auditing operations and completing the audit chapter 16 mcgraw-hill/irwin copyright © 2012 by the...
TRANSCRIPT
Auditing Operations and Completing the Audit
Chapter 16
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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Auditing OperationsAuditing Operations
Corporate earnings are considered as an extremely important indicator of health and well-being of corporations
Measurement of income is generally regarded as the single most important function of accounting
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Conservatism in the Conservatism in the Measurement of IncomeMeasurement of Income
Powerful influence on revenue and expenses Important because of subjectivity involved
with accounting estimates Assets – accountants choose lower of two or
more reasonable alternative values Liabilities – higher amount is chosen Results in income statement with a low or
conservative income figure
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Objectives for audit of revenue Objectives for audit of revenue and expensesand expenses
1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to revenues and expenses.
2. Consider internal control over revenues and expenses.
3. Assess the risks of material misstatement of revenues and expenses and design further audit procedures that:
a. Establish the occurrence of recorded revenue and expense transactions.
b. Determine the completeness of recorded revenue and expense transactions.
c. Establish the accuracy of revenue and expense transactions.
d. Verify the cutoff of revenue and expense transactions.
e. Determine that the presentation and disclosure of revenue and expense accounts are appropriate, including the proper classification of amounts and the proper presentation of earnings-per-share data.
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Figure 16-1 Comparative Income Statement AnalysisFigure 16-1 Comparative Income Statement Analysis
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Relationships Between Balance Sheet Relationships Between Balance Sheet and Income Statement Accountsand Income Statement Accounts
Balance Sheet Item Revenue Expenses
Accounts receivable
Notes receivable Securities and investments
Sales Interest, Interest, dividends, gains, investee’s income
Uncollectible accounts Uncollectible notes Losses
Inventories Purchases, cost of goods sold, payroll
Property, plant and equip. Intangible assets Prepaid expenses Accrued liabilities
Rent, gains
Royalties
Depreciation; repairs
Amortization Various expenses Various expenses
Interest-bearing debt Interest
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Misc. Revenue (1 of 2)Misc. Revenue (1 of 2) Mixture of minor items, some nonrecurring and others
received at regular intervals Auditor should analyze account to look for items
improperly recorded as miscellaneous: Collections on previously written-off accounts or notes
receivable Write-offs of old outstanding checks or unclaimed
wages Proceeds from sales of scrap Rebates or refunds of insurance premiums Proceeds from sales of plant assets
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Misc. Revenue (2 of 2)Misc. Revenue (2 of 2)
Auditor should Propose adjusting journal entry to classify
items correctly Perform analytical procedures and investigate
unusual fluctuations• Can detect material amounts of unrecorded
revenue and• Significant misclassifications affecting revenue
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Substantive Tests for Selling, General Substantive Tests for Selling, General and Administrative Expenses and Administrative Expenses (1 of 2)(1 of 2)
Perform analytical procedures Develop an expectation of the account balance
• Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data and relevant nonfinancial data
Determine the amount of difference from the expectation that can be accepted without investigation
• Use estimates of materiality Compare the company’s account balance with the
expected account balance Investigate significant deviations from the expected
account balance
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Substantive Tests for Selling, General Substantive Tests for Selling, General and Administrative Expenses and Administrative Expenses (2 of 2)(2 of 2)
Obtain or prepare analyses of selected expense accounts
Examine accounts based on results of analytical procedures
Which accounts? AICPA suggests• Advertising• Research and development• Legal expenses and other professional fees • Maintenance and repairs• Rents and royalties
Obtain or prepare analyses of critical expenses in the income tax return
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PayrollPayroll Importance – typically largest operating cost Payroll fraud had been common and often
substantial but now fraud difficult to conceal because of: Extensive segregation of duties relating to
payroll Use of computers with proper controls for
preparation of payrolls Filing of frequent payroll reports to the
government
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Segregation of Functions--Payroll
Separate departments should handle:
• Employment (personnel)
• Timekeeping
• Payroll preparation and record keeping
• Distribution of pay to employees
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Internal Control over Payroll Internal Control over Payroll DocumentationDocumentation
Typical questions Are employees paid by check or direct deposit? Is a payroll bank account maintained on an imprest basis? Are the activities of timekeeping, payroll compilation, payroll
check signing, and paycheck distribution performed by separate departments or employees?
