Audit Stages

8/3/2019 Audit Stages

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Audit Stages

FIRST INTERIM AUDIT

STAGE 1: Understand the Business

Understand the business and industry in which it operates.

An example of business risk factors evaluation report is shown in Illustration 1.

Other aspects of understanding the business:

A general understanding may lead to other areas of investigation and planning.

(1) First time audits require more work than a repeat engagement.

(2) Work with company internal auditors.

(3) Analyses of the clients financial statements.

(4) Employment ofspecialists on the audit.

The auditor must have a knowledge and understanding of the clients business. Theunderstanding aids in planning and developing an audit program, which is a list ofprocedures necessary to obtain sufficient competent evidence.

Methods and sources of information:

The auditor obtains an understanding of the clients business and industry by:

Inquiry and reviews with client management and personnel.

Review of prior year audit work papers.

Observation and tour of companys physical facilities.

Study and review of published materials, guides, Web sites, and references onindustry and client.

Financial Statements

There are two important points to remember about client financial statements:

(1) Management is responsible for preparing them, and they containmanagements assertions about economic actions and events.

(2) The financial statement numbers are produced by the companysaccounting system, and summarized in the trial balance.

The Financial Statements are mainly Balance Sheet and Income Statement (profit andloss account) and additional statement; cash flow statement, fond flow statement, cost ofsales statement, as are identified as being within the scope of the audit opinion.


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The Balance Sheet gives a statement of financial position of a company at a particulardate. Assets represent the resources owned by the firm, whereas liabilities andshareholders equity indicate how those resources are financed.

The Income Statement gives a statement of profit or loss of the company for the specifiedperiod. An income statement answers the question how profitable is the business?

For the preparation of the financial statements, every company must keep accountingrecords and they must be sufficient to show and explain the company 's transactions andfinancial position.

All transactions in the company must show source documents, which are;

Invoices, checks, receipts, delivery notes, payrolls...

These documents are attached with the cash receipt voucher, cash payment voucher. Thesource documents are first authorized by senior staff and then entered in accountingrecords, which are:

Daily book, ledger, cashbook, inventory book, check book.

According to the Turkish Tax and Commerce Code, Notary public must stamp thesebooks.

The company has on the right to keep auxiliary book if necessary (Customers book,Suppliers book, Debtors book...).

The balances on the ledger accounts are extracted to form a trial balance to prove thatthey are arithmetically correct. The financial statements are produced from the trialbalance to provide a balance sheet and profit and loss account.

Accounting records must be kept for; 5 years according to the Turkish Tax Code, 10years according to the Commerce Code.

STAGE 2: Plan the Audit

Use audit planning tools to guide the audit work.

After these planning tools, plan the audit program.

Record the work in the auditors' working papers.

Audit Planning Tools

Audit planning tools used to guide and direct audit work are classified as:

Preliminary Risk Assessment

Preliminary Materiality Decisions

Preliminary Analytical Procedures


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Audit Programs

Preliminary Assessment of Audit Risks

Preliminary analytical review can help auditors make broad risk assessments. However,

the following technical risks must also be assessed.Audit riskis the probability that an auditor will give an inappropriate opinion onfinancial statements. The auditing profession has no official standard for anacceptable level of overall audit risk, except that it should be acceptably low.

Inherent risk is the probability that material misstatements have occurred intransactions entering the accounting system used to prepare financial statements.Relative risk refers to conditions of more or less inherent risk. Audit care attentionshould be greater where relative and inherent risk are judged to be higher.

Control riskis the probability that the clients internal control system will fail to

detect material misstatements. Control risk should not be assessed so low thatcomplete reliance is on controls and no other audit work is performed.

Detection risk is the probability that audit procedures will fail to produceevidence of material misstatements. Detection risk is realized when substantive procedures fail to detect material misstatements. Substantive proceduresinclude(1) audit of the details of transactions or balances, and (2) analyticalprocedures.

Risk Model

Audit risk can be expressed in the following model which assumes the elements to be

independent:

Audit risk (AR) = Inherent risk (IR) x Control risk (CR) xDetection risk (DR)

Auditors want to perform an audit of a balance or disclosure well enough to hold auditrisk (AR) to a relatively low level. AR is a quality criterion based on professionaljudgement. All other risk assessments are estimates based on professional judgement andevidence.

Preliminary Assessment of Planning Materiality

When planning an audit, materiality is considered to be the largest amount of uncorrecteddollar misstatement that could exist in published financial statements.

Financial Statement Materiality: Materiality is described in the following way:Information is material and should be disclosed if it is likely to influence the economicdecisions of financial statement users. Accounting numbers are not perfectly accuratebecause of the nature of accounting, but accountants and auditors want to maintain thatfinancial reports are materially accurate and do not contain material misstatement.


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Materiality Judgement Criteria: Auditors are generally left without definite, quantitativeguidelines to determine materiality. A rule of thumb is that anything less 5 percent isprobably not material, and anything greater than 10 percent probably is material. Some ofthe common factors auditors use in making judgment are:- Absolute size

- Relative size

- Nature of the item or issue

- Circumstances

- Uncertanity

- Cumulative effects

Top-Down Approach for Materiality Assignment:

To plan the audit of various accounts, auditors need to assign part of the planningmateriality to each account. The amount assigned is the tolerable misstatement, theamount by which an account may be misstated and yet still not cause the financialstatements taken as a whole to be materiality misleading. Some methods of assigningtolerable misstatement based on overall materiality include assigning amounts:

(1) that add up to twice the overall materiality,

(2) such that the square root of the sum of the squared tolerable misstatement is equal tooverall materiality, and

(3) that exactly add up to materiality.

Two methods of assigning overall materiality to tolerable misstatement for accounts are:

Bottoms-up approach: Judging materiality amounts in each account separately, thencombining them to determine the overall effect, and

Top-down approach: Judging an overall material amount for the financial statementand then allocating it to particular accounts.

