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Auditing & Attestation 4

Auditing & Attestation 4


1. Transaction cycles ......................................................................................................... 3

2. Audit documentation .................................................................................................... 20

3. Audit evidence ............................................................................................................ 24

4. Evidential procedures for selected accounts ..................................................................... 35

5. Audit evidence: miscellaneous items .............................................................................. 48

6. Appendix—financial ratios ............................................................................................. 54

7. Class questions ........................................................................................................... 65


A4-2
Becker CPA Review Auditing & Attestation 4

TRANSACTION CYCLES

I. SUMMARY OF TRANSACTION CYCLES

Cycle Description
Revenue Includes sales revenues, receivables, and
cash receipts
Expenditure Includes purchases, payables, and cash
disbursements
Payroll and Personnel Includes payroll (salaried and hourly)
and personnel functions
Inventory and Production Includes perpetual inventory,
physical counts, and manufacturing
costs
Property, Plant, and Includes acquisitions and disposals and
Equipment related depreciation expense
Investments Includes investments, related interest
and dividend payments, proceeds from
issuance and from payments of principal,
and payments for treasury stock
Other Liabilities Includes accrued liabilities, warranty
costs, deferred income taxes, and
lease obligations

PASS
KEY
Transaction cycles are frequently
tested on the exam.

SALES
II. REVENUE CYCLE
A. SALES
Under strong internal control, segregation of the functions in a sales transaction should exist
as follows:
1. Preparation of the Sales Order
The sales function begins with the receipt of a customer purchase order by the sales
department. If it is determined that the order can be filled, a serially numbered sales
order is prepared and sent to the credit department for approval.
2. Credit Approval
The credit department determines whether or not the customer may receive goods on
open account. If the order is approved, a copy of the approved sales order is sent to
the shipping department, the billing department, and the accounting department.

© 2009 DeVry/Becker Educational Development Corp. All rights A4-3


reserved.
3. Shipment
In the shipping department, a serially numbered bill of lading is prepared and a copy is
sent to the customer. The goods are shipped, and at this point a receivable arises.
4. Billing
The billing department prepares a serially numbered sales invoice. Shipping
documents, sales orders, and invoices are compared to assure that all shipments were
based on valid customer orders and were properly billed. Prices and discounts are
applied to the invoice, and necessary extensions and footings are computed. The
invoice is then sent to the customer and to the accounts receivable department.
5. Accounting
The sale is entered into the sales journal, and a receivable is recorded.
B. ACCOUNTS RECEIVABLE
1. Sales
RECEIVAB A receivable is recorded in the accounts receivable control account in the general
LES ledger and in the accounts receivable subsidiary ledger. Periodically, an independent
person should reconcile these two records.
2. Collection of Cash Receipts
When payment is received from the customer, the receivable is eliminated.
3. Uncollectible Receivables
An aging schedule is prepared and sent to the credit department for use in carrying out
its collection program. At some point, uncollectible receivables should be written off.
Controls for writing off receivables include proper authorization (by the treasurer) and
recordkeeping. Without proper control, amounts subsequently collected easily could
be misappropriated by employees.
a. The auditor observes the preparation of the aging schedule as part of the study
of internal control.
4. Sales Returns
Returned goods must be examined to ensure that they correspond with the reason for
return before credit is given. A serially numbered receiving report may be used as a
sales return slip. Once the return is approved, the related receivable is eliminated.
a. Credit memos should not be prepared by individuals who collect or receive cash
payments on accounts receivable; to do so would be an inadequate segregation
of duties.
5. Sales Discounts
Sales discount procedures and records should be reviewed to ensure that discounts
are properly given and recorded. This ensures that receivables are not overstated.
C. CASH RECEIPTS
CAS
1. Collection of Cash Receipts H
RECEIP
TS

Incoming mail must be opened by a person who does not have access to the accounts
receivable ledger. The receipts should be listed in detail with one copy and the actual
receipts sent to the cashier to prepare the bank deposit, another copy sent to the
accounts receivable department for entry in the accounts receivable subsidiary records,
and a third copy sent to the accounting department for entry in the general ledger
accounts receivable control account. The accounts receivable department should
match the details from the bank deposit ticket with the details from the remittance
advices. This will reveal any discrepancies. Cash collections should be restrictively
endorsed upon receipt and deposited daily. Devices such as cash registers or lock
boxes should be used as safeguards.
D. FLOWCHART OVERVIEW
1. Sales Flowchart

Revenue Cycle
— Sales

Depts: Sales Credit Treasurer Shipping Billing (A/R) Accountin


(Authorizati (Authorization) (Authorization (Custody) (Recordkeeping) (Recordkee
g
on) ) ping)
Custo Approved Approv
mer Prepare Write- Approve ed
sales order
order sales offs d sales write-
order order off
B/L
Approve
d sales
Approve Approved order
Sales credit, 1. Pull
follow up Review write-off Sales
order on old and invent
accounts, Summary
and initiate approve ory 1. Match Inventory
write- write- 2. Prepare docs Summary
offs bill of 2. Prepare
offs invoice
lading
3. Update
A/R
master PostG/L
file
4. Print
sales
Inventory journal
Write-offs Approved sales Approved
write-offs summary B/
order L Sale Periodic
Invoice s reconcilia Updated
Good tion by G/L
s journ independ
To al ent party
Billing
To Shipping, To Billing
and To Updated
To Customer
A/R
master
file
To Treasurer Billing, Accounting To
Accounti Sales
and ng Customer
Accounti summ
ng ary

To
Accounting
2. Collections Flowchart

Revenue Cycle —
Collections
Cash Receipts and
Accounts Receivable

DEPTS: Cashi Accounts Accounting


er Receivable (Recordkeeping)
Mailroom (Custo (Recordkeeping)
(Custody) dy)

From From CR Summary


Custo 1. Separate Checks cashier mailroom
Check Remittance Check
mer check and 1 deposit advice deposit
check advice; Listing summary
of summary
restrictivel 2
y
Listing Listing 3
endorse check chec of of checks
2. Prepare ks check
listing of s
checks
Match
Prepa documents:
3 re  Listing of checks
12 depos 1. Match  CR
Listing of 1 it remittance summary
checks Chec advice/chec 
ks k deposit Deposi
summary t
Chec 2. Update A/R summ
Chec
ks k master ary
To To file
depo A/ Post
Accounting Cashi sit R 3. Print CR G/L
, er journal
summ
ary
CR
Cashier, mast summar Updated
and er y– G/L
Remitta
Accounts file deposit
nce
Receivable To To upda summar
advice
Ban Account te y
k ing
Remitta
CR nce
advice
journ D
To al
A/R To
Accounting
E. TESTS OF CONTROLS RELATED TO THE REVENUE CYCLE
1. Testing Controls Related to Sales

Testing
Controls: Sales

Departme Control Procedure Sample Test of Control


nt Procedure
Order & 1. Prepare prenumbered sales  Inquire about credit
Credit order. procedure for new
2. Perform credit check customers (valuation).
(authorization).  From a population of
3. Approve credit for returns. approved sales orders (and
4. Follow up on old or returns), select a sample and
past-due accounts. examine documents for
5. Initiate write-offs, which evidence of credit check
Warehou 1. Receive approved sales  Observe warehouse personnel
se & order from credit dept filling sales orders (existence ).
Shipping (must have approved
sales order before release
of goods from  Observe physical controls
warehouse). over inventory.
2. Pull inventory from
warehouse and release to  Observe evidence of
shipping. independent checks
3. Perform independent (existence).
check of goods received
from warehouse and
approved sales orders in  Inspect a sample of
shipping department. prenumbered shipping
4. Prepare prenumbered bill of documents and:
lading. – Agree to sales order
Billing/ 1. Match shipping documents  Vouch a sample of sales invoices
Account and sales orders before (select approved sales orders
s preparing invoice. from the sales journal) to
Receiva shipping documents and
ble approved sales orders
(existenc e).
 Trace a sample of shipping
documents (selection from
prenumbered shipping
2. Periodically account for documents) to sales invoice,
all prenumbered shipping sales journal, and A/R master
documents. file (completeness).
3. Perform independent check  Observe procedure.
of sales Reperform procedures for a
order sample period (completeness).
pricing.  Reperform pricing check: From
a sample of sales invoices,
4. Prepare prenumbered sales check pricing with master price
invoice. list (valuation).
5. Batch and total invoices.
6. Update A/R master file.
Agree input to invoice batch  Observe procedure and
totals. reperform
Testing Controls: Sales
(continued)

Departme Control Procedure Sample Test of Control


nt Procedure
Accountin 1. Receive sales summary.
g 2. Perform independent • Observe and reperform
check of invoice batch (valuation, existence,
totals and sales summary. completeness).
3. Review sales account • Observe and
classifications. reperform (report
4. Post to G/L. presentation).
5. Follow-up customer • Inspect customer exception file
exceptions and disposition (existence,
NOTE: A formal audit program can be prepared organized by assertion and
sample population.
SEGREGATION OF DUTIES:
• Authorization: Sales Order & Credit, Treasurer
• Recordkeeping: Billing/Accounts Receivable/Accounting
• Custody: Warehouse & Shipping
2. Testing Controls Related to Collections

Testing Controls:
Collections

Departme Control Procedure Sample Test of Control


nt Procedure
Mailroom 1. Separate checks and
remittance advices.
2. Stamp restrictive • Inspect checks prior to
endorsement on checks. deposit for endorsement
3. Prepare prelisting (completeness).
of checks received. • Observe preparation of
4. Forward checks to Cashier. prelisting (existence,
Forward remittance completeness, valuation).
advices to A/R. Forward
prelisting to Accounting,
Cashier, and Accounts
Cashier 1. Receive checks and prepare
deposit. • Observe preparation of cash
2. Prepare daily cash summary summary
(copy to (existence, completeness,
A/R and valuation).
Accounting).
3. Deliver checks to bank. • Inspect deposit slip and
4. File validated deposit slip. compare to cash summary
Accounts 1. Match remittance advices • Observe procedure
Receivable and check deposit (completeness).
summary.
2. Update A/R master file.
3. Print CR journal/Updated
A/R master file.
4. Print CR summary (copy to
Accounting).
Accounting 1. Independent check: • Inspect evidence of
Compare the cash summary independent check
(Cashier), the prelisting of (existence, completeness,
checks (Mailroom), and the valuation).
CR summary (A/R). • Reperform independent check
2. Post G/L. for selected dates (existence,
3. Prepare bank reconciliation. completeness, valuation).

SEGREGATION OF DUTIES:
• Recordkeeping: Accounts Receivable/Accounting
• Custody: Mailroom & Cashier (Treasurer)
F. AUDIT PROCEDURES RELATED TO THE REVENUE CYCLE
1. Sales
The auditor should verify that recorded sales are based on approved sales orders and
shipping documents. The auditor must also determine that all sales are recorded at the
appropriate amount and in the proper period.
a. Books and Records
The auditor should match the sales invoices with supporting shipping documents.
The auditor should compare the sales journal with the subsidiary ledgers, test the
mathematical accuracy of the trial balance, and compare the total in subsidiary
ledgers with the general ledger.
b. Cutoff
Sales invoices before and after year-end should be examined. In addition, the
auditor should analyze sales returns after year-end.
2. Accounts Receivable
The auditor should review the accounts receivable schedule for accuracy and
collectibility.
a. Confirmation
Confirmation of receivables (covered later) is considered to be a generally
accepted auditing procedure.
b. Adequacy of Uncollectible Accounts
Calculations should be made to determine the adequacy of the allowance for
uncollectible accounts. An aging schedule of accounts receivable should be
constructed. Tests of the adequacy of the allowance relate to the financial
statement assertion of valuation and allocation.
3. Cash Receipts
Audit procedures related to cash are covered in item IV below.

III. EXPENDITURE CYCLE


A. PURCHASES
Under strong internal control, segregation of the functions in a purchase transaction should
exist as follows:
1. Purchase Requisition
The purchase requisition starts the purchasing cycle. The department in need of the
PURCHAS
ES
asset or services sends a properly approved, serially numbered requisition to the
purchasing department. The requisitioning department should not have the authority to
actually place the purchase order. This would indicate a weakness in internal control.
2. Purchase Orders
The purchasing department should place the order only after giving proper
consideration to the time to order and the quantity to order. The purchasing
department should also obtain competitive bids from various suppliers to make sure
that the best price is obtained. The purchase order is issued only after proper
approval.
For internal control purposes, it is best that prenumbered purchase orders be used.
There should be multiple copies that will be sent to: (i) the requisitioning department;
(ii) the vendor; (iii) the receiving department; and (iv) the accounting department.
If the purchase order is canceled, all copies should be recalled and filed so that every
purchase order number is accounted for.
3. Receipt of Goods or Services
The copy of the purchase order sent to the receiving department serves as an
authorization to accept the goods when they arrive. It is preferable that the copy not
indicate the quantity ordered. Thus, the receiving department is forced to count the
goods upon arrival. A receiving report is prepared by this department and forwarded to
the accounting department. The goods are forwarded to the requisitioning department.
B. ACCOUNTS PAYABLE
The accounting department has three functions: (i) to record the payable; (ii) to approve the
invoice for payment; and (iii) to record the payment after it is paid by the Treasurer.
A/P
1. Recording the Payable
The copy of the purchase order sent to the accounting department notifies them that
there will be a future cash disbursement. The receiving report is compared with the
purchase order and the vendor's invoice as to quantity. This comparison is made to
prevent payment of charges for goods in excess of those ordered and received. The
accounting department records the goods as received in inventory, and records a
payable.
2. Approving Invoice for Payment and Recording Payment
When the invoice arrives, the accounting department approves it by matching the
invoice, purchase order, receiving report, and (sometimes) the requisition. When
payment is made, the payable is reversed. The accounting department should ensure
that the invoice amount is correct, and that it accurately reflects any purchase
discounts, before approving it for payment.
C. CASH DISBURSEMENTS
It is best for internal control purposes to pay invoices by check. For effective internal control,
the functions of approving the payment and signing the checks should be segregated.
Approved voucher packets (matched invoice, purchase order, receiving report, and
requisition) prepared by the accounting department (Accounts Payable) are received by the
Treasurer, who prepares, signs, and mails the checks and cancels all supporting documents
after payment. Paid vouchers are returned to the accounting department for posting of the
payment and filing of the documents.
A4-12

Auditing & Attestation 4


PURCHASI RECEIVING ACCOUN TREASUR
NG TS

D.
ER
PAYABL
From From From From
From Purch. E

FLOWCHART OVERVIEW
Stores Purch. vendor Accounts
From Payable
Receiv-
ing

1 4 Requisition 1 Voucher Requisition 1

and Disbursements
Expenditure Cycle—Purchases, Payables,
Approved Purchase Receiving package Purchase order 5
report Invoice
requisition order Purchase Rec. report 1
order
Invoice
By 1
Approve & Receive goods; name Approved
File pending
prepare match with voucher
arrival of all
purchase purchase order documents
order

Match Review documents;


Prepare prepare check
Requisition 1 receiving documents
& remittance
Purchase order 5 report advice
Purchase order 4
Purchase order 3 Sign check;
Prepare and
Purchase order 2 approve voucher; cancel
reserved.
© 2009 DeVry/Becker Educational Development Corp.