Are all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed?
Are employee time reports approved by supervisors? Is the payroll bank account reconciled monthly by an employee
having no other payroll duties?
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Audit Program for Payroll Audit Program for Payroll (1 of 2)(1 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures:a. Compare names and wage or salary rates to records maintained by the
human resources department.
b. Compare time shown on payroll to time cards and time reports approved by supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by employees.
e. Test extensions and footings of payroll.
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Audit Program for Payroll (2 of 2)Audit Program for Payroll (2 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures (continued):f. Compare total of payroll with total of payroll checks issued.
g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
h. If wages are paid in cash, compare receipts obtained from employees with payroll records.
i. If wages are paid by check, compare paid checks with payroll and compare endorsements to signatures on withholding tax exemption certificates.
j. If wages are paid by direct deposit, compare listing of employee payments with payroll and direct deposit authorizations.
k. Observe the use of time clocks by employees reporting for work and investigate time cards not used.
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Audit of Statement Audit of Statement of Cash Flowsof Cash Flows
Amounts are audited in conjunction with the audit of balance sheet and income statement accounts
Presentation and disclosure important audit objective is important Operating Investing Financing
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Audit Procedures Completed Audit Procedures Completed Near the End of Field WorkNear the End of Field Work
Search for unrecorded liabilities Review the minutes of meetings Perform final analytical procedures Perform procedures to identify loss
contingencies Perform the review for subsequent
events Obtain the representation letter
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Loss ContingenciesLoss Contingencies
Loss contingencies should be reflected in the financial statement amounts when:
It is probable that a loss had been sustained before the balance sheet date
The amount of the loss can be reasonably estimated
Loss contingencies should be disclosed in the notes to the financial statements when it is at least reasonably possible that a loss has been sustained
Loss contingencies need not be disclosed when the possibility of loss is remote
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LitigationLitigation
Most common loss contingency – pending or threatened litigation Letter of inquiry to client’s legal counsel
• Evidence of pending and threatened litigation• Unasserted claims - need to be disclosed if
probable and reasonably possible SAS 12
• Auditors should obtain from management a list describing and evaluating threatened or pending litigation
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Other ContingenciesOther Contingencies
Income tax disputes Accommodation endorsements and other
guarantees of indebtedness Accounts receivable sold or assigned with
recourse Environmental issues Commitments General risk contingencies
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Audit Procedures for Loss Audit Procedures for Loss ContingenciesContingencies
1. Review the minutes of directors’ meetings to the date of completion of fieldwork.
2. Send letter of inquiry to client’s lawyer
3. Send confirmation letters to financial institutions to request information on contingent liabilities of the company.
4. Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts receivable.
5. Review reports and correspondence from regulatory agencies to identify potential assessments or fines.
6. Obtain a representation letter from the client indicating that all liabilities known to officers are recorded or disclosed.
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Procedures to Identify Procedures to Identify Subsequent EventsSubsequent Events
Review latest available financial statements and minutes of the board and selected committees
Inquiry about matters dealt with at meetings for which minutes are not available
Inquiry of management Obtain lawyer’s letter Obtain representations from management
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Obtain Representation LetterObtain Representation Letter
Purpose is to have the client’s principal officers acknowledge that they are primarily responsible for the fairness of the financial statements
Dated as of the date of the audit report Not a substitute for application of
necessary audit procedures
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MisstatementsMisstatements
Known misstatements Specific misstatements identified during the
course of the audit Likely misstatements
Due to extrapolation from audit evidence or differences in accounting estimates
Evaluation Material misstatements must be corrected
• Quantitative and qualitative factors
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Qualitative Materiality FactorsQualitative Materiality Factors
Likely to be material when: Arise from an item capable of precise measurement (e.g., the amount of a
sale) rather than from an estimate (e.g., the amount in the allowance for doubtful accounts).
