In what ways might auditors' professional skepticism influence their materiality judgments?

Auditors' professional skepticism affects their materiality judgments by influencing how conservatively they approach risk assessments and evidence requirements. More skeptical auditors are likely to set lower materiality thresholds and require more extensive evidence to gain confidence in conclusions. Different levels of skepticism can lead to varying thresholds in the assessment of what constitutes material misstatements, especially in higher-risk clients .

How do auditors verify cash balance accuracy and ensure proper cutoff at year-end?

Auditors verify cash balance accuracy and ensure proper cutoff by obtaining a cutoff bank statement to compare deposits in transit and outstanding checks against bank records. They trace prior-year checks to outstanding lists and verify the number of final checks issued by the year-end. Additionally, auditors review bank statements and bank reconciliations to detect any irregularities or kiting, thus ensuring that the cash balance is accurately and comprehensively recorded at year-end .

Explain how auditors assess inventory cutoff and the implications of improper cutoff.

Auditors assess inventory cutoff by examining receiving reports and delivery receipts to ensure transactions are correctly recorded in the proper period. They test the numerical sequence of purchase requisitions and sales journal entries. Implications of improper cutoff include misstated inventory levels and inaccurate financial results; goods might be excluded or included erroneously in ending inventory, affecting cost of goods sold and net income .

How does the risk-based audit approach help auditors address the risk of material misstatements?

The risk-based audit approach helps auditors by assessing the types and likelihood of misstatements in account balances. Auditors adjust the amount and type of audit work based on the likelihood of material misstatements. This approach involves understanding the client's objectives and management's risk mitigation plans, enabling auditors to design precise audit procedures to assess and address risks effectively .

Describe the stages of the risk-based audit process and their importance.

The risk-based audit process has three stages: Risk Assessment, Risk Response, and Reporting. During Risk Assessment, auditors identify and assess the risk of material misstatement. In Risk Response, they design and implement responses to these risks, aiming to reduce audit risk to an acceptably low level. Reporting involves evaluating the obtained evidence, forming an audit opinion, and preparing the audit report. These stages ensure that the audit is focused on the most significant risks, improving efficiency and effectiveness .

What are the inherent limitations of an audit that affect the detection of material misstatements?

Audits have inherent limitations due to several factors: the use of testing, the inherent limitations of internal control (including the possibility of management override or collusion), and the persuasive nature of most audit evidence, which is generally not conclusive. Additionally, auditors rely on judgment in gathering and assessing audit evidence, such as deciding the nature, timing, and extent of audit procedures and evaluating management's estimates .

What procedures are typically included in audit tests of controls over sales transactions?

Audit tests of controls over sales transactions typically include verifying the sequence and approval of sales documents (like customer orders and shipping documents), checking that invoices have been properly signed and reviewed, confirming credit approval, and ensuring that receiving reports match sales journal entries. Observations of control procedures help identify control weaknesses and potential misstatements .

What is the relationship between audit risk and reasonable assurance in an audit?

Audit risk is the risk that the auditor may express an inappropriate audit opinion when the financial statements are materially misstated. Reasonable assurance is achieved when audit risk is reduced to an acceptably low level, consistent with the audit's objective to provide an opinion on whether the financial statements are free from material misstatements. Reasonable assurance acknowledges that there is some risk the audit opinion could be wrong .

How do auditors use substantive tests to verify inventory transactions and balances?

Substantive tests for inventory involve verifying the existence, rights, completeness, and valuation of inventory balances. Auditors test quantities by comparing inventory records with physical counts, examine receiving reports to verify completeness, ensure transactions are for inventory owned by the entity, and trace costs to supporting documentation to ensure correct valuation. These tests help confirm that inventory balances are accurate and properly recorded .

What factors must auditors consider when setting the materiality threshold for financial statements?

Auditors must consider both quantitative and qualitative factors when setting the materiality threshold. Quantitative benchmarks like percentages of total assets or net income are used, but ultimately, it's the auditor's professional judgment that determines materiality. The level of riskiness, such as weaker internal controls, influences the materiality threshold. A riskier client may have a lower threshold to require more extensive audit evidence .

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AUDITING and ASSSURANCE Concepts and Applications PDF

This document appears to be the table of contents for an auditing textbook focused on concepts and applications of auditing and assurance. The table of contents outlines 6 chapters that will cover: 1. Core concepts of a risk-based audit approach 2. Preliminary engagement activities and planning the audit 3. Performing risk assessment procedures 4. Designing overall responses and further audit procedures 5. Auditing the revenue and collection cycle 6. Additional cycles likely to be covered. The chapters will provide learning outcomes and discuss key concepts like risk assessment, internal controls, audit planning, materiality, audit procedures, and applying the risk-based audit approach to specific accounting cycles like revenue.

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100% found this document useful (8 votes)

437K views829 pages

AUDITING and ASSSURANCE Concepts and Applications PDF

Uploaded by

Ynnah Mae A. Jalipa

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2020 – 2021

EDITION

AUDITING
AND
ASSURANCE
Concepts and Applications
• Based on PSQC, Framework, ISAs, PSAs,
PAPSs, PSREs, PSAEs, PSRSs
• With Illustrative Audit Working Papers

MA. ELENITA BALATBAT CABRERA

BBA MBA CPA CMA

GILBERT ANTHONY B. CABRERA

BBA MBA CPA

1
Contents
UNIT I OVERVIEW OF THE CORE CONCEPTS OF
FINANCIAL STATEMENTS AUDIT

Chapter 1 CORE CONCEPTS OF A RISK-BASED

APPROACH TO CONDUCTING A 1
QUALITY AUDIT

Expected Learning Outcomes 1

Nature of Independent Financial Statements
Audit 2
Overall objectives of the Independent Auditor
and the Conduct of an Audit in Accordance
with Philippine Standards on Auditing (PSA
200) 2
Objectives of an Audit 2
Ethical Requirements Relating to an Audit of
Financial Statements 3
Conduct of an Audit of Financial Statements 4
Scope of an Audit of Financial Statements 4
Professional Skepticism 5
Reasonable Assurance 5
Audit Risk and Materiality 7
Responsibility for the Financial Statements 7

The Risk-Based Audit Process 8

Introduction 8
Stages of the Risk-Based Audit Process 8
Relevant PSAs used in the Risk-Based Audit
Process 11
Understanding the Audit Risk Model 14
Components of Audit-Risk Model 16
Factors to Consider in Implementing the
Audit Risk Model 18
Limitations of the Audit Risk Model 19

Review Questions 20

2
UNIT II APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE I - RISK ASSESSMENT

Chapter 2 PRELIMINARY ENGAGEMENT

ACTIVITIES 23

Expected Learning Outcomes 23

Client Acceptance and Continuance Decision 24
Introduction 24
New Client Investigation 24
Continuing Clients 25
Quality Control Policies Relative to Client
Selection and Retention 26
Progress to Accept or Continue with an Audit
Engagement 27
Preconditions for an Audit 31
Agreeing the Terms of Engagement 32
Illustrative Engagement Letter 34

Review Questions and Exercises 36

Chapter 3 PLANNING THE AUDIT AND

DEVELOPMENT OF OVERALL AUDIT
STRATEGY 38

Expected Learning Outcomes 38

Planning the Audit 39
Nature and Scope of Audit Planning 39
Benefits of Audit Planning 40
Concept of Materiality Applied to Audit
Planning 40
Levels of Materiality 42
Performance of Materiality 43
SEC Requirements Relative to
Materiality 46
Levels of Audit Planning 49
The Overall Audit Strategy 49

3
The Detailed Audit Plan 53
Scope of the Audit Engagement 54
Reporting Objectives, Timing of the
Audit and Communications Required 55
Direction, Supervision and Review 56
Documentation 57
Communications with those Charged
with Governance and Management 57
Additional Considerations in Initial Audit
Engagements 58
Other Critical Matters in Engagement
Planning 58
Engagement Team Conference 67
Planning a Repeat Engagement 71
Special Consideration in the Audit of Small
Entities (PAPS 1005) 72

Review Questions 73

Chapter 4 PERFORMANCE OF RISK ASSESSMENT

PROCEDURES 79

Expected Learning Outcomes 79

Introduction 80
Risk Identification and Assessment 70
Identification of Inherent Risk (Business and
Fraud Risks) and Significant Risks 82
How to Identify Inherent Risk Factors 83
How to Identify Fraud Risk 86
How to Identify Significant Risks 88
Understanding the Design and Implementation
of Relevant Internal Controls 91
Illustrative Documentation of Identification and
Evaluation of Relevant Internal Control 94
Practical Pointers 98
Concluding the Risk Assessment Phase 99

Review Questions and Exercises 100

4
UNIT III APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE II - RISK RESPONSE:
TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF
TRANSACTIONS

Chapter 5 DESIGNING OVERALL RESPONSES AND

FURTHER AUDIT PROCEDURES 105

Expected Learning Outcomes 105

Introduction 105
Overall Response 106
Types of Response 107
Audit Procedures 108
Nature of Audit 108
Selecting the Audit Procedures that will be
Applied 111
Summary of Relevant Philippine Standards of
Auditing (PSA 300 and 330) 113
Tests of Controls 115
Substantive Tests 116
Illustrative Comprehensive Case Study on Risk
Assessment and Response 117

Review Questions and Exercises 135

Chapter 6 AUDIT OF THE REVENUE AND

COLLECTION CYCLE 145

Expected Learning Outcomes 145

Introduction 146
Nature of the Revenue and Collection Cycle 147
Processing Revenue Transactions 148
Accounts and Documents Used in Revenue and
Collection Cycle and their Audit Significance 149
Accounting Records in the Revenue and
Collection Cycle 152

5
Auditing the Revenue and Collection Cycle 153
Phase I - Risk Assessment 153
Phase II - Risk Response 157
Audit of Sales Transactions 158
Evaluation and Obtaining Evidence
About Internal Control Operating
Effectiveness in the Revenue Cycle 160
Tests of Controls Over Sales and
Receivables 161
Illustrative Audit Program for Tests
of Controls: Sales Transactions 164
Substantive Tests of Sales
Transactions 168

Audit of Sales Adjustments Transactions 171

Evaluation of Internal Control Over
Sales Adjustments Transactions 173
Tests of Controls Over Sales
Adjustments Transactions 174
Sample Audit Program for Test of
Controls: Sales Adjustments
Transactions 175
Substantive Tests for Sales Returns
and Allowances 176

Audit of Cash Receipts Transactions 177

Basic Considerations 177
Evaluation of Internal Control over
Cash Receipts Transactions 179
Tests of Controls Over Cash
Receipts Transactions 180
Sample Audit Program for Test of
Controls: Cash Receipts
Transactions 183
Substantive Tests of Cash Receipts
Transactions 185

Review Questions 187

6
Chapter 7 AUDIT OF EXPENDITURE (OR
ACQUISITION AND PAYMENT (CYCLE) 197

Expected Learning Outcomes 197

Introduction 198
Nature of the Expenditure Cycle 199
Accounts in the Acquisition and Payment Cycle 200
Processing Expenditure Transactions 201
Documents and Accounting Records Used in the
Expenditure Cycle and their Audit Significance 203

Audit of the Expenditure Cycle 205

Phase I - Risk Assessment 205
Phase II - Risk Response 210
Auditing Acquisition Transactions 211
Evaluation and Obtaining Evidence
About Internal Control Operating
Effectiveness in the Acquisition
Cycle 214
Test of Controls over Acquisition
Transactions 215
Illustrative Audit Program for Test
of Controls: Acquisition 218
Transactions
Substantive Tests of Acquisitions 220
Transactions

Audit of Cash Disbursements 222

Evaluation and Obtaining Evidence
about Internal Control over Cash
Disbursements Transactions 224
Test of Controls over Cash
Disbursements Transactions 225
Illustrative Audit Program for Tests
of Controls: Cash Disbursements
Transactions 227
Substantive Tests of Transactions:
Cash Disbursements 229

Review Questions and Problems 231

7
Chapter 8 AUDIT OF THE EXPENDITURE CYCLE,
CONTINUED ... 237

Expected Learning Outcomes 237

Audit of Production Cycle Transactions 238
Nature of the Production Cycle 238
Documents Used in the Payroll & Personnel
Cycle and their Audit Significance 238
Accounting Records Involved in production
Activities 239
Evaluation of Internal Control Over Payroll
Transactions 242
Tests of Controls: Production Transactions 243
Audit Program for Tests of Controls Over
Production Transactions 245
Substantive Tests of Transactions:
Production Transactions 247
Audit of Inventory Warehousing 248
Tests of Controls: Inventory Warehousing 248
Audit Program for Tests of Controls over
Inventory Warehousing Transactions 250
Substantive Tests of Inventory Warehousing
Transactions 251
Audit of Payroll Transactions 254
Nature of Payroll Transactions 254
Documents Used in the Payroll and
Personal Cycle and their Audit Significance 254
Accounting Records in the Payroll and
Personal Cycle 255
Evaluation of Internal Control over Payroll
Transactions 256
Tests of Controls: Payroll 256
Audit Program for Tests of Controls over
Payroll Transactions 261
Substantive Tests of Transactions: Payroll
Transactions 262

Review Questions and Problems 266

8
Chapter 9 AUDIT OF THE INVESTING CYCLE 275

Expected Learning Outcomes 275

Introduction 276
Nature of the Investing Cycle 277
Processing Investing Cycle Transaction 277
Accounts, Documents and Records Used in
the Investing Cycle 278
Auditing the Investing Cycle 280
Phase I - Risk Assessment 280
Phase II - Risk Response 285
Basic Considerations 285
Evaluation and Obtaining Evidence
About Internal Control Operating
Effectiveness in the Investing Cycle
Transactions 286
Tests of Controls and Substantive Tests
of Transactions 290
Illustrative Audit Program for the Test of
Controls and Substantive Tests of
Transactions 290

Review Questions and Exercises 292

Chapter 10 AUDIT OF THE FINANCING CYCLE 301

Expected Learning Outcomes 301

Introduction 302
Nature of the Financing Cycle 302
Activities Related to Financing Cycle 303
Overview of the Accounts Associated with the
Financing Cycle 303
Documents and Records 305

9
Auditing the Financing Cycle 306
Phase I - Risk Assessment 306
Phase II - Risk Response 311
Obtaining Evidence About Internal
Control Operating Effectiveness for
Debt Obligations and Stockholders'
Equity Transactions 311
Obtaining Substantive Evidence in
Auditing Debt Obligations and
Shareholders' Equity Transactions 312
Substantive Tests of Details:
Debt Obligations Transactions 312
Substantive Tests of Details:
Shareholders' Equity Transactions 313

Review Questions and Exercises 315

UNIT IV APPLICATIONS OF THE RISK-BASED AUDIT

PROCESS
PHASE II - RISK RESPONSE:
SUBSTANTIVE TESTS OF DETAILS OF
BALANCES

Chapter 11 AUDIT OF CASH BALANCES 321

Expected Learning Outcomes 321

Introduction 322
Audit Objectives and Procedures 323
Discussion of Substantive Audit Procedures 324
Illustrative Cash Count Sheet 327
Illustrative Bank Reconciliation Statement 328
Illustrative Proof of Cash or Reconciliation of
Receipts and Disbursements 331

Review Questions, Exercises and Problems 345

10
Chapter 12 AUDIT OF TRADE RECEIVABLES,
ALLOWANCE FOR DOUBTFUL
ACCOUNTS AN SALES 355

Expected Learning Outcomes 355

Introduction 356
Audit Objectives and Procedures 356
Discussion of Audit Procedures 357
Illustrative Accounts Receivable Aging Schedule 358
Working Papers for Notes Receivable 359
Positive Form of Accounts Receivable
Confirmation Request 361
Negative Form of Accounts Receivable
Confirmation Request 362
Illustrative Audit Case: Sales Cut-Off Exam
Illustrative Audit Case: Audit Allowance for
Doubtful Accounts 372
Illustrative Audit Case: Audit of Notes
Receivable and Related Accounts 373

Review Questions, Exercises and Problems 376

Chapter 13 AUDIT OF INVENTORIES, COST OF

SALES AND TRADE PAYABLES 385

Expected Learning Outcomes 385

Introduction 386
Audit of Inventories and Cost of Sales
Discussion of Audit Procedures 386
Illustrative Inventory List 388
Audit of Trade Accounts and Notes Payable 396
Audit Objectives and Procedures 396
Illustrative Schedule of Accounts Payable 398
Positive Form of Accounts Payable
Confirmation Request 399
Illustrative Working Paper for Notes Payable -
Trade 401
Illustrative Audit Case: Purchases Cut-Off
Examination 409
Illustrative Audit Case: Sales and Purchases
Cut-Off Examination 410

Review Questions, Exercises and Problems 414

11
Chapter 14 AUDIT OF INVESTMENTS 431

Expected Learning Outcomes 431

Introduction 432
Audit Objectives and Procedures 432
Discussion of Audit Procedures 433
Illustrative Audit Case: Analysis of Investments
in Securities Equity @ FVOCI 438

Review Questions and Problems 447

Chapter 15 AUDIT OF PROPERTY, PLANT AND

EQUIPMENT, AND THE RELATED
DEPRECIATION AND DEPLETION 455

Expected Learning Outcomes 455

Introduction 456
Audit Objectives and Procedures 457
Illustrative Lead Schedule for Property, Plant
and Equipment 459
Audit of Natural Resources 463

Review Questions, Exercises and Problems 481

Chapter 16 AUDIT INTANGIBLE ASSETS 493

Expected Learning Outcomes 493

Introduction 494
Audit Objectives and Procedures 494
Discussion of Audit Procedures 495
Positive Form of Accounts Payable
Confirmation Request 499

Review Questions and Exercises 505

12
Chapter 17 AUDIT OF PREPAID EXPENSES,
DEFERRED CHARGES AND OTHER
CURRENT LIABILITIES 517

Expected Learning Outcomes 517

Introduction 518
Audit Objectives and Procedures 518
Substantive Audit Procedures 518
Audit of Prepaid Expenses 519
Audit of Deferred Charges 521
Audit of Other Current Liabilities 521
Discussion of Audit Procedures 522

Review Exercises and Problems 532

Chapter 18 AUDIT OF LONG-TERM LIABILITIES 537

Expected Learning Outcomes 537

Introduction 538
Audit of Long-Term Liabilities (Notes Payable,
Mortgage Payable, Bonds Payable) 538
Audit Objectives and Procedures 538
Discussion of Audit Procedures 540
Illustrative Letter of Confirmation of Lines of
Credit 543
Analytical Procedures for Long-Term Debts 544
Illustrative Analytical Procedures for Notes
Payable 544
Working Papers for Long-Term Debt 544
Illustrative Schedule of Loan Payable and
Accrued Interest 545

Review Questions, Exercises and Problems 552

13
Chapter 19 AUDIT OF OWNER(S)' EQUITY
ACCOUNTS 561

Expected Learning Outcomes 561

Introduction 562
Audit of Sole Proprietorship and Partnership
Accounts 562
Audit of Shareholders' Equity Accounts 562
Audit Objectives and Procedures 563
Discussion of Audit Procedures 564

Review Questions, Exercises and Problems 581

Chapter 20 AUDIT OF OTHER ACCOUNTS IN THE

STATEMENT OF PROFIT OR LOSS AND
COMPREHENSIVE INCOME 593

Expected Learning Outcomes 593

Introduction 594
Audit Objectives 594
Auditors Approach in the Examination of
Revenues and Expenses 595
Substantive Procedures for Selling, General and
Administrative Expense 596
Analytical Review of Operation 597
Account Analysis 598
Classification and Disclosure 600

Review Exercises and Problems 609

14
UNIT V APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE III - REPORTING

Chapter 21 EVALUATION OF AUDIT EVIDENCE

AND COMPLETION OF THE AUDIT 617

Expected Learning Outcomes 617

The Reporting Phase of the Risk-Based Audit
Process 618
Evaluating the Sufficiency and Appropriateness
of Audit Evidence 619
Competence or Appropriateness of Evidence 620
Sufficiency of Evidence 622
Factors to Consider 625
Final Analytical Procedures 626
Documentation 626
Nature and Objective of Audit
Documentation 626
Form, Content and Extent of Audit
Documentation 627
Types of Working Papers 629
Financial Statement Checklists, Analytical
Procedures and Tests of Balances 631
Completing the Audit 634
Related Party Transactions 634
Subsequent Events Review 635
Letters of Inquiry / Review for Contingent
Liabilities 636
Evaluation of Going Concern Assumption 637
Management Representations 637
Perform Final Analytical Procedures 638
Review the Minutes of Meetings 638
Evaluating Findings, Formulating an Opinion
and Drafting the Audit Report 639
Making a Final Assessment of Materiality
and Audit Risk 639
Evidence Supports Auditor's Opinion 639

Review Questions and Problems 640

15
Chapter 22 FORMING AN OPINION AND
REPORTING ON FINANCIAL
STATEMENTS 649

Expected Learning Outcomes 649

Introduction 650
Forming an Opinion on the Financial Statements 651
Forms of Opinion 652
Unmodified Opinion 652
Modified Opinion 652
Illustrative Audit Report with Unmodified
Opinion 653
Preparation of the Auditor's Report for Audits
Conducted in accordance with Philippine
Standards on Auditing 659
Responsibilities for the Financial Statement 662
Auditor's Responsibilities for the Audit of the
Financial Statements 663
Other Reporting Responsibilities 666
Name of the Engagement Partner 667
Signature of the Auditor 667
Auditor's Address 667
Date of the Auditor's Report 667
Supplementary Information Presented with
Financial Statements 668

Review Questions and Problems 669

Chapter 23 MODIFICATIONS TO THE OPINION IN

THE INDEPENDENT AUDITOR'S
REPORT 673

Expected Learning Outcomes 673

Introduction 674
Types of Modified Opinions 674
When is Modified Opinion Expressed? 675
Determining the Type of Modification to the
Auditor's Opinion 676
Form and Content of the Auditor's Report when
the Opinion is Modified 679

16
Description of Auditor's Responsibility When the
Auditor Expresses a Qualified of Adverse
Opinion 680
Description of Auditor's Responsibility When the
Auditor Disclaims an Opinion 680
Communication with Those Charged with
Governance 681
Illustrative Audit Reports with Modified Opinion 681

Review Questions and Exercises 687

Chapter 24 PREPARATION OF FINANCIAL

STATEMENTS 703

Expected Learning Outcomes 703

Introduction 704
Financial Statements 704
Purpose of Financial Statements 704
Complete Set of Financial Statements 705
Who are Required to Submit Audited Financial
Statements? 705
Sources of Audited Financial Statements in the
Philippines 706
General Features of Financial Statements 706
Statement of Financial Position 709
Statement of Profit or Loss and Comprehensive
Income or Statement of Comprehensive
Income 712
Statement of Changes in Equity 715
Statement of Cash Flows 716
Notes to Financial Statements 716
Illustrative Financial Statements 718

Review Problems 736

Appendix A: Audited Financial Statements of

Selected Companies in the Philippines 765

17
UNIT I
OVERVIEW OF THE CORE
CONCEPTS OF FINANCIAL
STATEMENTS AUDIT

Chapter
1 Core Concepts of a Risk-Based
Approach to Conducting a
Quality Audit

18
Chapter
CORE CONCEPTS
RISK-BASED
APPROACH TO
CONDUCTING A
QUALITY AUDIT

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Understand the core concepts of a Financial Statement Audit including the following:
 Nature of an independent Financial Statement Audit
 The overall objectives of the Independent Auditor and the conduct of an audit in
accordance with Philippine Standards on Auditing.
 Ethical Requirements Relating to an Audit of Financial Statements.
 Conduct of an Audit of Financial Statements.
 Scope of an Audit of Financial Audit.
 Professional Skepticism.
 Reasonable Assurance.
 Audit risk and Materiality.
 Responsibility for the Financial Statements

2. Understand the Risk-Based Audit Process

 Distinction between risk-based audit approach and account based activities
 Stages and the activities in the risk-based audit process
 Relevant Philippine Standards on Auditing (PSAs) used in the Risk-Based Audit
Process
 Components of the Audit-Risk Model
 Factors to consider in Implementing the Audit Risk Model
 Limitations of the Audit Risk Model

19
CHAPTER 1

CORE CONCEPTS OF A RISK-BASED APPROACH

TO CONDUCTINGA QUALITY AUDIT

NATURE OF INDEPENDENT FINANCIAL STATEMENTS AUDIT

Auditing is a systematic process by which a competent, independent person objectively obtains and
evaluates evidence regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating the results to
interested users.

OVERALL OBJECTIVES OF THE INDEPENDENT AUDITOR AND THE CONDUCT OF AN

AUDIT IN ACCORDANCE WITH PHILIPPINE STANDARDS ON AUDITING (PSB200)

The Philippine Standard on Auditing (PSA) establishes the independent auditor's overall responsibilities
when conducting an audit of financial statements. Specifically, it sets out the overall objectives of the
independent auditor, and explains the nature and scope of an audit designed to enable the independent
auditor to meet those objectives. It also explains the scope, authority and structure of the PSAs, and includes
requirements establishing the general responsibilities of the independent auditor applicable in all audits,
including the obligation to comply with the PSAs.

OBJECTIVES OF AN AUDIT

In conducting an audit of financial statements, the overall objectives of the auditor are:

(a) To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud. or error, them by enabling the auditor to express an
opinion on whether the financial statements are prepared, in all material respects, in accordance
with an applicable financial reporting framework; and

(b) To report on the financial statements, and communicate as required by the PSAs, in
accordance with the auditor's findings.

20
The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements.
This is achieved by the expression of an opinion by the auditor on whether the financial statements are
prepared in all material respects, in accordance with an applicable financial reporting framework. In the
case of most general-purpose frameworks, that opinion is on whether the financial statement are presented
fairly, in accordance with PSAs and relevant ethical requirement enables the auditor to form that opinion.

An audit of financial statements is an assurance engagement, as defined in the Philippine Framework for
Assurance Engagements. The Framework defines and describes the elements and objectives of an
assurance engagement. The PSAs apply the Framework in the context of an audit of financial statements
and contain the basic principles and essential procedures, together with related guidance, to be applied in
such an audit.

ETHICAL REQUIREMENTS RELATING TO AN AUDIT OF FINANCIAL STATEMENTS

The auditor should comply with relevant ethical requirements relating to audit engagements.
As discussed in PSA220, "Quality Control for an Audits of Financial Statements,” ethical requirements
relating to audits of financial statements ordinarily comprise Parts A and B of the Code of Ethics for
Professional Accountants in the Philippines (Ethics Code)' effective April 6, 2018 adopted and
promulgated by the Board of Accountancy. PSA 220 (Revised) identifies the fundamental principles of
professional ethics established by Parts A and B of the Ethics Code and sets out the engagement partner's
responsibilities with respect to ethical requirements.

PSA 220 recognizes that the engagement team is entitled to rely on a firm's systems in meeting its
responsibilities with respect to quality control procedures applicable to the individual audit engagement (for
example, in relation to capabilities and competence of personnel through their recruitment and formal
training; independence through the accumulation and communication of relevant independence information;
maintenance of client relationship through acceptance and continuance system. ; and adherence to
regulatory and legal requirements through the monitoring process), unless information provided by the firm
or other parties suggest otherwise. Accordingly, Philippine Standard on Quality Control (PSQC) 1,
“Quality Control for Firms that Perform Audits and

21
Reviews of Financial Statements, and Other Assurance and Related Services Engagements”, requires the
firm to establish policies and procedures designed to provide it with reasonable assurance that the firm and
its personnel comply with relevant ethical requirements.

CONDUCT OF AN AUDIT OF FINANCIAL STATEMENTS

The auditor should conduct an audit in accordance with Philippine Standards on Auditing.
PSAs contain basic principles and essential procedures together with related guidance in the form of
explanatory and other material, including appendices. The basic principles and essential procedures are to
be understood and applied in the context of explanatory and other materials that provide guidance for their
application. The text of a whole Standard is considered in order to understand and apply the basic principles
and essential procedures.

In conducting an audit in accordance with PSAs, the auditor is also aware of and considers Philippine
Auditing Practice Statements (PAPSs) applicable to the audit engagement. PAPSs provide interpretative
guidance and practical assistance to auditors in implementing PSAs. An auditor who does not apply the
guidance included in a relevant PAPS needs to be prepared to explain how the basic principles and essential
procedures in the Standard addressed by the PAPS have been complied with.

The auditor may also conduct the audit in accordance with both ISAs and PSAs. However, there are
currently no fundamental differences between the IAASB pronouncements and corresponding
requirements issued by the AASC and no such differences are expected in the future.

SCOPE OF AN AUDIT OF FINANCIAL STATEMENTS

The term "scope of an audit" refers to the audit procedures deemed necessary in the circumstances to
achieve the objective of the audit. In determining the audit procedures to be performed in conducting an
audit in accordance with Philippine Standards on Auditing, the auditor to the auditor should comply with
each of the Philippine Standards on Auditing relevant to the audit.

2 As stated in the Preface to the Philippine Standards on Quality Control, Auditing, Review, and Other Assurance and Related Services, it is the
stated policy of the AASC to make the International Standards and Practice Statements issued by the IAASB the applicable standards and practice
statements in the Philippines. To implement such policy, the AASC makes Philippine specific those paragraphs or sections in International
Standards and Practice Statements that are addressed in broad terms to the international community as a whole to make them clearly applicable the
Philippine, or provides additional information certain paragraphs or sections, whenever necessary to facilitate and clearly establish their application
in the Philippines.

22
The auditor should not represent compliance with Philippine Standards on Auditing unless the auditor has
complied fully with all of the Philippine Standards on Auditing relevant to the audit. The auditor may, in
exceptional circumstances, judge it necessary to depart from a basic principle or an essential procedure that
is relevant in the circumstances of the audit, in order to achieve the objective of the audit. In such a case, the
auditor is not precluded from representing compliance with PSAs, provided the departure is appropriately
documented as required by PSA 230 (Clarified), "Audit Documentation."

PROFESSIONAL SKEPTICISM

The auditor should plan and perform an audit with an attitude of professional skepticism recognizing that
circumstances may exist that cause the financial statements to be materially misstated.

An attitude of professional skepticism means the auditor makes a critical assessment, with a questioning
mind, of the validity of audit evidence obtained and is alert to audit evidence that contradicts or brings into
question the reliability of documents and responses to inquiries and other information obtained from
management and those charged with governance. For example, an attitude of professional skepticism is
necessary throughout the audit process for the auditor to reduce the risk of overlooking unusual
circumstances, of over generalizing when drawing conclusions from audit observations, and of using faulty
assumptions in determining the nature, timing and extent of the audit procedures and evaluating the results
thereof. When making inquiries and performing other audit procedures, the auditor is not satisfied with
less-than persuasive audit evidence based on a belief that management and those charged with governance
are honest and have integrity. Accordingly, representations from management are not a substitute for
obtaining sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base
the auditor's opinion.

REASONABLE ASSURANCE

An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial
statements taken as a whole are free from material misstatement, whether due to fraud or error. Reasonable
assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to
conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable
assurance relates to the whole audit process.

23
An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the
auditor's ability to detect material misstatements. These limitations result from factors such as the
following:
 The use of testing.
 The inherent limitations of internal control (for example, the possibility of management override
or collusion).
 The fact that most audit evidence is persuasive rather than conclusive.
Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in particular
regarding:
a) The gathering of audit evidence, for example, in deciding the nature, timing and extent of audit
procedure; and
b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the
reasonableness of the estimates made by management in preparing the financial statements.
Further, other limitations may affect the persuasiveness of evidence available to draw conclusions on
particular assertions (for example, transactions between related parties). In these cases, certain PSAs
identify specified audit procedures which will, because of the nature of the particular assertions, provide
sufficient appropriate audit evidence in the absence of:
a) Unusual circumstances which increase the risk of material misstatement beyond that which would
ordinarily be expected; or
b) Any indication that a material misstatement has occurred.

Accordingly, because of the factors described above, an audit is not a guarantee that the financial statements
are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion
does not assure the future viability of the entity nor the efficiency or effectiveness with which management
as conducted the affairs of the entity.

24
AUDIT RISK AND MATERIALITY

The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the financial
statements give a true and fair view or are presented fairly, in all material respects, in accordance with the
applicable financial reporting framework. The concept of reasonable assurance acknowledges that there is a
risk the audit opinion is inappropriate. The risk that the auditor expresses an inappropriate audit opinion
when the financial statements are materially misstated is known as "audit risk".

The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is
consistent with the objective of an audit. The auditor reduces audit risk by designing and performing audit
procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on
which to base an audit opinion. Reasonable assurance is obtained when the auditor has reduced audit risk to
an acceptably low level.

RESPONSIBILITY FOR THE FINANCIAL STATEMENTS

While the auditor is responsible for forming and expressing an opinion on the financial statements, the
responsibility for the preparation and presentation of the financial statements in accordance with the
applicable financial reporting framework is that of the management of the entity, with oversight from those
charged with governance. The audit of the financial statements does not relieve management or those
charged with governance of their responsibilities.

