final review phase are required. However analytical procedures
used as substantive tests are not required.

Documentation requirements, expectation, factors, results, additional audit procedures performed and results of
those procedures

Investigate significant differences (if found): make inquires of mgmt, in necessary expand audit procedures or
alternative substantive procedures. Differences do not necessarily indicate errors or fraud, but simply indicate
the need for further investigation

Analytical procedures are applied during the overall review stage of an audit to evaluate the overall F/S
presentation and assess the conclusions reached

Test of Details
Directional testing refers to testing either forward or backward

If a test starts with items in the accounting records, the proper assertion is most likely existence
If a test starts with source documents, it is most likely related to the completeness assertion

Standard auditing procedures – FIVE CARROTS

F – Footing, crossfooting, recalculation – verify mathematical accuracy
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I – Inquiry – both internal and external
V – Vouching – directional testing; auditor examines support for existence and occurrence assertions
E – Examination/Inspection – provides evidence about the existence assertion
C – Confirmation – Type of inquiry obtained from third party
A – Analytical procedures – evaluate financial information through the study of data relationships
R – Reperformance – auditor re-performs procedures or controls originally performed by the client
R – Reconciliation – substantiates the existence and valuation of accounts
O – Observation – auditor looks at a process or procedure performed by others
T – Tracing – directional testing; examines support for the completeness assertions
S – Subsequent events review – perform certain procedures after balance sheet date

Other procedures
• Cut-off testing
• Test related account simultaneously
• Requesting a comprehensive mgmt representation letter
• Reading pertinent information

Evidential Procedures for Selected Accounts

Inventory
The observation of beginning and ending inventory is required. May use alternative procedures to justify an
opinion (acceptable when its impractical or impossible to observe inventory.

The client counts the inventory and the auditor simply observes and test counts certain items

Consigned inventory on hand is excluded from inventory count

Related accounts – inventories, purchases, sales, sales returns and allowances, and COGS

The auditor should examine purchase invoices and receiving report around yr end for cut-off testing
The auditor should examine sales invoices and compare them to shipping documents around yr end for cut-off

Determine whether inventory adhere to lower of cost or market principles and whether inventory is pledged or
subject to liens

Examine vendor invoices, direct labor rates and test the computation of overhead rates

Accounts receivable confirmations

Positive confirmations – request response from the recipient (may be blank)
• Best type of confirmation for: large accounts, expect errors and disputes, weak internal controls
• A greater degree of assurance but may result in lower response rate
• Non-responses should be: followed up, the client may have to intervene, perform alternative procedures
• Generally provide evidence regarding existence and rights and obligations

Negative confirmations – recipient is asked to respond only if the amount stated in incorrect
• Not as good as positive confirmation
• Use when there is low risk, small balances, belief that the receipt would respond if there was a discrepancy

Accounts payable confirmation – not required

• Are positive confirmations and generally left blank

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• Objective is to determine whether A/P is understated
• Should be sent when internal control is weak
• Typically send to vendors with small or zero balances would be selected for confirmation
However, unrecorded liabilities generally surface eventually when unpaid vendors stop delivering goods

Payroll and Personnel

There should be segregation of duties as follows
• Authorization to employ and pay – function of HR to hire new employees
• Supervision – all pay base data (hours, time-off) should be approved
• Timekeeping and costs accounting – data on which pay is based, hours worked or jobs completed
• Payroll check preparation – computes salary based on information received, later signed by the treasurer

Control procedures – PAID TIPS

PPE
• Acquisition – a special requisition form is needed. Acquisitions are ties to the capital budget and the board
of directors should also have to approve the acquisition.
• Subsidiary ledgers – detailed information on each asset is kept in the subsidiary ledger
• Physical security
• Written policies – on depreciation and capitalization
• Disposition – retirement of assets should be documented and sequentially numbered

Audit procedures
• Vouch additions
• Review retirements and recalculate any gains/losses
• Review repair and maintenance accounts in order to locate items that should have been capitalized
• Be alert for lien’s on assets (borrowed)
- Companies cannot/do not insure fixed assests they do not have
- Companies do not pay real estate taxes on property they don’t own
- Tour plant and inquire

Liabilities
• Notes payable – examine the note, comparing terms and amounts to board approval. Interest expense should
be independently computed
• Long term debt – ensure that interest expense is properly reported, valuation is fairly reported, all debt has
been recorded. Compare interest expense with the bond payable amount for reasonableness
• Contingencies – look at guarantees, purchase commitments, leases, tax returns, clients legal counsel

Owners Equity
• Treasury stock – auditor should examine all shares of treasury stock and reconcile the number of TS shares.
Compare to authorization in the minutes of the board meeting
• Stock transactions – vouch to supporting documentation

All issues relating to stock, dividends, and TS must be authorized by the board of directors

Articles of incorporation goes in the permanent audit file

If the client uses a stock transfer agent, use third party confirmations
If the client doesn’t use a stock transfer agent, check the stock certificate book

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Consider whether any appropriations of retained earnings are necessary (due to loan covenants). The auditor
focuses on evaluating the presentation and disclosure of the F/S (mgmt assertions = classification &
understandability)

Audit Evidence: Miscellaneous Items

Related Party Transactions
• Concerned about valuation and accuracy
• A related party transaction is not considered to be an arms length transaction
• Should be adequately disclosed

Determining the existence of related party transactions

• Evaluate company’s procedures and policies for related party transactions
• Inquire mgmt and predecessor auditor
• Review entity’s filings with the SEC
• Review board minutes
• Compensating balance agreements
• Loan agreements
• Unusual, non-recurring transactions new year end

Accounting Estimates
• Assess mgmt’s written policies and practices of acctg estimates
• Verify that all material estimates have been developed
• Determine that the accounting estimates are reasonable
• Ensure that the accounting estimates are properly presented and disclosed in conformity with GAAP
• Test for reasonableness
• Are they using the same methods
• Past track record of estimates is good
• Justify any changes in approach

Auditing Fair Values

• Estimates and valuation methods may be used when market values are not available
• Changes in fair value measurements may be treated in different ways under GAAP (NI or OCI)
• Evaluate the sufficiency, competency, and consistency of evidence obtained with respect to fair value
measurements and disclosures.
• Determine whether mgmt’s significant assumptions provide a reasonable basis for fair value measurement

Litigation
• Mgmt is the primary source of information regarding litigation. An external inquiry of the entity’s attorney
is simply a means to corroborate information provided by mgmt. R
• Review minutes, invoices from lawyers, and IRS correspondence
• Its mgmt’s responsibility to identify and account for litigation, claims

Letter inquiry to clients attorneys should be signed by the client but sent to the lawyer by the auditor

The lawyers response to the letter should include a professional opinion on the expected outcome of any
lawsuit and the likely outcome of any liability, including court costs

If the lawyer refuses to respond  scope limitation  qualified or disclaimer opinion

Client refuses to permit inquiry  disclaimer opinion
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