Mask a change in earnings or other trends. Hide a failure to meet analysts’ consensus expectations for the company. Change a loss into income, or vice versa. Concern a particularly important segment or other portion of the registrant’s
business. Affect compliance with regulatory requirements, loan covenants, or other
contractual requirements. Increase management’s compensation. Involve concealment of an unlawful transaction. Are of an amount that management or the auditors believe would affect the
stock’s price.
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Total Likely MisstatementOverstatements
(Understatements)W/P ref. Current
AssetsNoncurrent
AssetsCurrent
LiabilitiesNoncurrent Liabilities
Owners’ Equity
Income before Taxes
Tax Expenses
Uncorrected Known Misstatements
D-8 Overstatement of prepaid expenses
$6,500$2,600
$6,500 (2,600)
$6,500$2,600
F-6 Overstatement of prior years’ depreciation
($10,000)(4,000)
(10,000)4,000
M-4 Unrecorded liabilities (11,215)4,486
11,215(4,486)
11,2154,486
Projected Misstatements
C-5 Overstatement of accounts receivable (confirmation results)
30,00012,000
30,000(12,000)
30,00012,000
Other Estimated Misstatements
C-10
Understatement of allowance for uncollectible accounts
5,0002,000
5,000(2,000)
5,000________ 2,000
Total Likely Misstatements
$41,500 ($10,000) $5,871 $25,629 $52,715 $21,086
Amount considered material
$100,000 $125,000 $100,000 $125,000 $200,000 $150,000
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Evaluation Materiality: Considering Evaluation Materiality: Considering
Previous Year Uncorrected MisstatementsPrevious Year Uncorrected Misstatements SEC SAB 108 Situation:
$70,000 current year misstatement $60,000 balance sheet carryover from preceding year
If either the $70,000 or the $130,000 total ($70,000 + 60,000) is material to this year, an adjustment must be made.
The current year’s income is decreased by at least $70,000
If the $60,000 is immaterial this year, it will also decrease current year income
• If the $60,000 is material this year, prior year financial statements should be adjusted.
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Review the EngagementReview the Engagement
Review of work of audit staff accomplished through review of audit working papers
Typically performed by seniors Review of working papers not completed until
near (of after) completion of fieldwork Partner and manager devote attention to
accounts with higher risk of material misstatement
Second partner review prior to issuance of audit report
16-32
Reporting on Other Information Reporting on Other Information with the Financial Statementswith the Financial Statements
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Required Communication with Required Communication with Those Charged with GovernanceThose Charged with Governance
Auditor responsibility under generally accepted auditing standards (e.g., to form and express an opinion, and management’s responsibilities)
An overview of the planned scope and timing of the audit
Significant findings from the audit Qualitative aspects of accounting practices Audit difficulties encountered Uncorrected misstatements Disagreements with management Management consultations with other accountants Auditor independence issues Other issues.
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Post-Audit ResponsibilitiesPost-Audit Responsibilities
Auditor subsequent discovery of facts existing at date of report Advise client to make appropriate disclosure
of the facts to anyone actually or likely to be relying upon the audit report and financial statements
If client refuses to make disclosure, CPA should inform each member of board and notify regulatory agencies
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Subsequent Discovery of Subsequent Discovery of Omitted Audit ProceduresOmitted Audit Procedures
Discovered during peer review or other subsequent review of working papers
Assess importance of omitted procedures to their previously issued opinion If omission impairs ability to support issued
opinion and report being relied upon by third parties, attempt to perform omitted procedure or appropriate alternative procedure