25
THE RISK-BASED AUDIT PROCESS

Introduction

Risk-based audit approach is an audit approach that begins with an assessment of the types and likelihood
of misstatements in account balance and then adjusts the amount and type of audit work, to the likelihood of
material misstatements occurring in account balances.

In risk-based audit, the audit team views all activities in the organization first in terms of risks to strategies
and objectives, and then in terms of management's plans and processes to mitigate the risk. The auditors
obtain an understanding of the client's objectives. The risks are identified and the auditors determine how
management plans to mitigate the risk and whether those plans are in place and operating effectively.

Account-based audit is an approach wherein the auditor obtains an understanding of control and assesses
control risk for particular types of errors and frauds in specific accounts and cycle.

STAGES OF THE RISK-BASED AUDIT PROCESS

Under the PSAs which are risk-based, specific audit procedures vary from one engagement to the next. The
following stages are, however, involved in every engagement.

Phase I. Risk Assessment

This phase involves the following activities:
a. Performance of preliminary engagement activities to decide whether to accept / continue an audit
engagement.
b. Planning the audit to develop an overall audit strategy and audit plan.
c. Performance of risk assessment procedures to identify / assess risk of material misstatement
through understanding the entity.
.

26
Phase II. I Risk Response

This phase covers the following activities:

a. Designing overall responses and further audit procedures to develop appropriate responses to the
assessed risk of material misstatement.
b. Implementing responses to assessed risk of material misstatement misstatement to reduce audit
risk to an acceptably low level.

Phase III. Reporting

This phase involves the following activities:

a. Evaluating the audit evidence obtained to determine what additional audit work (if any) is
required.
b. Forming an opinion based on audit findings and preparing the auditor's report.

A simpler way of describing the three elements is illustrated below.

Figure 1-1: Describing the Three Elements

RISK ASSESSMENT RISK RESPONSE REPORTING

What events* could occur that Did the events* identified occur What audit opinion, based on the
would cause a material and result in a material evidence obtained, is appropriate
misstatement in the financial misstatement in the financial on the financial statements?
statements? statements?

* An "event" is simply a business or fraud risk factor that, if it actually occurred, would adversely affect the
entity's ability to achieve its objective of preparing financial statements that do not contain material
misstatements resulting from error and fraud. This would also include risks resulting from the absence of
internal control to mitigate the potential for material misstatements in the financial statements.

Figure 1-2 shows the schematic risk-based audit process in accordance with the guidelines provided by the
International Federation of Accountants.

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Figure 1-2: Risk-Based Audit Process*

* Adapted from “Guide to using International Standards of Auditing in the Audits of Small and Medium Sized
Entities” Volumes I and II, Core Concepts / Practical Application – Fourth Edition”. Copyright © November 2018 by
IFAC, All rights reserved. Used with permission of IFAC.

28
Figure 1-3 presents the Relevant Philippine Standard On Auditing (PSAS) To Be Used In The Risk Based
Audit Process

Figure 1-3Relevant Philippine Standard On Auditing (PSAS) To Be Used In The Risk Based Audit
Process

GUIDANCE ON FUNAMENTAL CONCEPTS

TOPIC Applicable PSA (s)

General Principles PSA 200, Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with International Standards on
Auditing
Quality Control PSA 200, Quality Control for an audit of Financial Statement
Management Assertions PSA 315, Identifying and Assessing the Risk of Material Misstatement
through Understanding the Entity and Its Environment (Newly Revised
Standard effective for audits of financial statement for periods ending on
or after December 15, 2013)
Audit Evidence PSA 500, Audit Evidence
Audit Documentation PSA 230, Audit documentation

PHASE I – RISK ASSESSMENT INCLUDING MAKING CLIENT ACCEPTANCE AND

CONTINUANCE DECISION

Client Acceptance and PSA 210, Agreeing the Terms of Audit Engagements
Continuance
Considering Fraud PSA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of
Financial Statements
Planning an Audit PSA 300, Planning an Audit of Financial Statements
Assessing Risk of Material PSA 315, Identifying and Assessing the Risk of Material Misstatement
Misstatement though Understanding the Entity and its Environment (Newly Revised
Standard effective for audits of financial statement for periods ending on
or after December 15, 2013)

PSA 320, Materiality in Planning and Performing an Audit

Planning Audit Procedures PSA 330, The Auditor’s Responses to Assessed Risk
Understanding Related Parties PSA 550, Related Parties

29
Communicating with those Charged PSA 260, Communication with Those Charged with Governance
with Governance about the Audit
Plan
PHASE II - RISK RESPONSE

Testing Controls for the Financial PSA 330, The Auditor's to Assessed Risks
Statement Audit
Audit Sampling for Tests of Controls PSA 530 Audit Sampling
Testing Controls in an Integrated
Audit
Obtaining Evidence PSA 250. Consideration of Laws and Regulations in an Audit of
about Compliances with Laws and Financial Statements
Regulations
Substantive Audit Procedures PSA 330. The Auditor's Responses to Assessed Risks
PSA 500 Audit Evidence
Audit Evidence regarding the PSA 501, Audit Evidence Specific Considerations for Selected
a. Valuation of investments items
in securities and
derivative instruments;
b. Existence and condition of
inventory
c. Completeness of litigation,
claims, and assessments
involving the entity; and
d. Presentation and disclosure
of segment information,
in accordance with
the applicable
financial reporting
framework

External Confirmations PSA 505, External Confirmations

Audit Sampling for Substantive Tests PSA 530, Audit Sampling

Obtaining Evidence about Related PSA 550, Related Parties
Parties
Auditing Accounting Estimates PSA 540, Auditing Accounting Estimates, Including Fair Value
Accounting Estimates, and relate Disclosures

30
Analytical Procedures as a PSA 520. Analytical Procedures
Substantive Test
Using an Auditor's Specialist/Expert PSA 620 Using the work of an Auditor's Expert

PHASE III - REPORTING

Evaluating the implications of PSA 250. Consideration of Laws and Regulation in an Audit of
Noncompliance with Laws and Financial Statements
Regulations
Evaluating Financial Statement PSA 450 Evaluation of Misstatements Identified during the Audit
Misstatements
Subsequent Events PSA 560. Subsequent Events
Disclosures about Related Parties PSA 550. Related Parties
Going Concern PSA 570. Going Concern
Management Representations PSA 580. Written Representations
Omitted Procedures PSA 250. Communication with those Charged with Governance
Communicating with those Charged PSA 700, Forming an Opinion and Reporting on Financial
with Governance Statements
Supervision
Engagement Quality Review
Audit Opinions
Audit Opinion Modifications PSA 705, Modifications to the Opinion in the Independent
Auditor's Report
Matter Paragraphs in the Audit PSA 706, Emphasis of Matter Paragraphs and Other Matter
Report Paragraphs in the Independent Auditor's Report
Special Considerations PSA 800. Special Considerations - Audits of Financial Statements
Prepared in Accordance with Special Purpose Frameworks
PSA 805, Special Considerations - Audits of Single Financial
Statements and Specific Elements, Accounts or items of a
Financial Statement

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UNDERSTANDING THE AUDIT RISK MODEL

Nature of Risk

Risk is a concept used to express uncertainty about events and/or their outcomes that could have a material
effect on the organization.

The four critical components of risk that are relevant to conducting the audit are:

1. Audit Risk. The risk that an auditor may give an unqualified opinion on financial statements that
are materially misstated.
2. Engagement Risk. The economic risk that a CPA Firm is exposed to simply because it is
associated with a particular client including loss of reputation, inability of the client to pay the
auditor, or financial loss because management is not honest and inhibits the audit process.
Engagement risk is controlled by careful selection and retention of client.
3. Financial Reporting Risk. Those risks that relate directly to the recording of transactions and the
presentation of financial data in an organization's financial statements.
4. Business Risk. Those risks that affect the operations and potential outcomes of organizational
activities.

The following considerations are important in integrating the concepts of materiality and risk in the conduct
of a risk-based audit:

1. Risky areas of a business must be identified by the auditors to determine which account balances
are more prone to material misstatements, how the misstatements might occur and how a client
might be able to cover them up.
2. Auditors need to develop approaches and methodologies to allocate overall assessments of
materiality to individual account balances because some account balances may be more important
to users.
3. Audits involve testing or sampling and thus cannot provide absolute (100%) assurance that the
financial statements are free of material misstatements without inordinately driving up the cost of
audits.
4. Not all clients are worth accepting. Since audits rely on testing and to some extent on the integrity
of management, there are some clients that an audit firm should not accept because the
engagement risk is too high.
5. Competition for clients among audit firms is high. Clients choose auditors based on a number of
factors including fees, service, industry knowledge, personal rapport and ability to assist the
client.

32
6. Auditors should understand society's expectations of financial reporting to reduce audit risk to an
acceptably low level and therefore minimize lawsuits that the users may possibly bring forth.

Although audit risk is a concept, it is often illustrated using quantitative examples. For instance, the
relationship between engagement risk and audit risk may presented as follows:

Engagement Risk
Audit Risk High Moderate Low
Do not accept client Set Very Low (1%) Set within professional standard but
can be higher companies with higher
engagement risk (5%)

 Setting audit risk at 1% is equivalent to performing a statistical test using 99% confidence level.
Audit risk set at 1% implies that the auditor is willing to take a 1% chance of issuing an
unqualified opinion on materially misstated financial statements.
 Audit risk set at 5%, implies that the auditor is willing to take a 5% chance of issuing an
unqualified opinion on materially misstated financial statements.
 High levels of audit risk are appropriate for client with lower levels of engagement risk.

Based on the assessment of engagement risk, the auditor sets the desired audit risk. Audit risk oftentimes
illustrated using numeric or quantitative examples. In fact many audit firms use the measures associated
with statistical sampling to set audit risk, e.g., setting audit risk at a 1% level for high-risk clients and 5% for
lower-risk clients. Other auditing firms use a broader description of audit risk as high, moderate or low and
adjust the nature of their audit procedures accordingly.

The following general observations are considered to have influenced the implementation of the audit risk
model:
 The better the company's internal controls, the lower the likelihood of material misstatement.
 Unusual or complex transactions are more likely to be erroneously recorded than am recurring or
routine transactions.
 The amount and persuasiveness of audit evidence gathered should vary inversely with audit risk;
i.e., lower audit risk requires gathering more persuasive evidence.

33
COMPONENTS OF AUDIT-RISK MODEL

These general premises have been incorporated into an audit risk (AR) model with three components:
inherent risk (IR), Control Risk (CR), and Detection Risk (DR) as follows:

AR = IR x CR x DR

where

Inherent risk (IR) is the initial susceptibility of a transaction or accounting adjustment to be recorded in
error, or for the transaction not to be recorded in the absence of internal controls.
Control risk (CR) is the risk that the client's internal control system will fail to prevent or detect a
misstatement.
Detection risk (DR) is the risk that the audit procedures will fail to detect a material misstatement.

Stated differently, audit risk is the risk that the auditor may give an unqualified opinion on materially
misstated financial statements. It is influenced by: (IR) the likelihood that a transaction, estimate, or
adjustment might be recorded incorrectly; (CR) the likelihood that the client's internal control processes
would fail to prevent or detect the misstatement and (DR) the likelihood that, if a misstatement occurred,
the auditor's procedures would fail to detect the misstatement.

The audit risk model may also be illustrated using a quantitative approach with probability assessments
applied to each of the model's component.

Illustrative Case I: Quantitative Example of Audit Risk:

High Risk of Material Misstatement

XYZ Mining Corporation, an audit client of Aquino and Marcos CPAs ., has many complex transactions
and weak internal control. The auditors assess both inherent risk and control risk at their maximum. This
implies that the client does not have effective control (CR) and there is a high risk that the transaction would
be recorded incorrectly (IR).

The auditors believe that engagement risk is high and have set audit risk at the 0.01 level. This means that
the auditors do not want to take much of a risk that the misstatement goes undetected in the financial
statements.
.

34
The effect on the extent of audit procedures and thus, detection risk is as follows:

AR = IR x CR x DR
𝐴𝑅
𝐷𝑅 =
(𝐼𝑅 𝑥 𝐶𝑅)
.
𝐷𝑅 = or 0.01 or 1%
( . . )

In this particular case, detection risk and audit risk are the same because the auditor cannot rely on internal
control to prevent or detect misstatements.

This illustration therefore yields the instinctive result:

"Poor controls and a high likelihood of misstatement would lead to extended audit work to maintain
audit risk at an acceptable level."

Illustrative Case II: Quantitative Example of Audit Risk:

Low Risk of Material Misstatement

Zoren Trading Corporation is an audit client of Cayetano and Loren CPAs. Zoren has simple transactions,
well-trained accounting personnel effective control and no incentive to misstate the financial statements.

The auditor's previous audit experience with the client; an understanding of the client's internal controls and
the results of preliminary testing this year indicate a low risk of material misstatement existing in the
accounting records. The auditor assesses inherent risk as low as 50% and control risk of 20%.

Audit risk is consistent with it low engagement risk of 0.05.

The detection risk for this engagement is determined as follows:

𝐴𝑅
𝐷𝑅 =
(𝐼𝑅 𝑥 𝐶𝑅)

.
𝐷𝑅 = or 0.50 or 50%
(. . )

35
The auditor could therefore design test of the accounting records with a lower detection risk, in this
situation 50%, because only minimal substantive test of account balances are needed to provide
collaborating evidence on the expectations that the accounts are not materially misstated. The auditor,
however would have had to test whether the controls are operating effectively in order to support a control
risk assessment below 100%.

FACTORS TO CONSIDER IN IMPLEMENTING THE AUDIT RISK MODEL

The following general observations on an audit client influence the implementation of the audit risk model:

1. High-risk activities

 This includes operations or events where a material misstatement could easily occur. For example,
an inventory of high-value diamonds or gold bars held by a jeweler, or a new / complex
accounting system being introduced.

2. Existence of large non-routine transactions

 Identified significant related party transactions outside the entity's normal course of business are
to be treated as giving rise to significant risks. This includes infrequent and large transactions.
For example:

 Unusual volume of routine transactions with a related party;

 A major sales or supply contract.
 The purchase or sale of major business assets or business segments; and
 Sale of the business to a third party.

 Routine non-complex transactions that are subject to systematic processing are less likely to give
rise to significant risks.

3. Matters requiring judgment or management intervention

 Examples would include:

 The assumptions and calculations used by management in developing major estimates;
 Complex calculations or accounting principles;
 Revenue recognition (presumed to be a significant risk) that is subject to differing
interpretation;

36
 Where management intervention is required to specify the accounting treatment to be used.

4. Potential for fraud

 The risk of not detecting a material misstatement resulting from fraud (which is intentional and
deliberately concealed) is higher than the risk of not detecting one resulting from error.
 In evaluating whether significant risk could result from the identified fraud risk factors and the
possible scenarios and schemes identified in team discussions, consider the following:
 Skillfulness of the potential perpetrator;
 Relative size of individual amount manipulated;
 Level of authority of management or employee to:
 directly or indirectly manipulate accounting records, and override control procedures;
 Significant fraud risks may be identified at any stage in the audit as a result of new information
being obtained.

LIMITATIONS OF THE AUDIT RISK MODEL

Audit risk is a concept that drives the auditor's thinking about planning the audit and then executing an audit.
The illustrations are designed to provide guidance, but should not be applied rotely to any audit client.
CPA firms in determining their approach to implementing the audit risk model should consider the
following limitations:

a) Inherent risk is difficult to formally assess. Some transactions because of their complexity are
more susceptible to error but it is quite difficult to assess that level of risk independent of the
client's accounting system.
b) The model treats each risk component as separate and independent when in fact the components
are not independent. It is also quite difficult to separate a client's material controls and inherent
risk.
c) Audit risk is judgmentally determined.
d) Audit technology is not so fully developed that each component of the model can be accurately
assessed. Auditing is based on testing and precise estimates of the model's components are not
possible. Auditors can, however, make subjective assessments and use the audit risk model as
guide.

37
REVIEW QUESTIONS

Questions

1. Explain why auditors' reports are important to users of financial statements.

2. What purpose is served by the Philippine Standards on Auditing?

3. Discuss the role of risk in the audit process and how its existence is communicated to the user in
the audit report.

4. Prior to naming Cruz and Company as its auditors, Del Pelayo of Verbatim, Inc, met with Gracie
Cruz and inquired about the auditors who would work on Verbatim audit. Pelayo wants Cruz to
assign only persons who graduated only in his alma mater.

Required: How should Gracie Cruz respond?

5. Describe the conditions under which an auditor is associated with financial statements.

6. What factors should an auditor consider in determining whether financial statements are
presented fairly in conformity with applicable financial reporting standards?

7. Why must the auditor refrain from explaining why she or he is independent?

8. Define the following terms:

a. audit risk c. control risk
b. inherent risk d. detection risk

9. a. What is the audit risk model?

c. How can an auditor use the audit risk model?

10. Describe the relationship between detection risk and evidence accumulation.

11. Below are an auditor's planned audit risk and assessment of inherent risk

Situation Planned Audit Risk Assessed Inherent Risk Assessed Control Risk
1 1% 20% 20%
2 1 100 50
3 4 20 20
4 5 100 50
5 5 100 100

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Required:
a. Determine the detection risk that can be allowed for each situation.
b. Rank the five situations, based on the amount of audit evidence that will be needed. You may
assume that all other factors that may affect audit evidence accumulation are the same.

12. Last year you were assigned to minor parts of the audit of the sales and collections cycle for
Patrick Corporation. This year you have been assigned significant responsibility in the audit of the
sales and collections cycle. You recall that last year, the credit manager, Josie Tan, treated you as
if you were one of the clerks. In fact, you had to call her "Ms. Tan" when you went to ask her
several questions. This year, she has become very friendly. Josie, as she now wants you to call her,
has just invited you to join her for dinner at a very exclusive private club in town. You were called
away before you could give Josie a reply, but she did indicate to you that last year she took your
predecessor to such a dinner.

Required: How do you respond to Josie?

13. The fairness of financial statements and the adequacy of internal controls are judged only by
reference to pre-established criteria. What serves as the criteria to judge the fairness of financial
statements and the adequacy "of internal controls? Explain why "reference to criteria" is
important to the audit function and the results communicated by the audit function.

14. How does complexity affect (1) the demand for auditing services and (2) the performance of
auditing services?

15. Who is the most important user of an auditor's report on a company's financial statements:
company management, the company's shareholders, or the company's creditors? Briefly explain
your rationale and indicate how auditors should resolve potential conflicts in the needs of the
three parties.

16. How does an audit enhance the quality of financial statements and management's reports on
internal control? Does an audit ensure a fair presentation of a company's financial statements or
that internal control systems are free of material deficiencies? Explain.

17. In what ways does the practice of internal auditing differ from the practice of public accounting?
To whom is the internal auditing function responsible?

39
18. Maria Cruz & Co, CPAs, is planning its audit procedures for its tests of the valuation of
inventories of Eastern Manufacturing Co. The auditors on the engagement have assessed inherent
risk and control risk for valuation of inventories at 100 percent and 50 percent, respectively.

Required:
a. Calculate the appropriate level of detection risk for the audit of this assertion, given that the
auditors wish to restrict audit risk for the assertion to 3 percent.
b. Calculate the appropriate level of detection risk for the audit of this assertion, given that the
auditors wish to restrict audit risk for the assertion to 5 percent.

19. State whether each of the following statements is correct or incorrect concerning audit risk and its
components - inherent risk, control risk, and detection risk.
a. The risk of material misstatement is composed of the three components of audit risk.
b. Inherent risk is the possibility of material misstatement before considering the client's
internal control.
c. Less control risk means in increase in the risk of material misstatement.
d. Detection risk does not exist when no audit is performed.
e. Rather than restrict detection risk through the performance of more substantive procedures,
auditors assess it.
f. Absent any other changes, an increase in the risk of material misstatement results in an
increase in audit risk.
g. Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately
modify their opinion on financial statements that are materially inherent risk or immaterially
misstated.
h. Both inherent risk and control risk exist independently of the audit of financial statements.

20. In applying a top-down, risk-based approach to an audit, should the auditor start with the ending
account balances or does the auditor start with the significant processes that lead to material
account balances? Is one approach preferred over the other? Explain.

40
41
UNIT II
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE I - RISK ASSESSMENT

Chapter
2 Phase I - Risk Assessment:
Preliminary Engagement
Activities

3 Phase I - Risk Assessment:

Planning the Audit and
Development of Overall
Audit Strategy

4 Phase I - Risk Assessment:

Performance of Risk
Assessment Procedures

42
Chapter
PHASE I -
RISK ASSESSMENT:
PRELIMINARY
ENGAGEMENT
ACTIVITIES

Expected Learning Outcomes

After Studying the chapter, you should be able able to:

1. Describe the activities involved in new client acceptance and continuance

decision.
2. Understand the Quality Control Policies Relative to Client Selection and
Retention.
3. Know the Process to accept or continue with an audit Engagement.
4. Explain the precondition for an audit.
5. Know how to document the agreed terms of engagement.

43
CHAPTER 2

PHASE I - RISKASSESSMENT:
PRELIMINARY ENGAGEMENT ACTIVITIES

CLIENT ACCEPTANCE AND CONTINUANCE DECISION

Introduction

One of the most important decisions that an audit firm can make is determining what engagements to accept
or which client relationships to retain. A poor decision can lead to unbillable time, unpaid fees additional
stress on partners and staff, potential lawsuits and worst of all, loss of reputation.

Even though obtaining and retaining clients is not easy in a competitive profession such as public
accounting, a CPA firm must use care in deciding which clients are acceptable. The firm's legal and
professional responsibilities are such that clients who lack integrity or argue constantly about the proper
conduct of the audit and fees can cause more problems than they are worth. Some CPA firms now refuse
clients in certain high-risk industries, such as savings and loans, health, and casualty insurance companies,
and may even discontinue auditing existing clients in those industries.

New Client Investigation

Before accepting a new client, most CPA firms investigate the company to determine its acceptability. To
extent possible, the prospective client's standing in the business community, financial stability, and
relations with its previous CPA firm should be evaluated. For example, many CPA firms use considerable
caution in accepting new clients in newly formed, rapidly growing businesses. Many of these businesses
fail financially and expose the CPA firm to significant potential liability.

For prospective clients that have previously been audited by another CPA firm, the new (successor) auditor
should endeavor to communicate with the predecessor auditor. The purpose of the requirement is to help the
successor auditor evaluate whether to accept the engagement. The communication may, for example,
inform the successor auditor that the client lacks integrity or that there have been disputes over accounting
principles, audit procedures, or fees.

44
Even when a prospective client has been audited by another CPA firm, other investigation are often made.
Sources of information include local attorneys, other CPAs, banks and other businesses. In some cases, the
auditor professional investigator to obtain information about the reputation and background of the members
of management. More extensive investigation is appropriate when there has been no previous auditor will
not provide the desired information, or if any indication of problems arises from the communication.

Many practitioners take advantage of the Internet as a search tools to learn more about the potential new
client and its key operations, by studying available client web sites and by using search engines for other
sites that discuss the potential client.

Continuing Clients

Many CPA firms evaluate existing clients annually to determine whether there are reasons for not
continuing to do the audit, previous conflicts over such things as the appropriate scope of the audit, the type
of opinion to issue, or fees may cause the auditor to discontinue association. The auditor may also
determine that the client lacks integrity and therefore should no longer be a client. If the client files a lawsuit
against a CPA firm or vice versa, the firm cannot do the audit. Similarly, if there are unpaid fees for services
performed more than 1 year previously, the CPA firm cannot do the current year audit. To do an audit in
either of these circumstances violates the Code of Ethics for Professional Conduct rules on independence.

Even if none of the previously discussed conditions exists, the CPA firm may decide not to continue doing
audits for a client because of excessive risk. For example, a CPA firm might decide that there is
considerable risk of regulatory conflict between a governmental agency and a client, which could result in
financial failure of the client and ultimately lawsuits against the CPA firm. Even if the engagement is
profitable, the risk may exceed the short-term benefits of doing the audit.

Investigation of new clients and reevaluation of existing ones is an essential part of deciding acceptable
audit risk. Assume a potential client in a reasonably risky industry, where management has a reputation of
integrity, but is also known to take aggressive financial risks. If the CPA firm decides that acceptable audit
risk is extremely low, it may choose not to accept the engagement. If the CPA firm concludes that
acceptable audit risk is low but the client is still acceptable, it is

45
likely to affect the fee proposed to the client. Audits with a low acceptance audit risk will normally result in
higher audit cost, which should be reflected in higher audit fees.

QUALITY CONTROL POLICIES RELATIVE TO CLIENT SELECTION AND RETENTION

A. The firm shall implement policies and procedures for the acceptance and continuance of client
relationships and specific engagements, designed to provide the firm with reasonable assurance that it
will only undertake or continue relationship s and engagements where the firm:
a) Is competent to perform the engagement and has the capabilities, including time and resources to
do so;
b) Can comply with relevant ethical requirements; and
c) Has considered the integrity of the client, and does not have information that would lead it to
conclude that the client lacks integrity.

The auditor shall be satisfied that appropriate procedures regarding the acceptance and continuance of
client relationships and audit engagements have been followed, and shall determine that the
conclusions reached in this regard are appropriate.

B. If the auditor obtains information that would have caused the firm to decline the audit engagement has
that information been available earlier, the engagement partner shall communicate that information
promptly to the firm, so that the firm and the engagement partner can take the necessary action.

C. The auditor shall undertake the following activities prior to starting an initial audit:
a) Performing procedures regarding the acceptance of the client relationship and the specific audit
engagement; and
b) Communicating with the predecessor auditor, where there has been a change of auditors, in
compliance with relevant ethical requirements.

46
D. Strict client acceptance / continuance guidelines should be established to screen out the following:
 Clients that are in financial and/or organizational difficulty - For example, clients that could go
bankrupt or clients with poor internal accounting controls and sloppy records
 Clients that constitute a disproportionate percentage of the firm's total practice - Clients may
attempt to influence the auditor into allowing unacceptable accounting practices or issuing
inappropriate opinions.
 Disreputable clients - External audit firms cannot afford to have their good reputation tarnished
by serving a disreputable client or by associating with a clear that has disreputable management.
 Clients that offer an unreasonably low free for the auditor's services - In response, the auditor
may attempt to cut corners imprudently or lose money on the engagement. Conversely, auditors
may bid for audits at unreasonably low prices.

PROCESS TO ACCEPT OR CONTINUE WITH AN AUDIT ENGAGEMENT

Determine the nature of the engagement and whether it can be undertaken in accordance with the firm's
policy. Then address the following questions, and document the findings and conclusions.

I. Are the engagement risks acceptable to the firm?

1. What are the values ("tone at the top") and future goals of the entity?
2. How competent are the entity's senior management and staff?
3. Has the firm conducted an Internet search and had discussions with firm personnel and other third
parties (such as bankers) to identify any reasons why the firm should not accept the engagement?
4. Are there difficult or time-consuming issues to address (accounting policies, estimates,
compliance with legislation, etc.)?
5. What changes have taken place this period that will impact the engagement (business trends and
initiatives, personnel changes, financial reporting, IT systems, purchase / sale of assets,
regulations, etc.)?
6. Is there a high level of public scrutiny and media interest?

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7. Is the entity in good financial health and does it have the ability to pay the firm's professional
fees?
8. Will the entity provide help to firm in obtaining information and preparing schedule, analysis of
balances, providing data files, etc.?
9. For new engagements, has the firm communicated with the predecessor auditor to determine if
there are any reasons for not accepting the engagement?

II. Does the firm have the competence, resources, and time required?

1. What is the nature and scope of the audit?

2. What accounting framework will be used?
3. How will the auditor's report and financial statements be used?
4. What is the deadline (if any) for completing the audit?
5. Does the firm have sufficient personnel with the necessary competence and capabilities?
6. Do the selected firm personnel have:
Knowledge of relevant industries or subject matters,
Experience with relevant regulatory or reporting requirements, or
Ability to gain the necessary skills and knowledge effectively?
7. Are experts available, if needed?
8. Where applicable, are there qualified persons available to perform the engagement quality control
review?
9. Can the firm and the available staff (in light of timing requirements for other clients) complete the
engagement within the reporting deadline?

An external audit firm should not undertake an engagement that it is not qualified to handle. Doing so is
especially important for smaller, growing firms that may be tempted to agree to conduct an audit for
which they are not qualified or not large enough to perform. Statistics show that firms covered by a
professional liability insurance plan that are most susceptible to litigation are those with staffs of eleven
to twenty-five auditors. They appear to become overzealous, leading to low audit quality and exposure
to subsequent litigation.

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III. Is the firm / staff independent and free from conflict?

1. Can the firm and the engagement team comply with ethical and independence requirements?
2. Where conflicts of interest, lack of independence, or other threats have been identified:
Has appropriate action been taken to eliminate those threats or reduce them to an acceptable
level by applying safeguards, or
Have steps been taken to withdraw from the engagement?
3. If the entity being audited is a component of a larger group, the group engagement team may
request certain work to be performed on the financial information of the component. In such cases,
the group engagement would first obtain an understanding of the following:
Whether the component auditor understands and will comply with the ethical (including
independence) requirements that are relevant to the group audit,
The component auditor's professional competence,
Whether the group engagement team will be able to be involved in the work of the
component auditor to the extent necessary to obtain sufficient appropriate audit evidence,
and
Whether the component auditor operates in regulatory environment that actively oversees
auditors.

IV. Can the client be trusted?

1. Is there any reason (or recent event) that casts doubt on the integrity of the principal owners,
senior management, and those charged with government of the entity? Consider the entity's
operations, including business practices, the business' reputation, and history of any ethical or
regulatory infringements.
2. Are there any indications that the entity might be involved in money laundering or other criminal
activities?
3. What is the identity and business reputation of related parties?
4. .Does management have a poor attitude toward internal control and an aggressive attitude toward
interpretation of accounting standards? Consider corporate culture, organizational structure, risk
tolerance, complexity of transactions, etc.

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To ensure that the information obtained from the entity is accurate, consider what third-party information
could be obtained to validate key aspects of the risk assessment. This simple step could avert problems later
on. Examples include information from sources such as previous financial statements income tax returns
credit reports and possibly (after receiving permission from the prospective client) discussion with key
advisors such as bankers etc.

Before contracting third parties and collecting information on a prospective client, take steps to ensure that
all partners and staff partners and staff are aware of:
 The firm's policies to protect confidential information maintained on clients;
 Requirements of any privacy legislation; and
 Requirements of the applicable code of ethics.

Figure 2-1 shows a sample questionnaire that could be used in assessing client acceptance / continuance.

Figure 2-1 Illustrative Questionnaire That Could Be Used in Assessing Client Acceptance /
Continuance (Partial)

Client: CYZ Company

Yes No Comments
Have the audit preconditions been met?
Have the acceptance / continuance requirements in the firm’s quality
control manual been followed?
Any change in the terms of reference or requirements for the audit
engagement?
Any independence issues or conflicts of interest?
Consider? Family / personal relationship with key client people, non-audit
services such as accounting, financial interest, and other business
relationship.
Any circumstances that would cast doubt on the integrity of the client’s
owners? Consider convictions, regulatory proceedings/sanctions,
suspicion or confirmation of illegal acts or fraud, police investigations,
and any negative publicity.

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Does the firm have the capacity in time, competencies, and resources to
complete the engagement in accordance with professional and firm
standards?
Are there any issues identified in previous audits and other engagements
for this entity that need to be addressed?
Are there any new circumstances that increase our engagement risk?
Can the client continue to pay our fees?
Conclusion:
Overall assessment of engagement risk ______ (Low, Moderate or High)
We should __________ client.

Chris Garcia
Santos & Associates, CPAs

*accept/decline
*continue with / discontinue with

PRECONDITIONS FOR AN AUDIT

In order to establish whether the preconditions for an audit are present, the auditor shall:

a) Determine whether the financial reporting framework to be applied in the preparation of the financial
statements is acceptable; and
b) Obtain the agreement of management that it acknowledges and understand its responsibility:
i. For the preparation of the financial statements in accordance with the practicable financial
reporting framework, including where relevant their presentation;
ii. .For such internal control as management determines is necessary to enable the presentation of
financial statements that are free from material misstatement, whether due to fraud or error; and

51
iii. To provide the auditor with:
 Access to all information of which management is aware that is relevant to the preparation of
the financial statements such as records, documentation and other matter;
 Additional information that the auditor may request from management for the purpose of the
audit; and
 Unrestricted access to persons within the entity from whom the auditor determines is
necessary to obtain audit evidence.

Where management does not acknowledge its responsibilities or agree to provide the written
representations, the auditor will not be able to obtain sufficient appropriate audit evidence.in such
circumstances, or where the financial reporting framework is not acceptable, the auditor is required by PSA
to decline the engagement unless required by law or regulation.

Likewise, the auditor should determine whether management or those charged with governance imposes
any type of limitation on the scope of the audit. This could include unrealistic deadlines, not accepting
certain firm's staff to perform the work, and denial of access to a facility, key personnel, or relevant
documents. If such a limitation would result in a disclaimer of opinion, the firm would decline the
engagement, unless the firm is required by law or regulation to proceed with the engagement.