Purchase order 4
1 verify voucher
Purchase Rec. report 4 accuracy package
order Rec. report 3
Rec. report 2 Voucher 2
Requisition 1 Check copy
1 Cancelled
To Receiving Purchase order 5 Remittance 2
voucher package
stores report Rec. report 1 Signed check
Invoice 1
Remittance
To 1
By advice
Accounts Approved
By num-
Payable voucher
num- To ber
To
ber Receiv- General
ing Accounting
For receipts

Becker CPA Review


To File unpaid To General
To and returns stores vouchers Accounting
To
Accounts by Cancelled
vendor
Payable date voucher
All rights

By
num- package file
To
ber vendor
To On
Treasurer due date
Becker CPA Review Auditing & Attestation 4

E. TESTS OF CONTROLS RELATED TO THE EXPENDITURE CYCLE


1. Testing Controls Related to Purchases

Testing Controls:
Purchases

Departme Control Procedure Sample Test of Control


nt Procedure
Requisition 1. Prepare prenumbered requisition.  Inspect requisitions for proper
er 2. Obtain approvals needed approval.
(authorization).  Observe procedures to
3. Send original copy to Purchasing. account for
4. Inspect goods when received prenumbering.
from Receiving dept. Sign
receiving report upon receipt of
Purchasing 1. Receive approved  Inspect purchase orders for
requisition. approved requisition.
2. Contact approved  Observe procedures to
vendors. account for
3. Issued prenumbered purchase order prenumbering.
(PO):
 Original to vendor
 Blind copy to Receiving
Receiving 1. Receive goods from vendor.
2. Inspect goods. All shipments
received must have a PO.
3. Prepare receiving report (RR).  Inspect receiving report and
4. Match details of order matching PO.
received with blind copy of PO  Observe performance by receiving
and indicate quantity received. clerk.
5. Send goods to Requisitioning
departme nt.
Obtain signature on receiving  Inspect receiving report for signed
report that requisitioner receipt
received goods. (existence).
6. Distribute receiving report:  Trace a sample of receiving
 Original to A/P reports (selection made from
 Copy to Purchasing prenumbered documents) to PO,
Accounts 1. Receive vendor’s invoice.
Payable 2. Match documents: vendor’s
invoice, RR, PO, requisition.
3. Check mathematical accuracy,
approvals,  Inspect vouchers for
G/L account coding supporting documents and
(independent check). evidence of independent checks
4. Prepare prenumbered voucher. (existence).
5. Account for the numerical  Observe procedure; reperform
sequence of vouchers. (completeness).
6. Data Entry:  Vouch a sample of vouchers
 Prepare purchase (selection made from the
journal purchases journal) to all required
 Update A/P master file supporting documents
 Daily purchase (existence).
Accounting 1. Receive purchase summary.  Observe evidence of independen t
2. Post to G/L. check;
3. Reconcile G/L and A/P file. reperform.
4. Reconcile vendor’s monthly  Observe evidence of
statements and A/P independent check; reperform
master file (independent check). (valuation, existence,
SEGREGATION OF DUTIES:
 Authorization: Purchasing/Requisitioning Dept.
 Recordkeeping: Accounts Payable/Accounting
 Custody: Receiving
© 2009 DeVry/Becker Educational Development Corp. All rights A4-13
reserved.
Auditing & Attestation 4 Becker CPA Review

2. Testing Controls Related to Payables

Testing Controls:
Payables

Department Control Procedure Sample Test of Control


Procedure

Accou 1. Pull voucher at due date • Compare debits to accounts


nts and send to payable to properly
Payab Treasurer for payment. cancelled voucher packages
le 2. Receive cancelled voucher (existence).
and supporting documents • Trace from cancelled voucher
from Treasurer. packages to cash
3. Receive check summary disbursement journal entries
from Treasurer (completeness).
for data entry. • Vouch cash disbursement
4. Data Entry: journal entries back to
√ Update A/P master file. cancelled voucher packages
√ Print cash disbursements (existence).
journal.

Treasurer 1. Receive voucher for


payment. • Observe performance of
2. Review document for independent check.
completeness and • Observe accounting for sequence
approvals. (completeness).
3. Prepare prenumbered
checks. • Inquire about procedure;
4. Prepare check summary. observe. Select checks for
5. Sign checks (authorized testing and inspect
signatory) and cancel signatures.
voucher and supporting
• Observe cancellation of
documents.
vouchers by check signer.
6. Mail check to vendor.
• Inquire about procedure.
7. Forward cancelled
Observe performance.
voucher/supporting
documents to Accounts
Payable.
8. Send copy of check
summary:
√ Accounts
Payable

Accountin
g

Accounting 1. Receive check summary. A/P.


2. Post to 4. Perform
G/L. periodic
3. Perform independent independent
check of totals per check bank
summary and amounts reconciliation.
journalized and posted by
A4-14 © 2009 DeVry/Becker Educational Development Corp. All rights
reserved.
Becker CPA Review Auditing & Attestation 4

• Observe procedure and reperform. • Inspect bank reconciliation.

SEGREGATION OF DUTIES:
• Authorization: Purchasing/Requisitioning Department
• Recordkeeping: Accounts Payable/Accounting
• Custody: Receiving and Treasurer

© 2009 DeVry/Becker Educational Development Corp. All rights A4-15


reserved.
F. AUDIT PROCEDURES RELATED TO THE EXPENDITURE CYCLE
The presentation/disclosure, valuation, and completeness of accounts payable should be
verified.
1. Confirmations
Confirmation of payables (covered later) is not required but may be used in certain
circumstances. Regular suppliers, especially those showing small or zero balances,
should be selected for confirmation.
2. Search for Unrecorded Liabilities
The auditor should select cash disbursements made subsequent to year-end and
examine the supporting documentation (e.g., receiving reports, vendor invoices, etc.).
The auditor looks for items that should have been recorded at the balance sheet date,
but were not.
Note that cash disbursements made subsequent to year-end may be identified by
reviewing the cash disbursements journal, subsequent bank statements, or the voucher
register.
The auditor should also examine open vouchers, receiving reports, vendors' invoices,
and statements received for a period after year-end as part of the search for
unrecorded liabilities.
3. Cash Payments
Audit procedures related to cash are covered in item IV below.

IV. CASH
A. AUDIT PROCEDURES RELATED TO CASH CASH

Cash is an integral part of both the revenue and expenditure cycles. The cash account
should be reviewed to verify the accuracy of the account and to detect theft and any evidence
of kiting or lapping. The auditor should look at all bank reconciliations and confirmations.
The auditor should obtain bank cutoff statements and, if there is more than one cash account,
the auditor should prepare bank transfer schedules for transfers between accounts.
1. Internal Control
Internal control over the handling of cash is one of the most critical areas of the audit.
Proper segregation of duties relating to cash demands that close consideration be
given to check-writing authority. Separation of cash handling, recordkeeping, and
reconciliation of bank statements should exist as well as separation of petty cash
activities. Good internal control for cash would include the use of a voucher system for
cash disbursements.
2. Cutoff
The auditor should obtain cutoff bank statements ten to fifteen days after year-end.
The auditor should verify the cutoff of cash receipts and cash disbursements and
examine all wire and interaccount cash transfers close to year-end.
3. Books and Records
Auditors should foot and crossfoot all books and records. They should mathematically
test calculations in the cash journals, vouch postings to ledger accounts, reconcile
bank statements, and verify cash transactions in one or more expense accounts.
Auditors should also compare the cash receipts journal with deposit slips for chosen
test periods.
4. Evidence: Internal and External (Simultaneous Verification)
The auditor should examine all internal evidence. This would include counting the cash
on hand and reconciling it with the journals.
Procedures used to obtain external evidence would include confirming amounts on
deposit with banks, confirming all securities on deposit, and obtaining bank cutoff
statements.
5. Related Accounts
Almost all asset, liability, and expense accounts are related to the cash disbursement
function. Specific attention should be devoted to petty cash, payroll, purchases, and
miscellaneous expenses. These accounts should be reconciled to the appropriate
supporting journals.
6. Identification and Prevention of Fraudulent Schemes with Respect to Cash
a. Lapping
(1) Definition
The theft of cash is often concealed by failing to account for cash receipts.
The most common of these methods is known as lapping. Lapping
involves withholding current receipts of cash or checks and not recording
them. The unrecorded receipt is covered by applying a subsequent receipt
to the previously unrecorded account.
(2) How to Prevent and Detect Lapping
Some of the safeguards against lapping include independent comparison
of recorded cash receipts with funds actually deposited, separation of
incoming receipts from subsidiary accounts receivable remittance advices,
comparison of the details of bank deposits and the details of remittance
credits, provision of timely statements, and confirmation of customer
balances. One of the best methods to guard against lapping is use of a
"lock box" system. In this system, customers send their payments directly
to the bank, which prevents company employees from having access to
payments received.
One of the best methods to detect lapping is to compare the dollar
amounts and dates on the bank deposit slips with customer remittance
credits recorded in the accounts receivable ledger. Any lapping not using
exact replacement dates and amounts would be detected.
b. Kiting
(1) Definition
Kiting occurs when a check drawn on one bank is deposited in another
bank and no record is made of the disbursement in the balance of the first
bank. Kiting may be used to cover a cash shortage or to pad a company's
cash position.
(2) How to Detect Kiting
To detect kiting effectively, the cash deposits in transit at the end of a
period and the paid checks returned with the bank statements of the next
period must be examined. This is accomplished by preparing a bank
transfer schedule. A bank transfer schedule compares the dates checks
are drawn (on the disbursing bank account) to the dates checks are
deposited (in the receiving bank account). Kiting is indicated when the
date stamped by the receiving bank on the rear of the returned (paid)
check precedes the date on which the disbursement was recorded.
7. Transfer Schedules, Bank Confirmations, and Bank Statements
a. The auditor's main emphasis in testing cash is on the verification of the ending
balances (existence) and on the detection of theft or kiting. Since cash is such
an active account, most evidence will be gathered with respect to ending
balances rather than individual transactions. Special attention should also be
paid to cash handling and internal controls. The auditor's sources of evidence
will include bank transfer schedules (kiting test), bank confirmations, bank
reconciliations, and cutoff bank statements.
b. The standard bank confirmation should be sent to all banks with whom the client
has done business during the year, regardless of whether there is a year-end
balance to confirm. This is done because the bank confirmation, in addition to
verifying year-end balances, also provides evidence about actual loans and
contingent liabilities, discounted notes, pledged collateral, and guarantee or
security agreements.
B. SAMPLE CONFIRMATION FORM

STANDARD FORM TO CONFIRM


ACCOUNT BALANCE INFORMATION WITH
FINANCIAL INSTITUTIONS

ORIGINA
L
To be mailed to
CUSTOMER NAME
accountant

We have provided to our accountants the following information as of

[ ] the close of business on , 20 , regarding our


deposit and loan balances. Please confirm the accuracy of the
Financial information, noting any exceptions to the information provided. If the
Institution's balances have been left blank, please complete this form by furnishing
the balance in the appropriate space below.* Although we do not
Name and request nor expect you to conduct a comprehensive, detailed search
Address
]
of your records, if during the process of completing this confirmation
[ additional information about other deposit and loan accounts we may
have with you comes to your attention, please include such information
below. Please use the enclosed envelope to return the form directly to
our accountants.

1. At the close of business on the date listed above, our records indicated the following deposit balance(s):

ACCOUNT NAME ACCOUNT NO. INTEREST RATE BALANC


E*

2. We were directly liable to the financial institution for loans at the close of business on the date listed above as follows:

ACCOUNT DATE THROUGH


NO. / BALANCE* DATE DUE INTEREST WHICH DESCRIPTION OF
DESCRIPTIO RATE INTEREST IS COLLATERAL

(Customer's Authorized Signature) (Date)

The information presented above by the customer is in agreement with our records. Although we have not conducted a
comprehensive, detailed search of our records, no other deposit or loan accounts have come to our attention except as noted below.

(Financial Institution Authorized Signature) (Date)

(Title)

EXCEPTIONS AND/OR
COMMENTS

Please return this form directly to our accountants:


[ ]

[ ]
* Ordinarily, balances are intentionally left blank if they are not available at the time the form is prepared.
Approved
1990 by American Bankers Association, American Institute of Certified Public Accountants, and Bank Administration
Institute. Additional forms available from: AICPA – Order Department, P.O. Box 1003, NY, NY 10108-1003 D 451 5951
V. RISKS TO CONSIDER
The auditor should be alert to the following risks related to the revenue and expenditure cycles.
A. INCENTIVE/PRESSURES
a. Pressure to overstate revenues to achieve EPS targets.
b. Pressure to overstate sales and/or receivables in order to improve the balance sheet
and liquidity ratios.
c. Pressure to understate liabilities in order to improve the balance sheet and liquidity
ratios.
B. POTENTIAL MISSTATEMENTS
a. Recording fictitious sales (existence assertion).
b. Holding open the sales journal to include next year's sales (improper cutoff).
c. Shipping goods that were not ordered at or near year-end (goods are generally
returned in the following period).
d. Failure to record payments.
C. OTHER POTENTIAL PROBLEMS
1. Errors
The possibility of errors may be increased due to the high volume of transactions that
flow through the sales, receivables, purchases, payables, and cash accounts.
2. Theft of Cash Collections
Sales adjustments (such as overstating discounts, recording fictitious returns, lapping
the accounts receivable, or improperly writing off customer balances) may be used to
conceal thefts of cash collections.
3. Omission
Existing sales and purchases may not be recorded (completeness assertion).
AUDI
T AUDIT DOCUMENTATION
DOCUMENTA
TION