Materiality and Planning: Auditors use the concept of materiality as a guide (1) to planning the audit program, (2) to evaluation of the evidence, and (3) for makingdecisions about the audit report.

Preliminary Analytical Procedures

Analytical procedures must be applied in the beginning stages of each audit. Five generaltypes of procedures for analysis of current year account balance are as follows:

(1) compare to balances for one or more comparable periods.

(2) Compare to anticipated results (budget and forecasts).


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(3) Evaluate relationships to other current-year balances for conformity with predictablepatterns.

(4) Compare with similar industry information.

(5) Study relationships with relevant non-financial information.

Analysis of Unaudited Financial Statements

Analytical Procedures Analysis:

There are two kinds of analysis of the unaudited financial statements:

Horizontal analysis examines changes of financial statement number and ratiosacross two or more years.

Vertical analysis examines financial statement amounts expressed each year asproportions of a base.

Auditors look for relationships in accounts as indicators of problems and to plan furtheraudit work. The analysis can also include:

(1) Attention directing, pointing out accounts that may contain errors and frauds andhelp plan the audit program;

(2) An organized approach, that begins with preliminary analytical procedures that canprovide familiarity with the clients business;

(3) A description of the financial changes and relationships that can be seen in the data;

(4) Asking relevant questions about what would account for the financial results beingwrong, or having errors and frauds; and

(5) Preparing a cash flow analysis to see the crucial information from operating,investment, and financing activities.

Analytical Procedures Requirement: Analytical procedures are required at thebeginning of an audit for planning, and at the end of an audit as part if the qualityreview.

Planning Memorandum

Auditors usually prepare a planning memorandum summarizing the preliminary

analytical procedures and the materiality assessment with specific directions about theeffect on the audit. All the planning becomes the basis for preparing an audit program,a specification of procedures that auditors use to guide the work of inherent and controlrisk assessment and to obtain sufficient competent evidence that serves as basis for theaudit report.


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Audit Programs

It has been stated that after those planning tools, the audit program should be planned. Anaudit program is a specification of procedures that guide to work for control risk &inherent risk and to obtain sufficient competent evidence that serves as the basis of theaudit report. While assessing control risk & inherent risk, they will be based on

preliminary risk assessments. While obtaining sufficient evidence that serves as the basisof the audit report, auditing team should develop the audit program.

There are mainly two types of audit programs. An internal control program contains procedures to obtain and understanding of the clients business and managementscontrol structure, and for assessing the inherent and control risk.

A balance-audit program contains substantive procedures for gathering direct evidenceabout the five assertions about dollar amounts in the account balances (i.e. existence,completeness, valuation, rights and obligations, presentation and disclosure).

The audit procedures are intended to enable auditors to conduct the work in accordancewith the three fieldwork standards concerning: planning and supervision of the audit,obtaining an understanding of the central structure and obtaining sufficient competentevidence.

Developing Audit Program- Cycles in the Accounting System

While developing the audit program, the auditors use cycles approach; in order tosimplify the audit plan, auditors group the accounts into several cycles (a set of accountsthat go together in an accounting system). These cycles are mainly:

Revenue & Collection Cycle

Acquisition & Expenditure Cycle

Production & Payroll Cycle

Finance & Investment Cycle

By grouping the accounts, the auditor makes sufficient supervision and review the workdone.

1) Revenue and Collection Cycle

We will first explain the typical revenue and collection cycle, the specific accountsaffected, and the elements of control within the cycle. The following includes specialtechnical notes on the existence assertion, confirmations, and bank reconciliationauditing. It is important to recognize that the control objectives and management

assertions introduced before should be applied to every cycle. The exact specification ofthe objectives and assertions will vary in each cycle, however.

Revenue and Collection Cycle: Typical Activities

The revenue and collection cycle includes transactions that flow through the followingbusiness activities:


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Receiving and processing customers orders, including credit granting.

Delivering goods and services to the customers.

Billing customers and accounting for accounts receivable.

Collecting and depositing cash received from customers.

Reconciling bank statements.

Sales and Accounts Receivable

The activities and transactions for the sales and accounts receivable control structureinvolve the following elements:

(1) Authorization: Processing customers orders and granting of credit.

(2) Custody: Physical custody of goods and accounts receivable records.

(3) Recording: Produces shipping records and sales invoices.

(4) Periodic reconciliation: Comparison of the sum of customers unpaid balances withthe accounts receivable control account total.

Cash Receipts and Cash Balances

The activities and transactions for the cash receipts and cash balances control structureinvolve the following elements:

(1) Authorization: Approving customers discounts and allowances.

(2) Custody: Control and custody of the physical cash.

(3) Recording: Accountants who record cash receipts and credits to customer accountsshould not handle the cash.

(4) Periodic Reconciliation: Bank accounts should be reconciled carefully.

Control Risk Assessment

Control risk assessment governs the nature, timing, and extent of substantive auditprocedures that will be applied in the audit of the account balances in the revenue and

collection cycle. These account balances include cash in bank; accounts receivable;allowance for doubtful accounts; bad debt expenses; sales revenue; and sales returns,allowances, and discounts.

General Control Considerations

1. Proper segregation of responsibilities for authorization, custody, recording andreconciliation


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2. Persons who handle cash should be insured under a fidelity bond

3. Provide for detail error-checking activities

4. Information about the control system can be gathered by (a) an internal controlquestionnaire, (b) a walk-through or a sample of one.