AGREEING THE TERMS OF ENGAGEMENT

Engagement Letter

A clear understanding of the terms of the engagement should exist between the client and the CPA firm.
PSA requires that auditors must document their understanding’s objectives, the responsibilities of the
working papers including the engagement’s limitations. This is typically done with an engagementletter.
The engagement letter is an agreement between the CPA firm and the client for the conduct of the audit
and related services.

The engagement letter states the scope of the work to be done on the audit so that system there should be no
doubt in the mind of the client, external auditor, or the court as to the expectations agreed to by the external
auditor and the client.

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The agreed terms of the audit engagement shall be recorded in an audit engagement letter or other suitable
form of written agreement and shall include:

a) The objective accounting framework, and the form of auditor's report resulting from scope of the
audit of the financial statements;
b) Identification of the applicable financial reporting framework for the preparation of the financial
statements;
c) Reference to the expected form and content of any reports to be issued by the auditor and a
statement that there may be circumstances in which a report may differ from its expected form and
content;
d) .The responsibilities of the auditor;
e) .The responsibilities of management; and
f) .Arrangements on how the audit will be conducted, involvement of other auditors and experts, if
any, dispute resolution, obligation and the basis on the computation of fees and billing.

The client should confirm the terms of the engagement by acknowledging receipt of the engagement letter.

Figure 2-2 presents a sample engagement letter.

If the terms of the audit engagement are changed, the auditor and management shall agree on and record the
new terms of the engagement in an engagement letter or other suitable form of written agreement.

If the auditor is unable to agree to a change of the terms of the audit engagement and is not permitted by
management to continue the original audit engagement, the auditor shall:

a) .Withdraw from the audit engagement where withdrawal is possible under applicable laws or
regulations; and
b) Determine w ether there is any obligation, either contractual or otherwise, to report the
circumstances to other parties, such as those charged with governance, owners or regulators.

53
Figure 2-2: Illustrative Engagement Letter

Santos & Co.CPAs

7650 Sen.Gil Puyat Aveneu,Makati City
October 15,20X8

Mr. Alberto Cruz.

Managing Director
ABC, Inc.
165 Tandang Sora, Quezon City

Dear Mr. Cruz:

You have requested that we audit the financial statements of ABC, Inc. which comprise the statementof
financial position as at December 31, 20X8, and the income statement, statement of changes in equity
and cash-flow statement for the year ended, and a summary of significant accounting policies and other
explanatory information. We are pleased to confirm our acceptance and our understanding of this audit
engagement by means of this letter. Our audit will be conducted with the objective of our expressing an
opinion on the financial statements.

Our Responsibilities

We will conduct our audit in accordance with Philippine Standards on Auditing. Those standards require
that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free from material misstatement. An audit involves
performing procedures to obtain audit evidence about the amounts and disclosures in the financial
statements. The procedures selected depend on the auditor's judgment, including the assessment of the
risks of material misstatement of the financial statements, whether due to fraud or error. An audit also
includes evaluating the appropriateness of accounting policies used and the reasonableness of
accounting estimates made by management, as well as evaluating the overall presentation of the
financial statements.

Because of the inherent limitations of an audit, together with the inherent limitations of internal control,
there is an unavoidable risk that some material misstatements may not be detected, even though the audit
is properly planned and performed in accordance with PSAS.

In making our risk assessments, we consider internal control relevant to the entity's preparation of the
financial statements in order to design audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the entity's internal control. However,
we will communicate to you in writing any significant deficiencies in internal control relevant to the
audit of the financial statements that we have identified during the audit.

Unless unanticipated difficulties are encountered, our report will be substantially in the following form:

[Form and content of the auditor's report has not been reproduced.]

The form and content of our report may need to be amended in the light of our audit findings.

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Management's Responsibility

Our audit will be conducted on the basis that management and those charged with governance
acknowledge and understand that they have responsibility:

a) For the preparation and fair presentation of the financial statements in accordance with Philippine
Financial Reporting Standards;
b) For such internal control as management determines is necessary to enable the preparation of
financial statements that are free from m misstatement, whether due to fraud or error; and
c) To provide us with:
i. Access to all information of which you are aware that is relevant to the preparation of the
financial statements such as records, documentation and other matters;
ii. Additional information that we may request from you for the purpose of the audit, and
iii. Unrestricted access to persons within the company from whom we determine it necessary to
obtain audit evidence.

As part of our audit process, we will request from management and, where appropriate those charged
with governance written confirmation concerning representations made to us in connection with the
audit.

We look forward to full cooperation from your staff during our audit.

Fees

Our fees which are based on the time required by individuals assigned to the engagement will be
Php100,000 plus out-of-pocket expenses and will be billed as work progresses. Individual hourly rates
vary according to the degree of responsibility involved and the experience and skill required.

This letter will be effective for future periods unless it is terminated, amended, or superseded.

Please sign and return the attached copy of this letter to indicate that it is accordance with your
understanding of the arrangements for our audit of the financial statements.

Yours truly, Acknowledged on behalf of ABC, Inc. by

Alvin Santos Mr. Alberto Cruz

Santos & Co., CPAS Managing Director
Date

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REVIEW QUESTIONS AND EXERCISES

Questions

1. What factors should an auditor consider prior to accepting an engagement? Explain.

2. List the four types of information the auditor should obtain or review as a part of gaining
background information for the audit, and provide one specific example of how the information
will be useful in conducting an audit.

3. Name the three sources of business and industry information.

4. What information should a CPA firm seek in its investigation of a prospective client?

5. Discuss what is meant by the phrase "shopping for accounting principles." What mechanisms
have served to prevent this practice by management?

6. Many CPA firms are taking a business risk approach to audits. Define what is meant by business
risk. Provide an example of a business risk that could result in a risk of material misstatement of
the financial statements.

7. Can a standard audit plan be used for most engagements?

8. "An audit plan is desirable when new staff members are assigned to an engagement, but an
experienced auditor should be able to conduct an audit without reference to it." Do you agree?
Discuss.

9. What is an engagement letter? Why is its use recommended prior to the rendering of professional
services by CPAs?

56
Exercises

Exercise 1

Martinez, CPA, is approached by a prospective audit client who wants to engage Martinez
to perform an audit for the current year. In prior years, this prospective client was
audited by another CPA.

Identify the specific procedures that Morgan should follow in deciding whether to accept
this client.

Exercise 2

Mary Dizon has been asked to accept an engagement to audit a small financial institution.
Dizon has not previously audited a financial institution.

a. Describe the types of knowledge about the prospective client and its environment that
Dizon should obtain to plan the engagement.
b. Explain how Dizon may obtain this knowledge.
c. Discuss how this knowledge of the client and its environment will help Dizon in
planning and performing an audit in accordance with generally accepted auditing
standards.

Exercise 3

You are invited by John Berlin, the president of Cherry Corporation, to discuss with him
the possibility of your conducting an audit of the company. The corporation is a small,
closely held manufacturing organization that appears to be expanding. No previous audit
has been performed by independent certified public accountants. Your discussions with
Berlin include an analysis of the recent monthly financial statements, inspection of the
accounting records, and discussion of policies with the chief accountant. You also are
taken on guided tour of the plant by the president. He then makes the following statement:

Before making definite arrangements for an audit, I would like to know about how long it
will take and about how much will it cost. I want quality work and expect to pay a fair price,
but because this is our first experience with independent auditors, I would like a full
explanation as to how the cost of the audit is determined. Will you please send me a
memorandum covering these points?

Write the memorandum requested by John Berlin.

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Chapter
PHASE I -
RISK ASSESSMENT:
PLANNING THE AUDIT AND
DEVELOPMENT OF OVERALL
AUDIT STRATEGY

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Explain the nature, scope and benefits of audit planning.

2. Understand the concept of materiality as applied to financialaudit.
3. Know the levels of planning for the audit such as:
 Establishment of overall audit strategy, and,
 Development of detailed audit plan
4. .Describe the process, benefits and documenting the overall audit strategy
5. Explain the significant matters embodied in the detailed audit plan such as
the
 Scope, objectives, timing and required communications
 Direction, supervision and review of audit work done
6. Understand the critical matters in engagement planning including, but not
limited to, the following:
 Application of analytical procedures
 Establishment of audit team
 Consideration of work by other auditors /parties
 Assessment of going concern assumption, related parties, client's legal
obligations
 Preparation of initial audit program, time budget

58
CHAPTER 3
PHASE I - RISK ASESSMENT:
PLANNINGTHEAUDIT AND
DEVELOPMENT OF OVERALL AUDIT
STRATEGY
PLANNING THE AUDIT

Nature and Scope of Audit Planning

Audit planning involves the establishment of the overall audit strategy for the engagement and developing
an audit plan, in order to reduce audit risk to an acceptably low level. Planning involves the engagement
partner and other key members of the engagement team to benefit from their experience and insight andto
enhance the effectiveness and efficiency of the planning process.

The nature and extent of planning activities will vary according to the size and complexity of the entity, the
auditor's previous experience with the entity, and changes in circumstances that occur during the audit
engagement.

Planning is a continuous and iterative process that often begins shortly after or in connection with the
completion of the previous audit and continues until the completion of the current audit engagement.
However, in planning an audit, the auditor considers the timing of certain planning activities and audit
procedures that need to be completed prior to the performance of further audit procedures. For example, the
auditor plans the discussion among engagement team members, the analytical procedures to be applied as
risk assessment procedures, the obtaining of a general understanding of the legal and regulatory framework
applicable to the entity and how the entity is complying with that framework, the determination of
materiality, the involvement of experts and the performance of other risk assessment procedures prior to
identifying and assessing the risks of material misstatement and performing further audit procedures at the
assertion level for classes of transactions, account balances, and disclosures that are responsive to those
risks.

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Benefits of Audit Planning

Audit planning generally involves the determination of the expected nature, timing and extent of the
audit .Among the benefits derived from audit from audit planning are the following:
a) It helps ensure that appropriate attention is devoted to important areas of
the audit
b) It aids in identifying potential problems and resolving them on a timely basis.
c) It helps ensure that the audit is properly organized, managed and performed in an effective and
efficient manner.
d) It assists in the proper assignment and review of the work of the engagement team members.
e) It helps coordinate the work to be done by auditors of components and other partiesinvolved such
as experts, specialists, etc.

Concept of Materiality Applied to Audit Planning

Assuring that the audit is conducted in a quality manner is paramount to fulfilling the users' expectations
about the approach and methodology used by the auditor. And one of the drivers of audit quality is the
auditor's thorough understanding and effective application of the concept of materiality in conducting the
audit.

Materiality provides a quantitative threshold or cut-off point, rather than being a primary qualitative
characteristic, which information must have if it is to useful. The auditor establishes materiality level based
on his professional judgment so as to detect quantitatively material misstatements. Information is material
if its omission or misstatement could influence the economic decisions of users taken on the basis of the
financial statements.

When establishing overall audit strategy, the auditor shall determine materiality for the financial statements
as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of
transactions, account balances of disclosures for which material misstatements of lesser amounts that the
materiality for the financial statements as a whole could be reasonably expected to influence the economic
decisions of users taken on the basis of the financial misstatements, the auditor shall also determine the
materiality level(s) to be applied to those particular classes of transactions, account balances or disclosures.

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PSA 320,"Materiality in Planning and Performing an Audit" establishes standards and deals with the
auditor's responsibility to apply the concept of materiality in planning and performing an audit of financial
statements

To reiterate the importance of the concept of materiality to audit, the definition of materiality in accordance
with the FRSC's "Framework for the Preparation and Presentation of Financial Statements" follows:

"Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements. Materiality depends on the size of the item or
error judged in the particular circumstances of its omission or misstatement. Thus, materiality
provides a threshold or cut-off point rather than being a primary qualitative characteristic which
information must have if it is to be useful."

This definition emphasizes the importance of materiality to reasonable users who rely on the statements to
make decisions. Auditors, therefore, must have knowledge of the likely uses of their client's statements and
the decisions that are being made.

In planning the audit, materiality should be considered by the auditor when:

a) determining the nature, timing and extent of audit procedures

b) identifying and assessing the risks of material misstatement; and
c) determining the nature, timing and extent of further audit.

The auditor's determination of materiality is a matter of professional judgment and is affected by the
auditor's perception of the financial information needs of users of the financial statements. In this context, it
is reasonable for the auditor to assume that users:

a) Have a reasonable knowledge of business and economic activities and accounting and a
willingness to study the information in the financial statements with renewable diligence;
b) Understand that financial statements at prepared mud and audited to levels of materiality;
c) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates,
judgment and the consideration of future events; and
d) Make reasonable economic decisions on the basis of the information in the financial statements.

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Levels of Materiality

The auditor assesses materiality at two levels:

 First is the overall materiality (or materiality level for the financial statements as a whole)
 Second is the specific materiality (or materiality level for particular classes of transactions
account balances or disclosures)

The auditor considers materiality at both the overall financial statement level and in relation to individual
account balances, classes of transactions and disclosures. Materiality may be influenced by considerations
such as legal and regulatory requirements and considerations relating to individual financial statement
account balances and relationships. This process may result in different materiality levels depending on the
aspect of the financial statements being considered.

1. Overall materiality
Materiality for the financial statements as a whole (overall materiality) is based on the auditor's
professional judgment as to the highest amount of misstatement(s) that could be included in the
financial statements without affecting the economic decisions taken by a financial statement user.
If the amount of unconnected misstatements, either individually or in the aggregate, is higher than
the overall materiality established for the engagement, it would mean that the financial statements
are materially misstated.

Overall materiality is based on the common financial information needs of the various users as a
group. Consequently, the possible effect of misstatements on specific individual users, whose
needs may vary widely, is not considered.

2. Specific materiality
In some cases, there may be a need to identify misstatements of lesser amounts than overall materiality
that would affect the economic decisions of financial statement users. This could relate to sensitive
areas such as particular note disclosures (i.e., management remuneration or industry-specific data),
compliance with legislation or certain terms in a contract, or transactions upon which bonuses are
based. It could also relate to the nature of a potential misstatement.

PSA 320 likewise requires that performance materiality be set.

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Performance Materiality

Performance materiality is used by the auditor to reduce the risk to an appropriate low level that the
accumulation of uncorrected and unidentified misstatements exceeds materiality for the financial
statements as a whole (overall materiality), or materiality levels established for particular classes of
transactions, account balances, or disclosures (specific materiality).

Performance materiality is set at a lower amount (or amounts) than overall specific materiality. The
objective is to perform more audit work than would be required by the overall or a specific materiality to:

 Ensure that misstatements less than overall or specific materiality are detected, so as to appropriately
reduce the probability that the aggregate of uncorrected errors and undetected misstatements exceed
materiality for the financial statements as a whole; and thus
 Provide a margin or buffer for possible undetected misstatements. This buffer is between detected but
uncorrected misstatements in the aggregate and the overall or specific materiality.

The margin provides some assurance for the auditor that undetected misstatements, along with all
uncorrected misstatements, will not likely accumulate to reach an amount that would cause the financial
statements to be materially misstated.

Performance materiality is set in relation to overall materiality or specific materiality. For example, a
specific performance materiality can be set at a lower amount than overall performance materiality for
testing repairs and maintenance expenses if there is a higher risk of assets not being capitalized. Specific
performance materiality may also be used to perform additional work in areas that may be sensitive due to
the nature of potential misstatements and their occurrence, rather than their monetary size.

For example, if overall materiality was set at P200,000 and the audit procedures were planned to detect all
errors in excess of P200,000, it is quite possible that an error of say P80,000 would go undetected. If three
such errors existed totaling to P240,000, the financial statements would be materially misstated. If
performance materiality was set at P120,000, it would be much more likely that at least one or all of the
P80,000 errors would be detected. Even if only one of the three errors is identified and corrected, the
remaining Pi60,000 misstatement would still be less than P200,000 and the financial statements as a whole
would not be materially misstated.

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How to Determine Materiality

Auditors make a preliminary assessment of materiality of the financial statements as a whole by

determining the amount by which they believe the financial statements could be misstated without affecting
users' decisions. This-amount is called "preliminary judgment about materiality" or" planning materiality".
This judgment need not be quantified but often is. It is called a preliminary judgment about materiality
because it is a professional judgment and may change during the engagement if circumstances change. The
reason for determining"planning materiality" is to help the auditor plan the appropriate evidence to
accumulate. If the auditor sets a low peso amount, more evidence is required than for a high amount.

In establishing planning materiality or preliminary judgment about materiality, an auditor must also
consider any potential effect a misstatement might have which may be greater than the peso amount
involved. A misstatement which may not be material based on quantitative factors but that does not allow a
client to meet a condition in a contractual obligation or expectations of a financial statement user may be
considered material. In these instances, amount of planning materiality based on the users expectations of
income or alter those working on the engagement to the potential for these types of material misstatement.

Rules of Thumb (For Use as a Starting Point)

Overall Specific Performance

Materiality is a matter of professional Establish a lower, specific No specific guidance is
judgement rather than a mechanical materiality amount (based provided in the PSA’s.
existence, As a result, no specific guidance is on professional judgement) Percentage range from 60%
provided in the PSA. However, profit from for the audit of specific or (of overall or specific
continuing operations (3% to 7%) is often sensitive financial statement materiality), where there is a
used in practices as having the greatest areas. higher risk of material
significant to the financial statement users. If misstatement, up to 85%
this is not a useful measure (such as for a where the assessed risk of
not-for-profit entity or where profit is not a material misstatement is
stable base) then consider other bases such less.
as:
 Revenues or expenditures- 1% to 3%

 Assets- 1% to 3%

 Equity - 3% to 5%

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Other Considerations

 When accepting new audit engagement, 'inquire about the overall materiality used by the previous
auditor. If available, this would help in determining whether further audit procedures may be required
on the opening asset and liability balances.
 Ensure that any experts employed by the entity (to assist the entity in preparing the financial statements)
or used by the audit team are instructed to use an appropriate materiality level in relation to the work
they perform.

Relationship between Materiality and Audit Risk

When planning the audit, the auditor considers what would make the financial statements materially
misstated. The auditor's assessment of materiality, related to specific account balances and classes of
transactions, helps the auditor decide such questions as what items to examine and whether to use sampling
and analytical procedures. This enables the auditor to select audit procedures that, in combination, can be
expected to reduce audit risk to an acceptably low level.

There is an inverse relationship between materiality and the level of audit risk, that is, the higher the
materiality level, the lower the audit risk and vice versa. The auditor takes the inverse relationship between
materiality and audit risk into account when determining the nature, timing and extent of audit procedures
For example, if, after planning for specific audit procedures, the auditor determines that the acceptable
materiality level is lower, audit risk is increased.

The auditor would compensate for this by either:

a) reducing the assessed level of control risk, where this is possible. and supporting the reduced level by
carrying out extended or additional tests of control OR;
b) reducing detection risk by modifying the nature, timing and extent of planned substantive procedures.

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Figure 3-1 shows an illustration of a memo on determining and using materiality.

Figure 3-1 Illustrative Memo on Determining and Using Materiality

Client: XYZ Company

Materiality Assessment

The main users of the financial statements are the bank and the shareholders. The materiality number
used in the last period was P80,000.

Using our professional judgment, we decided to base our materiality on 5% of the profit before tax.
Other bases for materiality, such as revenues, were also considered but it was felt that profit before tax
was the most meaningful amount in relation to the identified financial statement users.

For this period, the plan is to use P100,000 as the overall materiality. The concept of materiality and its
use in the audit has been discussed in general two terms with the client.

Using professional judgment, and the types of misstatements identified in previous audits, overall
performance materiality has been set at P75,000.

A specific materiality for the local sales taxes paid has been set at P10,000 as we are required to audit
and report on this amount to the local government.

Prepared by: Date:

Reviewed by:______________ Date:______________

SEC Requirement Relative to Materiality [Amended SRC Rule 68]

 On test of materiality, in case of a disclosure deficiency or inconsistency, information is material

if it involves a transaction, amount or that represents 10% or more of the total of related accounts
transactions in the financial statements. The test to be used shall be for companies under groups A
& B categories.
 In case of a misstatement or error, it shall be material if the amount misstatement or error
represents 5% or more of the total of related accounts or transaction in the financial statements.
The test to be shall be 2% for companies under groups A & B categories.

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 Related accounts hall be determined based on the classification and aggregation on the face of
financial statements such as current assets, non-current assets, current liabilities, non-current
liabilities, equity items, revenues, cost of sales, cost of service, administrative expenses or
operating expenses, as the case may be.

SEC Requirements for Independent Auditors of Regulated Entities

 The SEC requires the following regulated entities to be audited by independent auditors by the
Commission under the appropriate category:

Group A

1) Issuers of registered securities which have sold a class of securities pursuant to a registration
under Section 12 of the Securities Regulation Code (SRC) except those issuers of registered
timeshares, proprietary and non-proprietary membership certificates which are covered in
Group B.
2) Issuers with a class of securities listed for trading in an Exchange;
3) Public companies or those which have total assets of at least Fifty million pesos
(P50,000,000) or such other amount as the Commission shall prescribe, and having two
hundred [200]or more holders each holding at least One hundred (100) shares of a class of its
equity securities.

Group B

1) Issuers of registered timeshares, proprietary and non-proprietary membership certificates;

2) Investment Houses;
3) Brokers and Dealers of securities;
4) Investments companies;
5) Government Securities Eligible Dealers (GSEDs);
6) Universal Banks Registered as Underwriters of Securities;
7) Investment Company Advisers;
8) Clearing Agency and Clearing Agency as Depository;
9) Stock and Securities Exchange/s;
10) Special Purpose Vehicles registered under the Special Purpose Vehicle act of 2002 and its
implementing rules;

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11) Special Purpose Corporations registered under the Securitization act of 2004 and its
implementing rules;
12) Such other corporations which may be required by law to be supervised by the Commission.

Group C

1) Financial Companies;
2) Lending Companies;
3) Transfer Agents;
4) Foundations and other non-stock non-profit organizations which solicit or received
donations or contributions or with fund balance aggregating to more than P10 million at any
given year; and
5) Large corporations or those with total assets of more than P350 million or total liabilities of
more than P250 million.

Group D

1) Companies not included above but are mandated by other regulatory agencies to have an
independent auditor accredited by the Commission. For Groups A and B, both the
independent auditor and auditing firms (if applicable) shall be accredited by the
Commission.
੦ For Group A and B, both the independent auditor and auditing firms [if applicable]
shall be accredited by the Commission.
੦ For Group C, the accreditation of the auditing firms shall be sufficient. However, an
individual independent auditor shall be accredited by the Commission as such.
੦ Accreditation under Group A shall be considered a general accreditation which shall
allow the independent auditor to also audit companies under Groups B, C and D.
Independent auditors with Group B accreditation can likewise audit companies under
Groups C and D. Accordingly, Group C accredited independent auditors are allowed
to audit Group D companies.

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LEVELS OF AUDIT PLANNING

The two levels of planning for the audit are

I. Establishment of overall audit strategy, and
II. Development of detailed audit plan

THE OVERALL AUDIT STRATEGY

The Process of Establishing the Audit Strategy

PSA 300 requires that the auditor establishes the overall strategy for the audit. This overall audit strategy
sets the scope, timing and direction of the audit and guides the development of the more detailed audit plan.
In developing the audit strategy, the auditor considers the results of the preliminary activities described in
the preceding section. The process of establishing the audit strategy involves

A. Identifying the characteristics of the engagement that define its scope.

Examples are:
1. The financial reporting framework
2. Industry specific reporting requirements, and
3. The locations of the components of the entity.

B. Ascertaining the reporting objectives of the engagement to plan the timing of the audit and the
nature of the communication required such as:
1. Deadlines for interim and final reporting, and
2. Key dates and organization of meetings with management and those charged with
governance to discuss the nature and extent of audit work.
3. Discussion with management regarding the expected communication on the status of audit
work throughout the engagement.

C. Considering the significant factors and experience that will determine the focus and direction of
the engagement teams efforts, such as:
1. Determination of appropriate materiality levels
2. Preliminary identification of areas where there may be higher risks of material
misstatement.
3. Preliminary identification of material components and account balances.

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4. Evaluation whether the of auditor may plan to obtain evidence regarding the effectiveness
internal control, and
5. Identification of recent significant entity-specific, industry, financial reporting or other
relevant developments.

D. Determining whether there are significant business developments affecting the entity such as:

a. Significant industry development (e.g., changes in industry regulations and new reporting
requirements.)
b. Significant changes in information technology and business processes, key management,
acquisition, mergers.
c. Significant changes in the financial reporting framework such as changes in accounting
standards.
d. Significant changes in the legal environment.

E. Determination of the nature, timing and extent of resources required.

F.
The audit strategy sets out clearly, in response to the matters identified in the above mentioned
process, and subject to the completion of the auditor's risk assessment procedures:

a) The resources to deploy for specific audit areas, such as the use of appropriately experienced
team members for high risk areas or the involvement of experts on complex matters;
b) The amount of resources to allocate to specific audit areas, such as
1. The number of team members assigned to observe the inventory count at material
locations,
2. The extent of review of other auditors' work in the case of group audits, or
3. The audit budget in hours to allocate to high risk areas;
c) When these resources are deployed, such as whether at an interim audit stage or at key cut-off
dates; and
d) How much resources are managed, directed and supervised, such as when team briefing and
debriefing meetings are expected to be held, how engagement partner and manager reviews
are expected to take place (for example, on-site or off-site), and whether to complete
engagement quality control reviews.
e) Engagement budgeting including time allocation.

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The Appendix of PSA 300 lists examples of matters the auditor may consider in establishing the
overall audit strategy for an engagement. Many of these matters will also influence the
auditor's detailed audit plan.

Benefits of Developing the Audit Strategy

 There sources to deploy for specific audit areas, such as the use of appropriately experienced team
members for high risk areas or the involvement of experts on complex matters.
 The amount of resources to allocate to specific audit areas, such as the number of team members
assigned to observe the inventory count at material locations, the extent of review of other
auditors' work in the case of group audits, or the audit budget in hours to allocate to high risk
areas;
 When these resources are to be deployed, such as whether at an interim audit stage or at key
cut-off dates; and
 How such resources are managed, directed and supervised, such as when team briefing and
debriefing meetings are expected to be held, how engagement partner and manager reviews are
expected to take place [for example, on-site],and whether to complete engagement quality control
reviews.

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Figure 3-2 presents an illustrative overall strategy memorandum.

Figure 3-2 Illustrative Overall Strategy Memorandum.

Name of Client: XYZ Company

Overall Strategy Memo

Period end December 31, 20X6

Scope

The scope of the audit has not changed this period. Audit to comply with PSAs and the PFRS accounting
framework. There have been no change in PFRS that affect XYZ Company this year.

Entity Changes

XYZ Company is planning to make sales to other Southeast Asian Countries.

Internet sales are also increasing and XYZ' IT capabilities will be stretched.

XYZ Company, is now selling to Momentus Merchandising. This company is renowned for squeezing
profit margins of suppliers in exchange for giving large orders. It also requires suppliers to maintain
additional inventories of some products for instant delivery as required.

Risk

Our assessment of risk at the financial level is low. Management is not particularly sophisticated but
there is a strong commitment to competence; it has introduced a code of ethics and, in general, has a
good attitude toward internal control.

Overall Strategy

1. Materiality for the financial statements as a whole will be increased from P80,000 to P100,000
this period to reflect the growth in sales and profitability during the last period. Performance
materiality (based on our assessment of audit risk) has been set at P75,000, except for certain
account balances.

2. Use the some senior staff as last period and perform the work at the same time.

3. Perform our risk assessment procedures at the end of August. There are no plans to change any
systems at present.

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4. At our team planning meeting to be held on November 15,20X6 we need to:

a) Consider the susceptibility of the financial statement to fraud,

b) Emphasize use of professional skepticism by our staff,

c) Identify fraud scenarios by employees and management, and

d) Focus on identification of related party transactions that have been growing and
expanding our testing

5. Attend the period-end inventory counts. There are still no ongoing inventory control
Procedures.

6. Use David [who is knowledgeable about IT systems] to identify the risks of material
misstatement relating to the internet sales and whether any relevant internal controls exist to
mitigate such risks. He will al. Assess the general IT controls.

Audit Partner (signed): Mauricio Cruz

Date: October 30, 20X6

II.THE DETAILED AUDIT PLAN

Once the audit strategy has been established, the auditor is able to start the development of a more
detailed audit plan to address the various matters identified in the audit strategy, taking into account the
need to achieve the audit objectives through the efficient use of the auditor's resources. Although the
auditor ordinarily establishes the audit strategy before developing the detailed audit plan, the two
planning activities are not necessarily discrete or sequential processes but are closely inter-related
since changes in one may result in consequential changes to the other. The auditor should develop an
audit plan for the audit in order to reduce audit risk to an acceptably low level.

The audit plan is more detailed than the audit strategy and includes the nature, timing and extent of
audit procedures to be performed by engagement team members in order to obtain sufficient
appropriate audit evidence to reduce audit risk to an acceptably low level. Documentation of the audit
plan also serves as a record of the proper planning and performance to the performance of the audit of
procedures that can be reviewed and approved prior further audit procedures.

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Likewise, with the governance auditor should imposes determine any type of whether limitation
management on the scope or of these the charged audit. This could include:

 A description of the nature, timing and extent of planned risk assessment procedures sufficient to
assess the risks of material misstatement, as determined under PSA 315, "Understanding the Entity and
Its Environment and Assessing the Risks of Material Misstatement";
 A description of the nature, timing and extent of planned further audit procedures at the assertion level
for each material class of transactions, account balance, and disclosure, as determined under PSA
330, "The Auditor's Procedures in Response to Assessed Risks.? The plan for further audit procedures
reflects the auditor's decision whether to test the operating effectiveness of controls, and the nature,
timing and extent of planned substantive procedures; and
 Such other audit procedures required to be carried out for the engagement in order to comply with
PSAs (for example, seeking direct communication with the entity's lawyers).

Planning for these audit procedures takes place over the course of the audit as the audit plan for the
engagement develops. For example, planning of the auditor's risk assessment procedures ordinarily occurs
early in the audit process. However, planning of the nature, timing and extent of specific further audit
procedures depends on the outcome of those risk assessment procedures. In addition, the auditor may begin
the execution of further audit procedures for some classes of transactions, account balances and disclosures
before completing the more detailed audit plan of all remaining further audit procedures.

Scope of the Audit Engagement

The auditor may consider the following matters when establishing the scope of the audit engagement:

 The financial reporting framework on which the financial information to be audited has been
prepared, including any need for reconciliations to another financial reporting framework,
 Industry-specific reporting requirements such as reports mandated by industry regulators.
 The expected audit coverage, including the number and locations of components to be included.

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 The nature of the business segments to be audited, including the need for specialized knowledge.
 The reporting currency to be used, including any need for currency translation for the financial
information audited.
 The need for a statutory audit of stand-alone financial statements in addition to an audit for
consolidation purposes.
 The availability of the work of internal auditors and the extent of the auditor's potential reliance on
such work.
 The entity's use of service organizations and how the auditor may obtain evidence concerning the
design or operation of controls performed by them.
 The expected use of audit evidence obtained in prior audits, for example, audit evidence related to
risk assessment procedures and tests of controls. The effect of information technology on the
audit procedures, including the availability of data and the expected use of computer-assisted
audit techniques.
 The coordination of the expected coverage and timing of the audit work with any reviews of
interim financial information and the effect on the audit of the information obtained during such
reviews.
 The discussion of matters that may affect the audit with firm personnel responsible for
performing other services to the entity.
 The availability of client personnel and data.

Reporting Objectives, Timing of the Audit and Communications Required

The auditor may consider the following matters when ascertaining the reporting objectives of the
engagement, the timing of the audit and the nature of communications required:

 The entity's timetable for reporting, with such management as at interim and those final charged
stages.
 The organization with management and those charged with governance to discuss the nature,
extent and timing of the audit work.
 The discussion with management and those charged with governance regarding the expected type
and timing of reports to be issued and other communications, both written and oral including the
auditor’s report, management letters and communications to those charged with governance.
 The expected nature and timing of communications among engagement team members, including
the nature and timing of team meeting and timing of the work performed.

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 Whether there are any other expected communications with third parties, including any statutory
or contractual reporting responsibilities arising from the audit.

Direction, Supervision and Review

The auditor should plan the nature, timing and extent of direction and supervision of engagement team
members and review of their work.

The nature, timing and extent of the direction and supervision of engagement team members and review of
their work vary depending on many factors, including the size and complexity of the entity, the area of audit,
the risks of material misstatement, and the capabilities and competence of personnel performing the audit
work. PSA 220 contains detailed guidance on the direction, supervision and review of audit work.

The auditor plans the nature, timing and extent of direction and supervision of engagement team members
based on the assessed risk of material misstatement. As the assessed risk of material misstatement increases,
for the area of audit risk, the auditor ordinarily increases the extent and timeliness of direction and
supervision of engagement team members and performs a more detailed review of their work. Similarly, the
auditor plans the nature, timing and extent of review of the engagement team's work based on the
capabilities and competence of the individual team members performing the audit work.