I. GENERAL
Audit documentation (also referred to as "working papers") is the principal record of audit
procedures performed, evidence obtained, and conclusions reached.
A. PURPOSE
The purpose of audit documentation is to provide:
1. Support for the auditor's report, including evidence that the audit was conducted in
accordance with generally accepted auditing standards.
2. Assistance in planning, conducting, and supervising the audit.
3. Accountability, emphasizing that the audit team is responsible for its work.
4. Information that may be useful for future audits, quality control reviews, or peer
reviews.
B. REQUIREMENTS
Audit documentation should:
1. Provide a record of accumulated evidence and the results of audit tests and
procedures;
2. Be prepared in enough detail so that an experienced auditor who has no previous
connection with the audit can understand the audit procedures performed, the evidence
obtained, the conclusions reached, and how the accounting records reconcile with the
financial statements;
3. Demonstrate compliance with the standards of fieldwork by showing that the work
performed was adequately planned and supervised, that a sufficient understanding of
the entity and its environment was obtained, and that sufficient appropriate audit
evidence was obtained to provide a reasonable basis for the opinion;
4. Include identifying characteristics of the specific items tested;
5. Enable reviewers to understand the work performed and the evidence obtained;
6. Include documentation of departures from mandatory GAAS requirements, including
justification for the departure and how appropriate alternative procedures were used to
achieve audit objectives;
7. Identify both the staff who performed the work and the staff who reviewed the work, as
well as the dates associated with each;
8. Contain proper indexing and cross-referencing; and
9. Indicate proper identification of client, purpose, and period covered.
C. RETENTION
1. Audit Documentation
Audit documentation is the property of the independent auditor, and while it may
sometimes be useful to the client, it is not considered to be part of the client's
accounting records.
2. Report Release Date
The "report release date" is defined as the date on which the auditor grants the client
permission to use the report. Often, this is the date on which the report is delivered to
the client.
a. Auditing standards require that audit documentation be retained for at least five
years from the report release date.
b. The PCAOB requires auditors of public companies to keep audit documentation
for seven years from the report release date.
3. Documentation Completion Date
The auditor is granted a certain window of time following the report release date, in
which to assemble the final audit documentation file. The end of this window is
referred to as the "documentation completion date." After this date, existing
documentation must not be deleted, and additions to the workpapers must be
documented as such.
a. Auditing standards require the final audit documentation file to be assembled
within 60 days following the report release date.
b. The PCAOB defines the documentation completion date as 45 days following
the report release date, and requires preparation of an "engagement completion
document" identifying all significant findings and issues. Also, under PCAOB
standards, if work is performed by another auditor, the office issuing the report
must obtain, review, and retain certain audit documentation from the other
auditor.
4. Safekeeping of Audit Documentation
Reasonable precautions should be established for the safekeeping of audit
documentation, as it is the proof that a professional audit was performed. The SOX Act
of 2002 imposes tough penalties for failure to retain workpapers or for the destruction
of records.
a. The auditor should establish appropriate controls for audit documentation to
protect its integrity, prevent unauthorized changes, etc.
D. NATURE AND EXTENT OF AUDIT DOCUMENTATION
Audit documentation may be in paper form, electronic form, or other media. Oral
explanations alone are insufficient, but may be used for clarification of information included in
the audit documentation.
The specific quantity, type, and content of audit documentation are based on the auditor's
judgment. In determining the nature and extent of documentation for a specific area, the
auditor should consider:
1. The risk of material misstatement;
2. The extent to which judgment was required in performing the work and evaluating the
results;
3. The nature of the specific auditing procedure;
4. The significance of the evidence obtained;
5. The nature and extent of any problems identified; and
6. The need to document conclusions that may not be obvious.
E. SPECIFIC CONTENTS
The form and content of audit documentation can vary, but it should be designed to meet the
circumstances of the particular engagement. Generally, audit documentation will consist of a
permanent or continuous audit file and a current file.
1. Permanent (Continuous) File
The permanent file includes audit documentation that has a continuing interest from
year to year (such as contracts, pension plans, leases, stock options, bylaws, articles
of incorporation, minutes of meetings, bond indentures, and internal information).
2. Current File
The current file contains all audit documentation applicable to the year under audit, and
generally includes the following audit documentation:
a. The audit plan (audit program).
b. Financial statements and the auditor's report.
c. Working trial balance, adjusting journal entries, and reclassification entries.
d. Letters of confirmation and representation (e.g., letters from attorneys, a
management representation letter, and confirmation responses).
e. Analyses, worksheets, issues memoranda, and schedules or commentaries
prepared or obtained by the auditor. Note that related accounts, such as notes
receivable and interest income, are often analyzed together.
f. Abstracts or copies of entity documents, such as contracts or agreements
examined to evaluate the accounting for significant transactions.
g. Summaries of significant audit findings or issues (see below), actions taken, and
conclusions reached.
h. Records of tests of controls and substantive tests that include identification of
specific items selected for testing (i.e., the source from which the items were
selected and specific selection criteria).
3. Significant Audit Findings
Audit documentation should include significant audit findings, actions taken, and
conclusions reached. Significant audit findings include matters that:
a. Are related to the selection and application of accounting principles (and the
consistency with which they are applied), especially those involving complex or
unusual transactions, or estimates and uncertainties.
b. Are related to possible material misstatements in the financial statements.
c. Suggest a need to revise the auditor's previous risk assessment.
d. Cause significant difficulty in applying necessary audit procedures, or indicate
the need for significant revision of planned audit procedures.
e. May result in modification to the auditor's standard report.
f. Result in audit adjustments or corrections identified by the auditor that are
material, either individually or when aggregated.
Note that the auditor should document discussions with management regarding
significant findings, including when and with whom the discussions occurred. Also, if
the auditor has identified information that is inconsistent with his or her final conclusion
regarding a significant finding, the auditor should document how such contradictory
evidence was addressed.
4. Other Documentation Requirements
Specific audit documentation may also be required by other auditing standards, such
as those related to the consideration of internal control, the consideration of fraud risk
factors, etc.
5. Tickmarks
Auditors often use tickmarks, or symbols indicating the work that has been performed.
Audit documentation should include explanations of any tickmarks used.

ABC Company
Bank Reconciliation
December 31, 20XX
Cash balance per bank $ 275,000 √
Add: deposits in transit
27 - Dec $ 8,490 Δ
29 - Dec 3,000 Δ
30 - Dec 2,500 Δ 13,990 И

Less: outstanding checks


#34582 $ 2,456 Φ
#34584 1,300 Φ
#34585 1,414 Φ 5,170 И

Cash balance per books $ 283,820 И ▲

Tickmark Legend
√ Agreed to 12/31 bank statement
Δ Agreed to deposit ticket
И Footed
Φ Agreed to voucher register
▲ Agreed to cash balance in general ledger

F. CONFIDENTIALITY
Audit documentation is the property of the auditor, and the information compiled therein is
confidential. Rule 301 of the Code of Professional Conduct states that "a member in public
practice shall not disclose any confidential client information without the specific consent of
the client." The auditor should adopt reasonable procedures to maintain confidentiality and
prevent unauthorized access to audit documentation. There are several situations in which
audit documentation can be provided to someone else without the client's permission:
1. If audit documentation is used as part of a voluntary quality review program under the
auspices of the AICPA or state society of CPAs.
2. If audit documentation is subpoenaed by a court.
3. If audit documentation is needed as part of an official investigation being conducted by
the AICPA, a state CPA society, or under State Board of Accountancy authorization.
4. If audit documentation is needed to respond to an official inquiry made by the AICPA, a
state CPA society, or a State Board of Accountancy (i.e., for the CPA's defense).
AUDIT EVIDENCE

I. GENERAL
Audit evidence is all the information the auditor uses to arrive at the conclusions on which the audit
opinion is based. It includes information in written or electronic form as well as observable assets
or activities, and it must be obtained to support auditor conclusions with respect to risk assessment,
tests of controls, and substantive testing. Some of the specific evidence applicable to individual
transaction cycles was covered previously. The use of sampling to collect audit evidence will be
discussed in Auditing & Attestation 5.

AUDIT EVIDENCE

II. TYPES OF AUDIT EVIDENCE


Audit evidence consists of underlying accounting records and corroborating evidence. The auditor
should have access to all pertinent accounting data and corroborating audit evidence.
A. UNDERLYING ACCOUNTING RECORDS
This type of audit evidence consists of records of initial entries and any supporting records.
For example, accounting records include checks, records of electronic fund transfers,
invoices, contracts, ledgers, journal entries, and worksheets. The auditor tests the
accounting records through analytical procedures and substantive tests, such as retracing
procedural steps, recalculation, and reconciliation. Note that accounting records alone do not
provide sufficient support for the audit opinion. However, internal consistency among the
accounting records provides some evidence that the financial statements are presented fairly.
B. CORROBORATING EVIDENCE
Corroborating evidence includes minutes of meetings, confirmations, industry analysts'
reports, data about competitors, and information obtained through observation, inquiry and
inspection. Corroborating evidence provides additional support and gives validity to the
recorded accounting data.
C. EVIDENCE IN ELECTRONIC FORM
In certain entities, some of the accounting records or corroborating evidence may be
available only in electronic form. Source documents may be replaced by electronic
messages, or business may be transacted electronically. While electronic evidence may be
initially available, it may not be retrievable indefinitely. The auditor should therefore consider
the time during which information exists or is available in determining the nature, extent, and
timing of auditing procedures.
III. THIRD STANDARD OF FIELDWORK
The third standard of fieldwork states:

"The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to
afford a reasonable basis for an opinion regarding the financial statements under audit."

A. REASONABLE BASIS FOR AN OPINION


The audit evidence must persuade the auditor that the ending balances in the financial
statements are fairly presented. The audit provides reasonable assurance regarding the
fairness of the financial statements. The auditor is not a guarantor, and, in most cases, cost-
benefit considerations prohibit an examination of 100% of the accounting data. Therefore, it
generally will not be practical or possible to obtain assurance beyond all doubt, and the
auditor usually must rely on evidence that is persuasive, rather than conclusive. Persuasion
is a subjective concept and relates uniquely to each audit.
Note that while the 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 for which there is no appropriate alternative. Thus, the auditor must exercise
professional judgment in determining the procedures to be performed and the sufficiency and
appropriateness of the evidence gathered.
B. SUFFICIENCY OF AUDIT EVIDENCE
Sufficiency refers to the quantity of audit evidence. The auditor must use professional
judgment in determining the amount and kinds of evidence sufficient to support an opinion.
As mentioned previously, judgments about materiality and audit risk underlie this
determination. The amount of evidence gathered directly affects the level of detection risk,
which is the risk that the auditor's evidence-gathering procedures will not be sufficient to
support the financial statement assertions. The auditor's decision regarding the sufficiency of
evidence is influenced by:
1. The risk of material misstatement: greater risk implies more evidence will be required.
2. The quality of audit evidence: less audit evidence may be required when that evidence
is of higher quality.
Note that even if it is conclusive, evidence regarding a small portion of a balance or a single
transaction would generally be insufficient to support the entire balance. For instance,
overwhelming evidence of the existence of a $500 account receivable would not be sufficient
to substantiate a total accounts receivable balance of $1,000,000.
C. APPROPRIATENESS OF AUDIT EVIDENCE COMPETE
NT
Appropriate audit evidence must be both reliable and relevant. The EVIDENCE
appropriateness of evidence depends on its being pertinent, objective, timely, and
corroborated by other evidence.
1. Reliability of Evidence VALIDI
TY

Reliability of audit evidence is dependent on the circumstances under which it is


gathered. Reliability of evidence is also influenced by its source and nature.
a. Auditor's Direct Personal Knowledge
Any evidence obtained directly by the auditor (i.e., through observation, physical
examination, inspection, or recalculation) provides more persuasive evidence
than evidence obtained indirectly.
b. External Evidence
External evidence obtained from independent sources outside the enterprise
provides greater assurance of reliability than internally generated evidence.
There are two types of external evidence:
(1) Evidence sent directly to an independent auditor; and
(2) Evidence received and held by the client.
Evidence sent directly to the auditor (e.g., a bank confirmation) is more valid than
evidence received and held by the client.
c. Importance of Effective Controls
Internal evidence generated within the enterprise is not as reliable as external
evidence, but strong, effective internal controls improve reliability. Internal
evidence includes purchase orders, sales orders, general ledgers, and
management reports.
d. Documentary Evidence
Audit evidence in documentary form is more reliable than oral evidence, and
original documentation is more reliable than photocopies or faxes. Oral evidence
consists of statements made by clients concerning the procedures involved in a
given transaction, often resulting in the explanation of an account balance. Oral
evidence is the least reliable form of evidence.
e. Consistency of Evidence
When audit evidence obtained from different sources is consistent, a greater
degree of assurance is provided.
f. Information Produced by the Client
If the auditor intends to use information produced by the client, evidence must be
obtained about the accuracy and completeness of such information.
2. Relevance of Evidence

RELEVA Evidence must relate to the financial statement assertion under consideration. For
NCE example, accounts receivable confirmations are relevant to the existence of
receivables, not to their valuation (i.e., a customer can confirm that a receivable exists,
but this does not necessarily imply that the customer has the intent or the ability to
pay).
D. EVALUATION OF AUDIT EVIDENCE
The evaluation of audit evidence must take into consideration the achievement of audit
objectives. The auditor must be unbiased in this evaluation, considering all evidence
regardless of whether it conflicts with the financial statements.
If the auditors have doubts about a material assertion, they are required to gather sufficient
evidence to eliminate the doubt or they must express a qualified opinion or disclaimer of
opinion.
IV. SUBSTANTIVE PROCEDURES SUBSTANTIVE
Substantive procedures consist of: (i) tests of details (as applied to transactions, PROCEDURES
balances, and disclosures), and (ii) substantive analytical procedures. These tests
are designed to substantiate the validity of management's assertions regarding the financial
statements.
A. TESTS OF DETAILS
Tests of details consist of audit procedures used to gather evidence to support the account
balances as reflected in the financial statements. Tests of details are performed on ending
balances, the details of transactions, or a combination of the two. If an account has a high
turnover rate with many transactions occurring during the year, the auditor generally will
concentrate more on the ending balance total. When this approach is used, the auditor must
be satisfied that internal control is strong. An alternative approach is to test the details of
transactions. This approach is employed when the account being substantiated has relatively
few transactions occurring during the year (e.g., an account for land or treasury stock). One
approach need not be used exclusively, and a combination of the two might be appropriate.
For example, during an audit of the sales revenue account, the auditor might use procedures
to substantiate the ending balance while also performing extensive procedures on samples of
transactions and related accounts (e.g., cash receipts and accounts receivable).
1. Examples of Substantive Procedures
The auditor may test the details supporting financial statement amounts and
disclosures through inspection, observation, inquiry, confirmation, recalculation,
reperformance, etc. Tests of details are discussed in greater detail later in this chapter.
B. ANALYTICAL PROCEDURES
Analytical procedures are evaluations of financial information made by a study of plausible
relationships among both financial and nonfinancial data, and they generally involve
comparisons of recorded amounts to independent expectations developed by the auditor.
Ratios, percentages, comparisons of actual to budget, and other comparisons may be used
to establish expected relationships, and the auditor then looks for unusual relationships,
discrepancies, or variances.
1. Use of Analytical Procedures
As discussed in Auditing & Attestation 3, the auditor must use analytical procedures for
planning and overall review in all audits, and also may decide to use analytical
procedures as substantive tests.
The following chart summarizes the use of analytical procedures:

Phas Requirement Purpo


e se
Planning Required To assist the auditor in planning the nature,
extent, and timing of other auditing
procedures.
Used for risk measurement to alert the
auditor to problem
areas requiring attention. This serves
Substan Not required As a substantive test to obtain audit
tive evidence about specific management
procedu assertions related to account balances or
res transactions.
The evidence is circumstantial and
generally, additional
corroborating evidence (such as
Final review Required To assist the auditor in the final
review of the overall reasonableness
of account balances.
Note: In recent years there has been an increased emphasis on the use of analytical
procedures.