Detail Test of Controls Audit Procedures

An organization should have input, processing, and output control procedures in placeand operating to prevent, detect, and correct accounting errors. The general controlobjectives (validity, completeness, authorization, accuracy, classification, accounting andposting, and proper period recording) must be related to the revenue cycle activities.Details tests of control procedures can be performed to determine whether controls arebeing performed properly. These include: (1) identification of the data population fromwhich a sample will be selected for audit, and (2) the action to be taken to producerelevant evidence (the action involves vouching, tracing, observing, scanning, and

recalculation). Test of controls audit procedures can be used to audit the accountingtransactions in two directions: (1) Completeness: determines whether all transactions thatoccurred were recorded (none omitted). (2) Validity: determines whether recordedtransactions actually occurred (were valid).

Summary: Control Risk Assessment

If control risk is assessed very low, then substantive audit procedures can be limited incost-saving ways. If it assessed very high, then substantive procedures will need to bedesigned to lower the risk of failing to detect material errors in the account balances. Aletter to the client should describe any reportable conditions.

Special Note: The Existence Assertion

When considering assertions and obtaining evidence about assets, auditors must putemphasis on the existence and rights (ownership) assertions. For liability accounts, theemphasis is on completeness and obligations assertions. The following audit procedurescan be used to obtain evidence about the existence and ownership of accounts receivableand other assets: (1) Recalculation, (2) Physical observation, (3) Confirmation, (4) verbalinquiry, (5) Examination of Documents (Vouching), (6) Scanning, (7) Analyticalprocedures.

Special Note: Using Confirmations

In general, the use of confirmations for cash balances and trade accounts receivable isconsidered a required generally accepted audit procedure. Auditors may decide not to useconfirmations if suitable alternatives procedures are available and applicable in particularcircumstances. Justifications for not using confirmations include: (1) receivable are notmaterial, (2) confirmations would be ineffective and unreliable, and (3) analyticalprocedures and other tests provide sufficient competent evidence.


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Confirmation of Cash and Loans balances

Auditors should use a standard bank confirmation form approved by Minister of Finance.

Confirmation of Accounts and Notes Receivable

Two types of confirmations are used:

(1) Positive confirmation: asks for a response, regardless of correctness of balance,

(2) Negative confirmation: asks for a response only if something is wrong with thebalance. Confirmations yield evidence about existence and gross valuation, bit notnecessarily about the collectibility of the accounts.

Special Note: Audit of Bank Reconciliations With Attention To Lapping and Kitting

The companys bank reconciliation is the primary means of valuing cash in the financialstatements. A normal procedure is to audit the reconciliation. A cutoff bank statement is

used by the auditor ro vouch the bank reconciliation items.

Accounts Receivable Lapping

Lapping is the process whereby an employee takes receipts and attempts to cover up byusing later receipts to credit accounts of customers from which receipts were taken. Totest for the possibility of stolen receipts, compare deposits slips to the detail of customerscredits posted to customers accounts receivable.

Check Kitting

Check kitting is the practice of building up apparent balances in one bank account basedon uncollected checks drawn against similar accounts in other banks. Test for checkkitting by preparing a schedule of interbank transfers.

Bank Transfer schedule and Proof of Cash

The proof of cash is a reconciliation in which the bank balance, the bank report of cashdeposited, and the bank report of cash paid are all reconciled to the clients general ledger.It is often used as a more extensive procedure to find check kitting.

Audit Cases: Substantive Audit Procedures

Auditors should not place total reliance on controls to the exclusion of substantive audit procedures. Substantive procedures are designed to obtain direct evidence about the

dollar amounts in account balances, while test of control procedures are designed toobtain evidence about the companys control activities. A dual-purpose procedure can beused for both purposes. The objectives in performing substantive procedures is to detectevidence of errors and frauds, and material overstatements or understatements of theaccount balance. The case illustrate the approach by first presenting the misstatement,followed by an audit approach.


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(1) Case Description: (a) Method: A cause of misstatement by some kind of failure ofcontrols. (b) Paper trail: A set of telltale signs of erroneous accounting. (c) Amount: Thedollar amount of overstated assets and revenue, or understated liabilities and expenses.

(2) Audit Approach: (a) Audit objective: A recognition of a financial statement assertionfor which evidence must be obtained. (b) Control: Recognition of the control proceduresthat should be used by an organization to prevent and detect errors and frauds. (c) Test ofcontrols: Ordinary and extended procedures designed to test the effectiveness of thecontrols that should be in operation. (d) Audit of balance: Ordinary and extendedsubstantive procedures designed to find errors and frauds in account balances and classesof transactions.

2) Acquisition and Expenditure Cycle

In this cycle, we will learn the cycle for the acquisition of goods and services, theacquisition of property, plant, and equipment, and the expenditure of cash to pay for theacquisitions. The following includes control risk assessment, and special notes on the

completeness assertion and physical inventory observation. Remember that the samegeneral control objectives and management assertions should be applied to each cycle.

Acquisition and Expenditure Cycle: Typical Activities

The acquisition and expenditure cycle includes transactions that flow through thefollowing business activities: (1) Purchasing goods and services. (2) Paying the bills.

The activities and transactions of the acquisition and expenditure control system includesthe following elements:

(1) Authorization: Purchase requisition, order, and payment.

(2) Custody: Receipt of goods, and supporting documents and records.

(3) Recording: Record in accounts payable and cash accounts.

(4) Periodic Reconciliation: Periodic comparison of existing assets to recorded amountsin various accounts.


Control risk assessment governs the nature, timing, and extent of substantive auditprocedures that will be applied in the audit of the account balances in the acquisition and

expenditure cycle. These accounts include inventory; fixed assets; depreciation expense;accumulated depreciation; accounts and notes payable; cash disbursements; and variousadministrative, selling, and manufacturing expenses.


1. Proper segregation of responsibilities for authorization, custody, recording, andreconciliation


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2. Persons who have custody of assets and cash disbursement authority should notdo accounting.

3. Provide for detail control checking activities

4. Information about the control structure can be gathered by the use of an internal

control questionnaire.