In audits of small entities, an audit may be carried out entirely by the audit engagement partner (who may be
a sole practitioner). In such situations, questions of direction and supervision of engagement team members
and review of their work do not arise as the audit engagement partner, having personally conducted all
aspects of the work, is aware of all material issues. The audit engagement partner (or sole practitioner)
nevertheless needs to be satisfied that the audit has been conducted in accordance with PSAs. Forming an
objective view on the appropriateness of the judgments made in the course of the audit can present practical
problems when the same individual also performed the entire audit. When particularly complex or unusual
issues are involved, and the audit is performed by a sole practitioner, it may be desirable to plan to consult
with other suitably-experienced auditors or the auditor's professional body.

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Documentation

The auditor should document the overall audit strategy and the audit plan, including any significant changes
made during the audit engagement.

The auditor's documentation of the overall audit strategy records the key decisions considered necessary to
properly plan the audit and to communicate significant matters to the engagement team. For example, the
auditor may summarize the overall audit strategy in the form of a memorandum that contains key decisions
regarding the overall scope, timing and conduct of the audit.

The auditor's documentation of the audit plan is sufficient to demonstrate the planned nature, timing and
extent of risk assessment procedures, and further audit procedures at the assertion level for each material
class of transaction, account balance, and disclosure in response to the assessed risks. The auditor may use
standard audit programs or audit completion checklists. However, when such standard programs or
checklists are used, the auditor appropriately tailors them to reflect the particular engagement
circumstances.

The form and extent of documentation depend on such matters as the size and complexity of the entity,
materiality, and the extent of other documentation and the circumstances of the specific audit engagement.

Communications with Those Charged With Governance and Management

The auditor may discuss elements of planning with those charged with governance and the entity's
management. These discussions may be a part of overall communications required to be made to those
charged with governance of the entity or may be made to improve the effectiveness and efficiency of the
audit. Discussions with those charged with governance ordinarily include the overall audit strategy and
timing of the audit, including any limitations thereon, or my additional requirements. Discussions with
management often occur to facilitate the conduct and management of the audit engagement [for example, to
coordinate some of the planned audit procedures with the work of the entity’s personnel]. Although these
discussions often occur, the overall audit strategy and the audit plan remain the auditor’s responsibility.

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Additional Considerations in Initial Audit Engagements

For initial audits, additional matters the auditor may consider in developing the overall audit strategy and
audit plan include the following:

 Unless prohibited by law or regulation, arrangements to be made with the previous auditor, liar
example, to review the previous auditor's working papers.
 Any major issues (including the application of accounting principles or of auditing and reporting
standards) discussed with management in connection with the initial selection as auditors, the
communication of these matters to those charged with governance and how these matters affect
the overall audit strategy and audit plan.
 The planned audit procedures to obtain sufficient appropriate audit evidence regarding opening
balances (see PSA 510, "Initial Audit Engagements - Opening Balances?).
 The assignment of firm personnel with appropriate levels of capabilities and competence to
respond to anticipated significant risks.
 Other Procedures required by the firm's system of quality control for initial audit engagements
(for example, the firm's system of quality control may require the involvement of another partner
or senior individual to review the overall audit strategy prior to commencing significant audit
procedures or to review reports prior to their issuance).

Other Critical Matters in Engagement Planning

1. Application of Analytical Procedures in Planning the Audit

When used for planning purposes, analytical procedures assist the auditors in planning the nature,
timing, and extent of audit procedures that will be used for the specific accounts. The approach used is
one of obtaining an understanding of the client's business and transactions, and identifying areas that
may represent higher risks. The auditors will then plan a more thorough investigation of these potential
problem areas, and perform a more effective audit. PSA 520 requires the auditors to perform analytical
procedures as a part of the planning process for every audit.

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2. Establishment of an Engagement or Audit Team

An audit team consists of people with different levels of expertise and experience. The team usually is
composed of an engagement partner, a manager, at least one senior, and one or more staff auditors. In
determining the number of people who will be assigned to an engagement, an auditor normally
considers the audit's size and complexity, the availability and experience of personnel, the necessity
for special expertise, the opportunity to train personnel, and the continuity and rotation of personnel.
An engagement involving an entity in a regulated industry, such as banking, also requires that the
major members of the audit team have necessary knowledge and experience in that industry.

3. Consideration of Work Performed by Other Auditors/Parties

 Predecessor Auditor

The successor auditor's examination may be greatly facilitated by consulting with the predecessor
auditors and reviewing the predecessor's working papers. Communication with the predecessor
auditors can provide the successor CPA with background information about the client, details
about the client's system of internal control, and evidence as to the account balances at the
beginning of the year under audit. Auditors are ethically prohibited from disclosing confidential
information obtained in the course of an audit without the consent of the client.

The successor auditor should obtain the client's consent before making inquiries from the
predecessor auditors.

If the auditor is unable to obtain cooperation from the preceding auditors, or if he feels that the
work done by the preceding auditors does not meet the requirements of PSAs he may have to treat
the audit of the new client, previously audited by other accountants, just as he would the first audit
of a client who has never been audited before.

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 Other CPAs

When a portion of the client [eg. subsidiary in a distant city] is audited by another CPA firm,
efforts may be coordinate. For example, if the accountants of the subsidiary are to be consolidated
with the overall enterprise, and if that subsidiary is audited by another CPA firm, the auditors
must coordinate timing of necessary reports and procedures to be performed.

 Specialists

CPAs may lack the qualifications necessary to perform certain technical tasks relating to the audit.
A specialist brings unique knowledge and judgment in a field other than accounting and auditing.
An auditor might decide to have an art appraiser place values on works of art, a mineralogist
determine the physical characteristics of mineral reserves, or an actuary provide data related to a
group’s life expectancy. Effective planning involves arranging for the appropriate use of
specialists both inside and outside of the client organization.

 Use of Client's Staff

The auditors should obtain an understanding with the client as to the extent to which the client's
staff, including the internal auditors, can help prepare for the audit. The client's staff should have
the accounting records up-to-date in when the auditors arrive. In addition, many audit working
papers can be prepared for the auditors by the client’s staff, thus reducing the cost of the audit and
freeing the auditors from routine work. The auditors may set up the columnar headings for such
working papers and give instructions to the client’s staff as to the label Prepared by clients, or
PBC, and also the initials of the auditor who verifies the work performed should by the clients’
staff. Working papers prepared by the client should never be accepted at face value; such papers
must be reviewed and tested by the auditors.

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Among the tasks that may be assigned to the client's employees are the preparation of a trial
balance of the general ledger, preparation of an aged trial balance of accounts receivable,
analyses of accounts receivable written off, lists of property additions and retirements during
the year, and analyses of various revenue and expense accounts. Many of these "working
papers" may be in the form of computer spreadsheets and other computerized data files.

 Internal Auditors
Internal auditors can affect the audit in two ways. First, they can enhance internal control. For
example, if internal auditors determined that bank reconciliations were properly prepared
and all cash receipts were deposited, the entity's controls would enhance the reliability of the
accounting records. In such cases, independent auditors would be able to reduce the extent of
substantive testing. In deciding whether to reduce the amount of testing for specific
assertions because of work performed by internal auditors, the independent auditor should
consider (1) the materiality of the amount, (2) the risk of misstatement, and (3) the degree of
subjectivity involved in evaluating the accumulated audit evidence. As these factors increase,
the auditor is less likely to rely on the internal auditor's work.

The second way internal auditors affect an audit is by assisting independent auditors in
performing specific audit procedures. For example, an internal auditor may observe client
personnel taking the inventory.

4. Assessment of Going Concern Assumption

When planning and performing audit procedures and in evaluating the results thereof, the auditor
should consider the appropriateness of management’s use of the going concern assumption in the
preparation of the financial statement.

PSA 570 requires auditors to evaluate whether substantial doubt exists about an entity’s ability to
continue as a going concern, based on procedures planned and performed to obtain evidence about the
management assertions embodied in the financial statement. That is, an auditor is not required to
design specific procedures to evaluate whether

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an entity is a going concern. But when the information obtained during the audit raises substantial
doubt about the entity’s ability to continue in operation for a year following the date of the financial
statement being audited, the auditor should add a paragraph calling attention to the fact that the
statement have been prepared assuming that the entity will continue as going concern.

5. Identification of Related Parties

Transactions with related parties are important to auditors because they will be disclosed in the financial
statement if they are material. Financial reporting standards require disclosure of the nature of the related
party relationship; a description of transactions, including peso amounts; and amounts due from and to
related parties. Most auditors assess inherent risk as high for related parties and related party transactions,
both because of the accounting disclosure requirement and the lack of independence between the parties
involved in the transactions.

A related party is defined as an affiliated company, a principal owner of the client company, or any other
party with which the client deals where one of the parties can influence the management or operating
policies of the other. A related party transaction is any transaction between the client and a related party.
Common examples include sales or purchase transactions between a parent company and its subsidiary,
exchanges of equipment between two companies owned by the same person, and loans to officers. A less
common example is the exercise of significant management influence on an audit client by its most
important customer.

Because material related party transactions must be disclosed, it is important that all related parties be
identified and included in the permanent files early in the engagement. Finding undisclosed related party
transactions is thereby enhanced. Common ways of identifying related parties include inquiry of
management, review of SEC filings, and examination of stockholders’ listing to identify principal
stockholders.

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6. Client's Legal Obligations

For new clients for which historical information relating to these matters is unavailable, the auditor
should review information relating to prior years. For example, instead of reading only the changes to
the articles of incorporation and by-laws, the auditor should read the articles of incorporation and
by-laws since the inception of the entity, making appropriate summaries for the permanent file. The
auditor should also read all contracts having an impact on the current year.

Pertinent current-year information that auditors should review includes (1) minutes of directors' and
stockholders' meetings, (2) changes to articles of incorporation or by-laws, and (3) any significant
contracts executed during the year. By reading the minutes, an auditor will obtain information about
significant events that have or will have an impact on the client. For example, an auditor should be alert
to the following:

 Major contracts or agreements, including merger and acquisition agreements, debt agreements,
compensation agreements, and asset purchase agreements
 Information about current situations and future business plans
 Authorization of dividends

7. Completion of the Initial Audit Program

An audit program is a set of audit procedures specifically designed for each audit. The program which
includes both substantive tests and tests of controls will enable the auditor to express an opinion on the
financial statements taken as a whole.

On initial engagements, the audit program typically develop in three stages:

1) the broad phases of the program can be outlined at the time of engagement;
2) other details of the program can be identified after the review of internal control structure and
accounting procedures has the begun; and
3) procedures on specific phases of the audit can be further challenged and revised as the work
progresses.

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On recurring engagement, the program for the preceding audit should be studied before preparing the
program for the current audit. The program foe the current audit should reflect modifications or are required
by the experience gained in the business, internal control or accounting methods of the client.

8. Preparation of a Time Budget

A time budget is an estimate of the total hours an audit is expected to take. It is based on the
information obtained in the first major step in the audit that is, obtaining an understanding of the client.
It takes into consideration such things as:

a) the client's size as indicated by its gross assets, sales, number of employees
b) location of client facilities
c) the anticipated accounting and auditing problems
d) the competence and experience of staff available.

The total time must be allocated by the preparation of work schedules indicating who is to do what and
how long it should take.

For repeat engagement, the development of time budget is facilitated by reference to the preceding
year's detailed nine records.

Figure 3-3 illustrates a Time Budget.

Figure 3-4 presents a portion of an Audit Budget and Time Summary.

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Figure 3-3: Time Budget
DELVEE AND JATCEE, INC.
Time Accounting and Budget
December 31, 20x7
Audit Area Staff Staff In-Charge Manager Partner Support Budgeted Actual Explanation of
Assistant 1 Assistant Senior Hours Hours Hours Variance
2
Cash 30 2 32 28
Accounts Receivable 60 5 65 110 See WP 20: Many
expectations to
confirmation
request
Inventory 30 30 5 65 96 See WP 30:
Plant Asset 20 10 30 35 Failure to achieve
proper cutoff
Investment 5 5 7
Other Assets 5 5 3
Accounts payable 10 10 3 23 22
Long-term debt and equity 10 10 20 Debt
restructuring
required more
audit hours
Revenue and expenses accounts 5 5 7
Payroll 10 5 15 12
Pension, profit sharing etc. 20 20 23
Planning, review and 25 10 5 40 38
supervision
Reports 10 5 15 15
Taxes 20 5 3 28 26
Encoding and proofreading 8 8 7

120 100 105 20 13 8 366 447

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Figure 3-4: Portion of an Audit Budget and Time Summary.

Actual Weekly Hours (by date)

Total // // //
Budgeted
Hours
Total hours:
Partner
Manager
Senior
Staff

Hours by type of work:

General
Supervision
Preparation of audit program
Trial balances and adjusting entries

Permanent file
Financial statement comparisons
Preparation of report

Sales and collection cycle

Study and evaluation of internal
control
Test of controls-sales
Substantive test-sales
Test of controls-collection

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9. Assignment of Personnel to the Engagement

Staff must, therefore, be assigned with that standard in mind. On larger engagements, there are likely to
be one or more partners and staff at several experience levels doing the audit. Specialists in such
technical areas as statistical sampling and computer auditing may also be assigned. On smaller audits
they may be only one or two staff members.

A major consideration affecting staffing is the need for continuity from year to year. An inexperienced
staff assistant is likely to become the most experienced non partner on the engagement within a few years.
Continuity helps the CPA firm maintain familiarity with the technical requirements and closer
interpersonal relations with client personnel.

Another consideration is that the persons assigned be familiar with the client's industry.

Engagement Team Conference

PSA 315 requires a discussion among the engagement team members and a determination by the
engagement partner of which matters are to be communicated to those team members not involved in the
discussion. This discussion shall place particular emphasis on how and where the entity's financial
statements may be susceptible to material misstatement due to fraud, including how fraud might occur. The
discussion shall occur setting aside beliefs that the engagement team members may have that management
and those charged with governance are honest and have integrity.

The auditor shall include the following in the audit documentation of the auditor's understanding of the
entity and its environment and the assessment of the risks of material misstatement:

a) The significant decisions reached during the discussion among the engagement team regarding
the susceptibility of the entity's financial statements to material misstatement due to fraud;
misstatement and due to fraud at

b) The identified and assessed risks of material the financial statement level and at the assertion
level.

The engagement partner and other key management team members shall discuss the susceptibility of the
entity’s financial statement to material misstatement, and the application of the applicable financial
reporting framework to the entity’s facts and circumstances. The engagement partner shall determine which
maters are to be communicated to engagement team members not involved in the discussion.

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Key Areas to Address During the Engagement Team Planning Meeting

Key Areas to
Purpose: To have an open discussion
Address
Share insights on the entity, The Entity
such as the people,  History and business objection
operations and objectives  The corporate culture
 Changes in operations, personnel, or system.
 Application of the applicable financial reporting framework to the
entity’s facts and circumstances

Management
 The nature/structure of the entity and management.
 The attitude toward internal control.
 Incentives to commit fraud.
 Unexplained changes in the behavior or lifestyle of key employees
 Any indications of management bias

Known Risk Factors

 Experience from previous audit engagements.
 Significant business risk factors.
 Opportunity for fraud to be perpetuated

Key Areas to Purpose: To brainstorm ideas and possible audit approaches

Address
Brainstorm Potential for Errors and Fraud
 Which financial statement areas may be susceptible to material
misstatement (fraud and error)? This step is a requirement on all
audits.
 How could management perpetrate and conceal fraudulent financial
reporting? It may be helpful to develop various fraud scenarios, or,
where possible, use the services of a forensic accountant. Consider
journal entries, management bias in estimates/provisions, changes in
accounting policies etc.
 How could asset be misappropriated or misused for personal purposes?
 Are there non-selfish incentives (such as to maintain a funding source
for a non-for-profit entity) to manipulate the financial statement?

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Response to Risk
 What possible audit procedures/ approaches might be considered to
respond to the risk identified above?
 Consider whether an element of unpredictability will be incorporated
into the nature, timing and extent of the audit procedures to be
performed.

Key Areas to Purpose: To provide direction

Address
Audit planning Specific Areas to Address
 Ensure that the specific requirements of all PSAs relevant to the audit
are appropriately addressed in the audit plan. PSAs that include
specific procedures to be performed include:
- PSA 240 The Auditor’s Responsibilities Relating to Fraud in
an Audit of Financial Statements
- PSA 402 Audit Considerations Relating to an Entity Using a
Service Organization
- PSA 540 Auditing Accounting Estimate, Including Fair Value
Accounting Estimates, and Related Disclosures.
- PSA 550 Related Parties
- PSA 600 Audit of Group Financial Statements (Including the
Work of Component Auditors)

 Provide direction to the audit team:

- Determine materiality levels
- Assign roles and responsibilities
- Provide staff with an overview of the audit sections they are
responsible for completing.
- Address the approach required, special considerations, timing,
documentation required, the extent of supervision provided, file
review, and any other expectations.
- Stress the importance of maintaining professional skepticism
throughout the audit.

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Figure 3-5 shows an illustration of a memo on audit team discussions.

Figure 3-5: Illustrative Memo on Audit Team Discussion

Client: XYZ Company

Date of Meeting: December 10, 20X6

Agenda Item

1. Materiality and significant account balances.

2. Timing, key dates, and availability of client personnel.

3. What can we learn from past experience such as issues / events that caused delays and areas of
over-/under-auditing?

4. Any new concerns about management integrity, going concern, litigation, etc.?

5. Changes this period in business operations and / or financial condition, industry regulations,
accounting policies used, and people

6. .Susceptibility of the financial statements to fraud. In what possible ways could the entity be
defrauded? Develop some possible scenarios, and then plan procedures that would confirm or
dispel any suspicions.

7. Significant risks that require special attention.

8. Appropriate audit responses to the risks identified.

9. Consider the need for specialized skills of consultants, testing internal control vs. substantive
procedures, the need to introduce unpredictability in some audit tests, and work could be completed
by the client.

10. Audit team roles, scheduling, and file reviews.

Prepared by:____ Date:

Reviewed by :_____________ Date:___________

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10. Scheduling of Work

Audit work that can always be performed during the interim period includes the consideration of
internal control, issuance of management letter, and substantive tests of transactions that have occurred
to the interim date.

Interim tests of certain financial statement balances, such as accounts receivable, may also be
performed, but this results in additional risk that must be controlled by the auditors. Significant errors
or irregularities could arise in these accounts during the remaining period between the time that the
interim test was performed and the statement of financial position date. Thus, to rely on the interim test
of a significant account balance, the auditors most perform additional tests of the account during the
remaining period.

Performance of other substantive tests is scheduled near at, and after year-end. Consideration should
be given to such factors as:

a) Deadline for submitting final audit report and filing of income tax returns
b) Ability of the client's staff to submit required schedules
c) Other audit clients

PLANNING A REPEAT ENGAGEMENT

It is far easier to plan for a repeat engagement than planning for a first audit of a new client. The working
papers in the previous year’s audit provide a wealth of information useful in planning the recurring
engagement. Of course, the auditor-in-charge of a repeat engagement would have a good working
knowledge of the client’s business. ’The audit however should not merely duplicate last year’s audit
program but should modify his approach to the audit for any changes in the client’s operations, internal
control structure, or business environment.

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Special Consideration in the Audit of Small Entities (PAPS 1005)

The Philippine Standards on Auditing [PSAs] contain basic principles and essential statement of any entity,
irrespective of its size, its legal form, ownership or management structure, or the nature of its activities. The
AASC recognizes that small entities give rise to a number of special audit considerations.

The Philippine Auditing Practice Statement 1005, "The Special Consideration in the Audit of Small
Entities," which was made effective for audits of financial statements for periods beginning on or after
December 15, 2004 describes the characteristics commonly found in small entities and indicates how they
may affect the application of PSAs. Reference may therefore be made by the auditor to PAPS 1005 when
handling audit of small entities.

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REVIEW QUESTIONS

Questions

1. Criticize the following statement: "Throughout this audit, for all purposes, we will define a
'material amount' as P500,000."

2. Suggest some factors that might cause an audit engagement to exceed the original time estimate.
Would the extra time be charged to the client?

3. What problems are created for a CPA firm when audit staff members under report the amount of
the time spent in performing specific audit procedures?

4. The overall audit strategy, the audit plan, and the time budget are three important working papers
prepared early in an audit. What functions do these working papers serve in the auditors'
compliance with generally accepted auditing standards? Discuss.

5. When planning an audit, the auditors should assess the levels of risk and materiality for the
engagement. Explain how the auditors' judgments about these two factors affect the auditors'
planned audit procedures.

6. Define the following terms: (a) performance materiality, (b) tolerable misstatement, (c) clearly
trivial.

7. Define the term misstatement and describe characteristics that would make a misstatement
material.

8. The audit report provides reasonable assurance that the financial statements are free from material
misstatements. The auditor is put in a difficult situation because materiality is defines from a
user's viewpoint, but the auditor must assess materiality in planning the audit to ensure that
sufficient audit work is performed to detect material misstatements.

a. Three major dimensions of materiality are (1) the peso magnitude of item, (2) the nature
b. Once the auditor develops an assessment of materiality, can it change during the course of
the audit? Explain. If it does change, what is the implication of a change for audit work that
has already been completed? Explain.

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9. How inherent risks of material misstatements related to internal controls? Why is it important to
assess inherent risks of material misstatement prior to evaluating the quality of an organization's
internal controls?

10. Explain how concepts of audit risk and materiality are related. Must an auditor make a decision on
materiality in order to determine the appropriate level of audit risk?

11. Brainstorming is a group discussion designed to encourage auditors to creatively assess client
risks, particularly those relevant to fraud.

a. When dose brainstorming typically occur?

b. Who attends the brainstorming session? Who leads it?
c. Besides encouraging auditors to creatively assess client risks, what other purpose does
brainstorming serve?
d. What are the guidelines that should be followed during a brainstorming session to maximize
effectiveness?
e. What are the typical steps in the brainstorming process?

Multiple Choice Questions

1. The concept of materiality will be least important to the CPA in determining the
a. scope of the audit of specific accounts.
b. specific transactions that should be reviewed.
c. effects of audit exceptions upon the opinion.
d. effects of the CPA's direct financial interest in a client upon his or her independence

2. Edison Corporation has a few large accounts receivable that total P1,400,000. Victor Corporation
has a great number of small accounts receivable that also total P1,400,000. The importance of a
misstatement in any one account is therefore greater for Edison than for Victor. This is an
example of the auditor's concept of
a. Materiality
b. Comparative analysis
c. Reasonable assurance
d. Relative risk

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3. Which of the following elements ultimately determines the specific auditing procedures that are
necessary in the circumstances to afford a reasonable basis for an opinion?
a. Auditor judgment
b. Materiality
c. Inherent risk
d. Reasonable assurance

4. Which of the following statements is not correct about materiality?

a. The concept of materiality recognizes that some matters are important for fair presentation of
financial statements in conformity with PFRS, whereas other matters are not important.
b. An auditor considers materiality for planning purposes in terms of the largest aggregate level
of misstatements that could be material to any one of the financial statements.
c. Materiality judgments are made in light of surrounding circumstances and necessarily
involve both quantitative and qualitative judgments.
d. An auditor's consideration of materiality is influenced by the auditor's perception of the
needs of a reasonable person who will rely on the financial statements.

5. Inherent risk and control risk differ from planned detection risk in that they
a. arise from the misapplication of auditing procedures.
b. may be assessed in wither quantitative or nonquantitative terms.
c. exist independently of the financial statement audit.
d. can be changed at the auditor's discretion.

6. In considering materiality for planning purposes, an auditor believes that misstatements

aggregating P10,000 would have a material effect on an entity's income statement but that
misstatements would have to aggregate P20,000 to materially affect the balance sheet. Ordinarily,
it would be appropriate to design auditing procedures that would be expected to detect
misstatements that aggregate.
a. P10,000
b. P15,000
c. P20,000
d. P30,000

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7. In planning and performing an audit, auditors are concerned about risk factors for two distinct
types of fraud: fraudulent financial reporting and misappropriation of assets. Which of the
following is the risk factor for misappropriation of assets?
a. Generous performance-based compensation systems.
b. Management preoccupation with increased financial performance.
c. An unreliable accounting system.
d. Strained relationships between management and the auditors.

8. Which portion of an audit is least likely to be completed before the balance sheet date?
a. Test of controls
b. Issuance of an engagement letter
c. Substantive procedures
d. Assessment of control risk

9. Which of the following should the auditors obtain from the predecessor auditors before accepting
an audit engagement?
a. Analysis of balance sheet accounts.
b. Analysis of income statement accounts.
c. All matters of continuing accounting significance.
d. Facts that might bear in the integrity of management.

10. Which of the following items would typically not be included in an audit program?
a. A list of audit procedures to be performed.
b. An indication of who performed the procedure.
c. A work paper heading.
d. All of the above would typically be included in an audit program.

11. Which of the following statements describes a purpose of an audit program?

a. An audit program is used to specific the procedures to be performed in obtaining audit
evidence.
b. An audit program is used to record the completion of each audit step.
c. An audit program is useful for monitoring the progress of the audit.
d. All f the above statements describe the purpose of an audit program.

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Exercises

Exercise 1:
The following information shows the past two periods of results for a fictional company, Amos
Manufacturing, and a comparison with industry data for the same period:

ANALYTICAL DATA FOR AMOS MANUFACTURING

20X5 20X6 Industry Average

Percent Percent Percent
Prior Period Current Period as a Percent of
of sales of sales Change
(000 omitted) (000 omitted) sales

Sales P10,000 100 P11,000 100 10 100

Inventory P2,000 20 P3,250 29.5 57.5 22.5
Cost of goods sold P6,000 60 P6,050 55 0.83 59.5
Accounts payable P1,200 12 P1,980 18 65 14.5
Sales commissions P500 5 P550 5 10 Not available
Inventory turnover 6.3 - 4.2 - -33 5.85
Average number of days
39 - 48 - 23 36
collect
Employee turnover 5% - 8% - 60 4
Return on investment 14% - 14.30% - - 13.8
Debt/Equity 35% - 60% - 71 30

a. From the preceding data, identify potential risk areas and explain why they represent potential
risk. Briefly indicate how the risk analysis should affect the planning of the audit
management.
b. Identify any of the above data that should cause the auditor to increase the level of
professional skepticism.
Exercise 2

Auditors make materiality judgments during the planning phase of the audit in order to be sure
they ultimately gather sufficient evidence during the audit to provide reasonable assurance that the
financial statements are free of material misstatements. The lower the materiality threshold that an
auditor has for an account balance, the more the evidence that the auditor must collect. Auditors
often use quantitative benchmarks such as 1% of total assets or 5% of net income to determine
whether misstatements materially affect the financial statements, but ultimately it is an auditor's
individual professional judgment as to whether a given misstatement is or is not considered
material.

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a) What is the relationship between the level of riskiness of the client and the level of
misstatement in an account balance that an auditor would consider material? For example,
assume that Client A has weaker controls over accounts receivable compared to Client B
(therefore, Client A is riskier than Client B). Assume that Client B is similar in size to
Client A and that the auditor has concluded that a misstatement exceeding P5,000 would
be material for Client B's accounts receivable account. Should the materiality threshold
for Client A be the same as, more than, or less than for Client B? Further, which client will
require more audit evidence to be collected, Client A or Client B?
b) How might an auditor's individual characteristics affect his or her professional judgments
about materiality?
c) Assume that one auditor is more professionally skeptical than another auditor, and that
they are making materiality judgment in part (a) of this problem. Compare the possible
alternative monetary thresholds that a more versus less skeptical auditor might make for
Client A.

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Chapter
PHASE I - RISK
ASSESSMENT:
PERFORMANCE OF RISK
ASSESSMENT PROCEDURES

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Enumerate and explain the activities involved in the performance of risk

assessment procedures.
2. Know the process of identifying and assessing
 Inherent Risk, Business and Fraud Risk
 Significant Risk
3. Understand how to design, perform and document risk assessment
procedures
4. Explain how to relate identified risks to material financial statement
areas
5. Understand the design, implementation and documentation of relevant
internal control.
6. Explain how to conclude the risk assessment phase

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CHAPTER4
PHASE I - RISKASSESSMENT:
PERFORMANCE OF RISKASSESSMENT
PROCEDURES

PERFORMANCE OF RISK ASSESSMENT PROCEDURES

This stage involves the identification and assessment of the risk of material misstatements whether due to
fraud or error at the financial statement and assertion levels, through understanding the entity and its
environment, including the entity's internal control, thereby providing a basis for designing and
implementing responses to the assessed risks of material misstatement.

The following are the activities involve in the performance of risk assessment procedures:

A. Identification of Inherent Risks (Business and Fraud Risks) and Significant Risks) and Significant
Risks
B. Understanding the Design / Implementation of Relevant Internal Controls
C. Concluding the Risk Assessment Phase

RISK IDENTIFICATION AND ASSESSMENT

A. Identification of Inherent Risk (Business and Fraud Risks) and Significant Risks

Identification of risk is the foundation of the audit. It is based upon, and forms an integral part of,
the auditor's procedures to understand the entity and its environment. Without a solid
understanding of the entity, the auditor may miss certain risk factors. For examples, if a client's
sales were increasing, it would be important for the auditor to know that the industry sales as a
whole were actually in sharp decline.

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The objective of the risk assessment phase of the audit is to identify sources of risk, and then to assess
whether they could possibly result in a material misstatement in the financial statements. This provides the
auditor with the information needed to direct audit effort to areas where the risk of material misstatement is
the highest, and away from less risky areas.

Risk assessment has two distinct parts:

 Risk identification (asking "what can go wrong"); and

 Risk assessment (determining the significance of each risk).

Risk identification answers the question what could go wrong and result in a misstatement in the financial
statement.

Performance of risk assessment procedures seeks to determine the significance of each risk by considering
the following:

a) the entity objectives,

b) external factors
c) performance measures, and
d) internal control

TYPES OF RISKS

There are two major classification of risks:

a) Business risk, and

b) Fraud risk

The difference between business risk and fraud risk is that fraud risk results from a person's deliberate
actions.

A risk can be both a business and a fraud risk.

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Business Risk

Business risks result from significant conditions, events, circumstances, actions, or inactions that could
adversely affect the entity's ability to achieve its objectives and execute its strategies. Business risk also
includes events that arise from change, complexity, or the failure to recognize the need for change. Change
may arise, for instance, from:

a) development of new products that may fail;

b) inadequate market even if new products are successfully developed,or
c) defects in the product that may result in liabilities and damage to the entity's reputation.

Fraud Risk

Fraud risk relates to events or conditions that indicate an incentive or pressure to commit fraud or provide
an opportunity to commit fraud.

The term "fraud" refers to an intentional act by one or more individuals among management, those charged
with governance, employees, or third parties involving the use of deception to obtain an unjust or illegal
advantage.

Fraud involving one or more members of management or those charged with governance is referred to as
"management fraud." Fraud involving only employees of the entity is referred to as "employee fraud." In
either case, there may be collusion within the entity or with third parties outside of the entity.

SOURCES OF RISKS

Errors and fraud in financial statements arise from risk factors that have their origin in one or more of the
six required areas of understanding the entity.

Sources of business and fraud risks are outlined below:

a. Entity objectives and strategies. Examples are

 Inappropriate, unrealistic or overly aggressive objectives and strategies
 New products or services
 Entering into business areas / transactions with which the entity has little experience
 Use of complex financing arrangements

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b. External factors such as
 state of the economy and changes in government regulations
 changes in industry
 deliberate sabotage of an entity's products or services
 inability to obtain required resources (materials or skilled personal)

c. Internal factors (nature of entity)

 Poor corporate culture and governance
 Incompetent personnel in key positions
 Complexity in operations, organizational structure or products
 Going concern and liquidity issue.

d. Performance indicators
 Failure to. use performance measures that assess the entity's performance and achievement of
objectives
 Failure to use measures to improve operations or take corrective actions.

e. Accounting policies
 Inconsistent application of accounting policies
 Inappropriate use of accounting policies

f. Internal control
 Inadequate management oversight of day-to-day operations
 Poor or nonexistent controls over entity-level activities as well as transactions.
 Poor safeguarding of assets

HOW TO IDENTIFY INHERENT RISK FACTORS

A three-step risk identification process is suggested as follows:

Step 1: Gather Basic Information about the Entity

The starting point is to obtain a basic understanding or frame of reference for designing the risk assessment
procedures to be performed. Without this understanding, it would be difficult, if not impossible, to identify
what errors and fraud could occur in the financial statements.
 Obtain (or update) relevant basic information about the entity, its objectives, culture, operations, key
personnel, and the internal organization and control.

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Sources of Information about Entity

The first step in the risk assessment process is to gather (or update) as much relevant information about the
entity as possible. This information provides an important frame of reference for identifying and assessing
possible risk factors.

Information about the entity and its environment can be obtained from both internal and external sources.

Figure 4-1 presents the sources of information about the entity.