ANALYTICAL
PROCEDURES

V. ANALYTICAL PROCEDURES
A. PROCEDURES
1. Comparisons of Financial Data
Analytical procedures generally include a review of the current and prior year's financial
statements and the current year's budget. Comparisons are made between the current
year's actual and budgeted financial statements, and between the current year's actual
and prior year's actual financial statements. Comparisons are also made within the
current year's financial statements for internal consistency. For example, net income
on the income statement should agree with the increase in retained earnings on the
statement of retained earnings.
2. Auditor Expectations
The auditor also develops independent expectations for comparison to recorded
amounts. These expectations may be developed based on:
a. Financial information for comparable prior periods;
b. Anticipated results from budgets and forecasts;
c. Relationships among data within the current period;
d. Industry norms; and
e. Relationships of financial data with nonfinancial information.
B. ANALYTICAL PROCEDURES USED AS SUBSTANTIVE TESTS
In certain situations, analytical procedures are a more effective means of gathering evidence
than tests of details, and in those cases, analytical procedures may be used as substantive
tests.
1. Efficiency and Effectiveness of Analytical Procedures
The efficiency and effectiveness of analytical procedures in detecting potential
misstatements depends, among other things, on the following four factors.
a. Nature of the Assertion Being Tested
Analytical procedures are most effective and efficient for assertions in which
potential misstatements are not apparent from an examination of the detailed
evidence or when such detail is unavailable.
b. Plausibility and Predictability of the Data Relationship
In order to use analytical procedures as a substantive test, the auditor must have
a clear understanding of the relationships among data. It is possible that data
may appear to be related when in fact they are not, and failure to properly
understand such situations may lead to erroneous conclusions.
In order to provide an appropriate level of assurance, analytical procedures
should be based on predictable relationships. More predictable relationships are
provided by data generated in a stable, rather than dynamic, environment;
involving income statement, rather than just balance sheet accounts; and
involving transactions that are less subject to management discretion.
c. Availability and Reliability of Data Used to Develop the Expectation
Data used by the auditor to develop expectations should be both readily
available and reliable. Reliability of data is enhanced if it is obtained from
external rather than internal sources, obtained from independent internal sources
(i.e., unrelated to those who are responsible for the amount being audited),
generated under effective internal controls, audited previously, and obtained from
a variety of sources.
d. Precision of the Expectation
More precise expectations are more effective in detecting misstatements. An
expectation is more precise when it is developed at a sufficiently detailed level,
and when there is effective identification and consideration of factors that
significantly influence the relationship.
2. Documentation Requirements
When an analytical procedure is used as the principal substantive test of a significant
financial statement assertion, the auditor is required to document the:
a. Auditor's expectation.
b. Factors considered in the development of the expectation.
c. Results of the comparison of the expectation to recorded amounts.
d. Additional audit procedures performed in response to significant unexplained
differences.
e. Results of such additional procedures.
C. RATIO ANALYSIS
In performing analytical procedures, recorded amounts are compared to expectations
developed by the auditor. The auditor may also choose to compare ratios developed from
recorded amounts to expected ratios developed by the auditor. A complete review of
pertinent ratios is included in the Appendix to this chapter.
D. INVESTIGATION OF SIGNIFICANT DIFFERENCES
Analytical review procedures may indicate a possible material misstatement, and therefore
the auditor should investigate any significant differences or unusual items that arise. The
auditor should reconsider the manner in which the expectation was developed, make
inquiries of management, and if necessary, expand audit procedures. If no adequate
explanations can be obtained, the auditor should obtain sufficient appropriate evidence about
the related assertion by performing alternative substantive procedures.
E. ANALYTICAL PROCEDURES USED AS AN OVERALL REVIEW

OVERA Analytical procedures are also applied during the overall review stage of an audit. Generally,
LL a manager or partner who has a comprehensive knowledge of the client's business and
REVIE industry performs this review.
W
The purpose of applying analytical procedures during the overall review stage of an audit is to
evaluate the overall financial statement presentation and to assess the conclusions reached.
The auditor should determine whether adequate evidence has been gathered in response to
unusual or unexpected balances identified during the audit. The auditor may also discover
additional unusual or unexpected balances during this overall review, and should consider
whether additional audit procedures are warranted.
F. LIMITATIONS OF ANALYTICAL PROCEDURES
Analytical review comparisons are based on expected plausible relationships among data.
Differences do not necessarily indicate errors or fraud, but simply indicate the need for further
investigation. Changes in an account, changes in accounting principle, and inherent
differences between industry norms and the client all contribute to fluctuations in expected
amounts.

VI. TESTS OF DETAILS


A. DIRECTIONAL TESTING
TESTS Directional testing refers to testing either forward or backward. Tracing forward from source
OF documents to journal entries provides evidence of completeness. Vouching backward from
DETAI
LS journal entries to source documents provides evidence of existence. For instance, if
evidence were being gathered relative to the completeness assertion for sales, the auditor
would want to verify that all sales were being recorded on the income statement. The auditor
would focus attention on sales invoices and supporting documents such as customer
purchase orders and client shipping documents, and then trace forward through the
accounting system up to the income statement. On the other hand, if the possibility of
overstated sales (the existence assertion) were being addressed, the auditor would focus
attention on the income statement (all recorded sales) and then vouch backward through the
ledger and journals and ultimately to the supporting source documents such as customer
purchase orders and related shipping documents.
V O U
C H
Testing for
Existence
Testing for
Support

ouch

Financial
Statements
Trial Balance
General
Ledger
Subsidiary
Ledger
Books of
Original Entry
Source
Documents
Execution of
Event
Transaction
Approved

rac
e
T R A
C E
Testing for
Completeness
Testing for
Coverage

PASS
KEY
Many exam questions require the candidate to determine which assertion is being tested
by a specific audit procedure. Remember that if a test starts with items in the accounting
records, the proper assertion is most likely to be existence – the auditor searches for
evidence indicating that the item truly exists and has not been created by management.
On the other hand, if a test starts with source documents, it is most likely related to the
completeness assertion, since the goal is probably to make sure all transactions (as
identified by the source documents) have been included in the accounting records.

B. STANDARD AUDITING PROCEDURES


In performing an audit, the auditor gathers evidence using a variety of procedures to
accomplish specific objectives. Sampling, which will be covered in Auditing & Attestation 5, is
an aspect of the performance of most audit procedures. The specifics for the sampling plan
(objective, population, sample size, method of selection) are included in the audit plan for
each procedure and are documented along with the results and evaluation of the results.
The following standard procedures are used in every audit as risk assessment procedures,
tests of controls, or substantive tests:
1. Footing, Crossfooting, and Recalculation
An auditor may verify the mathematical accuracy of statements and schedules by
adding down (footing), adding across (crossfooting), or recomputing amounts included
therein. For example, the auditor may substantiate the valuation of financial accounts
and the allocation of items such as depreciation, amortization, and accruals by
recomputing those items.
2. Inquiry
Inquiry consists of requesting information from knowledgeable parties both internally
(e.g., managers and supervisors) and externally (e.g., attorneys and bankers).
Examples include inquiries about pending litigation or pledged or obsolete inventories.
Inquiry is used extensively throughout most audits, but since inquiry alone is generally
considered insufficient, it is most often used in conjunction with other audit procedures.
In using inquiry, the auditor should:
a. Consider the specific characteristics (knowledge, objectivity, qualifications, etc.)
of the person to whom the inquiry is directed.
b. Ask appropriate questions.
c. Evaluate the response and take appropriate action (e.g., following up with
additional inquiry, modifying planned audit procedures, etc.)
3. Vouching
Vouching is directional testing in which the auditor examines support for what has been
EXISTEN recorded in the records and statements, going from the financial statements back to
CE
OCCURRE
supporting documents. The objective of vouching is to gather evidence regarding
NCE possible overstatement errors (the existence or occurrence assertions).
4. Examination / Inspection
The auditor may inspect or examine records, documents, or tangible assets. Records
or documents may be internal or external, and may be in paper or electronic form.
Inspection or examination generally provides evidence about the existence assertion,
rather than about ownership, rights, obligations, or valuation. Examination may also
provide evidence of the exact terms of contracts, loans, and commitments. The
procedure of inspecting documents is often referred to as examination of evidence, and
includes the activities of scanning, scrutinizing, and reading. For example, the auditor
may scan or scrutinize entries in general ledger accounts for a period, looking for
evidence of unusual amounts or unusual sources of input, which, if found, would be
investigated further. Or, the auditors may read the minutes of the board of directors
meetings for authorization of treasury stock transactions.
5. Confirmation
Confirmation is a specific type of inquiry that involves obtaining representations from
independent third parties about account balances and transactions or events.
Confirmations are controlled by the auditor in that the auditor selects the parties to be
contacted, prepares and mails the confirmation requests, and receives the responses
directly from the third parties. Examples include bank confirmations of the amount on
deposit or of a loan outstanding, or a confirmation from a customer regarding the
existence of a receivable balance at a certain date.
6. Analytical Procedures
Analytical procedures consist of evaluations of financial information made by a study of
meaningful relationships among data, to help highlight unusual fluctuations that could
be the result of errors or fraudulent omissions or overstatements. Scanning may also
be considered an analytical procedure, as the auditor uses professional judgment to
search for large, significant, or unusual items in the accounting records.
7. Reperformance
Reperformance occurs when an auditor independently performs procedures or controls
that were originally performed as part of an entity's internal control.
8. Reconciliation
Reconciliation substantiates the existence and valuation of accounts. It involves
comparing financial amounts from two independent sources for agreement, such as
reconciling the physical inventory count with the perpetual inventory records. Other
examples include reconciling the cash balance per the books with the balance per
bank, and reconciling lead schedules to general ledger amounts.
9. Observation
Observation occurs when an auditor looks at a process or procedure performed by
others. For example, at the beginning of an audit, the auditor may tour the client's
facilities to gain an understanding of the client's business, or the auditor may observe
the client's employees taking a physical inventory to obtain firsthand knowledge
regarding ending inventory.
Note that while observation provides the auditor with direct personal knowledge, the
evidence provided applies only to the point in time during which the observation
occurred. The auditor should also be aware that a process or procedure may be
performed differently when the client is aware that that the auditor is observing.
10. Tracing COMPLETENESS
As with vouching, tracing is directional testing. However, tracing is
looking for coverage in the opposite direction from vouching. Tracing starts with the
source documents and traces forward to provide assurance that the event is being
given proper recognition in the books and records. The objective of tracing is to gather
evidence regarding possible understatement errors (the completeness assertion).
11. Subsequent Events Review
The auditor is required to perform certain procedures for the period after the balance
sheet date up to the date of the auditor's report. Evidence not available at the close of
the period often becomes available before the auditors complete their fieldwork and
write their report. For example, the bankruptcy of the auditor's client's customer shortly
after the balance sheet date indicates that the financial strength of the customer had
probably deteriorated before year-end. The settlement of a pending lawsuit constitutes
evidence that a real (rather than a contingent) liability may have existed at year-end.
Decreases in long-term debt occurring after year-end may indicate that such debt
should be reported as a current liability on the balance sheet. Evidence becoming
available after the balance sheet date should be used in making judgments about the
valuation of assets and liabilities on the balance sheet date.
12. Other Procedures
Other common procedures include:
a. Performing a cutoff review of year-end transactions, especially inventory, cash,
purchases, sales, and accruals;
b. Auditing related accounts simultaneously, such as auditing long-term liabilities
with interest expense, capital additions to plant and equipment with repairs and
maintenance expense, and investments with dividend and interest income;
c. Requesting a comprehensive management representation letter; and
d. Reading pertinent information, such as the minutes of the board of directors'
meetings, shareholder meetings, and management committee meetings.

PASS
KEY
Candidates should try to use proper auditing terminology. If a question asks for audit
procedures, words such as foot, crossfoot, inquire, vouch, examine, inspect, review,
confirm, analyze, recalculate, reconcile, observe, and trace should be used.
C. MATCHING AUDITING PROCEDURES TO SPECIFIC ASSERTIONS
A workable outline for developing an audit plan uses the financial statement assertions
approach. Although audit procedures for each account vary significantly, a generic
framework can be developed using the financial statement assertions. Certain audit
procedures relate specifically to financial statement assertions:

Assertion Auditing Procedure

Completeness 1. Tracing of transactions forward, starting from


source documents through their accounting
recognition and ultimately to the financial
statements. Notice that this directional testing is the
opposite of the directional testing for the
existence/occurrence assertion.
2. Analytical review procedures. The auditor should
consider how certain items might be omitted from
the account balance, such as unrecorded liabilities
Proper Period 1. Cutoff procedures analyzing end-of-year
Cutoff transactions of the account and related accounts to
ascertain proper accounting period recognition. For
example, the auditor might examine transactions
occurring just before or just after year-end.
Accuracy 1. Inspection of documentation supporting
transactions.
2. Footing and crossfooting of schedules.
Classification
1. Inspection of documentation supporting
transactions.
Occurrence 1. Vouching of transactions from financial
statements back to supporting documents.

Allocation and 1. Independent recalculation. Examples would be


Valuation aging of accounts receivable to substantiate the
value of the allowance account, or the
recalculation of depreciation charges. A prime
area for recalculation is estimates made by the
client.
Rights and 1. Inspection of documentation supporting
Obligations transactions, inspection of contracts, etc.

Existence 1. Confirmation of accounts with third parties.

