Audit Exam 3 Study Guide
Audit Exam 3 Study Guide ACCT 4150
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This 21 page Study Guide was uploaded by Victoria Andreski on Thursday April 7, 2016. The Study Guide belongs to ACCT 4150 at Clemson University taught by Nancy Harp in Spring 2016. Since its upload, it has received 49 views. For similar materials see Auditing in Accounting at Clemson University.
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Date Created: 04/07/16
CHAPTER 10—Auditing the Revenue Process Revenue Recognition • Revenue—inflows of an entity from producing goods, rendering services, or other activities that constitute the entity’s major or central operations o Promise of cash for services • Recognition Criteria—SAB 101 o 1. Persuasive evidence of an arrangement exists § Contract or purchase order o 2. Delivery has occurred or services have been rendered § You must EARN the revenue o 3. Seller’s price to the buyer is fixed or determinable o 4. Collectability is reasonably assured • Fraud Risks o 1. Side Agreements § Alter the terms of the sale § Used to get customers to get delivery early as a way to inflate revenues o 2. Channel Stuffing § When selling to a distributor and they hope to sell at resale § We entice them to buy our stuff as a way to inflate our sales § They buy too much § Inflate revenue at the end of the year but the goods are returned at the beginning of January o 3. Related Party Transactions § Must be disclosed § Must identify them o 4. Bill & Hold Sales § Where customer agrees to buy stuff but tells manufacturer that they must keep it § Customer will tell manufacturer when to deliver the goods throughout the year • Will have an invoice but not a shipping document Types of Transactions & Financial Statement Accounts Affected • 3 types of transactions are typically processed through the revenue process: o 1. The Sale of goods or rendering of a service for cash or credit § Accounts affected: • Trade accounts receivable • Sales • Allowance for uncollectible accounts • Bad-debt expense o 2. The receipt of cash from the customer in payment for goods/services § Accounts affected: • Cash • Trade accounts receivable • Cash discounts o 3. The return of goods by the customer for credit or cash § Accounts affected: • Sales returns • Sales allowances • Trade accounts receivable Types of Documents & Records • Customer Sales Order o Contains the details of the type & quantity of products/services ordered by the customer o Aka purchase order • Credit Approval Form o For credit sales, the client must have a formal procedure for investigating the creditworthiness of the customer o Formal document showing all the considerations you had o Checklist • Open-Order Report o A report of all customer orders for which processing has NOT been completed o All orders not shipped out yet • Shipping Document o Generally serves as a Bill of Lading & contains information on the type of product shipped, the quantity shipped, & other relevant information o Cartons, weights, etc. o Important b/c it proves that we can recognize the sale § It’s out of our warehouse & we’ve attempted to ship it • Sales Invoice o Document used to bill the customer o Contains information on the type of product/service, the quantity, the price, & the terms of trade o Used to book entry in sales journal • Sales Journal o Once a sales invoice has been issued, the sale needs to be recorded in the accounting records o The sales journal is used to record information about the sales transaction • Customer Statement o Document mailed to the customer & contains details of all sales, cash receipts, & credit memorandum transactions o Good control • Accounts Receivable Subsidiary Ledger o Ledger contains an account & the details of transactions for each customer • Aged Trial Balance of Accounts Receivable o Report summarizes all the customer balances in the accounts receivable subsidiary ledger o Each account is classified as current or placed into one of the several past due categories o Use AR to understand the delinquent accounts so that we can call those people (to collect the amounts) & estimate what is uncollectible (determine our allowance for doubtful accounts) • Remittance Advice o Part of the customer’s bill that should be returned with the payment o Turnaround document • Cash Receipts Journal o Journal is used to record the cash receipts of the entity o Report every time you receive cash § Interest, loans, cash, AR, etc. • Credit Memo o Document used to record credits for the return of goods by a customer o Credit (decrease) AR for what you return o Must check to see if customer actually received the goods (receiving report) to approve credit memo before you do the credit memo • Write-Off Authorization o Document authorizes the write-off of an uncollectible accounts receivable o Final authorization is generally received from the treasurer o Write-off customers if they go bankrupt or if you’ve tried getting in contact w/ customer but can’t or you turn account over to a collection agency o Journal entryà credit AR (take person’s account down to 0) & debit the allowance Functions of the Revenue Process • Order Entry o Acceptance of customer orders for goods & services into the system in accordance w/ management criteria o Control for this is that checks are mailed to a lockbox o The initial function in the revenue process is the entry of a new sales order into the system • Credit Authorization o Appropriate approval of customer orders for creditworthiness o Process must determine that the customer is able to pay for the goods/services o Failure to properly authorize credit can lead to extensive bad debts for the entity • Shipping o Shipping of goods that have been authorized o Goods should not be shipped, nor should services be provided without proper authorization o The main control is payment or proper credit authorization • Billing o Issuance of sales invoices to customers for goods shipped or services provided o Processing of billing adjustments for allowances, discounts, or returns o The objective is to ensure that all goods shipped & all services rendered are billed to the customer • Cash Receipts o Processing of the receipt of cash from customers o All cash collected must be properly identified & promptly deposited INTACT at the bank • Accounts Receivable o Recording of all sales