Figure 4-1: Sources of Information about Enti

Entity

Internal Sources External Sources

Financial statements Information on the Internet

Industry
Budgets information
Reports Competitive intelligence
Performance measures Credit rating agencies
Tax returns Creditors
Accounting policies in use Government agencies
Judgments and estimates Media and other external parties

Vision, values, objectives, and

strategies Information on the internet
Organization structure Trade association data
Job descriptions Industry forecasts
Human Resources files Government agencies
Performance indicators Media articles
Policy & procedure manuals

The information gained from risk assessment procedures conducted before engagement acceptance a
continuance can be used as part of the audit team's understanding of the entity.

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Step 2: Design, Perform and Document Risk Assessment Procedures

 Risk assessment procedures / activities are required to be performed so that:

The sources of risks of material misstatement are identified,
An appropriate understanding of the entity is obtained, and
The necessary supporting audit evidence is obtained.
 Using the basic understanding of the entity obtained in step 1 above, design and performs risk
assessment procedures and related activities.
 Hold discussions among the audit team regarding the susceptibility of the entity's financial statements
to material misstatement, caused by error or fraud.
 Make inquiries of management as to how they identify and manage risk factors (particularly fraud),
and what risk factors have in fact been identified and managed. Also ask management if errors or fraud
have actually occurred.
 Document all risk factors identified.

Step 3: Relate or Map the Risks Identified to Material Financial Statement Areas

For each risk factor (risk cause) identified, identify the effect (specific misstatements such as fraud and
error) that could occur in the financial statements as a result. Note that a single risk factor can result in a
number of differing types of misstatements that may affect more than just one financial statement area.
 Identify the material account balances, class of transactions, and disclosures in the financial
statements.
 Relate or map the risk identified to the specific financial statement areas, disclosure, and assertions
affected. Is the risk identified is pervasive, then related it to the financial statements as a whole.
Identifying the effect of risks by financial statement area helps in assessing risks at the assertion level.
Identifying the effect of pervasive risks helps in assessing risks at the financial statement level.

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HOW TO IDENTIFY FRAUD RISK

Types and Characteristics of Fraud

Although fraud can occur at any level in the organization, it tends to be more is serious (and involve
higher monetary amounts) when senior management is involved.

Some of the major conditions that create an environment for fraud include:
 Ineffective corporate governance ;
 Lack of leadership by management and poor "tone at the top"
 High incentives provided for financial performance;
 Taxes or other expenses that are considered very high or onerous;
 Complexity in the entity's rules, regulations, and policies;
 Unrealistic expectations from bankers, investors, or other stakeholders;
 Downward and unexpected shifts in profitability;
 Unrealistic budget targets for staff to attain; and
 Inadequate internal control, especially in the presence of organizational change.

The Fraud Triangle

There are three conditions that often provide clues to the existence of fraud. Forensic accountants often
refer to this as the "fraud triangle" because when all three conditions are present, it is highly likely that fraud
may be occurring.

The conditions are:

 Pressure
This is often generated by immediate needs (such as having significant personal debts or meeting an
analyst's or bank's expectations for profit) that are difficult to share with others.

 Opportunity
A poor corporate culture and a lack of adequate internal control procedures can often create confidence
that a fraud could go undetected.

 Rationalization
Rationalization is the belief that a fraud has not really been committed. For example, the perpetrator
rationalizes that “this is not a big deal” or “I am only taking what I deserve.”

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Sources of Fraud Risk

1. Incentives and Pressures

 Excessive pressure exists for management to meet the requirements or expectations of third parties or
those charged with governance (such as earnings targets or compliance with onerous environmental
regulations, etc.).
 Personal financial obligations may create pressure on management or employees with access to cash or
other assets susceptible to theft to misappropriate those assets.
 Adverse relationships between the entity and employees with access to cash or other assets. For
example:
Known or anticipated future employee layoffs,
Recent or anticipated changes to employee compensation or benefit plans, and
Promotions, compensation, or other rewards inconsistent with expectations.

2. Attitudes and Rationalizations

Attitudes
 Management has a known history of violations of laws and regulations, or allegations of fraud.
 Management exhibits changes in behavior or lifestyle that may indicate assets have been
misappropriated.
 Senior managers demonstrate a poor ethical example (such as inflating expense accounts and
committing petty thefts, etc.). Management has overridden existing controls.

Rationalizations
 Management is interested in employing inappropriate means to:
Minimize reported earnings for tax-motivated reasons, and
Increase reported earnings to avoid violating bank covenants, increase the sale price of the
entity, or meet targets set by a third party.
 Employee behavior indicates displeasure or dissatisfaction with the entity.
 Low morale exists among senior management.
 Management does not enforce the entity's values or ethical standards.

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3. Opportunities

Assets susceptible to of misappropriation cash

 Large amounts of cash on hand or processed
 Inventory items that are small in size, of high value, or high demand.
 Easily convertible assets, such as bearer bonds, diamonds, or

Inadequate internal controls

 Inadequate oversight by those charged with governance of management's processes for
identifying and responding to the risks of fraud.
 Inadequate segregation of duties or checks.
 Inadequate oversight of senior management expenditures.
 Lack of complete and timely reconciliations of assets.

HOW TO IDENTIFY SIGNIFICANT RISKS

Nature and Determination of Significant risks and the Consequences for the Audit

Significant risk is where the assessed risk of material misstatement is so high that in the audit’s judgement
it will required special audit consideration.

Examples of significant risks are as follows:

1. High-risks activities
These include operations or event where a material misstatement could easily occur. Example are:
a) Inventory of high-value diamonds or gold bars held by a jewelry store;
b) Identification of new complex accounting system being introduced.

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2. Large non-routine transactions (size or nature)
These are significant related party transactions outside the entity's normal course of business.
Examples are:
a) a major sales or supply content;
b) sale of the business to the third party;
c) unusual value of routine transactions with a related party.

3. Matters requiring judgment or management intervention Examples are:

a) assumptions used by management in developing major estimates.
b) complex calculations or accounting principles.

4. Potential for fraud Examples are:

a) Possible degree of collusion.
b) Intentional misrepresentation being made to the auditor.
c) Frequency and extent of manipulation involved.

Responding to Significant Risks

When a risk is classified as being "significant", the auditor should respond as outlined below:

1. Evaluate internal control design and implementation over lack significant risk
2. Design an audit response to the identified significant risks.
3. No reliance can be placed on evidence obtained in previous period.
4. Substantive analytical procedures alone are sufficient.

Documenting Significant Risks

Documentation is required for identified significant risks. This simply may be an extension of the
information already documented.

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Illustrative Documentation of Risk Identification and Implications to Financial Statement
CLIENT: XYZ COMPANY

Business Risk
Risk Event / Sources Implication of the Risk Factor to FS Assertions
1. Downturn in economy a. Receivable may be difficult to collect V
b. Inventory write-down may be required due to V
obsolescence
c. Breach of debt covenants P
2. New sales being sought in a. Foreign exchange risks in receivables A
other countries
3. General IT controls are a. Data integrity may be compromised or data may even P
weak in a number of areas be lost
4. Inventory clerk known to a. Inventory balance may be misstated CAEV
make error
Fraud
Pressures
1. Minimize tax burden a. Management bias in estimates (such as valuation of CAV
inventory) to reduce income
b. Unauthorized journal entries or manipulation of P
financial statements.
2. Bonus to salesman based on Inflated sales to meet thresholds E
sales
3. Giving bribes to facilities Damage to reputation, overstatement of expenses, CAE
service or to obtain contracts unaccrued fines
4. Rapid growth putting Financial statement manipulation to avoid violation of P
pressure on financing bank covenant
Opportunities
1. High incidence of cash sales Goods/Cash Stolen E
2. Transaction with related Sales/ Purchases may not be valid, nor properly valued P
parties or disclosed in the financial statement
3. High volume, easily Goods stolen from inventory E
transportable items of
inventory
Key:
P=Persuasive (all assertions), C= Completeness, A=Accuracy E=Existence, V=Valuation

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B. Understanding the Design and Implementation of Relevant Internal Controls

PAS 315.12 requires that the auditor shall obtain understanding of internal control relevant to the audit.
Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that
relate to financial reporting are relevant to the audit. It is a matter of the auditor's professional judgment
whether a control, individually or in combination with others is relevant to the audit.

Specifically the auditor is required to obtain an understanding of the following:

a. Control Environment

The auditor shall obtain understanding of the control environment. As part of obtaining this
understanding, the auditor shall evaluate whether:

a) Management with the oversight of those charged with governance, has created and maintain a
culture of honesty and ethical behavior; and
b) The strengths the control environment elements collectively provide an appropriate foundation
for the other components of internal control, and whether those other components are not
undermined by deficiencies in the control environment.

b. Risk Assessment

The auditor shall obtain an understanding of whether the entity has a process for:

a) Identifying business risks relevant to financial reporting objectives;

b) Estimating the significance of the risks;
c) Assessing the likelihood of their occurrence; and
d) Deciding about actions to address those risks.

c. Information System

The auditor shall obtain an understanding of the information system, including the related business
processes, relevant to financial reporting, including the following areas:

a) The classes of transactions in the entity's operations that are significant to the financial statements;

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b) The procedures, which both information technology (IT) and manual systems, by which those
transactions are initiated, recorded, processed, corrected as necessary, transferred to the general
ledger and reported in the financial statement.
c) The related accounting records, supporting information and specific accounts in the financial
statements that are used to initiate, record, process and report transactions; this includes the
correction of incorrect information and how information is transferred to the general ledger. The
records may be either manual or electronic form;
d) How the information system captures events and conditions, other than transactions, that are
significant to the financial statements;
e) The financial reporting process used to prepare the entity's financial statement, including
significant accounting estimates and disclosures; and
f) Controls surrounding journal entries, including non-standard journal entries used to record
non-recurring, unusual transactions or adjustments.

d. Control Activities

The auditor shall obtain an understanding of control activities relevant to the audit, being those the
auditor judges it necessary to understand in order to assess the risks of material misstatement at the
assertion level and design further audit procedures responsive to assessed risks. An audit does not
require an understanding of all the control activities related to each significant class of transactions,
account balance, and .disclosure in the financial statements or to every assertion relevant to them.

In understanding the entity’s control activities, the auditor shall obtain an understanding of how the
entity has responded to risk arising from IT.

e. Monitoring

The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal
control over financial reporting, including those related to those control activities related to the audit,
and how the entity initiates remedial actions to deficiencies in its controls.

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Evaluating Internal Control Design and Implementation

The four steps in evaluating control design and implementation are shown in Figure 4-3.

Figure 4.3: Four steps in Evaluating Control Design and Implementation

1. Risk Identification

What risk, of not mitigated bi internal

controls, could result in material
misstatements in the financial statements?

2. Evaluate Control Design

Are there controls capable of effectively preventing, or

detecting and correcting the material misstatements
identified in step 1?

Yes No

3&4. Evaluate Control Implementation and

Document Operation
Do the controls exist and is the entity using them?

No
Report significant deficiencies in control to
management and
those charged with governance
Yes

Document the results and conclusions reached

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Illustrative Documentation of Identification and Evaluation of Relevant Internal Control

Step 1: Risk Identification

This is the first and most important steps in evaluating internal control. This requires identification of the
risks which need to be mitigated by internal control. The question this step seeks to find answer to is:

"What risks, if not mitigated by internal control could result in material misstatement in the financial
statement?"

The risk could be identified as a result of obtaining an understanding of the entity with persuasive risk
factors and the used transactional risk factors associated with business procedures such as sales purchasing
and payroll. Examples are:

1. Risk 1 No emphasis is placed on need for integrity and ethical values

2. Risk 2 Incompetent employees may be hired or retained.
3. Risk 3 Management has a poor attitude toward internal control and / or managing business risk.

Step 2: Control Design

This step involves inquiry about controls and evaluation of controls that management has put in place to
address the risks that have been identified in Step 1 above.

The question answered in this step is:

"Are there controls capable of effectively preventing or detecting and correcting the material misstatements
identified in Step 1?”

In relation to the three risks identified in Step 1, the following possible controls may be inquired about and
evaluated

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Risk 1 No emphasis is placed on need for integrity and ethical values.

Possible Controls
a) Management continually demonstrates through words and actions, a commitment to high
ethical standards.
b) Management removes or reduces incentives that might cause personnel to engage in
dishonest or ethical acts.
c) Adoption of a Code of Conduct that sets out expected standards of ethical and moral
behavior.
d) Employees are always disciplined for improper behavior.

Risk 2 Incompetent employees may be hired or retained

Possible Controls
a) Management specific required knowledge and skills for employee positions.
b) Job descriptions exist and are effectively
c) Management provides personnel with access to training and professional development
programs on relevant topics
d) Staff are compensated and rewarded for good performance.

Risk 3 Management has a poor attitude toward internal control and/or managing business risks.

Possible Controls
a) Management demonstrates positive attitudes and actions toward the establishment and
maintenance of sound internal control over financial reporting.
b) Management emphasizes appropriate behavior to operating personnel.
c) Management has established procedures to prevent unauthorized access to or destruction of
assets, documents and records.

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Step 3: Control Implementation

The third step is to determine whether the controls exist and are in use by the entity through inquiry and
testing.

The question answered in the step is:

"Do the controls exist and is the entity using them?"

If this question is answered yes, the conclusions auditor then proceeds to Step 4. . Where the auditor
documents the result and conclusion reached.

If the question is answered no, the auditor then reports significant deficiencies in control to management
and those charged with governance. The auditor then documents the results and conclusion reached.

Step 4: Control Documentation

If the auditor determines, through inquiry and testing, that the company has strong risk management and
control processes in place, the auditor may be able to focus the audit program on testing internal controls
and developing corroborative evidence based on more limited direct tests of account balances. On the other
hand, if the company does not have an effective risk management process in place, the auditor will identify
areas where account balances are more likely to be misstated and concentrate direct tests of account
balances in those areas.

Based on the foregoing, the auditor develops expectations and makes an assessment of the risk that a
particular account balance may be misstated. If the may be able to gain satisfaction regarding the account
balance without directly testing it. Other techniques, such as using substantive analytical procedures or
analyzing the quality of the control system, may yield persuasive evidence about the correctness of an
account balance. This is not meant to imply that an auditor can perform a complete audit without ever
directly testing some account balances; it means that the amount of testing can be minimized if risks are
adequately addressed. However, if there is a high risk that an account balance may misstated, the auditor
should direct more attention to the audit of that account.

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Illustration Documentation of Control Deficiencies and Impact on Audit Response

Example 1
Risk factor / assertion affected Management has not considered or assessed the risk
of fraud occurring.
Auditor, Thought Process
a.) Deficiency Members of the management team trust each other
and are reluctant to introduce costly policies etc that
address the risk of fraud.
b.) Potential on the financial statement Management could override controls and materially
manipulate the financial statements.
c.) Is deficiency considered significant YES
d.) Audit response Review the specific procedures performed on
journal entries, related parties and revenue
recognition.

Example 2
Risk factor/ Assertion affected Sales/services recorded in wrong accounting period.
Auditor’s thought Process
a.) Deficiency identified No controls existing to prevent this from occurring a
number of cutoff errors have been found in
conducting the test of details.
b.) Potential effect on the financial statement Revenues misstated could be materially misstated in
the financial statements.
c.) Is deficiency considered significant? YES
d.) Audit response Additional audit procedure should be performed
relating to cutoff.

Example 3
Risk factor/ Assertion affected
Auditor’s thought Process
a.) Deficiency identified Client does not provide back-up document to
support their estimates
b.) Potential effect on the financial statement Considering the size of the estimates an error could
result in a material error in financial statement
c.) Is deficiency considered significant? YES
d.) Audit response Obtain evidences to support the assumption and per
re-calculation.

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Practical Pointers

 The auditor’s testing of the internal audit work be done limited but should be sufficient to formulate an
opinion on whether internal audit's conclusions are supported by independent evidence on the
operation of controls.

 To obtain evidence about whether a control is effective, the auditor must directly test the control. The
auditor cannot infer the effectiveness of a control from the absence of misstatements in the financial
statements.

 The external auditor must perform enough work to make an independent decision about the quality of
the client's internal controls.

 The more material the account is, the more evidence about internal controls should be gathered
independently by the external auditor.

 Auditors are required to assess control risk for each relevant assertion and for important classes of
transactions and account balances as a basis for planning the audit.

 Not all controls need to be tested. Further, controls for all assertions need not be tested if the auditor
believes that a misstatement related to a particular assertion would not be material.

 Once the significant accounts and their relevant assertions, as well as the processes related to those
accounts, have been identified, the auditor determines the important controls, such as those shown in
the immediately preceding table, that need to be tested. The nature of the testing will vary with the
nature of the process, the materiality of the account balance, and the control.

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C. Concluding the Risk Assessment Phase

From the audit risk model, we know that companies with strong internal controls should require less
substantive testing of account balances. We also know that greater computerization of processes
increases the likelihood of consistent processing throughout the year. The fundamental questions that
the auditor must address to determine the optimal amount of audit work are as follows:

1. How much assurance can be obtained regarding audit risk when internal control is present and
working?
2. If control activities within major processes are working properly throughout the year, what is the
residual risk that remains that an account balance can still be misstated?
3. What is the risk that the auditor's evaluation of internal controls might be incorrect?
4. Which account balances contain more than an acceptable amount of risk that a material
misstatement could occur?
5. How could a misstatement in a material account balance most likely occur?
6. What are the most effective substantive tests of account balances to determine whether there is a
misstatement in the account balance?

The auditor must answer these six important questions to plan an effective integrated audit. There is no
one right answer - all of the questions are interrelated. For example, the residual risk of a material
misstatement is dependent on the joint answer to the first three questions. The remaining three
questions address the identification of accounts that might be misstated, how a misstatement could
occur, and how the auditor would most effectively determine if a misstatement did occur.

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REVIEW QUESTIONS AND EXERCISES

Questions

1. Who participates in the pre-audit conference, and what topics should be covered?

2. Why must the auditor test the information system prior to testing transactions and balances?

3. Describe the relationship between detection risk and audit risk.

4. Identify and describe the two components of the risk of material misstatement.

5. Define inherent risk. Can the auditors reduce inherent risk by performing audit procedures?
6. Distinguish between the component of audit risk that the auditors gather evidence to assess
versus the component of audit risk that they collect evidence to restrict.

7. Define internal control over financial reposing. What is the difference between internal control
and internal control over financial reporting? What are the implications of the difference to the
auditor?

8. What is an organization's control environment? What are the major elements of a control
environment?

9. One element of the control environment is the organization's commitment to financial reporting
competencies. In your view, is the auditor capable of evaluating the competency of the accounting
staff? How would the auditor go about evaluating the competency of the counting department and
the competencies of those making judgments on financial reporting and issues?

10. What is the implication of a material misstatement in the account balances at year end in terms of
providing feedback on the effectiveness of internal control over financial reporting? Explain.

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11. What are the primary factors that should be considered in determining whether the auditor needs
to directly test year-end account balances?

12. Assume that the auditor's tests of internal controls did not yield any material weaknesses in
controls. However, during the audit, a, material misstatement in an important account was found.
Does the auditor have to analyze the cause of the misstatement and report materiel weakness in
internal control? Explain your answer.

13. Explain the relationship between risk analysis, internal control, and material account balances in
designing an approach to an integrated audit. In doing so, explain the differences between
business risks and the risk that an account balance may be misstated.

Exercises

Exercise 1

Michael Reyes, CPA, is considering audit risk at the financial statement level in planning the audit of
National Bank (NB) Company's financial statements for the year ended December 31, 20X1. Audit
risk at the financial statement level is influenced by the risks of material misstatements (including
fraud risks), which may be indicated by a combination of factors related to management, the
environment, and the entity. For each of the following factors, indicate whether it increases or
decreases the risk of material misstatement and (2) whether it creates a risk of fraud.

Effect on Risks Create a

of Material Risk of
Misstatement Fraud?
(Increase or (yes or
Decrease) no)
Factor
a. NB is a continuing audit client.

b. The banking industry has been significantly impacted

by the downturn in the in the economy in recent years.

c. NB operates in a growing, propesrous area and has

remained profitable over the years.

d. Government regulation and overview of the banking

industry is extensive and effective

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e. NB's board of directors is controlled by Smith, the
majority stockholder, who also acts as the chief
executive officer.

f. Interest rates have been very volatile recently

g. Management at the bank's branch offices has authority

for directly and controlling NB's operations and is
compensated based on branch profitability

h. The internal audit reports directly to Harris, a minority

shareholder, who also acts as chairman of the board's
audit committee.

i. The accounting department has experienced little

turnover in personnel during the five years Green has
audited NB.

j. During 20x1, NB increased the efficiency of its

accounting operations by installing a new,
sophisticated computer system.

k. NB's formula has consistently underestimated the

allowance for loan losses in current years.

l. Management has been receptive to Green's

suggestions relating to accounting adjustment.

Exercise 2

Segregation of duties is an important concept in internal control. However, segregation of duties is

often a challenge for smaller business because they do not have sufficient staff to segregate duties.
Normally, the segregation of duties identified below results in either a significant deficiency or a
material weakness in internal control.

Required:
For each "segregation of duties" problem identified here:
a. Identify the risk to financial reporting that is associated with the inadequacy of the segregation of
duties.
b. Identify other controls, if any that might mitigate the segregation of duties risks.
c. If a control is identified that would mitigate the risks, briefly indicate what evidence the auditor
would need to gather to determine that the control is operating effectively.

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The inadequate segregation of duty situations to be considered are as follows:
(1) The same individual handles cash receipts, the bank reconciliation, and customer complaints.
(2) The same person prepares billings to customers and also collects cash receipts and applies them to
customer accounts.
(3) The person who prepares billings to customers does not handle cash, but does the monthly bank
reconciliation, which, in turn, is reviewed by the controller.
(4) The controller is responsible for making all accounting estimates and adjusting journal entries. The
company does not have a CFO and has two clerks who report to the controller.
(5) A start-up company has very few transactions, less than P 1 million in revenue per year, and has only
one accounting person. The company's transactions are not complex.
(6) The company has one computer person who is responsible for running packaged software. The
individual has access to the computer to update software and can also access records.

Exercise 3

The auditor is evaluating the internal control of a new client. Management has prepared its assessment of
internal control and has concluded that it has some deficiencies but no significant deficiencies and no
material weaknesses. However, in reviewing the work performed by management, including the internal
auditor, the auditor serves the following:

 Sample sizes taken by the internal auditor were never more than ten transactions, and most of the tests
were based on a sample performed as part of a walkthrough of a transaction.
 Management has fired the former CFO and a new CFO has not been appointed, but management
indicates it has depth in the accounting area and is searching for a new CFO.
 The company has no formal whistle blowing function because management has an "open-door" policy
so that anyone with a problem can take it up the line.
 Management's approach to monitoring internal control is to compare budget with actual expenses and
investigate differences.

In response to inquiries by the auditor, management responds that its procedures are sufficient to support its
report in internal control.

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There auditor's is subsequent work yields following:

 Many control procedures do not operate in the way described by management, and the procedure are
not effective.
 There is no awareness of, or adherence to, or adherence to, the company’s code of conduct.
 The accounting department does not have a depth of talent; more over, although the department can
handle most transactions it is not capable of dealing with newer contracts that the firm has entered into.
The response of management is: “That is why we pay you auditors the Big Bucks-Help us make these
decision.”

The auditor reaches a conclusion that there are material weaknesses in internal control, thus differing from
management's assessment. Management points out that every issue on which there is a subjective issue, and
there is no one position that is better than the others. Management's position is that these are management's
financial statements, and the auditor should accommodate management's view because there are no right
answers.

Required:
a. Identify the audit approach the auditor could utilize to gather evidence regarding the effectiveness of
the organization's code of ethics.
b. The partner in charge of the job appears to be persuaded that the differences are of only a subjective
nature and is proposing that an unqualified opinion on internal controls be issued. Recognize that this
is a first-year client-and an important one to the office. Apply the ethical framework developed earlier
to explore the actions that should be taken by the manager on the audit regarding (1) whether to
disagree with the partner, and (2) if there is a disagreement, to what level it should be taken in the firm.
c. Given the deficiencies noted, does the information support that there is a material weakness in internal
control? If yes, what are the major factors that lead you to that conclusion?
d. Assume that the engagement team makes a decision that there is a material weakness in internal
control. Write two or three paragraphs that describe those weakness.

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UNIT III
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE II - RISK RESPONSE:
TEST OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS

Chapter
5 Designing Overall Responses
and Further Audit
Procedures

6 Audit of the Revenue and

Collection
Cycle

7 Audit of the Expenditure Cycle

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8 Audit of the Expenditure Cycle
Continued

9 Audit of the Investing Cycle

10 Audit of the Financing Cycle

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Chapter
PHASE II -
RISK RESPONSE:
DESIGNING OVERALL
RESPONSES AND FURTHER
AUDIT PROCEDURES

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Understand the activities involved in designing the overall audit response

and further audit procedures.
2. Know the general types of the auditor's response to address the risks
identified and assessed.
3. Explain the nature of audit procedures to be performed in conducting an
audit.
4. Distinguish between Tests of Controls and Substantive Tests of Details.
5. Know the factors to be considered in selecting the audit procedures to be
applied.
6. Understand the PSA Guidelines in performing the tests of controls and
substantive tests.

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CHAPTER 5
PHASE II - RISK RESPONSE:
DESIGNING OVERALL RESPONSES AND
FURTHER AUDIT PROCEDURES

INTRODUCTION

The Risk Response Phase in the Risk-Based Audit Approach includes following steps:

(a) Designing the overall audit responses and further audit procedures. This will require:
i. Updating overall audit strategy
ii. Developing response to assessed risks
iii. Briefing team on audit plans as required

(b) Performance of further audit procedures. This step will involve:

i. Performing planned procedures
ii. Assessing results and evidence obtained
iii. Documenting findings and conclusion

The starting point for designing an effective audit response is the listing of assessed risks that was
developed at the conclusion of the risk assessment phase of the audit.

OVERALL RESPONSE

The auditor shall design and implement overall responses to address the risks identified and assessed at the:
 financial statement level; and
 assertion level for financial statement areas and disclosures.

An assessment of the risks of material misstatement is required at the financial statement and assertion
levels to obtain evidence that addresses risk assessments developed for each relevant assertion.

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Areas that the auditor would address in developing an overall response shall include the determination of:

 The extent that the audit team needs to be reminded about the use of professional skepticism;
 Which staff to assign, including those with special skills, or whether to use experts;
 The extent of supervision required throughout the audit;
 The need for incorporating some elements of unpredictability in the selection of further audit
procedures to be performed; and
 Any general changes that need to be made to the nature, timing, or extent of audit procedures.
These could include the timing of procedures (interim or period-end), or new/extended
procedures to address specific risk factors such as fraud.

TYPES OF RESPONSE

The types of response required is summarized in Figure 5-1.

Figure 5-1 Types of Response

Assessed Risk:

At Financial Statement Level At Assertion Level

Auditor’s Response

Overall Response Further Audit Procedure

Examples include:
 Professional skepticism Substantive Test of
Procedure Control
 Level of staff assigned

 Ongoing staff supervision

 Evaluate accounting policies Substantive Substantive

Procedure Procedure
 Nature/ extent/timing and
unpredictability of planned

Result

Sufficient appropriate audit evidence to reduce audit risk to an acceptably low level

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AUDIT PROCEDURES

In developing the detailed audit plan, the auditor would use his/her professional judgment to select the
appropriate types of possible audit procedures. To obtain the required reasonable assurance, the auditor
applies the audit procedures that' in the judgment and based on the PSAs are deemed appropriate in the
circumstances and in determining the audit procedures to be performed in conducting an audit in
accordance with Philippine Standards on Auditing, the audits should comply with each of the PSAs relevant
to the audit.

Nature of Audit Procedures

An effective audit program will be based on an appropriate mix of procedures that collectively reduce audit
risk to an acceptably low level: Audit procedures are the methods or acts that auditors use to gather
evidence to determine the validity of financial statement assertions. One way for the auditors to increase the
amount of evidence obtained is to select a more effective audit procedure. For example, if the auditors want
to increase the amount of evidence about the existence of accounts receivable, they could decide to confirm
the accounts rather than rely upon the inspection of internal documents.

The various types of an audit procedures available to the auditor are categorized as follows.

I. Test of Controls or Compliance Tests

These are audit procedures designed to evaluate the operating effectiveness of controls in
preventing, or detecting and correcting, material misstatements at the assertion level.

Types of Compliance Tests

1) No Trail
This type does not leave a visible trail m the supporting documents of the performance of
control procedure by the client's employee. The auditor makes inquiries and observation of
office personnel and routines to determine how control procedures are performed and who
performs them.

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2) Documentary Trail
This type leaves a visible trail in the supporting documents. Hence, the auditor inspects the
documents supporting a particular type of transaction to see whether a control procedure,
such as approval or other checking, was performed and who performed it as indicated by
signatures or initials.

II. Substantive Procedures

These are audit procedures designed to detect material misstatements at the assertion level. Substantive
procedures comprise:

i. Tests of details (of classes of transactions, account balances and disclosures), and
ii. Substantive analytical procedures.

The auditor applies compliance tests when the purpose is to see whether prescribed accounting control
procedures are being followed. This evaluation identifies the control procedures that can be relied on in
performing restricted substantive tests. Substantive tests are applied when the auditor's purpose is to
see whether the peso amount of an account is properly stated. Thus, there is a relationship between the
amount of reliance and the amount of additional work that will be needed.

Types of Substantive Tests

There are two general categories of substantive tests.

(a) Tests of Details of Transactions or Balances; and

(b) Analytical Review Procedures

Irrespective of the assessed risks of material misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.

(a) Tests of Details

This type of substantive test involves obtaining evidential matter on the items (or details) involved
in an account balance or class of transactions.

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Tests of details are also referred to as follows:
૦ Tests of Transactions
These are test of the processing of individual transactions by inspection of the documents and
accounting records involved in processing. For example, tracing a sample of receiving reports to
the purpose journal to see whether receipts of merchandise have been recorded as purchases.

૦ Tests of Balances
These are test applied directly to the details of balances in general ledger accounts. For example,
confirming the balances of accounts in the accounts payable subsidiary ledger with individual
customers. These test have the objective of establishing the correctness of the accounts they relate
to.

Some auditors refer to tests of balances as direct tests of balances to emphasize the substantive
nature of the test as directly supporting an account balance. It should be noted that substantive
tests and compliance tests of control procedures that leave a documentary trail both involve the
inspection of documents supporting the transactions. For this reason, these tests are often applied
together to the same group of documents. In that case, the test is referred to as a dual purpose test
because it has both compliance and substantive objectives.

(b) Analytical Review Procedures

Analytical types of test involve study and comparison of relationships among accounting data and
related information. They identify unusual fluctuation for investigation and focus on the rationale
of relationship. They are substantive that may achieve specific audit objectives if the evidential
matter is considered persuasive by the auditor. Auditing standards require the application of
analytical procedures at planning and overall final review stage of audits. The auditors may also
decide to use them during the audit as substantive test to provide evidence as to be the
reasonableness of the specific account balances.

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Figure 5-2 presents examples of analytical procedures that involve comparison.

Figure 5-2 Common Analytical Procedures that Involve Comparison

Analytical Procedure Example

(1) Compare current financial information for Compare inventory level for the current year
the prior period. to that of prior years.
(2) Compare current financial information Compare research and development expense
with anticipated data. to that budgeted amount
(3) Compare current financial information Compare interest expense to the average
with known or predictable relationship. outstanding balance of interest-bearing debt
(4) Compare current financial information Compare client's gross profit percentage to
with industry information published industry averages
(5) Compare current financial information
Compare production records in units to sales.
with current nonfinancial information.

SELECTING THE AUDIT PROCEDURES THAT WILL BE APPLIED

Audit procedures vary according to the risks associated with the client and the methods used to records
transactions. The following framework identifies audit procedures according to three major phases of the
audit:

1. Understanding Client and Industry: Preliminary Planning and Risk Analysis

a. Review prior-year work.

b. Review publicly available data about the organization.
c. Perform analytical procedures.
d. Inquire of management and employees.
e. Perform internal control walkthroughs.

2. Assess Risk of Material Misstatement: Understand and Test Internal Controls and System
Processing

a. Inquire of management and supervisory personnel.

b. Review system documentation and perform a walkthrough of processes.
c. Observe system in operation. For computer applications, consider tracing transaction through the
system.
d. Document process flow and control points.

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e. Determine the effectiveness of procedures that the client has developed to monitor the continued
effectiveness of internal controls over financial reporting.
f. Select transactions and trace through processing to determine if controls are working properly.

3. Test Details of Account Balances and Transactions

a. Review authoritative documents and client records:

(1) Vendor invoices and monthly statements
(2) Receiving and shipping records
(3) Legal documents and others

b. Testimonial evidence:
(1) Inquire of client personnel
(2) Inquire of outside parties

c. Auditor-generated evidence:
(1) Direct observation
(2) Perform recomputations, including recalculations and mathematical test
(3) Reprocess transactions from origin to final records
(4) Vouch transactions from final records back to origin
(5) Physically examine assets
(6) Perform analytical procedures
(7) Auditor analysis through reasoning and examining integrated portions of the evidence

Evidence of these procedures has strengths and weaknesses that should be considered in
determining the optimal approach for a client. The auditor looks at the relative weight of evidence
from the three basic phases of the audit, including the test controls, and considers the costs of
procedures and the persuasiveness of evidence needed for a particular account balance related
management assertion(s).