2. Observation, inspection, and examination of


assets, processes, and procedures. (These provide
very persuasive forms of evidence.)
Understanda 1. Review of all related disclosures for compliance with
bility and GAAP.
Classification
2. Inquiry of management regarding disclosures
for the account and for related accounts.
This basic financial statement assertion outline is by no means a complete audit plan, but it
does provide a good starting point when addressing audit plans for a given account.
EVIDENTIAL PROCEDURES FOR SELECTED ACCOUNTS

I. INVENTORY
INVENTORY
A. INTERNAL CONTROL
Proper internal control over inventory includes adequate safeguarding of inventory and
proper segregation of duties. Separate people should be responsible for the authorization,
execution, receiving, recording, and cash disbursement functions.
The following duties should be segregated:
1. Purchasing
Serially numbered, properly approved purchase orders should be prepared and issued
to the accounting and receiving departments.
2. Receiving
The receiving department is solely responsible for the receipt of goods. This
department is responsible for verification of quantities received, detection of damaged
goods, preparation of a receiving report, and delivery of goods received to the storage
department. The receiving department should receive a copy of the purchase order
with the amounts blackened out.
3. Storage
This department acts as custodian for the verified quantity of goods received.
4. Shipping
The shipping department is responsible for shipment of goods after authorization (in
the form of an approved sales order from the credit department).
B. OBSERVATION NECESSARY
The observation of (beginning and ending) physical inventory counts is a required generally
accepted auditing procedure. An auditor who is not present to observe the physical inventory
must use alternative procedures to justify any opinion expressed. This is acceptable when it
is impractical or impossible to observe physical inventory, or when inventories are not
material.
An auditor's observation procedures with respect to well-kept perpetual inventories that are
periodically checked by physical counts may be performed before, during, or after the end of
the audit period. If, on the other hand, the assessed level of control risk is high, the
observation procedures should be performed at year-end.
The auditor should observe the physical inventory count of goods held in public warehouses
if the inventory held therein is significant; otherwise, confirmation of such inventory is
sufficient.
The auditor should also observe and make inquiries regarding proper segregation of duties.

PASS
KEY
Candidates sometimes believe that "inventory observation" implies that the auditor
counts the client's inventory. This is not the case – the client counts the inventory, and
the auditor simply observes. The auditor may make test counts of certain items, which
he or she will later try to trace to inclusion in a client-prepared inventory schedule, but
generally the auditor would not count the client's entire inventory.
C. CALCULATION
The auditor should test the physical inventory report by tracing test counts taken by the
auditor to the report, thereby verifying its completeness. The auditor should also test the
mathematical accuracy of the report, and should reconcile it to the general ledger inventory
accounts. For the completeness of inventory, the auditor also traces from prenumbered
inventory tags to the physical inventory report sheets. (For existence, the direction of the
testing is reversed.)
D. CONSIGNED GOODS
The auditor should ascertain that consigned inventory on hand is excluded from the physical
inventory count, whereas consigned goods in the hands of customers are included in
inventory balances.
E. RELATED ACCOUNTS
The auditor should perform simultaneously procedures for related accounts such as
inventories, purchases, sales, sales returns and allowances, and cost of goods sold.
F. CUTOFF PROCEDURES
A review of year-end purchases and sales must be made to ensure that transactions were
recorded in the proper accounting period. (This tests completeness or occurrence,
depending on the direction of testing.)
1. Purchases
The auditor should examine purchase invoices and receiving reports for several days
before and after year-end.
2. Sales
The auditor should examine sales invoices and compare them to shipping documents
(noting dates and terms) for several days before and after year-end.
G. CONFORMANCE
The auditor should determine whether the client's presentation of inventories is in conformity
with GAAP, including whether lower of cost or market principles were properly applied. The
auditor should also inspect agreements to determine whether inventory is pledged or subject
to liens, and whether such situations are properly disclosed.
H. ANALYTICAL REVIEW
The auditor must exercise professional judgment concerning the overall presentation of
inventories in the financial statements. This includes evaluating the overall reasonableness
of the amounts, disclosure of pricing methods, and performance of ratio analysis. In addition,
the auditor should determine whether the inventories have been properly classified in the
financial statements.
I. OBSOLETE OR DAMAGED GOODS
The auditor should inquire about obsolete or damaged goods, scan the perpetual records for
slow-moving items, and be alert during inventory observation for damaged goods or signs of
obsolescence. (This tests valuation.)
J. VALUATION
The auditor should examine vendor invoices, review direct labor rates, test the computation
of standard overhead rates, and examine standard cost variance analyses.
II. ACCOUNTS RECEIVABLE CONFIRMATIONS RECEIVAB
LE
The auditor should review the accounts receivable schedule for accuracy and CONFIRMATI
ONS
collectibility. Confirmation is considered a required generally accepted auditing procedure unless:
(i) receivables are immaterial, (ii) confirmation would be ineffective, or (iii) inherent and control risks
are very low and evidence provided by other procedures is sufficient to reduce audit risk to an
acceptably low level. If confirmations are not sent, the auditor must document how omission of this
procedure was overcome.
A. POSITIVE CONFIRMATIONS
Positive confirmations are those where the auditor requests a response from the recipient.
Generally, the auditor sends (to the client's customer) a confirmation stating the amount
owed. The customers are requested to return a statement to the auditor indicating whether
they agree with the amount, or providing information about any exceptions. Positive
confirmations should be used when there are large individual accounts, expected errors, or
items in dispute, and when internal control is weak.
Note that positive confirmations may also be "blank," which means that the recipient is
requested to fill in the balance. Blank forms provide a greater degree of assurance (since the
recipient cannot simply sign off without actually checking the balance) but may also result in
lower response rates because a greater effort is required for response.
Confirmation responses received electronically (e.g., faxes, e-mails) should be verified by
calling the sender. The sender should also be requested to mail the original confirmation
directly to the auditor.
Non-responses should be followed up with second (and sometimes third) requests; the client
may also be asked to intervene. The auditor may also perform alternative procedures (such
as inspecting shipping documents or reviewing subsequent cash receipts) when confirmation
responses are not received. Alternative procedures may not be necessary if even a 100%
overstatement would be immaterial, as long as there is no unusual pattern to the
nonresponses.
The auditor should consider the types of information respondents will be readily able to
confirm. For instance, some accounting systems facilitate the confirmation of single
transactions rather than entire balances. In such cases, the auditor would either confirm
individual invoices or would include a client-prepared statement of account showing details of
the customer's account balance being confirmed.
Note that confirmations generally provide evidence regarding existence and rights and
obligations. They do not provide reliable evidence regarding valuation (e.g., customers may
confirm a balance owed despite an inability to pay) or completeness (e.g., customers may not
report understatement errors).
B. NEGATIVE CONFIRMATIONS
The auditor may send to a sample of customers another type of confirmation in which an
answer is requested only if the amount stated is incorrect. Negative confirmations should be
used when:
1. The combined assessed level of inherent and control risk is low;
2. A large number of small account balances are being confirmed; and
3. There is no reason to expect that recipients of the requests will ignore them.
Negative confirmations are somewhat less effective than positive confirmations because lack
of a response does not provide explicit verification of the existence of the receivable.
III. ACCOUNTS PAYABLE CONFIRMATIONS

PAYABL Confirmations may also be sent to creditor accounts. These confirmations are similar to
E those used for accounts receivable. Accounts payable confirmations are positive and
CONFIRMATI generally "blank" (i.e., they do not state a balance). The objective is to determine whether
ONS
accounts payable are understated.
Since good external evidence to support accounts payable is generally available, the use of
accounts payable confirmations is not required. Confirmations of accounts payable should be sent
when internal control is weak, when there are disputed amounts, or when monthly vendor
statements are not available. Typically, vendors with small or zero balances would be selected for
confirmation.
The major limitation of accounts payable confirmations is that they may only be sent to recorded
liabilities. If a material error were present in accounts payable, it would most likely involve
unrecorded liabilities; as such, no record would exist. On the other hand, unrecorded liabilities
generally surface eventually, as when unpaid vendors stop delivering goods.

IV. LONG-TERM INVESTMENTS

INVESTME Sufficient audit evidence must be obtained by the auditor for investments in debt and equity.
NTS These types of investments may be in the form of capital stock or other equity in trust, bonds
and other debt obligations, and loan and advance accounts. In particular, the auditor must
determine whether: (i) GAAP is consistently applied; (ii) gains and losses are accurately computed
and disclosed; (iii) investment income (interest and/or dividends) is properly reported; (iv) valuation
is fairly stated and properly disclosed; and (v) the investments, in fact, exist and are owned by the
entity under audit.
A. INTERNAL CONTROL
Internal control relating to investments requires strong segregation of duties. One person (or,
more commonly, the board of directors) should authorize the purchase or sale, another
person should act as custodian (preferably an independent third-party custodian, who has no
direct contact with entity employees, or joint control by two company officials), and a third
person should maintain the detailed record of investments.
B. AUDITOR'S ASSESSMENT OF RISK
The auditor must consider inherent risk and control risk in light of the specific circumstances
surrounding investments.
1. Inherent Risk
The auditor's assessment of inherent risk related to assertions surrounding securities
or derivatives may be affected by:
a. The complexities and evolving nature of certain types of transactions;
b. The potential for the occurrence of noncash transactions;
c. The entity's experience (or lack thereof) with the security or derivative;
d. The extent of the entity's reliance on outside expertise;
e. The sensitivity of assertions to external factors and risks;
f. The nature of particular transactions (e.g., whether they are freestanding
agreements or embedded within other agreements);
g. Whether the proper accounting treatment is determined based on management's
intent and ability; and
h. The extent to which assumptions about the future are required.
2. Control Risk
Control risk evaluation may encompass controls implemented by the entity and/or by
service organizations. Controls should include:
a. Proper authorization and approval;
b. Reconciliations to ensure accuracy; and
c. Continuous monitoring and review.
In some cases, where it is not practicable or possible to reduce audit risk to an
acceptable level otherwise, tests of controls may be necessary.
C. CONFIRMATION
Confirmations should be requested from the custodian for securities that are in the
possession of third parties. It is also advisable to send confirmations to the broker-dealer and
to counterparties concerning any unsettled transactions.
D. PHYSICAL INSPECTION
An examination of the securities on hand should be made to coincide with the examinations
of other liquid assets, such as cash. This procedure prevents the concealment of theft by
making it impossible for one asset to serve as a substitute for another (i.e., to conceal a
stolen asset). The face of the instrument should also be examined to determine if ownership
is correctly recorded. The auditor should record the details of the security count on a
worksheet, which should also include an acknowledgement by the client that the securities
were returned intact. If a safe-deposit box is used, the securities should be counted on the
balance sheet date, or the bank should be requested to seal the box until the count is later
completed.
E. CUTOFF PROCEDURES
A cutoff review should be performed to ensure that purchases, sales, and investment
revenue were recorded in the proper period.
F. CONFORMITY WITH GAAP
The auditor should review and evaluate the methods (cost or equity method) used to account
for, classify, and value securities. For investments using the equity method, the auditor
should examine the audited financial statements of the investee. Trading and available-for-
sale securities over which the investor has no significant influence should be carried at fair
value, and held-to-maturity securities should be carried at amortized cost. The auditor must
obtain evidence corroborating the quoted year-end fair market value by comparing assigned
values to prices published by various sources or obtained from a third party, such as an
independent broker-dealer or appraiser. Auditing fair values will be discussed further later in
this class.
1. Hedges
An entity may invest in derivatives to hedge against risks, such as the risk associated
with fluctuating prices. Under these circumstances, generally accepted accounting
principles specify that, in order to qualify for hedge treatment, the entity must
demonstrate and disclose a number of transaction features, including risk exposure.
The auditor would therefore need to examine the contracts to evaluate the character of
the hedge and the degree to which losses should be recognized in the determination of
income, as well as to determine the appropriate character of any disclosures.
G. COMPUTATIONS
Independent calculations should be made to determine the validity of recorded gains or
losses from security sales and of discount and premium amortization. In addition, a
recalculation should be made to determine the accuracy of recorded dividend and interest
income. Investment income from dividends may be recalculated by comparing recorded
income with dividend record books produced by investment advisory services such as
Moody's. Analytical procedures may also be used to test the reasonableness of dividend and
interest income.
H. MANAGEMENT REPRESENTATIONS
The auditor should inquire of management and obtain written representation concerning
management's intent and ability with respect to holding versus selling securities, and with
respect to the exercise of significant influence over investments.
I. BOARD MINUTES
The auditor should review the minutes of board of directors' meetings to ascertain that
company policy was followed and that securities were traded with proper authority.
J. REASONABLENESS
The auditor must assess the reasonableness and appropriateness of assumptions, market
variables, and valuation models, and of any decline in fair value.

PAYROLL

V. PAYROLL AND PERSONNEL


The auditor should review the payroll account to determine that only authorized people are being
paid and that they are being paid the right amounts. Time records for hourly employees should
also be verified. The auditor is mostly concerned with the valuation assertion (and will perform
recalculations of payroll amounts) and the rights/obligations assertion for any year-end accruals.
A. INTERNAL CONTROL
The most common errors that occur in the payroll and personnel cycle are the existence of
fictitious employees on the payroll and the falsification of hours worked.
1. Segregation of Duties
There should be a proper segregation of duties as follows:
a. Authorization to Employ and Pay
It is the function of the human resources department to hire new employees (on
the basis of requisitions from user departments) and to maintain the personnel
records containing hire date, department, salary, and position.
b. Supervision
All pay base data (hours, absences, time off, etc.) should be approved by an
employee's immediate supervisor.
c. Timekeeping and Cost Accounting
Data on which pay is based, such as hours worked or jobs completed, should be
accumulated independent of any other function.
Where there are employees who are paid by the hour, it is advisable to use time
clocks. Each department supervisor should compare the job time tickets with
employee clock cards that have been signed by the employee. Salaried
employees should prepare time sheets, which also require supervisory approval.
d. Payroll Check Preparation
The payroll department computes salary based on information received, for
example, total hours worked for hourly employees. This department is
responsible for issuing the unsigned payroll checks that are later signed by the
treasurer.

PASS
KEY
Remember that the payroll department is a recordkeeping department, not a custodial
department. While employees in this department compute salaries, create the payroll
register, and prepare unsigned checks, they should not have the authority to initiate
changes in hours or rates, nor should they have the ability to sign checks.

e. Check Distribution
The payroll checks should be distributed by a person who has no other payroll
function. In larger corporations, this individual is often referred to as the
paymaster.
The employees should be required to show some form of identification before
receiving their paychecks.
The internal auditing department periodically compares the personnel files with
the payroll files. This is to help ensure that only authorized payments have been
made in the proper amounts to appropriate personnel.
2. Control Procedures

P a. Prenumbering
Time cards, checks, and payroll change documents should be prenumbered and
accounted for.
A b. Authorization
Transactions should be initiated with proper authority.
(1) New hires should be properly documented.
(2) Pay rates should be authorized at the appropriate level.
(3) Deduction authorizations should be obtained from the employee.
(4) The personnel department should authorize all changes to the payroll
master file.
(5) The personnel department should keep personnel files on each employee.
(6) Terminations should be properly documented.
(7) Time cards (time clock) should be used to record time worked.
(8) Authorized signatures should be required on all payroll checks.
I c. Independent Check to Maintain Asset Accountability
(1) Calculation of payroll amounts should be internally verified.
(2) Account classification of payroll transactions should be internally verified.
(3) The accounting department should prepare a voucher for the amount of
the payroll based upon input from the payroll department.
(4) A bank reconciliation of the imprest payroll account should be prepared by
an individual independent of custody or recordkeeping functions.
(5) Unclaimed payroll checks should be returned to an independent individual
for follow up.
D d. Documentation
(1) All changes to payroll should be supported by authorized change
documents.
(2) Hours worked should be documented by approved time records.