An organization should have input, processing, and output control activities in place andoperating to prevent, detect, and correct accounting errors. The general control objectives(validity, completeness, authorization, accuracy, classification, accounting, and proper period recording) must be related to the acquisition and expenditure cycle. Auditors perform detail tests of control audit procedures to determine whether controls areoperating. The actions to be taken to produce the relevant evidence include vouching,tracing, observing, scanning, and recalculating.

Details Test of Controls for Inventory Records

Auditors need to determine whether they can rely on the accuracy of perpetual inventoryrecords. Tests of controls over accuracy involve tests of the additions (purchases) andreductions (issues) of the item balances. A dual direction test of audit samples should beperformed.


If the control risk is assessed very low, substantive audit procedures can be limited incost-saving ways. If it is assessed very high, substantive procedures will need to be

designed to lower the risk of failing to detect material misstatement in the accountbalances. A letter to the client should describe any reportable conditions.

Special Note: The Completeness Assertion

When considering assertions and obtaining evidence about accounts payable and otherliabilities, auditors must put emphasis on the completeness and obligations assertions.The emphasis is on completeness because companies tend to be less concerned aboutrecording expenses and liabilities. Auditors cannot rely entirely on the managementassertion of completeness. The search for unrecorded liabilities is designed to yield auditevidence of liabilities that were not recorded in the reporting period.

Special Note: Physical Inventory Observation

The audit procedures for inventory and related cost of sales accounts frequently areextensive in an audit engagement. A material error or fraud in inventory has a pervasiveeffect on the financial statement. Auditing standards require that the auditor observe theinventory-taking and make test counts. They seldom take or count the entire inventory.Many physical inventories are counted at year-end when the auditor is present to observe


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and perform dual-direction testing to gather evidence for the existence and completenessassertions.

Physical Inventory Not on Year-End Date

The inventory on the count date is reconciled to the year-end inventory and auditing procedures are performed on purchases, inventory additions, and issues for theintervening period.

Cycle Inventory Counting

The auditor must be present during some counting operations to evaluate the counting

plans and execution and must evaluate the accuracy of perpetual records.

Auditors Not Present at Clients Inventory Count

The auditor must review the clients plan for the completed count. Some test counts ofcurrent inventory should be made and traced to current records to determine reliability ofperpetual records.

Inventories Located Off the Clients Premises

The auditor must determine the amount and location of the inventory off the clientpremises. If amounts are material and controls are not strong, the auditor may wish tovisit locations and conduct onsite test counts. If amounts are not material, and controlrisk is low, direct confirmation with the custodian may be sufficient competent evidence.

Inventory Existence and Completeness

The physical observation procedures are designed to audit for existence, completeness,and valuation.

Special Note: Finding Fraud Signs in Accounts Payable

A companys accounts payable and cash disbursements systems may be used byfraudsters to generate false payments. This may be done by sending false invoices to the

company and having an insider manipulate controls or documents to make payment.Examples of the fraud signs auditors should look for include photocopies of invoices,vendors invoices submitted in numerical order, vendors invoices that are always in roundnumbers, and vendors invoices that are always slightly lower than a review threshold.


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The audit of account balances consists of procedural efforts to detect errors and fraudsthat might exist in the balances, thus making them misleading in financial statements.The cases present first the method, paper trail, and amount, followed by the auditapproach, consisting of the audit objective, control, test of controls, and audit of balances.

Self-Assessment

True or False Questions:

Indicate in the space provided if the following statements are true or false.

___1. The basic acquisition and expenditure activities are (1) purchasingthe goods and (2) paying the bills.

___2. Purchases are requisitioned by a purchasing department that seeksthe best prices and quality

___3. Checks are signed by the accounts payable department afterassembling the invoice, purchase order and receiving report.

___4. Purchase order are open from the time they are issued until thegoods are received.

___5. Normally, liabilities should be recorded on the date the goods arereceived and accepted by the receiving department or by aresponsible person.

___6. The audit search for unrecorded liabilities should emphasize thelarge balances, especially for regular vendors

___7. Auditors can inspect the unmatched invoice file and compare it tothe unmatched receiving report file to determine whetherliabilities are unrecorded.

___8. Proper segregation involves authorization of purchases by personswho do not have custody, recording, or reconciliation duties.

___9. If personnel in the organization are not performing their controlprocedures very well, auditors will need to design substantive auditprocedures to try to detect whether control failures have producedmisleading account balances.

__10. If the control risk is assessed very low additional substantive auditprocedures will be required.


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__11. Auditors emphasize the existence assertion when auditing liabilitiesbecause companies typically are less concerned about timelyrecording of liabilities than of revenues and assets.

__12. Evidence is much easier to obtain to verify the completenessassertion for liabilities than the existence assertion for assets.

__13. The search for unrecorded liabilities should normally be performedup to the report date in the period following the audit clientsbalance sheet date.

__14. The audit procedures for inventory and related cost of salesaccounts frequently are extensive in the audit engagement.

__15. The auditors best opportunity to detect inventory errors and fraudsis during the physical observation of the inventory count.

3) Production and Payroll Cycle

We will learn the production and payroll cycle in two sections. Part I covers theproduction cycle, dealing with inventory valuation, depreciation, and cost of goods soldaccounting. Part II covers the audit of payrolls and labor cost accounting. The followingincludes control risk assessment for the production and payroll cycle. As with all of thecycles, remember that the same general control objectives and management assertionsapply.

Part I: Production Cycle Typical Activities

The production cycle includes transactions that flow through the following business

activities: (1) Production planning, inventory planning and management. (2) producinggoods and services. (3) Cost accounting and cost of goods sold determination.

The activities and transactions for the production control structure involve the followingelements:

(1) Authorization: Production authorization based on sales forecasts interacts withproduction orders, bills of materials, materials requisitions.