After the auditor has developed specific audit objectives in relation to the assertion for a particular account
balance or class of transactions, the next step is to select audit procedures to achieve these objectives.

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In determining which audit procedures to use to obtain evidence, the auditor must consider whether one or
more procedures will provide evidence that can reduce the risk of that assertion being misstated to an
acceptable low level. It is possible that more than one audit procedure may be required to determine the
validity of an assertion. In some cases however, an audit procedure may provide evidence about the validity
of more than one assertion.

The selection of particular procedures to achieve specific audit objectives in influenced by the following
considerations:

1. The nature and maternity of the particular component of the financial statements (account balance
or class of transaction).
2. The nature of the audit objective to be achieved.
3. The reliance that can be placed on internal control structure.
4. The relative risk of material errors or irregularities,
5. The kinds and competence of available evidence.
6. The expected efficiency and effectiveness of possible audit procedures.

Auditing standards suggest that the auditor must use professional judgment in determining the nature,
timing and extent of audit procedures appropriate in a particular situation. The procedure should satisfy the
auditor's objectives so that the evidence gathered enables the auditor to verify the assertions in the financial
statements. Thus the combination of the auditor's reliance on internal control (structure) and on selected
substantive tests should provide a reasonable basis for his opinion on the financial statements.

SUMMARY OF RELEVANT PHILIPPINE STANDARDS ON AUDITING (PSA 300 AND 330)

The Philippine Standards on Auditing require that the auditor shall conform with the following guidelines:

1. The auditor shall design and implement overall response to address the assessed risks of material
misstatement at the financial statement level.
2. The auditor shall design and perform further audit procedures whose nature timing and extent are
based on and are responsive to the assessed risks of material misstatement at the assertion level.

135
3. In designing the further audit procedures to be performed, the auditor shall:

a) Consider the reasons for the assessment given to the risk of material misstatement at the
assertion level for each class of transactions, account balance and disclosure, including:
i. The likelihood of material misstatement due to the particular characteristics of the
relevant class of transactions, account balance, or disclosure (that is, the inherent risk);
and
ii. Whether the risk assessment takes account of relevant controls (that is, the control risk),
thereby requiring the auditor to obtain audit evidence to determine whether the controls
are operating effectively (that is, the auditor intends to rely on the operating
effectiveness of controls in determining the nature, timing and extent of substantive
procedures); and
b) Obtain more persuasive audit evidence the higher the auditor's assessment of risk.

4. The auditor shall develop an audit plan that shall include a description of:
a) The nature, timing and extent of planned risk assessment procedures;
b) The nature, timing and extent of planned further audit procedures at the assertion level; and
c) Other planned audit procedures that are required to be carried out so that the engagement
complies with PSAs.

5. When designing and performing audit procedures, the auditor shall consider the relevance and
reliability of the information to be used as audit evidence.

6. When designing tests of controls and tests of details, the auditor shall determine means of
selecting items for testing that are effective in meeting the purpose of the audit procedure.

136
TESTS OF CONTROLS

1. The auditor shall design and perform tests of controls to obtain sufficient appropriate audit evidence as
to the operating effectiveness of relevant controls if:

a) The auditor's assessment of risks of material misstatement at the assertion level includes an
expectation that the controls are operating effectively (that is, the auditor intends to rely on the
operating effectiveness of controls in determining the nature, timing and extent of substantive
procedures); or
b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at the
assertion.

2. In designing and performing tests of controls, the auditor shall obtain more persuasive audit evidence
the greater the reliance the auditor places on the effectiveness of a control.

3. In designing and performing tests of controls, the auditor shall:

a) Perform other audit procedures in combination with inquiry to obtain audit evidence about the
operating effectiveness of the controls, including:
i. How the controls were applied at relevant times during the period under audit.
ii. The consistency with which they were applied.
iii. By whom or by what means they were applied.
b) Determine whether the controls to be tested depend upon other controls (indirect controls) and, if
so, whether it is necessary to obtain audit evidence supporting the effective operation of those
indirect controls.

4. If the auditor pans to rely on controls over a risk the auditor has determined to be a significant risk, the
auditor shall test those controls in the current period.

137
SUBSTANTIVE TESTS

1. Irrespective of the assessed risks of materials misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.

2. The auditor shall consider whether external confirmation procedures are to be performed as
substantive audit procedures.

3. The auditor's substantive procedures shall include the following audit procedures related to the
financial statement closing process:

a) Agreeing or reconciling the financial statements with the underlying accounting records; and
b) Examining material journal entries and other adjustments made during the course of
preparing the financial statements.

4. If the auditor has determined that an assessed risk of material misstatement at the assertion level is
a significant risk, the auditor shall perform substantive procedures that are specifically responsive
to that risk. When the approach to a significant risk consists only of substantive procedures, those
procedures shall include tests of details.

5. If substantive procedures are performed at an interim date, the auditor shall cover the remaining
period by performing:
a) Substantive procedures, combined with tests of controls for the intervening only,
b) If the auditor determines that it is sufficient, further substantive procedures only,
that provide a reasonable basis for extending the audit conclusions from the interim date to the
period end.

6. The auditor shall perform audit procedures to evaluate whether the overall presentation of the
financial statements, including the related disclosures, is in accordance with the applicable
financial reporting framework.

138
ILLUSTRATIVE COMPREHENSIVE CASE STUDY ON RISK ASSESSMENT AND RISK
RESPONSE

CASE FACTS:

Introduction

Mercury Technologies and Networks, Inc. (MTN) designs, develops, manufactures, markets, services and
supports a wide range of computer systems and networking hardware and software.

The CPA firm of Villamor & Co ., has audited the financial statements of MTN for the past three years. For
this year's audit, the staff of the firm has prepared audit planning working papers.

Read through the information for you to obtain an understanding of the nature of the information that is
important to planning an audit engagement.

The selective audit planning working papers include:

 The statement of financial position and statement of comprehensive income for the company for
20X6.
 A trial balance for December31, 20X7, with comparative amounts for 20X6.
 The analytical ratios working paper that is partially completed. (The. ratios for 20X7 have been
left off.)
 The audit plan for the audit of the financial statements for the year ended December 31, 20X7.
 A fraud risk assessment.

139
MERCURY TECHNOLOGIES AND NETWORKS INC.
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 20X6
(In P000'S)
Assets
Current Assets
Cash P 27
Trade receivables, less allowance for doubtful accounts P10 844
Accounts receivable - officers 57
Inventory 696
Prepaid expenses 40
Total current assets P 1,664
Non-current assets
Equipment and leasehold equipment, at cost
Office equipment and furniture P 281
Leasehold improvements 17
P 298
Less accumulated depreciation 125
Total fixed assets P 1,836
Total assets

Liabilities and Shareholders' Equity

Current Liabilities
Note payable P 309
Accounts payable 505
Current maturities of capital obligations 20
Accrued expenses 115
Total current liabilities P 949

Capital lease obligations, less current maturities 135

Total liabilities P 1,084

Shareholders' equity
Ordinary shares, P1 par value; 100,000 shares authorized;20,000 shares issued and
P 20
outstanding
Additional paid-in-capital 42
Retained earnings 690
Total shareholders' equity 752
Total liabilities and shareholders' equity P 1,836

140
MERCURY TECHNOLOGIES AND NETWORKS, INC.
STATEMENT OF COMPREHENSIVE INCOME AND RETAINED EARNINGS
YEAR ENDED DECEMBER 31, 20X6
(In P000's)
Net sales P 10,227
Cost of goods sold 6,867
Gross profit P 3,360
Selling expenses:
Salaries P 513
Payroll benefits and taxes 97
Advertising and promotion 82
Travel and entertainment 38
Miscellaneous 16 P 746
Operating and administration expenses:
Operating salaries P 803
Administrative salaries 438
Payroll benefits and taxes 223
Rent 124
Utilities 92
Insurance 110
Legal and accounting 73
Bad debt 34
Supplies 93
Depreciation 25
Software development 83
Miscellaneous 42
Total selling,operating and administrative expenses 2,140 P 2,886
Operating income P 474
Interest expense 69
Income before income taxes P 405
Income taxes:
Current P 71
Deferred 3 P 74

Net income 331

Retained earnings, January 1, 20X6 P 358

Retained earnings, December 31, 20X6 P 689

141
MERCURY TECHNOLOGIES AND NETWORKS, INC.
WORKING STATEMENT OF FINANCIAL POSITION
YEAR ENDED DECEMBER 31, 20X7
(In P000's)
Account # Balance 12/31/X6 Unadjusted Trial Balance Adjustment Adjusted Balance
Account name Dr Cr Dr Cr Dr Cr Dr Cr
101 Cash-First National Bank ₱27.00 ₱46.00
102 Cash in register 1 1
103 Accounts receivable- trade 853 1023
104 Accounts receivable -officers 57 84
105 Allowances for bad debts ₱10.00 ₱10.00
106 Inventories 696 903
107 Prepaid expenses 40 42
201 Furniture and fixture 35 41
202 Office equipment 245 305
203 Leasedhold improvements 17 17
204 Accumulated depreciation 125 154
211 Software development cost 58
301 Accounts payable - trade 505 586
311 Capital lease obligations-current 20 21
321 Accrued liabilities 115 130
331 Unearned service revenue 22
341 Note payable 309 365
441 Capital lease obligations - non current 135 114
501 Share capital 20 20
511 Paid-in-capital 42 41
517 Retained earnings 690 689
591 Dividends 90
₱2,610.00 ₱2,152.00
458
Prepared by Reviewed by ₱1,971.00 ₱1,971.00 ₱2,610.00 ₱2,610.00
Initial Date Initial Date

142
MERCURY TECHNOLOGIES AND NETWORKS, INC.
WORKING PROFIT AND LOSS
YEAR ENDED DECEMBER 31, 20X7
(P000's)
Account # Balance 12/31/X6 Unadjusted Trial Balance Adjustment Adjusted Balance
Account name Dr Cr Dr Cr Dr Cr Dr Cr
601 Sales of computers ₱9,044
602 Services revenue 187
603 Consulting revenue 996
701 Cost of sales ₱6,867 ₱7,397
702 Salaries - sales 513 584
703 Payroll benefits 97 125
704 Advertising & entertainment 82 93
705 Travel & entertainment 38 45
706 Miscellaneous exp. - sales 16 22
707 Salaries - operations 803 984
708 Salaries - administrative 438 596
709 Payroll benefits - admin 223 320
711 Rent 124 167
712 Utilities 92 111
721 Insurance 110 94
722 Legal & accounting 73 92
731 Bad debt expense 34 56
741 Supplies 93 120
751 Depreciation 25 29
761 Software development 83 63
771 Miscellaneous exp. - administrative 42 45
781 Internet expense 69 77
791 Current income taxes 71 122
792 Deferred income taxes 3 3
₱9,896 ₱10,227 ₱11,145 ₱11,603
801 P & L Summary 331 458
Prepared by Reviewed by ₱10,227 ₱10,227 ₱11,603 ₱11,603
Initial Date Initial Date

143
MERCURY TECHNOLOGIES AND NETWORKS, INC
ANALYTICAL REVIEW RATIOS
FOR THE YEAR ENDED DECEMBER 31, 20X7
(In P000's)

Ending Ending
Ratio Industry
12/31/X7 12/31/X6
Current ratio 1.752 1.3
Days' sales in accounts receivable, computed with
33.224 37
average accounts receivable

Allowance for doubtful accounts/ accounts receivable 0.011 -

Bad debt expense/net sales 0.003 -

Inventory turnover computed with average inventory 10.397 10

Day's inventory on hand computed with average

35.222 36
inventory

Total liabilities/ net worth 1.444 2.9

Return on total assets 0.18 0.09
Return on net work 0.441 0.29
Return on net sales 0.032 0.023
Gross profit/ net sales 0.329 0.24
Selling, operating, and administrative expense/ Net sales 0.282 0.239
Time interest earned 6.902 5.5

Prepare by Reviewed by
Initial Date Initial Date

144
Mercury Technologies and Networks, Inc.
Audit Plan
December 31, 20X7
Date
Prepared by: KC Lopez (Senior) August 14, 20X7
Reviewed by: Jo Hernandez (manager) August 28, 20X7

Audit Objective

Audit of the financial statements of Mercury Technologies and Networks, Inc. (MTN) for the year ended
December 31, 20X7. Also, the company's debt agreement with Eastern Financial Services requires the
company to furnish the lender a report by our firm on MTN's compliance with various restrictive debt
covenants.

Business and Industry Environment

MTN sells and installs microcomputers and networking hardware and software to business customers. The
company's primary competitive strategy is to maintain a high level of technical expertise and a broad range
of services. The company provides repair, maintenance, training, and software customization services.
MTN has also begun developing its own computer networking software to be sold as a product to its
customers and MTN competes with large retailers of microcomputers. The market for microcomputers and
related products is extremely competitive. The company also competed with other value-added resellers
who provide microcomputers and software products directly to customers. To effectively compete, the
company must be able to obtain inventories of state-of-the-art equipment on a timely basis. Because the
company does not have the buying power of some of its competitors, it generally must charge a higher
price for its products. Its customers are willing to pay the higher price because of the high level of expertise
and service that the company provides.

Planning Meetings

On July 20, Jo Hernandez and I met with Janelle Santos, controller, and Gian Basco, president, of MTN to
discuss the planning of the audit for the current year. On August 2, a planning meeting was held in our
office with all members of the engagement team assigned to the audit.

145
Audit Approach

The company has had no significant changes in its internal control from the prior year. Therefore, consistent
with the approach used in last year's audit, we plan to perform tests of controls to assess control risk at less
than the maximum for most financial statement assertions.

Risks

Several factors affect the risk of this engagement, including:

 As described above, MTN is in a very competitive business that is sensitive to economic conditions

 MTN is a closely held company owned by five shareholders, Miguel Lee, Patrick Lee, Francis Lee,
Rain Young, and JC Young. Miguel and Patrick are active members of the company's board of
directors. None of the other owners take an active part in management of the business.

 Audited financial statements are required by Bank of the Philippine Islands as a part of the
company's line of credit agreement.

 The officers receive significant bonuses based on quarterly results. (see P10 for implications of this
risk)

These factors indicate that the engagement to audit MTN has high risk.

Significant Accounting and Auditing Matters

The company began offering for sale extended warranties on computers during the current year. We need to
review the method of revenue recognition to determine whether it complies with the requirements of PAS
18, Revenue.

In the prior year, MTN began developing networking software products for sale. This year the company has
started capitalizing certain costs of development. We need to review the method of accounting for the cost of
software development to determine whether it complies with the requirements of PAS 38,Intangibles.

Planning Materiality

Because the firm has experienced steady growth in sales and earnings over the last three years, we believe
that operating results are the most appropriate basis for estimating planning materiality as described on the
next page:

146
Comparison of Bases Computation of Planning Materiality
Financial Annualized for Materiality
Base Amount Percentage
Statement Base 12/31/X7 Estimate
Sales P11,000,000 Sales P11,000,000 1% P110,000.00
Total assets 2,000,000 Total assets 2,000,000.00 1 20,000.00
Pretax net income 525,000 Pretax net income 525,000.00 10 52,500.00

The range for planning materiality is from P20,000 to P110,000. Based on the company's steady growth in
sales and earnings and the fact that the company is not a public company, we have selected P70,000 as a
reasonable materiality amount for planning purposes.

Scheduling and Staffing Plan

Based on discussions with Ms. Santos, the following are tentative dates of importance for the audit:

Begin interim audit work November 10, 20X7

Complete interim audit work By November 15, 20X7
Issue management letter on interim work By November 30, 20X7
Observe physical inventory December 31, 20X7
Begin year-end audit work February 12, 20X8
Complete fieldwork By February 20, 20X8
Closing conference February 25, 20X8
Issue audit report By March 5, 20X8

Issue letter required by financing agreement By March 5, 20X8

Issued updated management letter By March 10, 20X8

Staffing time requirements for the engagement are described below:

Assistant Senior Manager Partner Total

Interim 40 40 10 10 100
Final 40 30 10 10 90
80 70 20 20 190

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Fraud Risk Assessment
8.14.X7

Client: Mercury Technologies and Networks, Inc.

Financial Statement Date: 12/31/X7

Procedure Performed by Comments

1. Consider the results of the discussion among engagement See WP-21 for the
personnel about the risk of material misstatement due to agenda.
fraud.
EH
2. Consider results of inquiries of management about the
risks of fraud and how they are addressed.
EH
3. Consider the results of planning analytical procedures
EH
4. Consider the existence of fraud risk factors listed on
WP-30 through WP-35
EH
5. Consider any other information that might be relevant to
the risk of material misstatement due to fraud
EH
Risk of Material Misstatement Due to Fraud

Management may be motivated to misstate financial results

due to performance bonuses. Specifically, management may
attempt to
1. Provide inappropriate incentives to sign sales contracts
near quarter- and year-end
2. Overstate revenue at quarter-end and year-end.
3. Overstate inventories, quantities, or pricing.
Overall Responses
Risks were considered in staffing the engagement and
determining the appropriate level of supervision

Alterations of the Nature, Timing, and Extent of

Procedures
Risks were considered in designing audit procedures for sales
and accounts receivable and inventories

Procedures were performed to address the risk of

management override of internal controls. (See
WP-23-WP-24).
WP-10

148
REQUIREMENTS

1. The audit plan for the audit of Mercury Technologies and Networks, Inc, appears on pages 118
through 126. Review each major section of the audit plan and briefly describe the purpose and
content of the section.

Organize your presentation in the following manner:

Section Purpose Content

Objectives of the To describe the services that are to The objectives are (1) audit of MTN's
Engagement be rendered to the client financial statements for the year ended
12/31/X7 and (2) issuance of a letter on
compliance with covenants of the client's
letter of credit agreement.

Business and Industry

Conditions

2. In the audit plan for the audit of Mercury Technologies and Networks, Inc., there is a section on
significant accounting and auditing matters. The first of the matters described in this section
involves the appropriate accounting for the sale r extended warranty contracts. Research this
accounting issue and write a brief memorandum for the working papers describing the issue
and summarizing the appropriate method of accounting for the revenue received from these
contracts.

3. In the audit for the audit of Mercury Technologies and Networks, Inc., there is a section on
significant accounting and auditing matters. The second matter described involves capitalizing
the costs of developing a software program for sale.

Required:

a. Research this issue and write a brief memorandum for the working
papers describing the issue and summarizing the appropriate method of
accounting for the development costs.

b. Based on your research, describe the major audit issue that you believe
will be involved in auditing the software development costs.

149
4. A partially completed analytical ratios working paper for Mercury Technologies and Networks, Inc., is
presented on page 122.

Required:

a. Complete the working paper by computing the financial ratios for 20X7.

b. After completing part (a), review the ratios and identify financial statement accounts that should
be investigated because there ratios are not comparable to priorytear ratios and industry ages.

c. For each account identified in part (b). list potential reasons for the unexpected account balances
and related ratios.

CASE ANALYSIS

Requirement (1) Analysis of Audit Plan for MTN

Section Purpose Content

OBJECTIVES OF THE To describe the services that The objectives are (1) audit of MTN's
ENGAGEMENT are to be rendered to the financial statements for the year Ended
client 12/31/X0 and (2) issuance of a letter on
compliance with covenants of the clients
letter of credit agreement

BUSINESS AND To describe the nature of MTN sells and services micro-computers
INDUSTRY MTN's business and industry networking hardware and software to
CONDITIONS business customers. The industry is
sensitive at economic conditions and
competitive with MTN competing with
companies much larger than itself.
PLANNING MEETINGS To indicate meetings held At this point, one meeting has been held
with client and with CPA with client personnel and one with the
engagement team. engagement team

150
Section Purpose Content
AUDIT APPROACH To describe the overall approach Consistent with the previous
to be taken on the audit. year's audit, the CPAs will plan to
perform tests of controls to assess
control risk at less than the
maximum for most assertions
RISK To describe factors affecting the The engagement has high risk.
risk of the engagement. The primary risk factors are: (1)
management domination by a few
individuals, (2) existence of a line
of credit agreement, and (3) the
owners have entered into an
agreement to sell the business and
the audited financial results will
significantly affect the sales price.
This last risk results in a fraud
risk.
SIGNIFICANT ACCOUNTING To describe particular accounting Two particular concerns exist: (1)
AND AUDITING MATTERS and auditing matters of concern. proper accountin for extended
warranties and (2) capitalization
of software costs.
PLANNING MATERIALITY To identify an amount to be used Based on an analysis of sales,
as a measure for planning total assets, and pretax net
materiality income, an amount of P70,000
will be used as a measure of
planning materiality.
SCHEDULING AND To provide the schedule for major The section includes major dates
STAFFING PLAN portions of the audit, and the beginning with interim audit work
staffing requirements for the through the issuance of an
engagement. updated management letter. A
total of 118 hours are budgeted
for the audit.

151
Requirement (2) Research made on MTN Extended Warranty Contracts

MERCURY TECHNOLOGIES & NETWORKS, INC.

December 31, 20X7

Memorandum on Accounting Issues-Accounting for Extended Warranties

MTN began offering extended warranties on computers during the current year. We must determine that
both revenues and expenses relating to these warranties are property accounted for. PAS 18, Revenue
and PAS 37, Provisions, Contingent Liabilities and Contingent Assets, provide guidance in this area
both for accrual of revenue and amortization of costs.

The Philippine Accounting Standards require that revenue from extended warranties be deferred and
recognized in income on a straight-line basis over the contract period except when sufficient historical
evidence indicates that the costs of performing services under the contract are incurred on other than a
straight-line basis. In those circumstances revenue should be recognized over the contract period in
proportion to the costs expected to be incurred in performing the services. Because the company has no
historical experience with these warranties, revenue should be deferred and recognized on a straight-line
basis.

The costs related to extended warranties include those directly related to acquisition of the warranty and
other costs. Costs directly related to the acquisition of a warranty contract that would not have been
incurred but for the acquisition of the contract should be deferred and charged to expense in proportion
to the revenue recognized. All other costs (e.g., costs of services performed, general and administrative,
advertising expenses) should be charged to expense as incurred.

In circumstances in which the sum of expected costs of providing services and unamortized acquisition
costs exceed unearned revenue a different approach is appropriate-a loss should be recognized first by
charging any unamortized acquisition costs to expense. If the loss is greater than the unamortized costs,
a liability should be recognized for the excess amount of costs.

KC Lopez
(September 30, 20X7),

152
Requirement (3) Research made on Capitalization of Software Development Costs
(a)

MERCURY TECHNOLOGIES & NETWORKS, INC.

December 31, 20X7

Memorandum on Accounting Issues-Capitalization of Software Development Costs

In 20X6, MTN began developing networking software product for sale. This year the company has
started capitalizing certain costs of development. PAS 38, Intangibles, provides guidance in this area.
PAS 38 makes clear that the nature of the activity for which the software is being developed should be
considered in determining whether software costs should be included or excluded in research and
development. PAS 38 indicates that to the extent that the acquisition, development, or improvement of a
process by an enterprise for use in its selling or administrative activities includes costs for computer
software, those costs are not research and development costs. Examples of such costs include
development of a general management information system and the computerized reservation system of
an airline. This does not appear to be the type of costs involved in this situation.

PAS 38 further clarifies the issue by stating that all costs incurred to establish the technological
feasibility of a computer software product to be sold, leased or otherwise marketed are research and
development costs. The technological feasibility of a product is established when the enterprise has
completed all planning, designing, coding, and testing activities that are necessary to establish that
the product can be produced to meet its design specifications including functions, features, and
technological performance requirements. PAS 38 provides a summary of tests to indicate whether
technological feasibility has been established.

Costs incurred subsequent to establishing technological feasibility are to be capitalized. The

capitalization of computer software costs ceases when the product is available for general release to
customers. Costs of maintenance and customer support should be charged to expense when related
revenue is recognized or when the costs are incurred, whichever occurs first.

KC Lopez
(October 15, 20X7)

153
b) The major audit issue involved will be determining that the client has properly involved categorized in
establishing costs technological between research feasibility) and and development those costs (those
that should costs be capitalized. The auditors will have to determine at what point the software product
reached the point of technological feasibility.

Requirement (4) MTN Ratio Analysis

Mercury Technologies & Networks, Inc.

Analytical Review Ratios
For the Report Ended December 31, 20X7

12/31/X7 12/31/X7 Industry

Current Ratio 1.858 1.752 1.300
Days’ Sales in Accounts Receivable
Computed with Average
Accounts Receivable 29.524 33.224 37.000
Allowance for Doubtful Accounts/ Accounts 0.010 0.011
_____
Receivable
Bad Debt Expense / Net sales 0.005 0.003 _____
Inventory Turnover computed with average
Inventory 9.255 10.397 10.000
Day's Inventory on Hand, Computed with
Average Inventory 39.436 35.222 36.000
Total Liabilities to Net Worth 1.107 1.444 2.900
Return on Total Asset 0.194 0.180 0.090
Return on Net Worth 0.409 0.441 0.290
Return on Net Sales 0.040 0.032 0.023
Gross Profit/ Net Sales 0.362 0.329 0.240
Selling, Operating and Administrative
Expense 0.305 0.282 0.239
Times Interest Earned 8.541 6.902 5.500

154
Supporting Computations for 20X7 ratios (P000's)

Current Ratio Current Assets / Current Liabilities

P2,091/P1,126 - 1.858
Days Sales in A/R Computed with Sales per day = Sales/365
Average A/R = P11,6027365 = 32
Average AIR = (Beg. A/R + End A/R)/2
= (P853 + P1,023) / 2 = p938
Days sales = Average A/R/Sales per day
Allowance for Bad Debt/A/R P10/P 1,023 = .010
Bad Debts Expense / Net Sales P56/P11,602 -=005
Inventory Turnover Computed with Average Inv. = (Beg. Inv. + End Inv)/2
Average Inventory =(P695+904)/2=P799
Inv. Turnover = Cost of Goods Sold / Ave. Inv.
= P7,397 / P799 = 9.255
Days Inventory Computed with CGS per day = Cost of Goods Sold/365
Average Inventory P7,397 / 365 = P20
Days Inv. = Average Inv./CGS per day
=P799/P20=39.436
Total Liabilities to Net worth Total Liabilities / Shareholders' Equity
P1,240/P1,120 = 1.107
Return on Total Assets Net Income / Total Assets
P458 / P2,360 = 194
Return on Net Worth Net Income / Shareholders' Equity
P458 / 1,120 = 409
Return on Net Sales Net Income / Net Sales
P458 / P11,602 = .040
Gross Profit / Net Sales Gross Profit/Net Sales
P4,205/P11,602 = .362
Selling, Operating and Admin. Selling, Operating and Admin. Exp. / Net Sales
Expense/ Net Sales P3,5447 P11,602 = 305
Times Interest Eamed Operating Income / Interest Expense
P661/P77 = 8.541

155
(b) and (c) This part of the case reveals how difficult ratio analysis is when there are no major
changes in ratios. However, the following might be considered in comparing the current year's
ratios with those of lay year's.

Days Sales in Accounts Receivable

 Changes in credit policy

 Better economic conditions

 Change in customer mix

 Overstatement of sales

 Understatement of receivables

Inventory Turnover
 Change in inventory policy

 Inventory obsolescence

 Overstatement of inventory

 Understatement of purchases

Days Inventory on Hand

 Change in inventory policy

 Inventory obsolescence

 Overstatement of inventory

 Understatement of purchases

Gross Profit / Net Sales

 Change in sales mix

 Increase in sales pricing

 Reduction of costs

 Understatement of cost of goods sold and related overstatement of inventory

A number of the other ratios show significant changes which seem due primarily the increased level of
profitability.

156
REVIEW QUESTIONS AND EXERCISES

Questions

1. What are examples of how an auditor might change (a) the nature of risk response, (b) the
timing of risk response, and (c) the extent of risk response?

2. How can an auditor introduce unpredictability audit procedures?

3. What audit procedures can be completed only at or after period end?

4. What are the five types of tests auditors use to determine whether financial statements are
fairly stated? Identify which tests are performed to reduce control risk and which tests are
performed to reduce planned detection risk.

5. What is the purpose of tests of controls? Identify specific accounts on the financial
statements that are affected by performing tests of controls for the acquisition and payment
cycle.

6. Distinguish between a test of control and a substantive test of transactions. Give two
examples of each.

7. A considerable portion of the tests of controls and substantive tests of transactions are
performed simultaneously as a matter of audit convenience. But the substantive tests of
transactions procedures and sample size, in part, depend on the results of the tests controls.
How can the auditor resolve this apparent inconsistency?

8. Distinguish between substantive tests of transactions and tests of details of balances. Give
one example of each for the acquisition and payment cycle.

9. Assume that the client's internal controls over the recording and classifying of fixed asset
additions are considered weak because the individual responsible for recording new
acquisitions has inadequate technical training and limited experience in accounting. How
would this situation affect the evidence you should accumulate in auditing fixed assets as
compared with another audit in which the controls are excellent? Be as specific as possible.

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10. The following are three decision factors related to assessed control risk effectiveness of
internal controls, cost-effectiveness of a reduced assessed control risk, and results of tests of
controls. Identify the combination of conditions for these three factors that is required before
reduced substantive testing is permitted.

11. Why is it desirable to design tests of details of balances before performing tests of controls
and substantive tests of transactions? State the assumptions that the auditor must make in
doing that. What does the auditor do if the assumptions are wrong?

Multiple Choice Questions

Questions No. 1 through 4 deals with tests of controls. Choose the best response.

1. Which of the following statements about tests of controls is most accurate?

a. Auditing procedures cannot concurrently provide both evidence of the effectiveness of
internal control procedures and evidence required for substantive tests.
b. Tests of controls include observations of the proper segregation of the duties.
c. Tests of controls provide direct evidence about monetary misstatements in transactions.
d. Tests of controls ordinarily should be performed as of the statement of financial position date
or during the period subsequent to that date.

2. Which of the following would be least likely to be included in an auditor's tests of controls?
a. Documentation c. Inquiry
b. Observation d. Confirmation

3. The two phases of the auditor's involvement with internal control are sometimes called
"understanding and assessment" and "tests of controls".
In the tests of controls phase, the auditor attempts to obtain:
a. A reasonable degree of assurance that the client's internal controls are operating effectively
on a consistent basis throughout the year.
b. Sufficient, competent evidential matter to afford a reasonable basis for the auditor's opinion.

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c. Assurances that informative disclosures in the financial statements are reasonably adequate.
d. Knowledge and understanding of the client's prescribed procedures and methods.

4. Which of the following is ordinarily considered a test of control audit procedure?

a. Send confirmation letters to banks.
b. Count and list cash on hand.
c. Examine signatures on check.
d. Prepare reconciliations of bank accounts as of the statement of financial position date.

Questions No. 5 through 7 concern types of audit tests. Choose the best response.

5. Analytical procedures may be classified as being primarily

a. Tests of controls. c. Tests of ratios.
b. Substantive test. d. Tests of details of balances.

6. To support the auditor's initial assessment of control risk below maximum, the auditor performs
procedures to determine that internal controls are operating effectively. Which of the following
audit procedures is the auditor performing
a. Tests of details of balances.
b. Substantive test of transactions.
c. Tests of controls.
d. Tests of trends and ratios.

7. The auditor faces risk that the audit will not detect material misstatements that occur in the
accounting process. To minimize this risk, the auditor relies primarily on
a. Substantive test.
b. Tests of controls.
c. Internal control.
d. Statistical analysis.

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Questions No. 8 and 9 concern the sequence and timing of audit tests choose the best response.

8. A conceptually logical approach to the auditor's evaluation of internal control consists of the
following four steps:
A. Determine the internal controls that should prevent or detect errors and fraud.
I. Identify weaknesses to determine their effect on the nature, timing, or extent of auditing
procedures to be applied and suggestions to be made to the client.
II. Determine whether the necessary procedures are prescribed and are being followed
satisfactorily.
III. Consider the types of errors and fraud that could occur.

What should be the order in which these four steps are performed?
a. I, II, III, and IV.
b. I, III, IV, and II.
c. .III, IV, I, and II.
d. IV, I, III, and II.

9. The sequence of steps in gathering evidence as the basis of the auditor's opinion is:
a. Substantive tests, initial assessment of control risk, and test of controls.
b. Initial assessment of control risk, substantive tests, and tests of controls.
c. Initial assessment of control risk, tests of controls, and substantive tests.
d. Tests of controls, initial assessment of control risk, and substantive tests.

10. Which of the following statements is true regarding the concept of materiality?
a. Materiality is the magnitude of an omission or misstatement of accounting information that,
in light of surrounding circumstances, makes it probable that the judgment of a reasonable
person relying on the information would have been changed or influenced by the omission or
misstatement.
b. Materiality is the magnitude of an omission or misstatement, of accounting information that,
in light of surrounding circumstances, makes it possible that the judgment of a reasonable
person relying on

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the information would have been changed or influenced by the omission or misstatement
c. A fact is material if there is a substantial likelihood that the fact would have been viewed by
the reasonable investor as having significantly altered the total mix of information made
available.
d. Both (a) and (c) are correct.