T e. Timely and Appropriate Performance Reviews


(1) Employees handling cash disbursements should be bonded.
(2) Personnel should be rotated to different functions.
(3) Budgetary controls should be used to enhance internal control.
I f. Information Processing Controls
(1) General and application controls should be in place to ensure that payroll
transactions are valid, properly authorized, and completely and accurately
recorded.

P g. Physical Controls for Safeguarding Assets


(1) There should be no unauthorized access to IT programs and data.
(2) Unsigned checks should be locked up.
(3) The treasurer should sign the payroll checks. An imprest payroll account
should be used.
S h. Segregation of Duties
(1) Authorization: operating department and personnel department.
(2) Recording: payroll department.
(3) Custody (payroll checks): treasurer should sign and distribute checks.
3. Flowchart Overview

PAYROLL AND
PERSONNEL
DEPT Person Payr Treasu Account
S: nel oll rer ing
(Authorizat (Recordkee (Custo (Recordkeep
ion) ping) dy) ing)

1
Approve From
2 4
 Payroll product
From 3
changes personnel
ion
 New hires

Termina tions
 Payroll checks Payroll
Payrol
 Check listing summ
l
ary
summ
Approved Authorizati
ary
time on change
Authorizati
records document
on change
document Compa Update
re D G/L
payroll check
listing, payroll
summary and
payroll checks
A 1 Data entry for
Updat
payroll ed
Sign
G/L
Compute payroll chec
ks

Distribute
Update  Payroll Payrol
Payr payroll
d checks l
oll checks
employ  Check summ
journ
ee listing ary
al
record

3 4 Hold unclaimed
D • Authorizations checks
2
• Time records

B. AUDIT PROCEDURES
1. Internal Control Evaluation
The auditor should evaluate whether internal controls provide reasonable assurance
that only valid employees are being paid, that payment is for the actual hours worked,
and that the correct rate of pay is used. The following procedures should be
performed:
a. Compare the personnel records for each department with the actual time cards
and the employees actually working in each department;
b. Observe payroll distribution on a surprise basis to ensure that all personnel being
paid are actually employed by the company;
c. Observe the use of time clocks and investigate time cards not used; and
d. Test transfers and underlying employee authorizations if direct deposit is used.
2. Substantive Tests
The following audit procedures should be performed to verify the accuracy of payroll
amounts:
a. Vouch time on payroll summaries by selecting a payroll register entry and
comparing to time cards and approved time reports;
b. Compare total recorded payroll with total payroll checks issued;
c. Test extensions and footings of payroll;
d. Verify pay rates and payroll deductions with employee records from personnel;
e. Recalculate gross and net pay on a test basis;
f. Recalculate any year-end accruals; and
g. Compare payroll costs with standards or budgets.
Substantive tests should be extended if unusual fluctuations or significant errors are
noted.

VI. PROPERTY, PLANT, AND EQUIPMENT


PROPER The term "property, plant, and equipment" includes all tangible assets with service lives
TY, greater than one year that are used in the operation of a business. The major functions
PLANT, associated with these assets are purchases, repairs and maintenance, depreciation, and
AND
EQUIPME retirement. The auditor's work is directed more toward the transactions than toward the
NT
ending balances.
A. INTERNAL CONTROL
The internal control for property, plant, and equipment includes the controls in both the
purchases and sales cycles as well as the following special controls:
1. Acquisition
A special requisition form is generated for acquisitions. This form includes a
description, reason for acquisition, amount to be charged, and probable cost, and it
should be approved by top management. Acquisitions are tied to the capital budget,
which the board of directors usually approves. Variances from this budget should be
promptly investigated. The board of directors should also approve acquisitions of
assets over a certain amount, regardless of whether these assets are purchased or
constructed.
2. Subsidiary Ledgers
Detailed information concerning each asset is kept in the subsidiary ledger. Usually
such information as the asset's description, identification number, location, acquisition
date, cost, depreciation method, and amount of depreciation can be found in this
ledger.
3. Physical Security
Fixed assets should have identification plates. The serial number on the plate should
be listed in the control account. Physical controls to safeguard assets from theft,
destruction, or unauthorized disposition should also be in place, including periodic
physical inspection of plant and equipment.
4. Written Policies
Written depreciation policies and records should be maintained. Specific capitalization
policies are also necessary to prevent misstatement of revenue and expenses.
5. Disposition
Retirements of assets should be documented on a sequentially numbered work order
containing evidence of proper authorization and the reason for retirement. This asset
retirement order form is the basis for recording any cash received and for removing the
asset and its accumulated depreciation from the subsidiary ledger. There should be a
proper segregation of duties between authorization and custody (i.e., those who
authorize a disposal should not be permitted to actually dispose of the asset).
B. AUDIT PROCEDURES
1. Purchases and Retirements
The auditor should vouch additions to the fixed asset accounts by examining internal
documents (such as the asset requisition form), by examining external evidence (such
as invoices), and by inspecting the actual asset (existence assertion). The auditor
should also ascertain that the basis of recording any new assets is in conformity with
GAAP (presentation and disclosure assertions).
The auditor should review retirements and recalculate any gains and losses thereon.
The auditor should also consider selecting older fixed assets from the subsidiary
ledgers and then trying to locate those assets, as a means of testing for unrecorded
retirements.
The auditor should also review the related repair and maintenance expense accounts
to test for completeness of asset additions (i.e., the auditor is looking for items
recorded as repairs that would more properly have been capitalized as a betterment of
an asset).
Finally, the auditor should perform cutoff tests to determine whether purchases and
retirements of fixed assets were recorded in the proper period.

PASS
KEY
The examiners sometimes try to trick the candidates with questions about the repairs
and maintenance account. Keep in mind that the auditor often reviews this account in
order to locate items that should have been capitalized.

2. Authorization
The auditor should ascertain that company policy was followed and that fixed asset
purchases were properly authorized.
3. Physical Security
Comparison of the serial number on the identification plate to that listed in the control
account should be made. The auditor should also determine whether there are
appropriate controls in place to safeguard fixed assets and prevent theft or destruction.
4. Depreciation
The auditor should recalculate depreciation charges taken, to evaluate accuracy and
conformity with GAAP.
5. Liens
The auditor should be alert for evidence indicating a lien on assets, such as a missing
insurance policy.
VII. LIABILITIES
A. NOTES PAYABLE
NOTES The auditor should examine the note, comparing terms and authorization of indebtedness to
PAYABLE board approval. Interest expense should be independently computed, and the auditor should
consider the appropriate classification of notes payable on the balance sheet (a renewal of
notes payable after year-end might result in a long-term classification).
B. LONG-TERM DEBT
LONG- Sufficient audit evidence should be obtained by the auditor to obtain reasonable assurance
TERM that: (i) GAAP is consistently applied; (ii) interest expense is properly reported; (iii) valuation
DEBT is fairly stated; and (iv) all debt has been recorded. For long-term liabilities, the auditor
employs substantially the same procedures as discussed above for investments, including a
comparison of interest expense with the bond payable amount for reasonableness. The
auditor should also examine bond trust indentures to determine whether the client has
violated any covenants.
C. CONTINGENCIES
CONTINGEN A loss contingency that is probable and that can be reasonably estimated should be
CIES
reflected in the accounts. The following procedures may aid the auditor in identifying
contingencies.
1. Review bank confirmations for hidden bank loans, discounted drafts, guarantee of
notes, etc.
2. Discuss long-term purchase commitments with the purchasing agent.
3. Review the status of long-term leases.
4. Review the status of tax returns for open years.
5. Send an inquiry letter to the client's attorneys.
6. Discuss sales contracts with the sales manager.
7. Review the interim financial statements after year-end.
8. Review the minutes from board of directors' and shareholder meetings.
9. Obtain a client representation letter.

OWNERS' EQUITY

VIII. OWNERS' EQUITY AND TREASURY STOCK


Owners' equity and treasury stock should be examined.
A. TREASURY STOCK
The auditor should examine all shares of treasury stock and reconcile the number of shares
stated in the treasury stock account. This procedure should be performed concurrently with
the examination of marketable securities and other highly liquid assets. Any treasury stock
transactions should be traced to the accounting records (cash accounts) and to authorization
in the minutes of the board meetings.
B. VOUCHING OF STOCK TRANSACTIONS
All stock transactions should be vouched to supporting documentation (e.g., cash receipts,
board minutes indicating original authorization for issuance, etc.).
C. MINUTES OF BOARD MEETINGS
All stock issuances, dividend declarations, and treasury stock purchases must be authorized
by the board of directors. Evidence of these events should be duly recorded in the minutes of
board meetings.
D. ARTICLES OF INCORPORATION
The auditor should read the Articles of Incorporation and prepare excerpts or obtain a copy of
pertinent provisions for the permanent audit file. A stock registrar may be used to ensure that
stock is issued in accordance with the authorization of the board of directors and the articles
of incorporation.
E. STOCK TRANSFER AGENTS
If the client uses a stock transfer agent, third-party confirmations should be used to provide
evidence of shares authorized, issued, and outstanding, as well as to provide evidence of the
individual transactions.
F. STOCK CERTIFICATE BOOK
If a client does not use a stock transfer agent, the primary source of evidence is the stock
certificate book. The auditor should examine the stock certificate stubs for proper recording,
for any canceled certificates, and for the existence of the remaining unissued certificates.
G. RETAINED EARNINGS
The auditor should analyze the account from inception (or since the last audit) and should
review the propriety of any direct entries to retained earnings. The auditor should also
consider whether any appropriations of retained earnings are necessary (e.g., due to loan
covenants, contingent liabilities, etc.). The auditor focuses on evaluating the presentation
and disclosure of the financial statements.
RELAT
AUDIT EVIDENCE: MISCELLANEOUS ITEMS
ED
PARTI
ES

I. RELATED PARTY TRANSACTIONS


A. AUDITOR'S RESPONSIBILITY
When auditors are performing an examination of financial statements, they are responsible
for identifying any related party transactions encountered during the course of the audit and
for determining whether the transactions are given proper disclosure in the financial
statements. Related parties may include the reporting entity's affiliates, principal owners,
management, and members of their immediate families.
B. ACCOUNTING FOR RELATED PARTY TRANSACTIONS
Except for very routine transactions, it generally isn't possible to determine whether a
transaction would have taken place in exactly the same manner if the parties weren't related.
Therefore, a related party transaction is not considered to be an arm's-length transaction.
For this reason, the substance of a related party transaction may be very different from its
form, and GAAP requires that such transactions be disclosed.
C. AUDIT OBJECTIVES
The auditor's primary concern with related party transactions is that they are properly
disclosed in accordance with GAAP. The auditor must determine the existence of related
parties, identify and examine related party transactions, and verify that disclosure is
adequate.
D. DETERMINING THE EXISTENCE OF RELATED PARTIES
Application of specific procedures regarding material transactions with related parties may
include:
1. Evaluating the company's procedures for identifying and accounting for related party
transactions, and obtaining a conflict of interest statement from the client.
2. Asking management for the names of all related parties and inquiring whether any
transactions occurred during the period.
3. Reviewing the reporting entity's filings with the SEC and other regulatory agencies
concerning the names of officers and directors who occupy management or
directorship positions in other businesses.
4. Reviewing material transactions (especially investment transactions) for related party
evidence.
5. Reviewing prior years' audit documentation or inquiring of the predecessor auditor.
E. IDENTIFYING AND EXAMINING RELATED PARTY TRANSACTIONS
1. Identifying Related Party Transactions
The auditor should provide the names of known related parties to the audit staff. In
addition, related party transactions may be identified by reviewing board minutes, SEC
filings, and confirmations. The auditor should remain alert for the following items,
which may be indicative of a related party transaction.
a. Compensating balance arrangements (which may be maintained by or for related
parties).
b. Loan guarantees.
c. Unusual, nonrecurring transactions near year-end.
d. Transactions based on terms that differ significantly from market terms.
e. Nonmonetary exchanges.
2. Examining Related Party Transactions
Once a related party transaction has been identified, the auditor should obtain an
understanding of the business purpose of the transaction and test the amounts to be
disclosed.
F. EVALUATING FINANCIAL STATEMENT DISCLOSURE
For each material related party transaction (except compensation arrangements, expense
allowances, and other similar items in the ordinary course of business), the auditor should
audit the transaction and determine whether it is adequately disclosed in accordance with
GAAP. If management indicates in the financial statements that the transaction was
consummated on arm's-length terms and the auditor believes this statement is
unsubstantiated, the auditor should express a qualified or adverse opinion due to a GAAP
departure.