invoices, collections, & credit memo in individual customer accounts o All billings, adjustments, & cash collections must be properly recorded in the customers’ accounts receivable records • General Ledger o Proper accumulation, classification, & summarization of revenues, collections, & receivables in the financial statement accounts o Must ensure that all revenues, collections, & receivable are properly recorded & classified Inherent Risk Assessment The 4 inherent risk factors that may affect the revenue process are: 1. Industry-related factors a. If the industry is in decline, that brings up IR (more risk that there are fraudulent things going on) b. Risky if industry is highly regulated 2. The complexity & contentiousness of revenue recognition issues a. How controversial are their revenue recognition issues? i. Harder to determine in software or tech services ii. The higher the IR, the more things that can go wrong 3. The difficulty of auditing transactions & account balances 4. Misstatements detected in prior audits a. If you have misstatements from last year, it gives you a higher IR Control Risk Assessment • Understand & document the revenue process based on a reliance strategy • Plan & perform tests of controls on revenue transaction • Set & document the control risk for the revenue process Understanding & Documenting Internal Control • Control Environment o Understanding the control environment is generally completed on an overall entity basis • Entity’s Risk Assessment Process o Auditor must understand how management considers risks that are relevant to the revenue process o Auditor should estimate the significance of the risk & assess the likelihood of occurrence • Control Activities o Auditor identifies what controls ensure that the assertions for transactions & events are being met o Documentation of the auditors understanding of the revenue process can be accomplished by using: § Procedures manuals § Narrative descriptions § Internal control questionnaires § Flowcharts • Information Systems & Communication o Auditor’s knowledge § Process by which sales, cash receipts, & sales returns and allowances transactions are initiated § The flow of each transaction from initiation to inclusion in the financial statements § The process used to prepare estimates for accounts such as bad debts & sales returns § Accounting records, supporting documents, & accounts that are involved in sales, cash receipts, & sales returns • Monitoring of Controls o Auditor must understand how management assesses the design & operation of controls in the revenue process o This understanding should include how supervisory personnel review the personnel who perform the controls & evaluate the performance of the entity’s IT function • Plan & Perform Tests of Controls o Auditor systematically examines the client’s revenue process to identify relevant controls that help to prevent, or detect & correct, material misstatements o In order to properly set control risk, the auditor must test controls over the revenue process. Such tests may include: § Inquiry of client personnel § Inspection of documents & records § Observations of the operation of control § Walkthroughs • Take one transaction & see it go all the way through the flowchart (how it goes through sales journal & GL & into the financial statements) § Reperformance of the control procedures • Set & Document the Control Risk o If the results of the tests of controls SUPPORT the planned level of control risk, the auditor conducts the PLANNED level of substantive procedures for the account balances o The level of control risk for the revenue process can be set using either quantitative amounts or qualitative terms such as “low,” “medium,” or “high” Control Activities & Test of Controls—Revenue Transactions • Assertions about classes of transactions & events for the period under audit o Occurrence § All revenue & cash receipt transactions & events that have been recorded have occurred & pertain to the entity § Is everything that is recorded actually valid? § The auditor is concerned about 2 major types of material misstatements: • 1) Sales to fictitious customers • 2) Recording revenue when goods have not been shipped or services have not been performed § Auditor needs assurance that all recorded revenue transactions are valid o Completeness § All revenue & cash receipts transactions/events that should have been recorded have been recorded § The major misstatement that concerns both management & the auditor is that goods are shipped & services are performed & NO revenue is recognized § Controls: • Accounting for numerical sequence of shipping documents & sales invoices • Matching shipping documents w/ sales invoices • Reconciling sales invoices to daily sales reports • Maintaining & reviewing the open-order file o Authorization § All revenue & cash receipts transactions/events are properly authorized § Possible misstatements due to improper authorization include shipping goods to, or performing services for, customers who are bad credit risks & making sales at unauthorized prices/terms § The presence of an unauthorized price list & terms of trade reduces the risk of inaccuracies o Accuracy § Amounts & other data relating to recorded revenue & cash receipt transactions/events have been recorded appropriately § The sales invoice should also be verified for mathematical accuracy before being sent to the customer o Cutoff § All revenue & cash receipt transactions/events have been recorded in the correct accounting period § Sales may be reported in the wrong accounting period unless proper controls are in place § All shipping documents should be forwarded to the billing department daily o Classification § All revenue & cash receipt transactions/events have been recorded in their proper accounts § Did you put it in the right account? (Problem when you have miscellaneous sale) § The use of a chart of accounts & proper codes for recording transactions should provide adequate assurance about the proper classification of revenue transactions Control Activities & Test of Controls—Cash Receipts Transactions • Occurrence o The possible misstatement that concerns the auditor is that cash receipts are recorded but not deposited in the client’s bank account • Completeness o A major misstatement is that cash/checks are stolen or lost before being recorded in the cash receipts records o