(2) Custody: Physical custody of materials, equipment and labor, and cost accountingrecords.

(3) Recordkeeping: Determination of cost-per-unit, standard costs, and variances.

(4) Periodic reconciliation: Periodic reconciliation of physical inventory to recordedamounts, analyses of internal production information.


Control risk assessment governs the nature, timing, and extent of substantive auditprocedures that will be applied in the audit of the account balances in the production


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cycle. These accounts include raw materials inventory, work-in-process inventory,finished goods inventory, cost of goods sold, depreciation expenses, and accumulateddepreciation.


1. Proper segregation of responsibilities for authorization, custody, recording andreconciliation.

2. Custody of inventories in hands of persons who do not authorize or account forproduction.

3. Cost accounting performed by persons who do not authorize production or havecustody of production assets.

4. Provide for detail control checking procedures

5. Complex computer systems may be used to manage production and materials flow.

6. Information about the control structure can be gathered by the use of an internalcontrol questionnaire.

Detail Tests of Controls Audit Procedures

An organization should have input, processing, and output control activities in place andoperating to prevent, detect, and correct accounting errors. The general control objective(validity, completeness, authorization, accuracy, classification, accounting and posting,and proper period recording) must be related to the production cycle. Auditors performdetail test of controls audit procedures to determine whether controls are operating. Theactions to be taken to produce the relevant evidence include vouching, tracing, observing,scanning, and recalculating.

Direction of the Test of Controls Procedure

The test of controls procedures are designed to test the production in the following twodirections:

(1) Completeness: the recording of all the production that was ordered to be started. (2)Validity: proper recording of work in process and finished goods in the general ledger.


If the control risk is assessed very low, substantive audit procedures can be limited in

cost-saving ways. If it is assessed very high, substantive procedures will need to bedesigned to lower the risk of failing to detect material errors in inventory and cost ofgoods sold account balances. A letter to the client should describe any reportableconditions. Computerized production cycle records will require computer audit ofbalances.


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The audit of account balances consist of procedural efforts to detect errors and frauds thatmight exist in the balances, thus making them misleading in financial statements. Thecases present first the method, paper trail and amount, followed by the audit approach,consisting of the audit objective, control, test of controls, and audit of balances.

Part II: Payroll Cycle Typical Activities

Personnel management and the payroll accounting cycle include transactions that affectthe wage and salary accounts and a number of related accounts. The payroll cycletypically would include the following five functional responsibilities performed byseparate people or departments.

(1) Personnel and Labor Relations: hiring and firing.

(2) Supervision: approval of work time.

(3) Timekeeping and cost accounting: payroll preparation and cost accounting.

(4) Payroll accounting: check preparation and related payroll reports.

(5) Payroll Distribution: actual custody of checks and distribution to employees.

The activities and transactions of the payroll control system involve the followingelements:

(1) Authorization: The personnel department, supervision, timekeeping, and costaccounting have authorization over their independent functions.

(2) Custody: Possession of payroll checks, payroll distribution, supervision andtimekeeping documents.

(3) Recordkeeping: Payroll accounting prepares checks and related state and federal taxreports.

(4) Periodic reconciliation: Payroll records and reports should be reconciled.

(5) Employees on fixed salary: The control system is simplified by not having to collecttimekeeping data.


The major risks in the payroll cycle are:

(1) Paying fictitious employees.

(2) Overpaying for time or production.

(3) Incorrect accounting for costs and expenses


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1. Proper segregation of responsibilities for authorization, custody, recording, andreconciliation of payroll functions.

2. Custody of payroll distribution by persons who do not authorize employees pay or

prepare payroll checks.

3. Recordkeeping is performed by payroll and cost accounting personnel who do notmake authorizations or distribute pay.

4. Provide for detail control checking activities

5. Even in complex computer-based payroll systems, basic management and controlfunctions should be in place.

6. Information about the control structure can be gathered by the use of an internalcontrol questionnaire.


An organization should have input, processing, and output control procedures in placeand operating to prevent, detect, and correct accounting errors. The general controlobjectives (validity, completeness, authorization, accuracy, classification, accounting andposting, and proper period reporting) must be related to the payroll cycle. Auditors perform detail tests of control audit procedures to determine whether controls areoperating. The actions to be taken to produce the relevant evidence involve vouching,tracing, observing, scanning, and recalculating.

Direction of the Test of Controls Procedures

The test of controls procedures are designed to test the payroll accounting in thefollowing two directions: (1) Completeness: the matching of personnel file content topayroll department files and the payroll register. (2) Validity: preparation of the payrollregister.


If the control risk is assessed very low, substantive audit procedures can be limited incost-saving ways. If it is assessed very high, substantive procedures will need to bedesigned to lower the risk of failing to detect material errors in financial statements.


The audit of account balances consist of procedural efforts to detect errors and frauds thatmight exist in the balances, thus making them misleading in financial statements. Thecases present first the method, paper trail and amount, followed by the audit approach,consisting of the audit objective, control, test of controls, and audit of balances.

4) Finance and Investment Cycle


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The finance and investment cycle deals with the major activities of a typical business (1)obtaining funds to finance the operation either from lenders who become creditors orfrom investors who become owners, and (2) investing funds not immediately needed tofinance operations. We will explain the flow of transactions of both the finance andinvestment activities, the accounts affected, and the elements of control within the cycle.

The following includes control risk assessment for the financial and investment cycle.

Financing and Investment Cycle: Typical Activities

The finance and investment cycle major functions are:

(1) Financial planning and raising capital.

(2) Interacting with the acquisition and expenditure, production and payroll, and revenueand collection cycles.

(3) Entering into mergers, acquisitions and other investments.