III. ACCOUNTING ESTIMATES ESTIMATES


A. DEFINED
An accounting estimate is an approximation of a financial statement element, item, or
account. Estimates are used because either data about past events cannot be accumulated
in a timely, cost-effective manner or because measurement of some accounts is dependent
upon the outcome of future events. It is the responsibility of management to make
reasonable estimates and include them in the financial statements.
Examples of estimates include:
1. Net realizable values of inventory and accounts receivable;
2. Compensation in stock option plans;
3. Future pension and warranty expenses; and
4. Probability of loss and related amounts due to litigation.
B. AUDITOR'S RESPONSIBILITIES
The auditor has four responsibilities when evaluating estimates:
1. Assess management's written policies and practices regarding the development and
use of estimates.
2. Verify that all material estimates have been developed.
3. Determine that the accounting estimates are reasonable. In evaluating
reasonableness, the auditor focuses on assumptions that are significant to the
estimate, sensitive to variations, deviations from historical patterns, or subjective and
susceptible to misstatement/bias.
4. Ensure that the accounting estimates are properly presented and disclosed in
conformity with GAAP.
C. PROCEDURES
In evaluating the reasonableness of an estimate, the auditor must first obtain an
understanding of how management developed its estimate. The auditor would then perform
one or a combination of the following procedures:
1. Review and test the procedures used by management to develop the estimate.
2. Develop an independent estimate of the item for comparative purposes.
3. Review subsequent events and transactions (occurring prior to the date of the auditor's
report) that corroborate the value of the estimate.
IV. AUDITING FAIR VALUES
A. FAIR VALUE REPORTING
FAIR Certain assets, liabilities, and specific components of equity are presented or disclosed at fair
VALUES value in financial statements.
1. Fair value is defined as the amount at which an asset could be bought or sold (or the
amount at which a liability could be incurred or settled) in a current transaction between
willing parties.
a. Market value (e.g., a published price quotation in an active market) should be
used where possible.
b. Estimates and valuation methods may be used when market values are not
available.
2. Fair value measurements may arise from both the initial recording of a transaction and
later changes in value.
a. Changes in fair value measurement may be treated in different ways under
GAAP (e.g., included in net income, reflected in other comprehensive income
and equity, etc.).
B. MANAGEMENT'S RESPONSIBILITY
1. Management is responsible for making fair value measurements and disclosures in
accordance with GAAP.
a. Where market prices are not available, appropriate valuation methods should be
used to estimate fair value.
b. Valuation methods should incorporate assumptions that would be used in the
market when possible.
c. Management should identify and support any significant assumptions used.
C. THE AUDITOR'S RESPONSIBILITY
1. The auditor should obtain sufficient competent audit evidence to provide reasonable
assurance that fair value measurements and disclosures are in conformity with GAAP.
The auditor should:
a. Understand the entity's process for determining fair value measurements and
disclosures.
b. Understand relevant controls.
c. Assess the risk of material misstatement of fair value measurements.
d. Evaluate conformity with GAAP.
e. Consider the need for a specialist.
f. Test fair value measurements and disclosures (covered further below).
g. Evaluate whether fair value disclosures are in conformity with GAAP.
h. Evaluate the sufficiency, competency, and consistency of evidence obtained with
respect to fair value measurements and disclosures.
i. Obtain relevant management representations (e.g., relating to the
reasonableness of significant assumptions, management's intent and ability to
carry out planned courses of action, completeness and adequacy of disclosure,
the effect of subsequent events, etc.).
j. Communicate relevant matters to those charged with governance (e.g., matters
related to particularly sensitive fair value estimates).
2. The auditor bases his or her evaluation on information available at the time of the audit,
and is not responsible for predicting future conditions that, if known at the time of the
audit, might have affected fair value measurements and disclosures.
D. TESTING FAIR VALUE MEASUREMENTS AND DISCLOSURES
In testing an entity's fair value measurements and disclosures, the auditor may:
1. Determine whether management's significant assumptions provide a reasonable basis
for fair value measurements.
2. Consider management's intent and ability to carry out courses of action that may affect
fair values.
3. Evaluate whether the valuation model is appropriate given the entity's circumstances.
4. Test the underlying data for accuracy, completeness, relevancy, and consistency.
5. Develop independent fair value estimates for corroborative purposes.
6. Review subsequent events and transactions (occurring before the date of the auditor's
report) for evidence regarding fair value measurements at the balance sheet date.

V. INQUIRIES REGARDING LITIGATION, CLAIMS, AND ASSESSMENTS LITIGATION


In performing an examination in accordance with generally accepted auditing , CLAIMS,
AND
standards, the independent auditor must obtain appropriate audit evidence ASSESSME
NTS
pertaining to litigation, claims, and assessments. An external inquiry of the entity's attorney is the
auditor's primary means of obtaining verification of management information about these issues.
A. REVIEW DOCUMENTS
The auditor should ask management about pending litigation or possible future litigation and
about controls adopted to identify, evaluate, and account for such items. In conjunction with
these inquiries, the auditor should also review appropriate documents. Those documents
could include:
1. Minutes of meetings of stockholders, board of directors, and other executive
committees;
2. Correspondence and invoices from lawyers; and
3. Contracts, loan agreements, loan guarantees, leases, and correspondence from taxing
authorities.
B. SPECIFIC INQUIRY INTO LITIGATION
If it comes to the auditor's attention that the entity is involved in litigation or is threatened with
litigation, the auditor should inquire regarding:
1. The nature of the matter, including the period of occurrence;
2. The progress of the case to date, including management's intended response;
3. The degree of probability of an unfavorable outcome; and
4. The amount or estimate of potential loss.
Note: It is management's responsibility to identify and account for litigation, claims, and
assessments through the policies adopted by management for such purposes. The
management representation letter should indicate that management has disclosed to the
independent auditor all such relevant information.
C. LETTER OF INQUIRY TO CLIENT'S ATTORNEYS
There must be a direct letter of inquiry to the client's attorneys. In this letter, management
details any pending or threatened litigation matters. This letter is signed by the client and
sent by the auditors to the attorneys.
1. Response by Attorneys
The attorneys in turn send their replies directly to the independent auditor. In these
replies, attorneys give their evaluation concerning litigation matters within their
knowledge or control.
2. Limitations on Response
The lawyer's response to the letter of inquiry should include a professional opinion on
the expected outcome of any lawsuit and the likely outcome of any liability, including
court costs.
a. "Substantial Attention" Limitation
Lawyers may limit their replies to matters to which they have given substantial
attention. Responses may also be limited to material matters if an understanding
has been reached between the lawyer and the auditor as to what amount would
be considered material.
b. Confidentiality Limitation
In some cases, it may be unwise for a lawyer to disclose certain confidential
information. An example of this may be knowledge of a patent violation, if the
disclosure of the violation in the financial statements could bring about a lawsuit.
3. Refusal to Respond
A lawyer's refusal to respond to a letter of inquiry where the lawyer has devoted
substantial attention to litigation matters is a limitation in the scope of an independent
auditor's examination, sufficient to preclude an unqualified opinion.
4. Refusal to Permit Inquiry
A client's refusal to permit inquiry of the attorneys generally will result in a disclaimer of
opinion.
5. Inherent Uncertainties
In some cases, inherent uncertainties may make it difficult for a lawyer to form
conclusions regarding pending litigation. If the auditor is satisfied that financial
statement disclosure is adequate, no modification to the opinion would be required.

PASS
KEY
Note that management is the primary source of information regarding litigation, claims,
and assessments. The letter sent to the client's lawyer is simply a means of
corroborating information provided by management.
6. Sample Letter of Audit Inquiry

(Company
Letterhead) (Date)
(Name of law
firm)
(Address)
(City, State, and
Zip Code)

Gentlemen:
In connection with an audit of our financial statements at (balance
sheet date) and for the (period) then ended, management of the
Company has prepared, and furnished to our auditors (name and address
of auditors), a description and evaluation of certain contingencies,
including those set forth below involving matters with respect to which
you have been engaged and to which you have devoted substantive
attention on behalf of the Company in the form of legal consultation or
representation. These contingencies are regarded by management of the
Company as material for this purpose. Your response should include
matters that existed at (balance sheet date) and during the period from
that date to the date of your response.
Pending or Threatened Litigation
[Ordinarily management’s information would include (i) the nature of
the litigation, (ii) the progress of the case to date, (iii) how
management is responding or intends to respond to the litigation, and
(iv) an evaluation of the likelihood of an unfavorable outcome and an
estimate, if one can be made, of the amount or range of potential loss.]
Please furnish to our auditors such explanation, if any, that you consider
necessary to supplement
the foregoing information, including an explanation of those matters as
to which your views may differ from those stated and an identification of
the omission of any pending or threatened litigation, claims, and
assessments or a statement that the list of such matters is complete.
Unasserted Claims and Assessments
[Ordinarily management’s information would include (i) the nature of
the matter, (ii) how management intends to respond if the claim is
asserted, and (iii) an evaluation of the likelihood of an unfavorable
outcome and an estimate, if one can be made, of the amount or range
of potential loss.]
Please furnish to our auditors such explanation, if any, that you consider
necessary to supplement
the foregoing information, including an explanation of those matters as
to which your views may differ from those stated.
We understand that whenever, in the course of performing legal services
for us with respect to a matter recognized to involve an unasserted
possible claim or assessment that may call for financial statement
disclosure, if you have formed a professional conclusion that we should
disclose or consider disclosure concerning such possible claim or
assessment, as a matter of professional responsibility to us, you will so
advise us and will consult with us concerning the question of such
disclosure and the applicable requirements of SFAS 5. Please specifically
confirm to our auditors that our understanding is correct.
Please specifically identify the nature of and reasons for any limitations on your
response.

Very truly
yours,
(Company
name)
APPENDIX
RATIO
Financial Ratios
ANALYS
IS

I. OVERVIEW
Ratios are financial indicators that distill relevant information about a business entity by quantifying
the relationships among selected items on the financial statements. An entity's ratios may be
compared to ratios of a different period and to industry ratios. These comparative analyses identify
trends that may be important to investors, lenders, and other interested parties.

PASS
KEY
Ratio questions on the auditing exam may require a simple ratio calculation, an
interpretation of what the ratio means, or an analysis of the effects of a change.
Sometimes, when both the numerator and denominator are affected by a given change,
the final result (increase or decrease) is not easy to determine. The best way to answer
questions like these is to make up numbers and plug them into the ratio formula.

II. BASIC FINANCIAL ANALYSIS RATIOS


Key financial ratios may be classified as:
A. LIQUIDITY RATIOS
Liquidity ratios are measures of a firm's short-term ability to pay maturing obligations.
B. ACTIVITY RATIOS
Activity ratios are measures of how effectively an enterprise is using its assets.
C. PROFITABILITY RATIOS
Profitability ratios are measures of the success or failure of an enterprise for a given time
period.
D. INVESTOR RATIOS
Investor ratios are measures that are of interest to investors.
E. LONG-TERM DEBT-PAYING ABILITY RATIOS (COVERAGE RATIOS)
Coverage ratios are measures of security for long-term creditors/investors.

III. LIMITATIONS OF RATIOS


Although ratios are easy to compute, they depend entirely on the reliability of the data on which
they are based (e.g., on estimates and on historical costs).
Other limitations include:
(i) Dissimilar business units may make analysis difficult.
(ii) Inflation can reduce comparability of balance sheet items.
(iii) Manipulation of ratios by management can occur.
(iv) The choice of different generally accepted accounting principles can affect ratios and reduce
comparability.
(v) Generalizations are difficult to make.
(vi) Ratios may use accounting data (e.g., fixed assets) that do not reflect fair market values.
IV. OTHER ANALYSES
Additional analyses, such as common size analysis (vertical and horizontal), analysis of industry
statistics, and trend analysis, may also be valuable.
A. COMMON SIZE ANALYSIS
Common size financial statements are used to compare a company's performance with the
performance of other smaller or larger companies, or with its own performance over time. To
draft a common size balance sheet, simply divide each balance by the total assets. The
result is each balance sheet component expressed as a percentage of the whole, with total
assets representing 100%. Similarly, to draft a common size income statement, simply divide
each income statement amount by the total revenue. Common size financial statements can
be compared to industry norms or to industry leaders.
B. ANALYSIS OF INDUSTRY STATISTICS
Ratio analysis is useful when comparing to norms in an industry. Benchmarking may be
performed against competitors or industry leaders.
C. TREND ANALYSIS
Ratio analysis can be used to analyze trends over time.

V. COMPREHENSIVE EXAMPLE
The following pages provide a comprehensive example illustrating how a variety of ratios can be
computed based on given financial information.
EXAMPLE: Ratio
Analysis

Gi
Company
BALANCE Decembe
SHEET r 31
Current 20X2
Assets:
20X1
Cash and cash equivalents $ 50,000 $ 35,000
Trading securities (at fair value) 75,000 65,000
Accounts receivable 300,000 290,000
Inventory (at lower of cost or market) 290,000 275,000
Total current assets 715,000
665,000
Investments available-for-sale (at fair value) 350,000 300,000
Fixed Assets:
Property, plant, and equipment (at cost) 1,900,000 1,800,000
Less: Accumulated depreciation (385,000)
(350,000)
1,515,000 1,450,000
Goodwill 35,000 35,000
Total assets $2,615,000
$2,450,000
Current Liabilities:
Accounts payable $ 150,000 $ 125,000
Notes payable 325,000 375,000
Accrued and other liabilities 220,000 200,000
Total current liabilities 695,000
700,000
Long-term Debt:
Bonds and notes payable 650,000 600,000
Total liabilities 1,345,000
1,300,000
Stockholders' Equity:
Common stock (100,000 shares outstanding) 500,000 500,000
Additional paid-in capital 350,000 350,000
Retained earnings 420,000 300,000
Total equity 1,270,000
1,150,000
Total liabilities and equity $2,615,000
$2,450,000

In addition, assume the following information for Gi Company for the year ended
December 31, 20X2.

Sales $1,800,000
Cost of goods sold
(1,000,000) Gross profit
800,000
Operating expenses

(486,970) Interest expense


(10,000)
Net income before income taxes 303,030
Income taxes (34%)
(103,030) Net income after income taxes $
200,000
Earnings per share $2
Operating cash flows $255,000
Dividends for the year $0.80 per share
Market price per share $12
Liquidity
Ratios

1. Working capital = Current assets - Current liabilities

20X2: $715,000 - $695,000 = $20,000


20X1: $665,000 - $700,000 = ($35,000)

Current assets
2. Current ratio (working
Current liabilities
capital ratio) =
$715,0
(20X2) = 1.03
00
$695,0
=
00 = 0.95
(20X1) $665,0
(Industry 00
average = 1.5) = $700,0
00
The ratio, and therefore Gi's ability to meet its short-term
obligations, has improved, though it is low compared to the
industry average.

3. Acid-test Cash equivalents + Marketable securities + Net receivables


(quick) =
ratio Current liabilities
$50,000 + $75,000 +
(20X2) = = 0.61
$300,000
$695,0
(20X1) = 00 = 0.56
$35,000 + $65,000 +
$290,000
$700,0
00
(Industry average = 0.80)
The industry average of .80 is higher than Gi's ratio, which
indicates that Gi may have trouble meeting short-term needs.

Cash equivalents +
4. Cash
Marketable securities
ratio =
Current
liabilities
(20 =
(20X2)
X1
=
$50,000 + $75,000
= 0.18
$695,000
$35,000 + $65,000
= 0.14
$700,000
Activity
Ratios

PASS
KEY
Turnover ratios generally use average balances (i.e., [beginning
balance + ending balance] / 2) for balance sheet components.
However, on some recent CPA exam questions, candidates have been
instructed to use year-end balances instead. Please be sure to read
the question carefully to determine the appropriate method to use.

Net credit
1. Accounts receivable turnover =
sales
Average
= receivables
$1,800,000
= ($300,000 +
$290,000) / 2
$1,800,000
$295,000
= 6.10
times
This ratio indicates the receivables' quality and indicates the
success of the firm in collecting outstanding receivables. Faster
turnover gives credibility to the current and acid-test ratios.