Proper segregation of duties & a lockbox system are strong controls o Terms of trade generally include discounts for payment within a specified period as a way of encouraging customers to pay on time § 2/10, net 30 • Accuracy o The wrong amount of cash could be recorded from the remittance advice, or the receipt could be incorrectly processed during data entry o To minimize these types of errors, daily remittance reports should be reconciled to a control listing of remittance advices o All bank statements should be reconciled monthly • Cutoff & Classification o If the client uses a lockbox system or if cash is deposited daily in the bank, there is a small possibility of cash being recorded in the wrong accounting period o The auditor seldom has major concerns about cash receipts being recorded in the wrong financial statement account Control Activities & Test of Controls—Sales Returns & Allowances • Sales returns & allowances is usually not a material amount in the financial statements • Credit memos that are used to process sales returns can also be used to cover an unauthorized shipment of goods or conceal a misappropriation of cash • As a result, all credit memos should be properly authorized Relating the assessed level of control risk to substantive procedures • The auditor’s testing of control for revenue processing impacts the detection risk & therefore the level of substantive procedures impacted by the controls o Accounts receivable o Allowance for doubtful accounts o Sales o Sales returns & allowance o Bad debts expense o Cash Auditing revenue related accounts • Substantive analytical procedures are used to examine plausible relationships among revenue related accounts o Ratios used for comparative purposes: § 1) Receivables turnover & days outstanding in AR § 2) Aging categories on aged trial balance of AR § 3) Bad-debts expense as a percentage of revenue § 4) Allowance for uncollectible accounts as a percent of AR or credit sales § 5) Large customer account balances compared to last period • Tests of details focus on transactions, account balances, or disclosures o Concentrate on the ending balance for AR & related accounts as well as related disclosures • Completeness o Auditor’s primary concern is whether all accounts receivable have been included in the AR subsidiary ledger & the general ledger AR account § Reconciliation of the aged trial balance to the general ledger account should detect an omission of a receivable from either the subsidiary or general ledger • Cutoff o The cutoff test attempts to determine whether all revenue transactions & related AR are recorded in the proper period § Test a few shipping documents just PRIOR to year-end § Test a few shipping documents just AFTER year-end § Are all transactions tested recorded in the proper period? • Existence and Rights & Obligations o Existence is one of the more important assertions for AR b/c the auditor wants assurance that this account balance is not overstated through the inclusion of fictitious customer accounts or amounts § Confirmation is the major audit procedure used to test this assertion o Auditor must determine that all AR are owned by the entity § Usually not a problem but in some cases, AR may be sold or factored w/ or without recourse • Valuation & Allocation o AR should be shown on the balance sheet at net realizable value (gross amount less allowance for uncollectible accounts) o Auditor must verify the adequacy of the allowance for uncollectible accounts § 1 step is to prepare an aged trial balance & discuss results w/ the credit manager § Next, a comparison w/ last year’s results should be examined • Classification o Major issues related to presentation, disclosure, & classification are: § 1) Identifying & reclassifying any material credits contained in AR § 2) Segregating short-term & long-term receivables § 3) Ensuring that different types of receivables are properly classified The Confirmation Process—AR rd • Confirmation is audit evidence that is a direct written response from 3 parties about the AR balance o Good source of evidence about the existence of the AR o Should be controlled by the auditor • Omitting Confirmations o AR are immaterial o The use of confirmations would not be effective o IR & CR are assessed “low” & evidence gathered from other substantive tests is sufficient to reduce AR to an acceptably low level • Factors affecting the reliability of AR Confirmations o Type of confirmation request (positive vs. negative) o Prior experience w/ the client or similar engagements (e.g. response rate, accuracy of returned confirmations, misstatements identified) o Intended respondent (competence, knowledge, ability, & objectivity) • Types of Confirmations o Positive Confirmation § Requests that customers indicate whether they agree w/ the amount due to the client § A response is expected whether the customer agrees or disagrees w/ the balance indicated o Negative Confirmation § Requests that the customer respond only when they disagree w/ the amount due to the client § Used when the client has many small account balances & CR is assessed as low • Timing o AR may be confirmed at an interim date or at year-end o Confirmation request should be sent soon after the end of the accounting period in order to maximize the response rate • Procedures o Auditor should mail the confirmation requests outside the client’s facilities o A record should be maintained of the confirmations mailed & those returned nd o 2 request may be necessary in some cases o For each exception received, the auditor should examine the reasons for the difference between the balance on the client’s books & the balance indicated by the customer • Alternative Procedures o When the auditor does NOT receive responses to positive confirmations, alternative audit procedures are used § Examination of subsequent cash receipts § Examination of customer orders, shipping documents, & duplicate sales invoices § Examination of other client documentation Auditing Other Receivables 1. Receivables from officers & employees 2. Receivables from related parties 3. Notes receivables • The auditor’s concern w/ satisfying the assertions for these receivables is similar to that for trade AR • Each of these types of receivables is confirmed & evaluated for collectability • The transactions that result in receivables from related parties are examined to