Debt and Stockholder Equity CapitalTransactions in debt and stockholder equity capital are normally few in number but largein monetary amount, and are handled by the highest level of management. The activitiesand transactions involve the following elements:

(1) Authorization: Financial planning includes a cash flow forecast and capital budget.Authorizations for sale of stock and debt financing is usually at the board of directorlevel.

(2) Custody: Large companies use registrars and transfer agents for custody of the stockcertificate book. Small companies keep their own stockholders records. Originals ofdebt instruments are held by lenders.

(3) Recordkeeping: Notes, bonds payable, and calculated liabilities are maintained byaccounting departments.

(4) Periodic Reconciliation: Inspect and reconcile stock certificate book. Confirm bondsheld by trustee.

Investments and Intangibles

Transactions in investments and intangibles may vary depending on the size and type ofcompany. The activities and transactions involve the following elements:

(1) Authorization: Investments approved by the board of directors or investment

committee.(2) Custody: Custody of investments and intangibles depend on the nature of the assets.

Some investments may be in physical custody, others in the form of managementresponsibility.

(3) Recordkeeping: Investment and intangible recordkeeping will vary depending oncomplexity and nature.

(4) Periodic Reconciliation: Inspect and count negotiable security certificates.


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Because finance and investment transactions are usually individually material, eachtransaction usually is audited in detail. Reliance on control does not normally reduce theextent of substantive audit work on finance and investment cycle accounts. However,lack of control can lead to significant extended procedures.


1. Responsibilities in the hands of senior management officials

2. Difficult to have strict segregation of functional responsibilities when seniormanagement officials are involved

3. A compensating control feature involving two or more persons in each kind ofimportant functional responsibility.

Control over Accounting Estimates

A clients management is responsible for making estimates and maintaining the controlsdesigned to reduce the likelihood of material misstatements. Auditors test of controlsover estimates amounts to inquiries and observations related to the specific features ofestimates. Substantive audit procedures include procedures to determine whether (a) thevaluation principles are acceptable under the general accounting principles (b) thevaluation principles are consistently applied, (c) the valuation principles are supported bythe underlying documentation, and (d) the method of estimation and the significantassumptions are properly disclosed according to the laws.


The involvement of senior officials in a relatively small number of high-dollartransactions makes control risk assessment a process tailored specifically to thecompanys situation. Substantive audit procedures are not limited in extent. Controldeficiencies and unusual or complicated transactions can adjust the nature and timing ofthe audit procedures.

Assertions, Substantive Procedures, and Audit Cases

The audit of three sections: (1) owners equity, (2) long-term liabilities and relatedaccounts, and (3) investment and intangibles are presented. The audit of the accountbalance consists of procedural efforts to detect errors and frauds that might exist in thebalances, thus making them misleading in financial statements. The cases present first themethod, paper trail and amount, followed by an audit approach, consisting of the auditobjective, control, test of controls, and audit of balances.

Owners Equity

The typical specific assertions include:

1. The number of shares shown as issued is in fact issued.


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2. No other shares have been issued and not recorded or reflected in the accounts anddisclosures

3. The accounting is proper for options, warrants, and other stock plans and relateddisclosures are adequate.

4. The valuation of shares issued for non-cash consideration is proper, and in conformitywith accounting principles

5. All owners equity transactions have been authorized by the board of directors.

Documentation: Owners equity transactions are well documented (e.g., board ofdirectors minutes, proxy statements) and transactions can be vouched to these documents.

Confirmation: Capital stock may be confirmed when independent registrars and transferagents are employed. When there are no independent agents, most audit evidence isgathered by vouching stock record documents.

Long-Term Liabilities and Related Accounts

The primary audit concern is that all liabilities are recorded and that the interest expenseis properly paid or accrued. The assertion of completeness is paramount. The typicalspecific assertions include:

1. All material long-term liabilities are recorded

2. Liabilities are properly classified according to their current or long-term status

3. New long-term liabilities and debt payments are properly authorized

4. Terms, conditions, and restrictions relating to non-current debt are adequatelydisclosed.

5. Disclosures of maturities for the next five years and the capital and operatinglease disclosures are accurate and adequate.

6. All important contingencies are either accrued in the account or disclosed infootnotes.

Confirmation: When auditing long-term liabilities, auditors usually obtain independentwritten confirmation for notes and bonds payable.

Off-balance Sheet Financing: Confirmation and inquiry procedures may be used toobtain responses for off-balance sheet information including off-balance sheetcommitments.

Analytical Relationships: Analytical relationships exist for debt, recorded interestexpense and accrued interest accounts. The auditor can compare audit results withrecorded interest to identify unrecorded debt and errors in interest accounts.


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Deferred Credits- Calculated balances: Several types of deferred credits depend oncalculations for their existence and valuation and should be recalculated for accuracy.

Investments and Intangibles

Companies can have a wide variety of investment and relationship with affiliates. Thetypical specific assertion includes:

1. Investment securities are on hand or held in safekeeping by a trustee

2. Investments are properly valued

3. Controlling investments are accounted for by the equity method

4. Purchased goodwill is properly valued

5. Capitalized intangible costs relate to intangible acquired in exchange transactions

6. Research and development costs are properly classified

7. Amortization is properly calculated

8. Investment income has been received and recorded

9. Investment are adequately classified, described and disclosed in the balance sheet

Confirmation: The practice of obtaining independent written confirmation from outsideparties is limited in the investment, intangible, and related accounts

Inquires about Intangibles: Company counsel can be queried about knowledge of anylawsuits, and legal questions in a specific attorneys letter.

Income from Intangible: Income from intangibles can be confirmed or vouched,depending on the intangible.

Inspection: Investment property may be inspected to determine existence and conditionsof the property.

Documentation Vouching: Investment property may be inspected to determine existenceand conditions of the property

External Documentation: Market value of securities and related income can bedetermined from external sources.

Equity method Investment: When equity method accounting is used for investments,auditors need to obtain audited financial statements of the investee company forrecalculating the amount of the clients share of income to recognize in the accounts.