11. Which of the following statements is true concerning the concept of performance materiality?
a. Performance materiality is set less than overall materiality and helps the auditor determine
the extent of audit evidence.
b. If performance materiality is set too low, the auditor might not perform sufficient procedures
to detect material misstatements in the financial statements.
c. If performance materiality is set too high, the auditor might perform more substantive
procedures than necessary.
d. Performance materiality is essentially the same posting materiality.

12. Which of the following statements represent the appropriate directional relationships between the
concepts of inherent risk, control risk, audit risk, and detection risk?
a. As inherent risk goes up, audit risk goes up.
b. As inherent risk goes up, audit risk goes down.
c. As control risk goes up, detection risk goes up.
d. As control risk goes up, inherent risk goes down.

13. Which of the following statements is true regarding the concept of control risk?
a. When control risk is high, the auditor is concerned that a misstatement may not be prevented,
or that is a misstatement exists in the organization's financial statements that it will not be
detected, and therefore corrected by management.
b. Some organizations have zero control risk because they have made a significant commitment
to the effective design and operation of controls.
c. Control risk relates to the susceptibility of an assertion to a misstatement, due to either error
or fraud, before consideration of any related controls.
d. All of the above are true.

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14. Which of the following statements is true regarding analytical techniques?
a. Ratio analysis takes advantage of economic relationships between two or more accounts.
b. Ratio and trend analysis are generally carried out through a comparison of client data with
expectations based on industry data, prior- period data, and expectations developed from
industry trends client budgets, and so on.
c. Developing expectations is the first step in performing analytical procedures.
d. All of the above are true.

15. Which of the following statements is false regarding brainstorming?

a. Brainstorming is a group discussion designed to encourage auditors to creatively assess
client risks, particularly those relevant to the possible existence of fraud in an organization.
b. Brainstorming predominantly occurs during the early planning phases of the audit.
c. To facilitate the generation and evaluation of quality ideas during the brainstorming session,
a typical practice during brainstorming is to invite criticism and value judgments about ideas
generated.
d. Participants are encouraged to provide more ideas rather than fewer. with the intent to
generate a variety of possible risk assessment scenarios that can be explored during the
conduct of the audit.

16. Which of the following statements is false regarding the nature, timing, and extent of risk
responses?
a. The nature of risk response refers to the types of audit procedures applied given the nature of
the account balance and the most relevant assertions regarding that account balance.
b. The timing of risk response refers to when audit procedures are conducted and whether those
procedures are conducted at announced or predictable times.
c. When the risk of material misstatement is low,the auditor conducts the audit procedures
closer to year end, on an unannounced basis, and includes some element of unpredictability
in the timing of procedures.
d. The extent of risk response refers to the sufficiency of evidence that is necessary given the
client's assessed risks, materiality, and the acceptable level of audit risk.

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Exercises

Exercise 1

For each of the following controls, identify whether the control leaves an audit trail. Also identify
a test of control audit procedure the auditor can use to test the effectiveness of the control.

a. An accounting clerk accounts for all shipping documents on a monthly basis and initials the
monthly shipping log.
b. Bank reconciliations are prepared by the controller, who does not have access to cash
receipts.
c. As employees check in daily by using time clocks, a supervisor observes to make certain that
no individual "punches in" more than one time card.
d. Vendors' invoices are approved by the controller after she examines the purchase order and
receiving report attached to each invoice.
e. The cashier, who has no access to accounting records, prepares the deposit slip and delivers
the deposit directly to the daily.
f. An accounting clerk verifies the price, extensions, and footing of all sales invoices in excess
of P300 and initials the duplicate sales invoice when he has completed the procedure.
g. All mail is opened and cash is prelisted daily by the president's secretary, who has no other
responsibility for handling assets or recording accounting data

Exercise 2

Maria Cabrera, CPA, follows the philosophy of performing interim tests of controls and substantive
tests of transactions on every December 31 audit as a means of keeping overtime to a minimum.
Typically, the interim tests are performed some time between August and November.

Required:

a. Evaluate her decisions to perform interim tests of controls and substantive tests of
transactions.
b. Under what circumstances is it acceptable for her to perform no additional tests of controls
and substantive tests of transactions work as a part of the year-end audit tests?
c. If she decides to perform no additional testing, what is the effect on other tests she performs
during the remainder of the engagement?

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Exercise 3

Following are several decisions that the auditor must make in an audit Letters indicate alternative
conclusions that could be made:

Decision Alternative Conclusions

1. Determine whether it is cost-effective to A. It is cost -effective
perform test of controls. B. It is not cost-effective
2. Perform substantive test of details of C. Perform reduced test
balances D. Perform expended test
3. Complete initial assessment of control risk E. Controls are effective
F. Controls are ineffective
4. Perform test of controls
G. Controls are effective
H. Controls are ineffective

Required:

a. Identify the sequence in which the auditor should make decisions 1-4 above.

b. For the auditor of the sales and collection cycle and accounts receivable, an auditor reached the
following conclusions: A,D,E,H.Put the letters in the appropriate sequence and evaluate whether
the auditor's logic was reasonable. Explain your answer.

c. For the audit of inventory and related inventory cost records, an auditor reached the following
conclusions: B, C, E, G. Put the letters in the appropriate sequence and evaluate whether the
auditor used good professional judgment. Explain your answer.

d. For the audit of property, plant, and equipment and related acquisition records, an auditor reached
the following conclusions: A, C, F, G. Put the letters in the appropriate sequence and evaluate
whether the auditor used good professional judgment. Explain your answer.

e. For the audit of payroll expenses and related liabilities, an auditor recorded the following
conclusions: D, F. Put the letters in the appropriate sequence and evaluate whether the auditor
used good professional judgment. Explain your answer.

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Exercise 4

Hazel Jess, a new staff auditor, is confused by the inconsistency of the three audit partners she has been
assigned to on her first three audit engagements. On the first engagement, she spent a considerable
amount of time in the audit of cash disbursements by examining canceled checks and supporting
documentations, but almost no testing was spent in the verification of fixed assets. On the second
engagement, a different partner had her do less intensive tests in the cash disbursements area and take
smaller sample sizes than in the first audit, even though the company was much larger. On her most
recent engagement under a third audit partner, there was a thorough test of cash disbursement
transactions, far beyond that of the other two audits, and an extensive verification of fixed assets. In
fact, this partner insisted on a complete physical examination of all fixed assets recorded on the books.
The total audit time on the most recent audit was longer than that of either of the first two audits
despite the smaller size of the company. Hazel's conclusion is that the amount of evidence to
accumulate depends on the audit partner in charge of the engagement.

REQUIRED:

a. State several factors that could explain the difference in the amount of evidence accumulated in
each of the three audit engagements as well as the total time spent.

b. What could the audit partners have done to help Hazel understand the difference in the audit
emphasis on the three audits?

c. Explain how these three audits are useful in developing Hazel's professional judgment. How
could the quality of her judgment have been improved on the audits?

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Exercise 5

The following are three situations in which the auditor is required to develop an audit strategy:

1. The client has inventory at approximately 50 locations in the Philippines. The inventory is
difficult to count and can be observed only by traveling by automobile. The internal controls over
acquisitions, cash disbursements, and perpetual records are considered effective. This is the fifth
year that you have done the audit, and audit results in past years have always been excellent. The
client is in excellent financial condition and is privately held.

2. This is the first year of an audit of a medium-sized company that is considering selling its
business because of severe underfinancing. A review of the acquisition and payment cycle
indicates that controls over cash disbursements are excellent, but controls over acquisitions
cannot be considered effective. The client lacks receiving reports and a policy as to the proper
timing to record acquisitions. When you review the general ledger, you observe that there are
many large adjusting entries to correct accounts payable.

3. You are doing the audit of a small loan company with extensive receivables from
customers. Controls over granting loans, collections, and loans outstanding are
considered effective, and there is extensive follow-up of all outstanding loans weekly.
You have recommended a computer system for the past 2 years, but management
believes the cost is too great, given their low profitability. Collections are an ongoing
problem because many of the customers have severe financial problems. Because of
adverse economic conditions, loans receivable have significantly increased and
collections are less than normal. In previous years, you have had relatively few adjusting
entries.

REQUIRED:
a. For audit 1, recommend an evidence mix for the five types of tests for the audit of
inventory and cost of goods sold. Justify your answer. Include in your recommendations
both tests of controls and substantive tests.
b. For audit 2, recommend an evidence mix for the audit for the acquisition and payment
cycle, including accounts payable. Justify your answer.
c. For audit 3, recommend and evidence mix for the audit of outstanding loans. Justify your
answer.

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Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE REVENUE
AND COLLECTION CYCLE

Expected Learning Outcomes

After studying this chapter, you should be able to

1. Enumerate and describe the steps involved in auditing the revenue and
collection cycle.
2. Describe the nature and the major classes of transactions in the revenue
and collection cycle.
3. Explain the process of analyzing and recording sales, sales adjustments
and cash receipts transactions and the corresponding documents and
records used.
4. Apply the risk assessment and risk response phases of the respective
audit process, test of controls and substantive tests of transactions to
sales, sales adjustments and cash receipts.

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CHAPTER 6
AUDIT OF THE REVENUE AND
COLLECTION CYCLE

INTRODUCTION

This chapter begins with an explanation of the revenue collection cycle and the internal control
environment and objectives pertaining thereto. Then, consideration is given to compliance tests of
controls and substantive tests over revenue and cash receipts transactions.

In performing the audit of the revenue and collection cycle, the auditor should be able to:

1. Identify the activities and types of transaction that occur in a company's revenue cycle;

2. Relate the effect of controls on the assertions embodied in the financial statements, sales
adjustments, and cash receipts transactions;

3. Determine the essential features of internal control over the transactions in the revenue and
collection cycle;

4. Prepare and perform the audit procedures for compliance tests of controls over these
transactions; and

5. After evaluating the effectiveness and of internal control, perform substantive tests of
transactions to meet transaction-related audit objectives for revenue and collection cycle.
these tests of transactions are not directly related to the key controls but their extent depends
in part, on which key controls exists and on the results of the tests of controls.

6. Design tests of details of accounts affected by the revenue and collection cycle and analytical
procedures to satisfy balance-related audit objectives.

Steps 1 to 5 are discussed in this chapter while Step number 6 is addressed in Chapters 11 and.12.

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NATURE OF THE REVENUE AND COLLECTION CYCLE

Basic Considerations

The revenue and collection cycle involves the process of receiving a customer's order, approving
credit for a sale, determining whether the goods are available for shipment, shipping the good, billing
the customer, collecting cash, and recognizing the effect of this process on other related accounts such
as accounts receivable, inventory, and sales commission expense.

In the revenue cycle, the most significant accounts include revenue and accounts receivable. The
auditor will likely obtain evidence related to each of the financial statement assertion discussed in this
Chapter for both accounts. However, for specific accounts and specific clients, some assertions are
more relevant than other assertions. For many clients, the existence assertion related to revenue may
be one of the more relevant assertions, especially if the client has incentives to overstate revenues. For
accounts receivable, the more relevant assertions are usually existence and valuation.

The revenue and collection cycle of an entity consists of the activeness relating to the exchange of
goods and services with customers and the collection of the revenue in cash. Different entities may
have different sources of revenue. The discussions and illustrations in this chapter are based on a
merchandising company. However, much of the commentary can easily be adapted to the other types
of entities.

Generally, the classes of transactions in the revenue and collection cycle involve:

A. Sales (cash and credit);

B. Sales adjustments (discounts, returns and allowances and uncollectible accounts provisions
and write-offs); and

C. Cash receipts (collections on accounts and cash sales).

D. Estimate of bad debt expense.

E. Charge-off of uncollectible accounts.

Figure 6-1 also shows that with the exception of cash sales, every transaction and amount ultimately is
included in one if two balance sheet accounts, accounts receivable or allowance for uncollectible
accounts. For simplicity, assume that the same internal controls exist for both cash and credit sales.

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PROCESSING REVENUE TRANSACTIONS

Processing Revenue Transactions

The revenue process may vary from client to client and each client may have more than one revenue
process. For example, a sales transaction for a shirt in a department store differs from a sale of
construction equipment, and both of these differ from a book sale on an Internet site. The Internet sale
and the retail sale most likely require cash or credit card for payment. The construction equipment sale
most likely involves an account receivable, or a loan may be arranged with a third party. Some sales
transactions involve long-term contractual arrangements that effect when and how revenue will be
recorded. Some organizations generate detailed paper trails for sales documentation; others maintain
an audit trail only in computerized form. Not-withstanding these differences, most sales transactions
include the procedures and related documents shown in Figure 6-1.

Accounts typically affected by the revenue and collection cycle are:

1. Sales

2. Sales returns and allowances

3. Sales discounts

4. Cash in bank

5. Accounts and notes payable-trade

6. Bad debts expense

7. Allowance for doubtful account

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REVENUE AND COLLECTION CYCLE ACCOUNTS
Accounts typically affected by Sales Transactions are shown in the Figure 6-1 Below
Figure 6-1 : Accounts typically affected by Sales Transaction
Directly Related Accounts
Cash
Beginning Balance Disbursement
Cash Sales
Collections
Other Receipts
Sales Ending Balance
Cash Sales
Credit Sales
Accounts Receivable Sales Discounts
Beginning Balance Collections Sales Discounts
Credit Sales Sales Discounts
Returns and Allowances
A/R Subdiary Ledger Write-offs Sales Returns and Allowanes
Customer A Ending Balance return and Allowance
Customer B
Customer C
etc Allowance for Doubtful Accounts Bad Debt Expenses
Total Write osff Beginning Balance Provision
Provision
Ending Balance

Indirect Related Accounts

Warranty Expense Allowance for Doutful Accounting Sales Commision Expense
% of Soul Written Off Est Expense % of Sales
(1%) Sole

Key: Transaction Flow

Balances shouls agree
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Documents Used in the Revenue and Collection Cycle and their Audit Significance

Several important documents and records are typically used in the revenue and collection cycle.

Documents Audit Significance

Customer's purchase order

A request for merchandise by a customer. A written purchase order from a

It may be received by telephone, letter, a customer provides evidence that a
printed form that has been sent to customer actually ordered the goods.
prospective and existing customers, Purchase order numbers are generally
through salespeople, or in other ways. recorded on sales invoices so that an
auditor can determine the purchase order
to which an invoice relates. Sellers
generally maintain a file of each
customer's purchase orders.

Sales order
A prenumbered document for recording A sales order contains the seller's
the description, quantity, and related understanding of the sales terms. A seller
information for goods ordered by a should account for the numerical
customer. This is frequently used to show sequence to help ensure that shipments
credit approval and authorization for are made for sales orders and that all
shipment. sales are billed.

Shipping document or Bill of lading

A prenumbered document prepared to This signature of the carrier or the
initiate shipment of the goods, indicating customer on the shipping document
the description of the merchandise, the provides externally crated evidence that
quantity shipped, and other relevant data. goods have been shipped. Sellers should
account for the numerical sequence to
help ensure that all shipments are
recorded as sales.

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Sales invoice
A prenumbered document indicating the A salesinvoice indicates credit terms,
description and quantity of goods sold, the shipping terms, and price charged for
price including freight, insurance, terms, merchandise. Sellers should account for
and other relevant data. the numerical sequence to help ensure
that all sales are recorded.

Credit memo
A prenumbered document indicating a A credit memo provides evidence that a
reduction in the amount due from a seller has reduced the amount previously
customer because of returned goods or an billed to a customer. Sellers should
allowance granted. It often takes the same account for the numerical sequence to
general form as a sales invoice, but it help ensure that all credit memos are
supports reductions in accounts receivable recorded.
rather than increases.

Remittance advice
A document that a customer attaches to a A remittance advice usually indicates the
check in payment of an invoice. The date and amount of payment and the
document may be a turnaround document, invoices paid. Sellers generally file
a part of a check, or statement identifying remittance advices by date.
the invoices being paid. Remittance
advices facilitate recording cash receipts.
Is a customer does not return a remittance
advice, the employee opening the mail
generally prepares one.

Uncollectible account authorization form

A prenumbered document used internally, Sellers should account for the numerical
indicating authority to write an account sequence to ensure that all written-offs
receivable off as uncollectible. are recorded.

Monthly statement
A document sent to each customer A statement mailed to a customer
indicating the beginning balance of reporting a beginning balance and
accounts receivable, the amount and date transactions that occurred during the
of each sale, cash payments received, period. if the statement is inaccurate,
credit memos issued, and ending balance many customer would contract the seller.
due.

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Accounting Records in the Revenue and Collection Cycle

Sales journal

A journal for recording sales transactions. A detailed sales journal includes each sales transaction. It
usually indicates gross sales for different classifications, such as product lines, the entry to accounts
receivable, and miscellaneous debits and credits. The sales journal can also include sales returns and
allowances transactions.

Sales returns and allowance journal

A journal similar to the sales journal except the merchandisers use it to record returns of merchandise
or adjustments to invoice prices.

Cash receipts journal

A journal for recording cash receipts from collection, cash sales, and all other cash receipts.

General journal

A journal in which are recorded all transactions for which a special journal has not been created. Sales
and collections cycle transactions frequently recorded in the general journal include entries to estimate
uncollectible accounts expense and entries to estimate uncollectible accounts expense and entries to
write off accounts identified as uncollectible.

Accounts receivable master file / subsidiary ledger

A file recording individual sales, cash receipts, and sales return allowances for each customer and
maintaining customer account balances.

Accounts receivable trial balance

A listing of the amount owed by each customer at a point in time. This is prepared directly from the
accounts receivable master file.

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AUDITING THE REVENUE AND COLLECTION CYCLE

PHASE I - RISK ASSESSMENT

I. PERFORMING RISK ASSESSMENT PROCEDURES IN THE REVENUE AND

COLLECTION CYCLE

The auditor obtains information that is useful in assessing the risk of material misstatement. This
includes information about
(a) Inherent risks at the financial statement level (e.g ., client's business and operational risks

(b) Fraud risks (e.g ., feedback on strengths and weakness in internal control; results from
preliminary analytical procedures.

Once the risks of material misstatement have been identified, the auditor then determined how be
best to respond to them as part of the audit opinion formation process.

Identifying Inherent Risks

Revenues: Identifying Inherent Risks

An important inherent risk related to revenue transactions is the timing of revenue recognition.
Revenue may only be recognized when it is realized or is realizable and earned. Through these
concepts seem simple, they are often difficult to apply in practice. Further, complex sales transactions
often make it difficult to determine when a sale has actually taken place. For example, a transaction
might be structured so that title passes only when some contingent situations are met, or the customer
may have an extended period to return the goods.

To audit the revenue cycle, the auditor must understand the following:

 The organization's principal business

 The earnings process and the nature of the obligations that exterd beyond the normal shipment of
goods.

 The impact of unusual terms, and when title has passed to the customer. The right of the customer
to return a product, as well as the returns history.

 Contracts that are combinations of leases and sales.

 The proper treatment of sales transactions made with recourse of that have an abnormal or
unpredictable amount of returns.

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Accounts Receivable: Identifying Inherent Risks

The primary inherent risk associated with receivables is that the net amount is not collectible, wither
because the receivables recorded do not represent genuine claims or an insufficient allowance exists
for uncollectible accounts.

The most relevant financial statement assertions for receivables are usually existence and valuation.
Other important risks may be related to ownership due to the company selling or pledging receivables.
Some of the inherent risks affecting receivables include the following:

 Receivables are pledged as collateral against specific loans with restricted use (disclosure of such
restrictions are required).

 Receivables are incorrectly classified as current when the likelihood of collection during the next
year is low.

 Collection of a receivable is contingent on specific events that cannot currently be estimated.

 Payment is not required until the purchaser sells the product to its end customers.

 Accounts receivable are aged incorrectly, and potentially uncollectible amounts are not
recognized

 Orders are accepted from customers with poor credit.

Identifying Fraud Risks Factors

Auditing standards state that auditors should ordinarily presume there is a risk of material
misstatement caused by fraud relating to revenue recognition.

Fraud Schemes

Fraud investigations undertaken by the SEC and other government agencies have uncovered a wide
variety of methods used to misstate accounts in the revenue cycle, including:
 Recognition of revenue on shipments that never occurred

 Hidden side letters, agreements containing contract terms that are not part of the formal contract,
giving customers an irrevocable right to return the product.

 Recording consignment sales as final sales

 Early recognition of sales that occurred after the end of the fiscal period

 Shipment of unfinished product

 Shipment of product before customers wanted or agreed to delivery

 Creation of fictitious invoices

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 Shipment of more product than the customer ordered

 Recording shipments to the company's own warehouse as sales

 Shipping goods that had been returned and recording the reshipment as a sale of new goods before
issuing credit for the returned sale

 Incorrect aging of accounts receivable and not recording write-downs of potentially uncollectible
amounts

 Recording purchase orders as completed sales

 Lapping which is a technique used to cover up embezzlement of cash

The examples but a few of the revenue risk factors to which auditors should be alert. Identifying these
risk factors involves the auditor:
 Assessing motivation to enhance revenue because of either internal or external pressures

 Reviewing the financial statements through preliminary analytical procedures to identify account
balances that differ from expectations or general trends in the economy.

 Recognizing that not all of the fraud will be instigated by management; for example, a CFO or
accounting staff person may engage in misappropriating assets for his or her own use.

 Becoming aware of representations made by management to analysts and the potential effect of
those expectations on stock prices

 Determining whether the company's performance is significantly different from that of the rest of
the industry of the economy.

 Determining whether the company's accounting is being investigated by organizations such as the
SEC

 Considering management compensation schemes, especially those that rely on stock options and
therefore current stock prices.

Identifying Control Risks

Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement in the revenue and accounts receivable accounts, the auditor needs to understand the
controls that the client has designed and implemented to address those risks.

Such understanding is normally gained by means of a walkthrough of the process, inquiry, observation,
and review of the client's documentation. The auditor considers both entity wide controls and
transaction controls at the account and assertion levels. This understanding provides the auditor with a
basis for making an initial control risk assessment.

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Performing Preliminary Analytical Procedures

When planning the audit, the auditor is required to perform preliminary analytical procedures. These
procedures can help auditors identify areas of potential misstatements. Auditors do not look at just the
numbers when performing analytical procedures. Possible expected relationships in the revenue cycle
include the following:

 There is no unusual year-end sales activity.

 Accounts receivable growth is consistent with revenue growth.

 Revenue growth, receivables growth, and gross margin are consistent with the activity in the
industry.

 There is no unusual concentration of sales made to customers(in comparison with the prior year).

 The accounts receivable turnover is not significantly different from the prior year.

 The ratio of the allowance for doubtful accounts total receivables or to credit sales is similar to the
prior year.

The following relationships might suggest a heightened risk of fraud:

 Revenue is increasing even though there is strong competition and a major competitor has
introduced a new product.

 Revenue increases are now consistent with the industry or the economy. Gross margins are higher
than average, or there is an unexpected change in gross margins.

 Large increases in revenue occur near the end of the quarter or year. Revenue has grin and net
income has increased, but there is negative cash flow from operations.

Trend analyses of account balances and ratios are preliminary analytical procedures that are routinely
used on revenue cycle accounts. Examples of ratios the auditor might consider for revenue cycle
accounts are as follows:

 Gross margin analysis

 Turnover of receivables (ratio of credit to average net receivables) or the number of days' sales in
accounts receivable Average receivables balance per customer

 Receivables as a percentage of current assets

 Aging of receivables

 Allowance for uncollectible accounts as a percentage of accounts receivable

178
 Bad debt expense as a percentage of net credit sales

 Sales in the last month (or quarter) to total sales

 Sales discounts to credit sales

 Returns and allowances as a percentage of sales

PHASE II – RISKRESPONSE

Responding to Identified Risks of Material Misstatement

Once the auditor understands the risks of material misstatement, the auditor is in a position to
determine the appropriate audit procedures to perform. Audit procedures should be proportional
to the assessed risks, with areas of higher risk receiving more audit attention and effort.
Responding to identified risks typically involves developing an audit approach that contains
substantive procedures (for examples, tests of details and, when appropriate, substantive
analytical procedures) and tests of controls, when applicable. The sufficiency and appropriateness
of selected procedures will vary to achieve the desired level of assurance for each relevant
assertion. While audit firms may have a standardized audit program for the revenue cycle, the
auditor should customize the audit program based on the assessment of risk of material
misstatement.

The auditor may develop an audit program that consists of first performing limited tests of
operating effectiveness of controls, then performing limited substantive analytical procedures,
and finally performing substantive tests of details. If the high risk is high, the auditor will want to
obtain a great deal of evidence directly from tests of details. In contrast, consider a client where
the auditor has assessed the risk of material misstatement related to the completeness of revenues
as low, and believes that the client has implemented effective controls in this area. For this client,
the auditor can likely perform tests of controls, gain a high level of assurance from substantive
analytical procedures such as reasonableness test, and then complete the substantive procedures
by performing tests of details at a limited level.

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A. AUDIT OF SALES TRANSACTION

This section covers the following areas:

I. Evaluation and Obtaining Evidence About Internal Control Operating

Effectiveness Over Sales Transactions

II. Tests of Controls over Sales and Receivables

III. Illustrative Audit Program for Tests of Controls on Sales

IV. Substantive Tests of Sales Transactions

Typically, the sales transactions involve the following business activities

a. Accepting sales order

b. Approving credit

c. Filling sales order

d. Shipping sales order

e. Billing customers

Figure 6-2 shows a flowchart of the manual system for executing sales transactions. The purpose of
the flowchart is to assist in identifying control points and the necessary control features related to each
point. The presentation reflects the segregation of functions considered characteristics of satisfactory
internal control.

180
Figure 6-2: Internal Control Flowchart for Processing

181
I. Obtaining Evidence About Internal Control Operating Effectiveness In The Revenue Cycle

Figure 6-3: Control Risk Assessment Questionnaire for Sales

Client _______________________________________________ Audit Date_______________
Client Personal Interview: __________________________________________________________
_______________________________________________________________________________
Auditor________________________________________________ Date Completed___________
Reviewed by:__________________________________________ Date Reviewed____________
Type of Testing: Compliance
Cycle: Revenue Class of transaction: Sales
Executing Yes No NA Remarks

1. Are customer orders compared to an approved customer lists?

2. Is a prenumbered sales order issued for each accepted customer order?

Is there internal verification of the agreement of sales order with customer

3.
order?
4. Are all credit sales approved prior to the sale?
5. Is a sales order required before an order is filed?
6. Is there internal verification of the goods in filing a sales order?

7. Are the goods compared with the sales order in shipping?

8. Is each shipment supported by a prenumbered shipping document?

9. Are shipping documents and sales orders compared in billing?

10. Are prenumbered sales invoices used in billing?
Is there internal verification of prices and mathematical accuracy of sales
11.
invoices?
12. Are daily sales summaries prepared and agreed to the invoices issued?
Recording
1. Are the daily sales journal entries agreed to daily sales summaries?
2. Are invoices joumalized in numerical sequence?
Is there periodic independent reconciliation of accounts receivable control
3.
and the customers' ledger?

Are postings to the subsidiary ledgers made independent of journalizing and

4.
posting the general ledger?

Custody

1. Are there adequate physical controls over accounts receivable records?

2. Is there independent mailing of monthly statements to customers?

182
II. Tests of Controls Over Sales and Receivables

Controls are important because of their effect on the assertions embodied in the financial
statements. Auditors identify specific assertions for each general assertion to be tested. The
general and specific audit assertions for Sales and Receivables are as follows:

Assertions
General Specific
1. Existence or occurrence 1. Recorded sales are for shipments actually
made to customers.
2. Completeness 2. All sales transactions that occurred are
recorded.
3. Rights and obligations 3. Sales recorded represent only sales
transactions.
4. Valuation or allocation 4. Sales are correctly billed and recorded.
5. Presentation and disclosure 5. Sales and accounts receivable are recorded to
result in presentation and disclosure in
accordance with PAS/PFRS.

Discussion:

A. Existence or Occurrence: Recorded sales are for shipments actually made to customers.

Controls Test of Controls

1. Recording of sales is supported 1. To test this control, the auditor mines approved
by customer orders, sales customer order, sales order, shipping document
orders approved by the credit and copy of sales invoice for sample of entries in
department and approved an the sales journal. The documents should bear the
executed shipping documents. required approval, such that of the credit
manager's approval. The description, quantity of
goods shipped, name, address and other details
regarding the transaction should be consistent.

183
2. A clerk independent of accounts 2. The auditor can observe whether a clerk
receivable prepares and mails independent of the accounts receivable
monthly statements to customers for bookkeeper prepares and mails monthly
all trade accounts receivable and statements and follows up any complaints. He
follows up on any complaints can also examine files on complaints received
shipping for selected months.
B. Completeness: All sales transaction that occured are recorded
3. Prenumbered shipping documents 3. The auditor can observe the client performing
are accounted for to determine that a the procedure or select a sample of shipping
sales invoice is prepared for all orders and examine the invoice that bills the
shipments sale. The presence of a sales invoice copy
indicates that the shipment was billed.

3. Prenumbered sales invoices are 4. The auditor can observe the clerk recording
accounted for to determine that all sales if he or she is accounting for the
sales are recorded. numerical sequence of invoices and determines
why any missing
invoices have not been processed. The auditor
can also select a sample of sales invoice copies
to trace into the sales journal.

5. Procedures to ensure timely 5. The auditor should inquire how procedures are
recording if sales and proper cut-off followed, observe procedures being followed
are established and inspect report on the shipments that the
shipping clerk sends to the billing clerk. Proper
cut-off also provides evidence about the
existence of transactions.

C. Rights of Obligation: Sales recorded represent only sales transactions.

6. Clerk should check sales orders and 6. The auditor should observe that
sales invoices for terms to determine the control is being performed.
that transaction is a sale rather than a
consignment

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D. Valuation or Allocation: Sales are correctly billed and recorded.
7. For all goods shipped, goods are 7. The auditor observes that the control is
counted and descriptions and being performed and examines a sample of
quantities are compared to quantities shipping orders for the signature on the
and descriptions on sales orders and shipping documents that indicates that the
shipping documents prior to counting and comparison occurred.
shipping.

8. Customer credit is approved by a 8. The auditor examines a sample of

responsible official prior to sales order for credit approval prior to
merchandise shipment. Although shipment
approval of credit
prior to shipment does not guarantee
absence of uncollectible accounts,
the
procedure reduces the likelihood of
the account becoming uncollectible.

9. Sales invoices are checked 9. To test these controls, the auditor

for performs the following:
a. Proper pricing a. Inquiry about the updating and use of
b. Mathematical accuracy price lists.
c. Terms b. Examine a sample of invoice copies to
determine that they contain a signature
indicating that the price, mathematical
accuracy and terms have been checked.

10. The accounts receivable subsidiary 10. To tests this control, the auditor
ledger is balanced to the general observes that is being performed. The
ledger auditor may also foot the accounts
control account regularly. The receivable subsidiary ledger and compare
absence of this control results in the the total with the balance appearing in the
possibility of careless recordkeeping general ledger control account
and omission
of postings of sales or payments.

185
E. Presentation and Disclosure: Sales and accounts receivable are
recorded to result in presentation and disclosure in accordance with PAS/PFRS
11. Sales must be properly classified to 11. The auditor can test this control by
generate accurate segment determining that the invoice copy contains
reporting. Entities may require a the signature that indicates approval of
second person to independently account classification used.
review or check the account coding
on invoices

III. Illustrative Audit Program For Tests Of Controls: Sales

An audit program for tests of controls for sales is presented in Figure 6-4. The audit procedures are
those included in the foregoing discussions, but they have been restated to enable the auditor to select
a minimum number of samples for testing. It will be noted that to test for existence or occurrence, the
auditor tests from accounting records back to underlying documents that indicate that the transaction
occurred. To test whether all transactions are recorded, an auditor compares pre-numbered documents
to entries in the accounting records. The auditor can also observe the presence of some controls, rather
than examine a sample of documents to obtain evidence about a control.

186
Figure 6-4: Sample Audit Program for Tests of Controls
Over Sales Transactions

Happy Sounds Corporation

Test of Controls: Sales
December 31. 20X7
Audit Procedure WP Done
Ref By Date
1. For a sample of entries in the sales journal,
a. Compare data in the sales journal to approved customer order, sales order, shipping
document, and copy of sales invoice for

1. Customer order number.

2. Invoice number.
3. Customer name.
4. Date.
5. Description of goods.
6. Quantity
7. Price.
8. Invoice amount.
9. Terms
b. Determine credit approval.
c. Determine that signatures are on invoices indicating independent checking for

1. Proper pricing
2. Mathematical accuracy.
3. Terms.
d. Examine signature evidencing recheck of account coding.
2. For a sample of shipping documents, examine signature indicating that for goods shipped, goods
are counted quantities and descriptions of the goods shipped are compared to quantities and
descriptions on sales orders and shipping documents prior to shipping, and the transactions are
recorded in the sales journal.