determine if they were at “arm’s length” • Notes receivables would also be confirmed & examined for repayment terms & whether interest income has been properly recognized Evaluating the Audit Findings • When the auditor has completed the planned substantive procedures, the likely misstatement (projected misstatement plus an allowance for sampling risk) for AR is determined • Likely misstatement LESS THAN tolerable misstatement o Accept the account as fairly presented • Likely misstatement GREATER THAN tolerable misstatement o Account is not fairly presented CHAPTER 11—Auditing the Purchasing Process Expense & Liability Recognition • Expenses—outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major/central operations o Using up an asset or incurring a liability o Categories: § Product Costs—COGS; something linked to revenue § Period Costs—something incurred during period where cash is spent or liability incurred (rent, salaries) • Linked w/ time § Systematic Allocation—tries to allocate expense into period you get the benefit (depreciation) • Liabilities—probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events o Future sacrifices o Pay something in the future Purchasing Process • Overview: o Purchase transaction usually starts w/ a purchase requisition generated by the user department o Purchasing department prepares a purchase order that is sent to the vendor o When the goods are received or the services are rendered, a liability is recorded o Then the entity pays the vendor • Types of transactions processed o Purchase transaction § Affectsà AP, inventory, purchases or COGS, various asset & expense accounts o Cash disbursement transaction § Affectsà Cash, AP, cash discounts, various asset & expense accounts o Purchase return transaction § Affectsà purchase returns (us sending stuff back to our suppliers), purchase allowances, AP, various asset & expense accounts • Voucher Packet—Invoice, Purchase Order, Receiving Reportà 3 way match • Documents & Records o Purchase Requisition—request to purchase goods or services § Internal documentà person saying hey I need something & sends to supervisor who will approve it o Purchase Order—includes description, quality, & quantity of goods or services being purchased o Receiving Report—records the receipt of goods o Vendor Invoice—the bill from the vendor § Vendor—3 party we’re buying from o Voucher—serves as the basis for recording a vendor’s invoice (list of all the invoices we have to pay) o Voucher Register—used to record vouchers for goods & services o Accounts Payable Subsidiary Ledger—includes amount owed to individual vendors o Vendor Statement—represents the purchase activity w/ vendor o Check—pays for goods or services o Check Register—contains columns to record credits to cash & debit to AP and cash discounts • Major Functions o Requisitioning—initiation & approval of requests for goods & services by authorized individuals consistent w/ management criteria o Purchasing—approval of purchase orders & proper execution as to price, quantity, quality, & vendor o Receiving—receipt of properly authorized goods & services § Count everything you got & inspect quality o Invoice Processing—processing of vendor invoices for goods & services received; processing of adjustments for allowances, discounts, & returns o Disbursements—processing of payment to vendors o Accounts Payable—recording of all vendor invoices, cash disbursements, & adjustments in individual vendor accounts o General Ledger—proper accumulation, classification, & summarization of purchases, cash disbursements, & payables in the general ledger • Inherent Risk Assessment o Industrial-Related Factors § 1) Is the supply of raw materials adequate? § 2) How volatile are raw material prices? o Misstatements Detected in Prior Audits § Auditor’s experience in past audits must be considered when assessing inherent risk • Control Risk Assessment o Major steps in setting the CR § Understand & document the purchasing process based on a reliance strategy • Reliance Strategy—relying on controls operating well to do less substantive testing (testing of dollars) as long as you can rely on good controls § Plan & perform tests of controls on purchase transactions • Controls around segregation of duties § Set & document the CR for the purchasing process • Hopefully you can set CR low if you can rely on controls o Control testing—testing of process o Detection risk—keep it low by doing more substantive testing o Information Systems & Communication § Auditor must obtain the following information: • 1. How purchase, cash disbursements, & purchase return transactions are initiated • 2. The accounting records, supporting documents, & accounts involved in processing purchases, cash disbursements, & purchase returns • 3. The flow of each type of transaction from initiation to inclusion in the financial statements (including computer processing) • 4. The process used to estimate accrued liabilities o After testing controls, the auditor sets the achieved level of CR § When tests of controls support the planned level of CR, no modifications are necessary to DR & auditor may proceed w/ the substantive procedures as planned § When tests do NOT support the planned CR, the auditor lowers the level of DR leading to more substantive procedures • Assertions—PURCHASES o Occurrence—all purchases & cash disbursements have been recorded & have occurred & pertain to the entity § Observe & evaluate proper segregation of duties § Test a sample of vouchers for the presence of an authorized purchase order & receiving report § Examine paid vouchers & supporting documents for indication of cancellation § Think about errors—if they didn’t occur, it’s a fictitious purchase o Completeness—all purchases & cash disbursements that should have been recorded have been recorded § Is anything missing? Are they all there? § Review procedures for accounting for numerical sequence of purchase orders, receiving reports, & vouchers § Trace a sample of receiving reports to their vendor invoices & vouchers § Trace a sample of vouchers to the purchases journal § Pull samples from outside population (outside GL)—start from receiving or shipping documents § Purchases that are missing; books will be understated in terms of what you bought (assets & liabilities) • Trace a sample of receiving reports & compare to vouchers o Authorization—all