Amortization Recalculation: Amortization of goodwill and other intangibles should berecalculated.


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Inquiries about Management Intentions: Inquiries should be held with management todetermine the nature of investments and reasons for holding them.

Self-Assessment

True or False Questions:

Indicate in the space provided if the following statements are true or false.

___1. Financial planning starts with the chief financial officers capital budget

___2. Sales of capital stock and debt financing transactions usually are authorized by theboard of directors

___3. In large companies, custody of stock certificate books is a significant managementproblem.

___4. Ownership of bonds can be handled by a trustee having duties and responsibilitiessimilar to those of registrars and transfer agents

___5. All investment policies should be approved by the board of directors or itsinvestment committee.

___6. the most significant reconciliation opportunity in the investment and intangibleaccounts is the inspection and count of negotiable securities certificates.

___7. reliance on controls normally reduces the extent of substantive audit work onfinance and investment cycle accounts.

___8. the segregation of functional responsibilities is relatively easy for the finance andinvestment cycle

___9. auditors test of controls over the production of estimates amounts to inquiries andobservations

__10. it is very common for auditors to perform substantive audit procedures on 100percent of the details in finance and investment accounts.

__11. when there are no independent agents, most audit evidence about capital stock isgathered by confirmation directly with the holders

__12. owners equity transactions usually are not well documented

__13. The primary audit concern with the verification of long-term liabilities is that allliabilities are recorded and that the interest expense is properly paid or accrued.

__14. when fixed assets are acquired during the year under audit, auditors should inquireabout the source of funds for financing the new asset.

__15. Confirmation requests should be sent only to lenders with a liability balance at theaudit date


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__16. Confirmation and inquiry procedures are not required for a class of items looselytermed off-balance sheet information.

__17. Interest expense generally is audited primarily by analytical procedures.

__18. Purchase-method consolidations usually create problems of accounting for the fair

value of acquired assets and related goodwill.

__19. The practice of obtaining independent written confirmation from outside parties isfairly limited in areas of investments and intangibles.

__20. the balance sheet classification of investment by management should be confirmedwith outside parties.

Auditors Working Papers

An audit must document the audit procedures performed to support the understanding,

tests, and evaluation of risks and the substantive tests performed directly on the amountsand disclosures shown in the financial statements. This evidence is accumulated in filesof audit working papers. Although the term working papers suggests paper documents,much audit evidence now exists only in electronic files. A number of accounting firmsare now developing paperless auditing systems. Spreadsheets, text, checklists, and otherevidence are prepared and saved in an electronic format. Even confirmation letters fromoutside parties can be electronically scanned into the audit files. The term working papersis used here to include all audit documentation, both electronic and paper. Workingpapers are records kept by the auditor of the procedures applied, the tests performed, theinformation obtained, and the pertinent conclusions reached in the engagement.

Working papers should be sufficient to show that the financial statements or otherinformation on which the auditor is reporting were in agreement with the clients records.Listed below are general guidelines as to what working papers should include:

i. The work has been adequately planned and supervised, indicating observance ofthe first standard of fieldwork.

ii. A sufficient understanding of the internal controls has been obtained to plan theaudit and to determine the nature, timing, and extent of tests to be performed,indicating observance of the second standard of fieldwork.

iii. The audit evidence obtained, the auditing procedures applied, and the testing of performed has provided sufficient component evidential matter to afford areasonable basis for an opinion, indicating observance of the third standard of

fieldwork.

Reasons for audit working papers

I. Reporting partner needs to be able to satisfy himself that work delegated by himhas been properly performed.


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II. Working papers provide, for future reference, details of problems together withevidence of audit and conclusions in arriving at the audit opinion.

III. The preparation of working papers encourages the auditor to adopt a methodicalapproach.

IV. To use working papers in the following years.In summary, properly prepared working papers are necessary for an auditor todemonstrate compliance with the standards of fieldwork. They should show how thework was planned (e.g. the use of audit programs) and the extent of supervision ofassistants (indication of reviews made by the auditor). They should contain sufficient,competent evidence (e.g. control risk checklists, confirmations from creditors, bankreconciliations) on which to base an opinion.

Contents of working papers

a. Information of continuing importance of audit

b. Audit planning information including the audit program.

c. The auditor assessment of the company's accounting system, his review and evaluationof internal control.

d. Details of audit work, notes of errors, action taken together with the opinion of thestaff.

e. Evidence with the staff review.

f. Records of balances, other financial information including analyses and summaries ofthe financial statements.

g. A summary of significant points effects the financial statements and audit reportpreparations.

Types of Working Papers

Auditors normally maintain two types of working paper files. One is referred to as apermanent or continuing audit file, and the other often is called the current-year audit file.

Permanent Audit Files

The permanent audit file is composed of documents, schedules and other data that will beof continuing significance to several years audits. For example, an auditor must obtain acopy of a clients articles of incorporation as evidence of the types (common andpreferred), par values, and number of authorized shares of stock that the company mayissue, as well as restrictions on payment of dividends, purchase of treasury stock, or othermatters requiring disclosure in the financial statements. Rather than obtaining a copy ofthe same document each year, the auditor places one copy in the permanent file, which is


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a part of each years audit evidence. Of course, it is necessary to check each year for anyamendment to the articles of incorporation and to indicate any changes on the documentin the permanent file. Amendments normally would be detected by the auditor during hisor her review of minutes of stockholders and directors meetings, because approval isgenerally required by one or both of these parties.