Average receivables
2. Accounts receivable turnover in days =
Net credit sales / 365
365
=
days
Receivable turnover
=
365
6.1
= 59.84
days
This ratio indicates the average number of days required to collect accounts
receivable.

Cost of goods sold


3. Inventory turnover =
Average inventory
$1,000,000
=
($290,000 +
$275,000) / 2
=
$1,000,000 $282,500
= 3.54
times
This measure of how quickly inventory is sold is an indicator of
enterprise performance. The higher the turnover, in general, the
better the performance.
Average inventory
4. Inventory turnover in days
Cost of goods sold / 365
=
365 days
Inventory turnover
=
365 days
= 3.54

= 103.11
days
This ratio indicates the average number of days
required to sell inventory.

5. Operating A/R turnover in days + Inventory


cycle = turnover in days
= 59.84 days + 103.11 days
= 162.95 days
The operating cycle indicates the number of days between
acquisition of inventory and realization of cash from selling
the inventory.

Sale
6. Working capital turnover
s
=
Average working capital
$1,800,0
=
00
[($715,000 - $695,000) + ($665,000 - $700,000)] / 2
= 240
times
This ratio indicates how effectively working capital is used.

Net
7. Total asset turnover =
sales
Average total assets
=
$1,800,000
($2,615,000 +
= $2,450,000) / 2
$1,800,000
$2,532,500
= 0.71
times
This ratio is an indicator of how Gi makes effective use of its
assets. A high ratio indicates effective asset use to generate
sales.
Cost of goods
8. Accounts payable
sold
turnover
= Average accounts
payable
This ratio indicates the number of times trade payables turn
over during the year. A low turnover may indicate a delay in
payment, such as from a shortage of cash.
Average accounts payable
9. Days in accounts
Cost of goods sold / 365
payable
=
This ratio indicates the average length of time trade payables are
outstanding before they are paid.
Profitability
Ratios

Note: Some forms of the profitability ratios below use net income
less preferred dividends in the numerator to better measure returns
accruing to common shareholders.

Net income
1. Net profit margin =
Net sales
$200,000
=
$1,800,000
= 11.11%
This ratio indicates profit rate and, when used with the asset
turnover ratio, indicates rate of return on assets, as shown in
item 3 below.

2. Return on total Net income ÷ Average


assets = total assets
= $200,000 / $2,532,500
= 7.9%

3. Return on assets
= Net profit margin x Total asset turnover
(alternate version)
Net income Net sales
= x
Net sales Average total assets
= 11.11% x 0.71
times = 7.9%
Note that this ratio uses both net profit margin and the total asset
turnover. This ratio allows for increased analysis of the changes in
percentages. The net profit margin indicates the percent return on
each sale while the asset turnover indicates the effective use of
assets in generating that sale.

Net income + Interest expense


4. Return on investment =
(1 - Tax rate) Average (Long-
term liabilities + Equity)
=
$200,000 + $10,000
(1 - 0.34)
($650,000 + $1,270,000 + $600,000
+ $1,150,000) / 2
=
11.3%
ROI measures the performance of the firm without regard to the method of
financing.
Net income - Preferred
5. Return on common equity
dividends
=
Average common
equity
=
$200,000 - $0
($1,270,000 +
$1,150,000) / 2
=
16.5%
6. Net operating Net operating income
margin =
percentage Net sales
$800,000 – 486,970
=
$1,800,000

17.39%

7. Gross (profit) Gross (profit) margin


margin =
percentage Net sales

$800,000
$1,800,000
=

44%

Operating
8. Operating cash flow per share =
cash flow
Common shares outstanding
=
$255,0
00
100,000 shares
= $2.55 per share
Investor Ratios

Earnings before interest and taxes


1. Degree of financial leverage
Earnings before taxes
=
$303,030 + $10,000
= $303,030

=
1.033
The degree of financial leverage is the factor by which net income
will change with a change in earnings before interest and taxes.
The degree of financial leverage indicates the leverage factor for
recurring earnings.

Net income - Preferred


2. Earnings per share =
dividends
Weighted average number of common shares
= outstanding
$200,000 - $0
100,000 shares
=
$2/share

Market price per share


3. Price/earnings ratio =
Diluted earnings per share
$12
=
$2
=
6
This statistic indicates the investment potential of an enterprise; a
rise in this ratio indicates that investors are pleased with the firm's
opportunity for growth.

Dividends per common share


4. Dividend payout ratio =
Diluted earnings per share
$0.80
=
$2
=
40%
This ratio indicates the portion of current earnings being paid out in
dividends.
Dividends per common share
5. Dividend yield =
Market price per common share
$0.80
=
$12
= 6.67%
This ratio indicates the relationship between dividends and market price.

Total stockholders' equity -


6. Book value per
Preferred stock
share =
Number of common shares
outstanding

$1,270,0
(20X2) = = $12.70
00
100,000
(20X1) = shares = $11.50
$1,150,0
00
100,000
shares
This ratio indicates the amount of stockholders' equity that relates
to each share of common stock. Note that preferred stock should
be stated at liquidity value if other than book value.
Long-term Debt-paying Ability Ratios

Total
1. Debt /
liabilities
Equity =
Common
stockholders' equity
(20X2) = $1,345,000 /
$1,270,000 = 1.06 (20X1) =
$1,300,000 / $1,150,000 =
1.13
This ratio indicates the degree of protection to creditors in case of
insolvency. The lower this ratio, the better the company's
position. In Gi's case, the ratio is very high, indicating that a
majority of funds come from creditors. However, the ratio is
improving.

Total liabilities
2. Debt
Total assets
ratio =
(20X2) = $1,345,000 /
$2,615,000 = 51.4% (20X1) =
$1,300,000 / $2,450,000 =
53.1%
This debt ratio indicates that more than half of the assets are financed by
creditors.

Recurring income before taxes and interest


3. Times interest earned =
Intere
st
=
$303,030 + $10,000
$10,0
00
= 31.30
times
This ratio reflects the ability of a company to cover interest
charges. It uses income before interest and taxes to reflect the
amount of income available to cover interest expense.

=
4. Operating cash flow / Total debt
=
Operating cash flow tal debt
T
o $255,000
$1,345,000
=
18.96%
This ratio indicates the ability of the company to cover total debt with yearly
cash flow.
AUDITING & ATTESTATION 4
Class Questions Answer Worksheet
MC Question

First Choice
Number

Answer

Answer
Correct

NOTE
S
1.
2.
3.
4.
5.
6.
7.
8.
9.
10
.
11
.
12
.
13
.
14
.
15
.
16
.
17
.
18
.
19
.
20
.
21
.
Grad
e:

Multiple-choice Questions Correct / 21 =


%
Correct

Detailed explanations to the class questions are located in


the back of this textbook.
NOTES

A4-66 © 2008 DeVry/Becker Educational Development Corp. All rights


reserved.
CLASS QUESTIONS

1. CPA-02595
Which of the following procedures concerning accounts receivable would an auditor most likely perform to
obtain audit evidence supporting the effective operation of controls?
a. Observing an entity's employee prepare the schedule of past due accounts receivable.
b. Sending confirmation requests to an entity's principal customers to verify the existence of accounts
receivable.
c. Inspecting an entity's analysis of accounts receivable for unusual balances.
d. Comparing an entity's uncollectible accounts expense to actual uncollectible accounts receivable.

2. CPA-02625
Upon receipt of customers' checks in the mailroom, a responsible employee should prepare a remittance
listing that is forwarded to the cashier. A copy of the listing should be sent to the:
a. Internal auditor to investigate the listing for unusual transactions.
b. Treasurer to compare the listing with the monthly bank statement.
c. Accounts receivable bookkeeper to update the subsidiary accounts receivable records.
d. Entity's bank to compare the listing with the cashier's deposit slip.

3. CPA-02680
An auditor tests an entity's control of obtaining credit approval before shipping goods to customers in
support of management's financial statement assertion of:
a. Valuation and allocation.
b. Completeness.
c. Existence.
d. Rights and obligations.

4. CPA-02589
An auditor observed that a client mails monthly statements to customers. Subsequently, the auditor
reviewed evidence of follow-up on the errors reported by the customers. This test of controls most likely
was performed to support management's financial statement assertion(s) of:
Classification and Rights and
understandability obligations
a. Yes Yes
b. Yes No
c. No Yes
d. No No

5. CPA-02606
For effective internal control, the accounts payable department generally should:
a. Stamp, perforate, or otherwise cancel supporting documentation after payment is mailed.
b. Ascertain that each requisition is approved as to price, quantity, and quality by an authorized
employee.
c. Obliterate the quantity ordered on the receiving department copy of the purchase order.
d. Establish the agreement of the vendor's invoice with the receiving report and purchase order.

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reserved.
6. CPA-02601
An auditor suspects that a client's cashier is misappropriating cash receipts for personal use by lapping
customer checks received in the mail. In attempting to uncover this embezzlement scheme, the auditor
most likely would compare the:
a. Dates checks are deposited per bank statements with the dates remittance credits are recorded.
b. Daily cash summaries with the sums of the cash receipts journal entries.
c. Individual bank deposit slips with the details of the monthly bank statements.
d. Dates uncollectible accounts are authorized to be written off with the dates the write-offs are actually
recorded.

7. CPA-02643
Audit documentation should:
a. Not be permitted to serve as a reference source for the client.
b. Not contain critical comments concerning management.
c. Show that the accounting records agree or reconcile with the financial statements.
d. Be considered the primary support for the financial statements being audited.

8. CPA-02342
Which of the following types of audit evidence is the most persuasive?
a. Prenumbered client purchase order forms.
b. Client work sheets supporting cost allocations.
c. Bank statements obtained from the client.
d. Client representation letter.

9. CPA-02334
The objective of tests of details of transactions performed as substantive tests is to:
a. Comply with generally accepted auditing standards.
b. Attain assurance about the reliability of the information system relevant to financial reporting.
c. Detect material misstatements in the financial statements.
d. Evaluate whether management's controls operated effectively.

10. CPA-02373
Auditors try to identify predictable relationships when using analytical procedures. Relationships involving
transactions from which of the following accounts most likely would yield the highest level of evidence?
a. Accounts receivable.
b. Interest expense.
c. Accounts payable.
d. Travel and entertainment expense.

11. CPA-04622
An auditor's analytical procedures performed during the overall review stage indicated that the client's
accounts receivable had doubled since the end of the prior year. However, the allowance for doubtful
accounts as a percentage of accounts receivable remained about the same. Which of the following client
explanations most likely would satisfy the auditor?
a. The client liberalized its credit standards in the current year and sold much more merchandise to
customers with poor credit ratings.
b. Twice as many accounts receivable were written off in the prior year than in the current year.
c. A greater percentage of accounts receivable were currently listed in the "more than 90 days overdue"
category than in the prior year.
d. The client opened a second retail outlet in the current year and its credit sales approximately equaled
the older, established outlet.
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reserved.
12. CPA-02354
In determining whether transactions have been recorded, the direction of the audit testing should be from
the:
a. General ledger balances.
b. Adjusted trial balance.
c. Original source documents.
d. General journal entries.

13. CPA-02314
An auditor suspects that certain client employees are ordering merchandise for themselves over the
Internet without recording the purchase or receipt of the merchandise. When vendors' invoices arrive,
one of the employees approves the invoices for payment. After the invoices are paid, the employee
destroys the invoices and the related vouchers. In gathering evidence regarding the fraud, the auditor
most likely would select items for testing from the file of all:
a. Cash disbursements.
b. Approved vouchers.
c. Receiving reports.
d. Vendors' invoices.

14. CPA-02443
To gain assurance that all inventory items in a client's inventory listing schedule are valid, an auditor most
likely would trace:
a. Inventory tags noted during the auditor's observation to items listed in the inventory-listing schedule.
b. Inventory tags noted during the auditor's observation to items listed in receiving reports and vendors'
invoices.
c. Items listed in the inventory-listing schedule to inventory tags and the auditor's recorded count sheets.
d. Items listed in receiving reports and vendors' invoices to the inventory-listing schedule.

15. CPA-04627
An auditor decides to use the blank form of accounts receivable confirmation rather than the positive
form. The auditor should be aware that the blank form may be less efficient because:
a. Subsequent cash receipts need to be verified.
b. Statistical sampling may not be used.
c. A higher assessed level of detection risk is required.
d. More nonresponses are likely to occur.

16. CPA-02430
In confirming with an outside agent, such as a financial institution, that the agent is holding investment
securities in the client's name, an auditor most likely gathers evidence in support of management's
financial statement assertions of existence and:
a. Valuation and allocation.
b. Rights and obligations.
c. Completeness.
d. Classification and understandability.

© 2009 DeVry/Becker Educational Development Corp. All rights A4-69


reserved.
17. CPA-02416
An auditor vouched data for a sample of employees in a payroll register to approved clock card data to
provide assurance that:
a. Payments to employees are computed at authorized rates.
b. Employees work the number of hours for which they are paid.
c. Segregation of duties exists between the preparation and distribution of the payroll.
d. Internal controls relating to unclaimed payroll checks are operating effectively.

18. CPA-02447
In performing a search for unrecorded retirements of fixed assets, an auditor most likely would:
a. Inspect the property ledger and the insurance and tax records, and then tour the client's facilities.
b. Tour the client's facilities, and then inspect the property ledger and the insurance and tax records.
c. Analyze the repair and maintenance account, and then tour the client's facilities.
d. Tour the client's facilities, and then analyze the repair and maintenance account.

19. CPA-02495
During an audit of an entity's stockholders' equity accounts, the auditor determines whether there are
restrictions on retained earnings resulting from loans, agreements, or state law. This audit procedure
most likely is intended to verify management's assertion of:
a. Existence.
b. Completeness.
c. Valuation and allocation.
d. Classification and understandability.

20. CPA-02536
Which of the following auditing procedures most likely would assist an auditor in identifying related party
transactions?
a. Inspecting correspondence with lawyers for evidence of unreported contingent liabilities.
b. Vouching accounting records for recurring transactions recorded just after the balance sheet date.
c. Reviewing confirmations of loans receivable and payable for indications of guarantees.
d. Performing analytical procedures for indications of possible financial difficulties.

21. CPA-02529
Which of the following is an audit procedure that an auditor most likely would perform concerning
litigation, claims, and assessments?
a. Request the client's lawyer to evaluate whether the client's pending litigation, claims, and
assessments indicate a going concern problem.
b. Examine the legal documents in the client's lawyer's possession concerning litigation, claims, and
assessments to which the lawyer has devoted substantive attention.
c. Discuss with management the controls adopted for evaluating and accounting for litigation, claims,
and assessments.
d. Confirm directly with the client's lawyer that all litigation, claims, and assessments have been
recorded or disclosed in the financial statements.

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reserved.