purchase & cash disbursements are properly authorized § Are purchases authorized & approved? § Examine purchase requisitions or purchase orders for proper approval § Review client’s competitive bidding process § Based on dollars o Accuracy—amounts relating to recorded purchase & cash disbursements have been recorded appropriately & properly accumulated from journals & ledgers § Are the numbers being put in accurately? On invoices, double check the quantity billed to receiving report & check prices on vendor invoice to purchase order § Recomputed the mathematical accuracy of vendor invoice § Agree information in the sample of vouchers for product, quantity, & price § Examine reconciliation of vouchers to daily accounts payable report o Cutoff—purchase & cash disbursements have been recorded in the correct accounting period § Compare the dates on receiving reports w/ the dates on the relevant vouchers § Compare the dates of vouchers w/ the dates they were recorded in the purchases journal § If it was received on 12/31, it must be recorded as a liability on 12/31 o Classification—purchase & cash disbursements have been recorded in the proper account § Review purchases journal & GL for reasonableness § Examine a sample of vouchers for proper classification • Assertions—CASH DISBURSEMENTS o Occurrence § Auditor is concerned w/ a misstatement caused by a cash disbursement being recorded in the client’s record when no payment was made § Primary control procedures to prevent misstatements: • Segregation of duties • Independent reconciliation & review of vendor statements • Monthly bank reconciliations § When a disbursement was recorded but no payment was made § Wrote a check but it was lost or stolen—never comes out of bank account § Segregation of duties—people who can handle checks shouldn’t be allowed to approve vouchers o Completeness § Major audit concern is that a cash disbursement is made but not recorded in the records § Auditor should account for the numerical sequence of checks & reconcile the daily cash disbursements w/ posting to the AP subsidiary records § You actually did disburse cash but didn’t record in records (not in GL) • Cash is too high • Make sure numerical sequence of checks is accounted for o Authorization § Proper segregation of duties reduces the likelihood that unauthorized cash disbursements are made § Individual who approves a purchase should not have direct access to the cash disbursement o Accuracy § Concern is that the payment amount is recorded incorrectly § To detect, client personnel should reconcile the total of checks issued each day w/ the daily cash disbursements report • Make sure a $1,000 check isn’t accidently recorded as a $100 check o Cutoff § Auditor’s tests of controls include reviewing the reconciliation of checks w/ postings to the cash disbursements journal & AP subsidiary records § Auditor also tests cash disbursements before and after year-end to ensure that transactions are recorded in the proper period o Classification § Auditor is concerned that a cash disbursement may be charged to the wrong GL account § The use of a chart of accounts & independent approval & review of the account code on the voucher should provide adequate control • Purchase Return Transactions o Substantive analytical procedures are used to test the reasonableness of the amount § CR is high, DR is low o Magnitude & # of purchase return transactions are not material § Auditor typically doesn’t test controls related to purchase returns • Assessed Level of CR & Substantive Procedures o If the results of the tests of controls support the achieved level of CR, the auditor conducts substantive procedures at the planned level o If the results do NOT support the achieved level of CR, the auditor reduces the DR, which will increase substantive procedures • Auditing AP & Accrued Expenses o Assertions about account balances at period end: § Existence—both are valid transactions § Rights & Obligations—both are obligations to the entity § Completeness—both have been recorded • Usually there is an expense w/ it • Expenses hurt bottom line so companies try to avoid recording some of them without getting caught § Valuation & Allocation—both are included in the financial statements at appropriate amounts & any resulting valuation or allocation adjustments are appropriately recorded o Assertions about presentation & disclosure § Occurrence & Rights/Obligations—all disclosed events, transactions, & other matters relating to AP & accrued expenses have occurred & pertain to the entity § Completeness—all disclosures that should have been included in the financial statements have been included § Classification & Understandability—financial information is appropriately presented & described, and disclosures are clearly expressed § Accuracy & Valuation—financial & other information are disclosed fairly & in appropriate amounts • Any footnotes related to these need to be recorded o Substantive Analytical Procedures § Look at ratios—look at last year & industry data § This year vs. last year for accruals—helps to determine if all expenses are recorded • Tests of Details of Transactions, Account Balances, & Disclosures o Accuracy—Recompute the mathematical accuracy of a sample of vendors’ invoices § Pull samples & details § Sample 30 invoices & check math o Completeness—auditor should conduct a search for unrecorded liabilities that includes: § 1) Ask management about control procedures used to identify unrecorded liabilities at the end of the period § 2) Obtain copies of vendors’ monthly statements & reconcile the amounts to the client’s AP records § 3) Confirm vendor accounts, including accounts w/ small or zero balances § 4) Vouch large-dollar items from the purchases journal & cash disbursements journal for a limited time after year-end § 5) Examine the files of unmatched purchase orders, receiving reports, & vendor invoices for any unrecorded liabilities § **Main concern is understatement of payables • Look for missing payables & unreported liabilities § Physical documents from 3 parties is good evidence o Existence—auditor’s main concern is whether the recorded liabilities are valid obligations of the entity § Auditor should vouch a sample of items on the listing of AP to other supporting documents o Cutoff—auditor attempts to determine if all purchase transactions are recorded in the proper