Although the organization of permanent files varies, most would contain the

following sections:

1) Historical information regarding the client: This section usually includes amemorandum describing the company and its operations, major plants and manufacturingprocesses, and products, distribution facilities, and important customers. An organizationchart listing the names and positions of key officers and employees and any recurringaudit administrative matters are also shown. This type of information is particularlyimportant to auditors assigned to a client for the first time. It allows them to learnsomething about the operations of the company in a brief period of time and makes themaware of any unusual matters concerning the audit, such as timing deadlines andreporting requirements. The client is saved the task of acquainting different members ofthe auditing firm with basic information about the company. A partial example of such amemorandum is shown in Illustration 2.

Illustration 2:

X Co.Company Operation

and

Audit Administration MemoX Co. was formed in 19X0 by Mr. Fitzgerald and Mr. Hamilton, both of who remain 50%stockholders. X Co. operates a 40,000-barrel per day refinery near Granville, Arkansas(also the location of its administrative offices), at the intersection of Highways 65 and 71.The President and Plant Manager is Mr. Foote and the Treasurer, with whom we arrangethe timing of our work, is Ms. Johnson. The company acquires most of its raw materials(crude oil) in the open market and is subject to the regulations of the Department ofEnergy (a copy of the DOE regulations is filled behind this memo). The crude oil isrefined into premium and regular gasoline, which is sold to a chain of independentgasoline stations. The company reports on a December 31 fiscal year. Out audit report isto be delivered to the shareholders by February 10. In the past we have experienced

difficulty and delay in obtaining confirmation of a significant accounts receivable fromthe chain of independent gasoline stations, so we must be sure to mail the confirmation atthe earliest possible date and include sufficient details to .

By regarding the memorandum, an auditor who had never worked on the X Companyengagement would know where the company is located and what it does, whom tocontact at the company, what some of the important reporting and timing requirements


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are, and that he or she would need a knowledge of regulations in the auditing about thecompany.

2) A description of the entitys internal controls: This material might consist ofnarrative descriptions of the clients control environment, accounting and control

procedures, internal control questionnaires, flowcharts, decision tables, or anycombination of these items. A chart of accounts and samples of any records that wouldaid in understanding company procedures may also be included. A brief example of adescription of accounting procedures to notes payable and long-term debt is shown inIllustration 3.

Illustration 3:

X Co.

Procedures for Notes Payableand

Long-Term DebtX Co. has outstanding a $5 million issue of 8% bonds due in installments of $500,000 peryear beginning in 20X2. All refinery property and equipment is pledged to these bonds.The bond indenture restricts payment of dividends of $200,000 per year. The companyalso borrows on short-term notes for working capital purposes.

All borrowings are authorized by the Board of Directors, and the banks or other creditorsare specifically mentioned. Both the President and the Treasurer must sign any notes thatare issued. The Treasurer maintains a schedule showing the due dates of all bond, note,and interest payments.

3) Legal Documents: In addition to the articles of incorporation, the permanent filenormally contains copies of loan agreements, bond indentures, labor contracts, stockoption plans, pension plans, important long-term operating agreements or contracts, andother documents. Because all of these documents could significantly affect thecompanys operations and its financial statements, the auditor must have evidence of theprovisions of these documents and his or her reviews thereof.

4) Continuing analyses of certain accounts: It is often more efficient to maintaincumulative schedules in the permanent files for certain accounts with little activity, or forwhich comparisons with several prior years are helpful, than to prepare such scheduleseach year in the current files. Continuing analysis might be used for capital stock, long-

term debt, checklists for compliance with loan agreements, equity in earnings ofsubsidiaries, and gross profit ratios by major product class. An illustration of such ananalysis is shown in Illustration 4.


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Illustration 4:

X Co.

Analyses of Uncollectible Accounts

19X6 19X7 19X8 19X9

Sales $4,365,000

$5,837,000

$5,679,000

$5,928,000

Bad debt provision 54,000 68,000 63,000 71,000

Bad debt charge-offs 54,000 67,000 63,000 91,000

Accounts receivable balance 12-31Current $372,000 $498,000 $501,000 $530,00030-60 days 31,000 54,000 53,000 57,000Over 60 days 2,000 19,000 16,000 52,000

Total $405,000 $571,000 $570,000 $639,000

Allowance for doubtful accounts $30,000 $35,000 $35,000 $15,000

Ratios-Bad debt charge-offs to sales 1,2% 1,1% 1,1% 1,5%

Allowance to total accountsreceivable

7,4% 6,1% 6,1% 2,3%

Allowance to accountsreceivable over 60 days

15,0 1,8 2,2 0,3

Days sales in accountsreceivable

33,9 35,7 36,6 39,3

This analysis should alert the auditor that there has been deterioration in accountsreceivable during the year, and it should raise a question as to the adequacy of theallowance for doubtful accounts.

5) Audit planning: This section would include a master copy of the audit program (oftenon computer diskettes) that could be revised and copied each year than completelywritten; schedules of plant capacity and volumes of tanks, bins and other containers (anauditor would be embarrassed to discover, after being satisfied as to inventory, that his or


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her client didnt have the physical capacity to store the amount of inventory shown in theaccounting records), and if certain procedures are performed on a rotating basis, a recordof the accounts (cost centers, bank accounts, etc.) or locations (branch offices,subsidiaries, etc.) tested each year to ensure that nothing is overlooked.

The permanent audit file can be very useful tool of the auditor if it is kept current andused. Occasionally, in his or her haste of complete the current-year audit, an audit willneglect to review and update the permanent file. When this happens, the file becomes lessuseful and less used each succeeding year, until it becomes a file of obsolete data. At that point, it becomes less than useless to the auditor; it becomes a threat because it isevidence of negligent and inadequate work.

Current Audit Files

The current audit files for each year contain the evidence gathered and the conclusionsreached in the audit for that year. The material in the current files includes schedules andanalyses of accounts; memoranda of audit work performed and audit problemsconsidered and resolved; an audit program; correspondence with third parties (banks,customers, creditors, legal counsel, etc.) confirming balances, transactions and otherdata,

and other documents.