period § On most audits, the purchase cutoff is coordinated w/ the client’s physical inventory count § Also determined for purchase return transactions o Rights & Obligations—little risk related to this assertion b/c clients seldom have an incentive to record liabilities that are not obligations of the entity o Valuation—AP are recorded at either the gross amount of the invoice or net of cash discount amount § The valuation of accruals depends upon the type & nature of the accrued expense § Most accruals are relatively easy to value § Are they recognized gross or net of the discount? o Major Classification Issues § 1. Identifying & reclassifying an material debits contained in AP • If there are any debits in AP—overpaid or returned items (they owe you money)à should be reclassified as a receivable b/c vendor owes you money § 2. Segregating short-term & long-term payables § 3. Ensuring that different types of payables are properly classified o Disclosure items for the purchasing process (things you would footnote) § Payables by type (trade, officers, employee, etc.) § Short- & long-term payables § Long-term purchase contracts, including any unusual purchase commitments § Purchases from & payable to related parties § Dependence on a single vendor or a small # of vendors § Costs by reportable segment of the business • AP Confirmations o Used less often than accounts receivable confirmations o Auditor is able to examine externally created source documents relating to AP o When confirmations are used, they are usually positive & referred to as blank conformations o Vendor is asked to supply the balance owed by the client o For AR, the invoices come from us rd o For AP, invoices come from the vendor (external document)—we trust that more b/c they’re 3 party documents § Rarely confirm AP § Make sure confirmations are positive § Blank confirmations (aka zero-balance confirmations)—missing balanceà no dollar amount to check off; must insert amount • Evaluate the audit findings o All identified misstatements should be aggregated (including any consideration for sampling risk) o The likely misstatement is then compared to tolerable misstatement o If the likely misstatement is LESS THAN the tolerable misstatement, the auditor has evidence that the account is fairly presented o If the likely misstatement EXCEEDS the tolerable misstatement, the auditor should conclude that the account is not fairly presented CHAPTER 13—Auditing the Inventory Management Process Types of Documents & Records • Production Schedule—based on the expected demand for the entity’s products (based on backlog) • Receiving Report—records the receipt of goods from vendors • Materials Requisition—used to track materials during the production process o Ask to get raw materials to get out of storage area to put into production • Inventory Master File—contains all the important information related to the entity’s inventory, including the perpetual inventory records o List of everything you have, where it’s located, which vendor you used to buy it, etc. • Production Data Information—contains information about the transfer of goods & related cost accumulation at each stage of production • Cost Accumulation & Variance Report—material, labor, & overhead costs are charged to inventory as part of the manufacturing process o The variance report compares actual costs to standard or budgeted costs § Variance—what did we actually spend on this product • Inventory Status Report—shows the type & amount of products on hand o See a snapshot of all the inventory we have & where it’s located on a specific day • Shipping Order—used to remove goods from the perpetual inventory records o Document the transfer Major Functions • Inventory Management—authorization of production activity & maintenance of inventory at appropriate levels o Issuance of purchase requisitions to the purchasing department • Raw Materials Stores—custody of raw materials & issuance of raw materials to manufacturing departments • Manufacturing—production of goods • Finished Goods Stores—custody of finished goods & issuance of goods to the shipping department • Cost Accounting—maintenance of the costs of manufacturing & inventory in cost records • General Ledger—proper accumulation, classification, & summarization of inventory & related costs in the GL Inherent Risk Assessment • The auditor should consider industry-related factors & operating & engagement characteristics when assessing the possibility of a material misstatement • If industry competition is intense, there may be problems w/ the proper valuation of inventory o Technology changes in certain industries may also promote material misstatement due to obsolescence • Products that are small & of high value are more susceptible to theft o The auditor must be alert to related-party transactions for acquiring raw materials & selling finished products o Prior-year misstatements are good indicators of potential misstatements in the current year • Issue for inventory is usually valuation—worry about obsolescence (valuation assertion) o Inventory may exist & be complete but should it be discounted? (some may be written off to zero) o Inventory—inherently risky that it will be stolen—smaller things have a greater risk of being stolenà things that are easy to sell (iPhones, jewelry, etc.) o If buying from related party, make sure you’re buying at a reasonable price Control Risk Assessment • Major steps in setting the CR in the inventory management process: o Understand & document the inventory management process based on a reliance strategy § Reliance strategy—you are relying on controls to avoid doing as much substantive testing • Bucket is filled up w/ CONTROL testing • Need less substantive testing • Rely on controls so you have to test them • If you test them, you hope to make CR low, making DR high, requiring less substantive testing § Substantive strategy—more filled with substantive testing; less control testing o Plan & perform tests of controls on inventory transactions o Set & document the CR for the inventory management process Assertions—Inventory Transactions • Occurrence o Observe & evaluate proper segregation of duties o Review & test procedures for transfer of inventory o Review & test procedures for issuing materials to manufacturing departments o Review & test client procedures for account for numerical sequence of materials requisitions o Observe the physical safeguards over inventory o Auditor’s main concern is that all record inventory exists & that goods may be stolen § Review & observation are the main tests of controls used by the auditor to test the control procedures • Completeness o Review & test client’s procedures for consignment goods o The primary control procedure relates to recording inventory that has been received o Did documents sampled actually get recorded? • Authorization o Review authorized production schedules o Review & test procedures for developing inventory levels & procedures used to control them o Auditor’s concern w/ authorization in the inventory system is w/ unauthorized purchase or production activity that may lead to excess levels of certain types of finished goods § Make sure there aren’t unauthorized purchases § Make sure PO’s are approved § If you’re producing too much, it can lead to obsolescence § Authorize purchase & production of things • Accuracy o Review & test procedures for taking physical inventory o Review & test procedures used to develop standard costs o Review & test cost accumulation & variance reports o Review & test procedures for identifying obsolete, slow-moving, & excess quantities o Review the reconciliation of perpetual inventory to GL control account o Inventory transactions that are not properly recorded result in misstatements that directly affect the amounts reported in the financial statements o Inventory purchases must be recorded at the correct price & actual quantity received § Pull inventory used for invoices § Make sure math is correct § Make sure inventory that is shipped is recorded correctly in COGS o Inventory shipped must be properly recorded in COGS & the related revenue recognized • Cutoff o Review & test procedures for processing inventory included on receiving reports into the perpetual records based on shipments of goods o Inventory transactions recorded in the improper period could affect a # of accounts, including inventory, purchases, & COGS • Classification o Review the procedures & forms used to classify inventory o The client must have control procedures to ensure that inventory is properly classified as raw materials, work in process, or finished goods o By knowing which manufacturing department holds the inventory, the auditor is able to classify it by type Assertions about Classes of Transactions & Events • Occurrence—inventory transactions & events are valid • Completeness—all inventory transactions & events have been recorded • Authorization—all inventory transactions are properly authorized • Accuracy—inventory transactions have been properly computed & recorded • Cutoff—inventory receipts & shipments are recorded in the correct accounting period • Classification—inventory is recorded in the proper accounts Assertions about Account Balances at the Period End • Existence—inventory recorded on the books & records actually exists • Rights & Obligations—the entity has the legal right to the recorded inventory • Completeness—all inventory is recorded • Valuation & Allocation—inventory is properly recorded in accordance w/ GAAP (e.g. lower of cost or market) o Valuation—bigger issue—obsolescence reserve o Accuracy—take vendor’s invoice Assertions about Presentation & Disclosure • Occurrence & Rights & Obligations—all disclosed events, transactions, & other matters relating to inventory have occurred & pertain to the entity • Completeness—all disclosures relating to inventory that should have been included in the financial statements have been included • Classification & Understandability—financial information relating to inventory us appropriately presented & described, & disclosures are clearly expressed • Accuracy & Valuation—financial & other information relating to inventory are disclosed fairly & in appropriate amounts Substantive Analytical Procedures • You don’t have to do substantive analytical procedures—not required o Simply an option • You can do test of details as well • Can do a combination • Look at inventory turnover from last year—is inventory moving slower this year than last year? o If yes, it may be a sign of obsolescence Auditing Standard Costs • Materials o Test the quantity & type of materials included in the profit & the price of the materials o Make a sample of all invoices of material bought during the year § Make sure prices are right • Labor o Gather evidence about the type & amount of labor needed for production & the labor rate o Talk to a lot of production people o How much labor is needed to produce items? • Overhead o Review the client’s method of overhead allocation for reasonableness, compliance w/ GAAP, & consistency o Is allocation a reasonable method? Observing Physical Inventory • During the observation of the physical inventory count, the auditor should do the following: o 1) Ensure that no production is scheduled § If production is scheduled, proper controls must be established for movement between departments in order to prevent double counting o 2) Ensure that there is no movement of goods during the inventory count o 3) Make sure that the client’s count teams are following the inventory count instructions o 4) Ensure that inventory tags are issued sequentially to individual departments o At the end of the year (NYE), go to client’s warehouse & go count § We aren’t counting everything § Section out different shelves & rows in warehouse—people must count everything in those areas § No production is scheduled before we do that inventory—shut down for the day so we can count § Observe the people who are counting the inventory—are they in the right teams and following the proper instructions? § We aren’t in charge of the countà just observing • It’s an internal control • It affects the # that goes on the balance sheet o 5) Perform test counts & record a sample of counts in the working papers o 6) Obtain tag control information for testing the client’s inventory compilation o 7) Obtain cutoff information, including the # of the last shipping & receiving documents issued § Make sure everything that were shipped off on last day are not recorded o 8) Observe the condition of the inventory for items that may be obsolete, show moving, or carried in excess quantities § Keep your eyes open & be skeptical § Consider opening boxes § Don’t trust what every box says on the outside (boxes could be empty) § Try to pick boxes that are more of a hassle b/c that may be where companies are trying to hide things o 9) Inquire about goods held on consignment for others or held on a “bill-and-hold” basis § on consignment—things we don’t actually own—make sure it isn’t included in inventory o Do test counts from TWO different directions o They’ll give us a list of everything counted § Pick 10 counts off the sheet of counts § Have someone help you & go to every location chosen & check • Floor checkingà sheet to floor o Go from something already recorded & go out & and check (occurrence/existence) o Is what was recorded right? • Floor to Sheetà wander around warehouse floor & choose locations to check o Could pick locations that are high up o Make sure it is actually on the floor & exists o Tests completeness § Make sure all tags are accounted for Substantive Tests of Transactions—Tests of Details • Occurrence—vouch a sample of inventory additions to receiving reports & purchase requisitions • Completeness—trace a sample of receiving reports to the inventory records o Do NOT start w/ journal or sheet or GL b/c you will never get the chance to find something not there o Take a sample of receiving report & see if it made it into inventory • Authorization—test a sample of inventory shipments to ensure there is an approved shipping ticket & customer sales • Accuracy—recompute the mathematical accuracy of a sample of inventory transactions o Audit standard costs or other methods used to price inventory • Cutoff—trace a sample of time cards before & after period end to the appropriate weekly inventory report • Classification—examine a sample of inventory checks for proper classification into expense accounts • When testing the physical, you’re getting assurance on quantity o Test price through vendor invoices, labor applied, & overhead Test of Details of Account Balances • Existence—observe count of physical inventory o Do test counts on inventory to make sure it actually exists • Rights & Obligations—verify that inventory held on consignment for others or “bill-and-hold” goods are not included in inventory • Completeness—trace test counts & tag control information to the inventory compilation o Take test counts from the floor & trace it into the tag & then into the compilation (records) • Valuation & Allocation—obtain a copy of the inventory compilation & agree totals to GL o Test mathematical accuracy of extensions & foot the inventory compilation o Inquire of management concerning obsolete, slow moving, or excess inventory o Review book-to-physical adjustment for possible misstatements Tests of Details of Disclosures • Occurrence & Rights and Obligations—inquire if management & review any loan agreements & BOD’s minutes for any indication that inventory has been pledged or assigned o Inquire of management about issues related to warranty obligations • Completeness—complete financial reporting checklist to ensure that all financial statement disclosures related to inventory are made • Classification & Understandability—review inventory compilation for proper classification amount raw materials, WIP, & FG o Read footnotes to ensure that required disclosures are understandable • Accuracy & Valuation—determine if the cost method is accurately disclosed o Inquire of management about issues related to LIFO liquidations § Read footnotes & other information to ensure that the information is accurate & properly presented at the appropriate amounts Possible causes of book-to-physical differences 1. Inventory cutoff errors 2. Unreported scrap or spoilage 3. Pilferage or theft • There will always be errors in inventory counts o People are moving things around & not accounting for it o Get sloppy o Too much shoved into boxes o Counting errors when receiving goods o Mostly human errors & laziness Possible Disclosure Items • Cost Method (FIFO, LIFO, retail method) • Components of inventory (raw materials, WIP, FG) • Long-term purchase contracts • Consigned inventory • Purchases from related parties • LIFO liquidations • Pledged or assigned inventory • Disclosure of unusual losses from write-downs or losses on long-term purchases commitments • Warranty obligations Evaluating the Audit Findings—Inventory • At the conclusion of testing, the auditor should aggregate all identified misstatements • The likely misstatement is compared to the tolerable misstatement is compared to the inventory account • Likely misstatement LESS THAN tolerable misstatement o The auditor may accept the inventory account as fairly presented • Likely misstatement GREATER THAN tolerable misstatement o The auditor must conclude the inventory is not fairly presented CHAPTER 16—Auditing the Financing/Investing Process: Cash & Investments • Cash—currency on hand & cash on deposit in bank accounts, including certificates of deposits, time deposits, & savings accounts • Cash Equivalents—frequently combined w/ cash for presentation in the financial statements o Short-term, highly liquid investments that are readily convertible to cash or so near their maturity that there is little risk of change in their value o Examples: treasury bills & money market funds Types of Bank Accounts • General Cash Account • Imprest Cash Accounts • Branch Accounts • In order to optimize its cash flow, an entity implements procedures for accelerating the collection of cash receipts & delaying the payment of cash disbursements, to the extent delay is appropriate The Effects of Controls • The reliability of the client’s controls over cash affects the nature & extent of the auditor’s tests of details o Controls for cash receipts o Controls for cash disbursements o Completion of monthly bank reconciliation Substantive Analytical Procedures—Cash • Because of the residual nature of the cash account, the auditor’s use of substantive analytical procedures for auditing cash is limited to: o Comparisons w/ prior years’ cash balances o Comparisons w/ budgeted amounts • This limited applicability of substantive analytical procedures is normally offset by 1) extensive tests of controls and/or substantive tests of transactions for cash receipts & disbursements or 2) extensive tests of the entity’s bank reconciliations Auditing the General Cash Account • To audit a cash account, the auditor should obtain these items: o Copy of
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