3 Discuss the procedures followed with the person (independent of the bookkeeper) who mails to
customers monthly statements for all trade accounts receivable and follows up on any
complaints. Review the client's correspondence files reflecting resolution of these items.

4 Observe the procedures followed to ensure a proper cutoff of sales at year-end.

5 Observe that the accounts receivable subsidiary ledger is balanced to the general ledger control
account regularly
6 Examine evidence of accounting for the sequence of sales orders, shipping documents, and sales
invoices.

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Briefly, the foregoing tests of controls over sales transactions may reveal the following weaknesses,
possible errors and misstatements:

Internal Control Weaknesses or

Factors That Increase the Risk of Description of Possible Errors
Misstatement Examples of Fraud / Error or Misstatement
1. Ineffective board of directors, 1. Recording fictitious sales 1. Recording unearned revenue
audit committee, or internal without receiving a customer
audit function; undue pressure to order or shipping the goods;
Intentional over shipment of
meet sales targets; top
goods.
management action not
conducive to ethical conduct.

2a. Ineffective billing process in 2a. Recording sales based on 2. Recording unearned revenue
which billing is not tied to the receipt of orders from
shipping information. customers rather than the
shipment of goods.

2b. Ineffective controls for testing 2b. Inaccurate billing and

invoices, or ineffective input recording sales
validation checks and computer
reconciliations to ensure the
accuracy of databases

2c. Inadequate accounting manual; 2c. Recording cash that

incompetent accounting represents a liability (e.g.,
personnel. receipts of a customer's
deposit) as revenue
3. Ineffective board of directors, audit 3. Holding the sales journal 3. Early (late) recognition of
committee, or internal audit open to record next year's revenue - "cutoff error"
function; top management action sales as having occurred in
not conducive to ethical conduct; the current year.
undue pressure to meet sales
targets.

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4. Ineffective cutoff procedures in the 4. Recording sales in the wrong 4. Early (lato) recognition
shipping department period based on incorrect of revenue - "cutoff-error"
shipping information

5. Ineffective board of directors, audit 5. Recording sales when the 5. Recording revenue when
committee, or internal audit function; customer is likely to return the significant uncertainties
top management action not conducive goods. exist
to ethical conduct; undue pressure to
meet sales targets

6. Aggressive attitude of management 6. Recording sales when the 6. Recording revenue when
toward financial reporting; customer's payment is significant uncertainties
incompetent chief accounting officer contingent upon the customer exist
receiving financing or selling
the goods to another party
(e.g., consignment sales)

7. Ineffective board of directors, audit 7. Recording franchise revenue 7. Recording revenue when
committee, or internal audit function; when franchises are sold even significant services still
top management action not conducive though an obligation to must be performed by
to ethical conduct; undue pressure to perform significant services seller
meet sales targets. still exists.

8. Ineffective board of directors, audit 8. Misstating the percentage o f 8. Overestimation of the

committee, or internal audit function; completion of several projects amount of revenue
top management action not conducive by a construction company earned.
to ethical conduct; incompetent using the percentage-of-
individuals involved in the estimation completion methods of
process revenue recognition

9. Aggressive attitude of management 9. Overestimating the percentage 9. Overestimation of the

toward financial reporting; of completion on projects by a amount of revenue
incompetent personnel involved in the construction company using earned
estimation/ accounting process. the percentage-of- completion
method of revenue recognition

189
IV. Substantive Tests of Sales Transactions

In deciding on substantive tests of transactions, some procedures are commonly employed on ever
audit regardless of the circumstances where as others are dependent on the adequacy of the controls
and the results of the tests of controls. The following schedule shows the substantive audit procedures
for sales transactions, the related audit objectives and assertion:

Assertions Audit Objectives Audit Procedures

I. Occurrence A. To determine that 1. Review the sales journal, general ledger and
and Validity recorded sales are accounts receivable master file or trial balance
authorized and are for large or unusual items.
II. Rights and for shipments 2. Trace sales journal entries to copies of sales
Obligations actually made to orders, sales invoices and shipping
non-fictitious documents.
customers. 3. Trace shipping documents to entry of
shipments perpetual inventory records.
4. Compare prices on sales invoices with
authorized price lists or properly executed
contracts.

III.. Completeness B. To determine that 5. Trace shipping documents to resultant sales

existing sales invoices and entry into sales journal and
transactions are accounts receivable master file.
recorded on a 6. Compare dates of recorded sales transactions
timely basis. with dates on shipping records or perform
sales cutoff tests.

190
IV. Valuation or C. To determine that recorded 7. Recomputed information on
Allocation sales are for the amount of sales invoices.
goods shipped and are 8. Trace entries in sales journal
correctly billed and recorded. to sales invoices.
9. Trace details on sales
invoices to shipping
documents, price tests and
customer's orders.
V. Presentation D. To determine that sales 10. Examine document
transactions are properly supporting sales transactions
classified. for proper classification
*This analytical procedure can also apply to other objectives including competence, valuation
and proper cutoff

Discussion of Audit Procedures

1-5. For a sample of entries in the sales journal, compare sales invoice copy, customer order and
shipping document.

To test the existence of sales, some auditors examine the sales invoice, the customer's order, the sales
order bearing credit approval and the shipping document for a sample of entries in the sales journal. If
an entity has a procedure to accumulate these documents before recording a sale, their accumulation is
an indication that the control was performed. Other procedures may include

a) Trace from the entry removing the goods from inventory to the perpetual inventory record.
b) Examine the cash receipts in payment for the sale.
c) Confirm the existence of individual transactions with the customers.
6. For a sample of shipping documents, trace sales invoice and entry into sales journal and
accounts receivable subsidiary ledger. Perform cutoff tests.

For a sample of shipping documents, the auditors may examine the sales invoice and determine
that an entry was made in the sales journal and the accounts receivable subsidiary ledger. When
testing to determine that all transactions have been recorded, auditors start with a renumbered
document, such as a bill of lading or a delivery ticket and trace it into the journals and ledgers.

191
For a sample of sales invoices, examine the customer order and shipping document to determine
whether the transaction should have been recorded as a consignment transaction rather than as a
sale.

To determine that the entity has a right to receivable arising from the sales transactions recorded, the
auditor examines a sample of sales transactions and be alert for indications of consigned shipments
treated as sales. Auditors should also investigate the procedure from recording movements of
merchandise among the various units of the company.

7-9. For a sample of entries in the sales journal, (a) examines sales invoice, shipping document and
customer order for consistency of descriptions and quantities; (b) examine sales orders for credit
approval; and (c) check prices and extensions. Foot sales journal and general ledger account.

This audit procedure for verification of a sales transaction that has been selected for testing may begin
with a comparison of the customer's purchase order, the client's sales order, and the duplicate copy of
the sales invoice. The descriptions and quantities of items are compared on these three documents and
traced to the duplicate copy of the related shipping document. The credit manager's signature denoting
approval of the customer's credit should appear on the sales order.

The extensions and footings on each invoice in the sample should be proved to be arithmetically
correct. After proving the accuracy of selected individual invoices, the auditors next trace the invoices
to the sales journal and to postings in the accounts receivable subsidiary ledger. In addition, the date of
each invoice should be compared with two other dates:

10. For a sample of entries in the sales journal, verify the accuracy of account coding.

Auditors may review entries in the ales journal and the supporting sales invoice to determine whether
the sales invoice was coded correctly and whether it results in proper presentation and disclosure of the
transaction in the financial statement.

192
B. AUDIT OF SALES ADJUSTMENTS TRANSACTIONS

Adjustments to sales may include:

a) Granting cash discounts,

b) Granting sales allowances or reduction in price,
c) Returns of merchandise,
d) Volume rebates,
e) Corrections of billing errors, and
f) Uncollectible accounts.

Figure 6-5 shows the manual system for processing and recording sales returns and account
write-offs.

This section covers

I. Evaluation of Internal Control over Sales Adjustments Transactions

II. Test of Controls over Sales Adjustments Transactions
III. Illustrative Audit Program for Sales Adjustments Transactions Test of Controls
IV. Substantive Tests over Sales Returns and Allowances

193
Figure 6-5: Sales Returns and Account Write-offs

194
I. Evaluation of Internal Control Over Sales Adjustments Transactions

The auditor may use the following internal control questionnaire in evaluating the effectiveness of the
client's system over the sales adjustments transactions (Figure 6-6)

Figure 6-6: Internal Control Questionnaire for

Sales Adjustments

Cycle: Revenue Class of Transactions: Sales Adjustments

Questions Answer
Yes No NA Remarks
1. Are all cash discounts approved?
2. Are sales returns and allowances approved by
sales personnel?
3. Are pre-numbered credit memos used for sales
returns and allowances?
4. Is there separation of duties between approval of
sales returns and allowances and issuance of
credit memos?
5. Are all bad debt write-offs approved in writing?
6. Is there separation of duties between
the approval of bad debt write-offs
and collections from customers?

A concern about these transactions is that a transaction may be recorded to cover a material
misappropriation of cash receipts. Auditors generally pay little attention to these adjustments unless
they are a material amount or individual adjustments are large.

195
196
II. Tests of Controls over Sales Adjustment Transactions

Audit of Cash Discounts

Auditors often audit cash discounts in connection with a test of cash receipts transactions and
sales returns and allowances in connection with sales. Oftentimes, auditors perform only
substantive tests of account balances.

Audit of Sales Returns, Allowances, Corrections

For sales returns and allowances, the primary emphasis is normally on testing the existence of
recorded transactions as a means of uncovering any diversion of cash from the collection of
accounts receivable that has been ered up by a fictitio sales return allowances. Although the
emphasis for the audit of sales returns and allowances is often on testing the existence of recorded
transactions, the completeness objective cannot be ignored. Unrecorded sales returns and
allowances can be material and can be used by a company's management to overstate net income.
The other objectives, rights and obligations, valuation, and proper classification should not of
course be ignored. The same methodology for controls over sales transactions should be applied
to controls over sales returns and allowances.

Audit of Uncollectible Accounts

Existence of recorded write-offs in the most important transaction-related audit objective that the
auditor should keep in mind in the verification of the write-off of individual uncollectible
accounts. This is because of the possibility of the client covering up a defalcation by charging off
accounts receivable that have already been collected. The major control for preventing this type
of misstatement is proper authorization of the write-off of uncollectible accounts by a designated
level of management only after a thorough investigation of the reason the customer has not paid.

197
III. Sample Audit Program for Test of Controls:
Sales Adjustments Transactions

Happy Sounds Corporation

Tests of Controls: Sales Adjustments
December 31, 20X7

Done
Audit Procedures WP Ref By Date
1. Account for credit memoranda.
2. Prove the footing of credit memorandum to the general ledger
3. Trace the posting of credit memorandum to the general ledger.
4. Review credit memoranda for approval
5. Check credit memoranda concerning returned goods for. (a)
arithmetical accuracy; (b) quantities returned (by reference to
the original invoice or record of the selling price.

6. Inspect credit files in support of accounts written off as

uncollectible.

The foregoing tests of controls over sales adjustments transactions may reveal the following
weaknesses and possible errors;

Control Weakness Possible Errors

1. Lack of numeric control over credit 1. Fictitious transactions recorded.
memoranda.
2. Unauthorized write-off of accounts 2. a.. Collectible accounts erroneously written
receivable. off as uncollectible
b. Customer account intentionally written off
to conceal misappropriation of customer
remittances.
3. Unauthorized returns and allowances 3. a. Credit memos issued for authorized
returns as for goods not actually returned.
b. Credit memos written and recorded to
conceal misappropriated of customer
remittances.

198
IV. Substantive Tests for Sales Returns and Allowances

The audit objectives are essentially the same for processing credit memos for returns and
allowances as those described for sales, with two important differences.

1. The first relates to "materiality." If the amount of sales returns and allowances are so
immaterial, they can be ignored in the audit altogether
2. The second relates to "emphasis on objective.” For sales returns and allowances, the
primary emphasis is normally on testing the validity of recorded transactions as a means of
uncovering any diversion of cash from the collection of accounts receivable that has been
covered by a fictitious sales returns or allowance.

Naturally, the auditor also gives due attention to the other objectives and should be able to
arrive at suitable substantive tests of transactions which are essentially the same as for sales to
verify amounts.

1) Review the use and authorization of credit memoranda.

All allowances to customers for returned or defective merchandise should be supported by
serially numbered credit memoranda signed by an officer or responsible employee having
no duties relating to handling cash or to the maintenance of customers' ledger.

2) Review credits for returned merchandise if supported by receiving a report on the

return shipment.
3)
4) Verify prices, extensions and footings and trace postings from the sales returns
journal or other accounting record to the customer's accounts in the subsidiary
receivable ledger.

199
C. AUDIT OF CASH RECEIPTS TRANSACTIONS

Basic Considerations

A high volume of transactions flows through cash accounts. Because of the vulnerability to error or
fraud, organizations and auditors usually emphasize the quality of controls over the cash transactions.
In this chapter, we examine approaches that auditors take to assess risks associated with cash and to
evaluate controls over cash accounts. This chapter primarily involves performing risk assessment
procedures, tests of controls, and substantive procedures for cash.

There are a variety of sources of cash receipts. Cash receipts may result from revenue transactions,
short and long-term borrowing, issuance of share capital, and sale of marketable securities, long-term
investments and other assets. The scope of this chapter is limited to cash receipts from sales
transactions which include cash sales and collections from trade customers on credit sales.

Executing cash receipts transactions generally involve:

a) Receiving mail receipts

b) Receiving over-the-counter receipts
c) Aggregating total cash received
d) Depositing cash in bank

Figure 6-7 shows a flowchart of a manual system for executing cash receipts transactions.

This section covers

1. Evaluation of Internal Control over Cash Receipts Transactions

II. Tests of Controls over Cash Receipts Transactions

III. Illustrative Audit Program for Test of Controls: Cash Receipts Transactions

IV. Substantive Tests of Cash Receipts Transactions

200
Figure 6-7:
7: Cash Receipts from Customer Flowchart

201
I. Evaluation of Internal Control over Cash Receipts Transactions

Figure 6-8 shows an Control Questionnaire which can be used evaluating internal control over cash receipts
transactions.

Figure 6-8 Internal Control Questionnaire for

Cash Receipts Transactions

Cycle: Revenue Class of Transactions: Cash

Receipts
Executing Yes No NA Remarks
1. Are mail receipts opened by personnel independent of Shipping,
Billing, and Accounting?

2. Is a remittance list prepared for mail receipts?

3. Are checks endorsed restrictively immediately upon opening the mail?

4. Are the cash registers used for over-the counter receipts?

5. Are prelists and checks independently reconciled with cash

summaries?

6. Are cash collections deposited daily?

7. Are deposits and daily cash summaries independently reconciled?

8. Are all employees who handle cash bonded adequately?

Recording
1. Are accounting personnel prohibited from handling cash?

2. Is there internal verification of the agreement of daily cash summaries

and cash receipts journal entries?

3. Is there separation of between the journalizing of cash receipts

transactions and posting to the customers ledger?

Custody
1. Is cash stored is safes or vaults prior to deposit?

2. Are periodic independent counts made of cash on hand?

202
Il. Tests of Controls over Cash Receipts Transactions

Although entities receive cash from many sources, this section focuses on collections of cash from
customers. Auditors are interested in the effect of controls on the financial statement assertions
embodied in the cash transactions. In testing cash collections, auditors focus on the following audit
assertions:

General Specific
1. Existence or occurrence 1. Recorded receipts represent actual collections of cash from
customers.

2. Completeness 2. All receipts are processed and recorded.

3. Rights and obligations 3. All cash receipts are deposited intact in the account of the
client.

4. Valuation or allocation 4. Debits to cash and credits to accounts receivable are valued
at amounts received.

5. Presentation and disclosure 5. Cash receipts transactions are recorded to result in

presentation and disclosure in accordance with PAS /
PFRS.

Discussion:
A. Existence or Occurrence: Recorded receipts represent actual cash collections from customers.

Controls Tests of Controls

1. A trustworthy employee prepared a prelisting To test this control, the auditor observes whether a
of cash receipts before further processing. prelisting is prepared and inquires of the prepare
about the procedures he or she follows.
2. A validated deposit slip is obtained for daily The auditor tests this control by obtaining copies
deposits and compared to the cash receipts of the validated deposit slips and comparing them
summary. to the cash receipts summary.

203
3. Duties of handling cash receipts are segregated The auditor can tests this control by
from posting to account receivable. A person observing the separation of duties and
performing both functions could misappropriate inquiring of client personnel about their
responsibilities.
cash and conceal the shortage by making an entry
directly to the customer's accounts/.

4. A bank reconciliation is prepared month by a The auditor tests this control by observing
person not -involved in handling cash, accounts the bank reconciliation have been prepared
receivable, general ledger records. The reconciler by an independent employee.
should receive the unopened bank statement and
maintain control over it until the reconciliation is
completed.

B. Completeness: All receipts are processed and recorded.

Controls Tests of Controls

5. Prelisting and cash register procedures should be Auditors observe the monitoring of these
monitored. procedures.

6. Checks should be restrictively endorsed as soon To test this control, auditors observe the
as they are received. This control prevents an procedure in effect.
authorized employee from gaining access to
check and cashing it.

7. A daily cash summary is prepared and reconciled Auditors can inquire of employees who
to total of prelisting and over-the counter receipts. carry out the procedure about the regularity
The summary total is compared to the total in to and consistency of its performance.
cash receipts journal and the total on the validated
deposit ticket. This control ensures that- all cash
receipts are deposited and recorded.

204
8. The cash receipts journal total is independently To test this control, the auditor observes
reconciled to total posted to accounts receivable. the procedures and make inquiry of
This control ensures postings to accounts personnel performing the procedure.
receivable.

C. Rights and Obligations: All cash receipts are deposited in the bank account of the client.

Controls Tests of Controls

9. Cash receipts are deposited intact daily in the The auditor tests this control by observing
company's bank account, this control reduces the the procedure and comparing the cash in
likelihood of misappropriation of cash. the prelisting with the validated deposit
slip.

D. Valuation or Allocation: Debits to Cash and Credits to Accounts Receivable are valued at
amounts received.

Controls Tests of Controls

10. Cash receipts should be recorded at the amount To test this control, an auditor compares
indicated on the remittance advice. A remittance entries in the cash receipts journal to
advice that has been processed by a third party remittance advices.
serves as strong evidence of the amount received
from the customer.

E. Presentation and Disclosure: Cash receipts transactions are recorded to result in presentation
and disclosure in accordance with PAS / PFRS.

Controls Tests of Controls

11. An accounting supervisor should approve This control can be tested by the auditor by
classification made in journalizing. This control determining that the supervisors signature
reduces the likelihood of payments being posted to of approval is recorded.
the wrong accounts, resulting in credit balances in
accounts receivable.

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lll. Sample Audit Program for Test of Controls: Cash Receipts Transactions

Happy Sounds Corporation

Test of Controls: Cash Receipts
December 31, 20x7

WP Done
Audit Procedures Ref By Date
1. Compare remittances or other details of cash receipts with the entries
on the receipts book.

2. Compare the recorded receipts with individual deposits as shown by

bank statements.

3. Compare the composition of authenticated duplicated deposit slips with

the recorded receipts.

4. Compare the recorded receipts with an independent record prepared

before receipts are transmitted to the cashier.

5. Test of ash discounts and other allowances or credits.

6. Test posting to the general ledger to the customer' ledger, and to other
subsidiary ledger.

7. Review cash receipts for unusual items.

Possible error that may result because of control weakness over cash receipts transactions follow:

Internal Control Weakness or

Factors That Increase the Risk Description of Possible
of the Misstatement Examples of Fraud / Error Errors or Misstatement
1. Lack of segregation of 1. Cash receipts are overstated 1. Fictitious cash receipts are
duties of cash handling and on the books by transferring recorded; Processing
recordkeeping; bank cash between accounts errors (intentional or
accounts not reviewed or without appropriate recording unintentional) are not
properly reconciled. of the transfer to cover up an discovered on a timely
embezzlement of cash. basis.

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2. Inadequate controls for reconciling 2a. Cashier fails to ring up 2a. Failure to record
cash register tapes and accounting and record cash sales receipts from cash sales.
records; inadequate controls for embezzles cash.
reconciling bank accounts 2b. Bookkeeper omits the 2b. Unrecorded cash
recording of the receipts receipts are not deposited in
from one cash register for the bank or recorded cash
the day. receipts are not deposited in
the bank.
3. Sales not coded on cash register 3. Sale of product A 3. Credits to wrong sales
tapes. recorded as a sale of Product account are committed.
B.
4. Lack of segregation of duties 4a. Cashier abstract or 4a&b. Failure to record cash
between personnel who have access embezzles cash payments by from collection of accounts
to cash receipts and those who make customers on receivables receivable.
without recording
entries into the accounts receivable
collections from customers.
records.

5. Inadequate reconciliations of 5a. Bookkeeper accidentally 5a. Failure to record cash

subsidiary records of accounts fails to record a payment on from collection of accounts
receivable with the general ledger a receivable receivable.
account.

6. Accounting manuals not used to 6. Collection of rent income 6. Miscellaneous cash

assist in properly recording recorded as sale of receipts credited to incorrect
miscellaneous cash receipts. merchandise. accounts.

7. Ineffective board of directors, audit 7. Keeping the cash receipts 7. Erroneous presentation of
committee or internal audit function; journal open to record next a more liquid position.
undue pressure to show improved years cash receipts
collections in the current
financial position; top management
year;
actuations 'not conducive to ethical
conduct.

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8. Failure to list and 8. Recording cash receipts "Cut-off " error (early or late recognition
deposit cash receipts on based on erroneous information of cash receipts) is committed.
timely basis. about date of receipt.

IV. Substantive Tests of Cash Receipts Transactions

Assertions Audit Objectives Audit Procedures

I. Existence or A. To determine that recorded 1. For as sample of entries in cash
Occurrence receipts represent actual receipts journal, trace to the
collections of ash from pre-listing of cash receipts and to
customers. remittance advice. For sample of
entries, reconcile daily deposit to
validated deposit ticket.

II. Completeness B. To determine that all 2. For a sample of days, verify that all
receipts of cash and checks cash receipts are recorded by
are recorded. reconciling daily listing(s) of cash
receipts and validated deposit ticket
to cash receipts journal.

III. Valuation or C. To determine that debits to 3. For a sample of entries in cash

Allocation cash and credits to receipts journal, examine
accounts receivable are remittance advice and verify that
valued at amounts discount taken was appropriate.
received. Foot accounts receivable subsidiary
ledger and reconcile to the general
ledger account.

IV. Presentation D. To determine that cash 4. Review account coding for a

receipts transactions are sample of entries in the cash
recorded to result in receipts journals
presentation and disclosure
in accordance with PAS /
PFRS.

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Discussion of Audit Procedures

1. For a sample of entries in cash receipts journal, trace to the prelisting of cash receipts and to
remittance advice. For a sample of entries, reconcile daily deposit to validated deposit ticket.

To test the credits to accounts receivable, an auditor can trace from the entry in the accounts
receivable ledger to a cash receipts listing to a deposit ticket listing the payment and to the
customer's remittance advice. These documents provide evidence that a collection was made.

2. For a sample of days, verify that all cash receipts are recorded by reconciling daily listing(s)
of cash receipts and validated deposit ticket to cash receipts journal.

To test whether all cash receipts are recorded, the auditor compares the names and amounts
included in the prelisting for selected days with the entries in the cash receipts journal. Any
discrepancies may suggest that lapping is occurring. To test for lapping, an auditor identifies a
period of several consecutive days and trace the names and amounts from the prelisting of cash
receipts to the validated deposit ticket to the cash receipts journal, and to the posting in the
accounts receivable subsidiary ledger. All dates, names and amounts should be consistent. If the
details are consistent, lapping did not occur during the time period examined.

Auditors also test the mathematical accuracy of the recording of cash collections by footing the
cash receipts journal, and by footing the accounts receivable subsidiary ledger and reconciling it
to the control account.

3. For a sample of entries in cash receipts journal, examine remittance advice and verify that
discount taken was appropriate. Foot accounts receivable subsidiary ledger and reconcile to
the general ledger account.

To determine whether the credit to accounts receivable is proper, the auditor selects transactions
from the cash receipts journal and re-computes the cash discounts allowed to customers who
have made payments. Auditors may also verify its approval by re-performing the procedure that
should have been performed when credit was approved.

4. Review account coding for a sample of entries in the cash receipts journal.

To determine that the transaction was coded correctly and will result in proper presentation and
disclosure, the auditors compare entries in the cash receipts journal with the remittance advises.

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REVIEW QUESTIONS

Questions

1. How do different levels of control risk in the revenue and collection cycle affect the nature,
timing and extent of accounts receivable confirmation procedures?

2. What feature(s) of cash receipts internal control system would be expected to prevent (a)
an employee's absconding with company funds and replacing the funds during the audit
engagements with cash from the employee pension fund, and (b) the cash receipts journal
and recorded cash sales from reflecting more than the amount shown on the daily deposit
slip?

3. What is the meaning of strength in the transaction processing controls of the revenue and
collection cycle? A weakness? Why are the weaknesses not subject to test of controls
auditing?

4. Why is it necessary to evaluate the control after the test of controls audit of the revenue and
collection cycle when an evaluation was already made after the understanding phase?

5. Describe the processing of transactions in the sales and collections cycle in the following
functions:
a. Order entry
b. Credit approval
c. Warehousing
d. Shipping
e. Customer billing
f. Collecting accounts receivable
g. Granting credit for returns and allowances
h. Recording uncollectible accounts expense
i. Writing off collectible accounts

6. Identify features of the following documents that facilitate control and explain how they do
so:
a. Shipping document
b. Remittance advice
c. Uncollectible account form

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7. Why do people perpetrate fraud involving sales transactions?

8. Why is it difficult to detect the withholding of cash receipts?

9. Identify three ways an employee might misappropriate cash receipts.

10. What concern does an auditor have in auditing adjustments to sales?

11. When an entity's controls for collection are ineffective, what potential misstatements could
arise in the financial statements?

12. What tests of controls related to uncollectible accounts do auditors perform?

Multiple Choice Questions

1. To determine whether an entity's internal control operated effectively to minimize error of

failure to post invoices to the customers' accounts ledger, the auditor would select a sample of
transactions from the population represented by the
a. Customer order file.
b. Bill of lading file.
c. Subsidiary customers' accounts ledger.
d. Sales invoice file.

2. To gather audit evidence that uncollected items in customers' accounts represented valid trade
receivables, the auditor would select a sample of items from the population represented by the
a. Customer order file
b. Bill of lading file
c. Subsidiary customers' accounts ledger
d. Sales invoice file

3. Tracing copies of sales invoices to shipping documents will provide evidence that all
a. Recorded sales were shipped.
b. Invoiced sales were shipped
c. Shipments to customers were invoiced.
d. Shipments to customers were recorded as sales.

211
4. Tracing copies of sales invoices to shipping documents will provide evidence that all
a. Shipments to customers were recorded as receivables.
b. Billed sales were shipped.
c. Debit to subsidiary accounts receivable ledger are for sales shipped.
d. Shipments to customers were billed.

5. To achieve good internal control, which department should perform the activities of matching
shipping documents with sales order and preparing daily sales summaries?
a. Billing
b. Shipping
c. Credit
d. Sales order

6. Which of the following would the auditor consider to be an incomplete operation for a cashier if
the cashier receives remittances from the mailroom?
a. Posting the receipts to the accounts receivable subsidiary ledger cards.
b. Making the daily deposit at the local bank.
c. Preparing the daily deposit
d. Endorsing the checks

7. The most likely result of ineffective internal controls in the sales cycle is that
a. Fictitious transactions could be recorded, causing an understatement of revenues and an
overstatement of receivables.
b. Irregularities in recording transactions in the subsidiary accounts could delay the shipment
of goods.
c. Omission of shipping documents could go undetected, causing an understanding of
inventory
d. Final authorization of credit memos by personnel in the sales department could permit an
employee defalcation scheme.

8. For the most effective internal control, monthly bank statements should be received directly
from the banks and reviewed by the
a. Controller
b. Cash receipts accountant
c. Cash disbursements accountant
d. Internal auditor

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9. Which of the following describes the most effective preventive control to ensure proper
handling of cash receipt transactions?
a. Have bank reconciliations prepared by an employee not involved with ash collections and
then have them reviewed by a supervisor.
b. Have one employee issue a pre-numbered receipt for all cash collections have another
employee match daily totals of pre-numbered receipts to bank deposits.
c. Use predetermined totals (hash totals) of cash receipts to control posting routines.
d. Have the employee who receives customer mail prepare the daily bank deposit; have
another employee actually make the deposit.

10. As payments are received, one mailroom employee is assigned the responsibility of prelisting
receipts and preparing the deposit slip prior to forwarding the receipts, the deposit slip, and the
remittance advices to accounts receivable for posting. Accounts receivable personnel refoot the
deposit slip, stamp a restrictive endorsement on the back of each check, and then forward the
receipts and the deposit slip to the treasury department. Which of the following is a reasonable
assessment of internal control in this process?
a. Internal control is adequate.
b. Internal control is inadequate because mailroom employees should not have access to cash.
c. Internal control is inadequate because treasury employees should prepare the deposit slip.
d. Internal control is inadequate because of a lack of segregation of duties.

11. For effective internal control, employees maintaining the accounts receivable subsidiary ledger
should not also approve
a. Employee overtime wages
b. Credit granted to customers
c. Write-offs of customer accounts
d. Cash disbursements

12. During an audit of the accounts receivable function, you found that the accounts receivable
turnover rate had fallen from 7.3 to 4.3 over the last three years. What is the most likely cause
of the decrease?
a. An increase in the discount offered for early payment
b. A more liberal credit policy

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c. A change form net 30 to net 25
d. Greater cash sales

13. Shipping documents should be traced to and compared with sales records or invoices to
a. Determine whether payments are properly applied to customer accounts.
b. Ensure that shipments are billed to customers.
c. Determine whether unit prices billed are in accordance with sales contracts.
d. Ascertain whether all sales are supported by shipping documents.

14. An auditor noted that the accounts receivable department is separate from other accounting
activities. Credit is approved by a separate credit department. Control accounts and subsidiary
ledgers are balanced monthly. Similarly, accounts are aged monthly. The accounts receivable
manager writes off delinquent accounts after one year or sooner, if a bankruptcy or other
unusual circumstance is involved. Credit memoranda are pre-numbered and must correlate with
receiving reports. Which of the following areas could be viewed as an internal control weakness
of the above organization?
a. Write-offs of delinquent accounts
b. Credit approvals
c. Monthly aging of receivables
d. Handling of credit memos

15. Checks from customers are received in the company mailroom each day. Which of the
following controls should be in place to safeguard them?
a. Establish a separate post office box for customer payments.
b. Forward all checks to the cashier upon receipt.
c. Require a specific mail clerk to list and restrictively endorse each check.
d. Provide bonding protection for mail clerks,

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Exercises

Exercise 1

The following matters were noted in the audit of Pat Express.

1. No collection was ever made for a sale to Sister Company because the invoice was never
billed.
2. A cash collection for the account of Rain Company was misappropriated by the cashier
3. The accounts receivable clerk posted to the Kiko's account a sale made to Josie.
4. A shipment included four pairs of JC-1 clamps rather than four individual clamps.
5. A properly executed invoice for a valid sale was not recorded.
6. An order was never billed because the shipping document was misplaced
7. In an attempt to meet profit goals, more goods were shipped than customers had ordered.
8. A sale that occurred on December 31, the last day of the accounting period, was recorded
in the next accounting period.

Required:

Answer the following questions about each of the eight situations.

a. What control would have prevented or detected the misstatement?
b. What test should an auditor perform to test the control?
c. To which financial statement assertion does the misstatement relate?

Exercise 2

The following questions related to cash are included on the internal control questionnaire for Niko
Company.

1. Do different people handle cash and maintain the records of cash receipts?
2. Is a prelisting of cash made immediately for mail receipts?
3. Are cash receipts deposited intact daily?
4. Is monthly bank reconciliation prepared by someone not involved in handling cash?
5. Does an employee verify and approve cash discounts taken?
6. Does someone other than the cashier obtain the validated deposit slip and compare the balance
to the cash summary?

215
Required:
For each of the six questions on the Niko Company internal control questionnaire,
a. Identify the financial statement assertion to which the control relates.
b. Identify a potential misstatement that could arise from the absence of the control
c. Identify the test of controls an auditor might perform the controls that exist.

Exercise 3

You are performing tests of controls for sales transactions for Ver Co., a distributor or consumer
electronics. While talking to Rain Yee, the senior sales clerk, you mention that your television has
just broken. A short time later, the sales manager comes around and offers you the opportunity to
purchase goods at the same price paid by employees, which is substantially below prices offered by
discounters. He informs you that employees frequently take advantage of this benefit for themselves
and for close friends. He informs you that all you need to do is order the goods from Rain Yee and
pay her with cash or a check.

Required: How should you respond?

Exercise 4

After determining that computer controls are valid, Honey is reviewing the sales system of Babe
Corporation to determine how a computerized audit program may be used to assist in performing
tests of Babe's sales records.

Babe sells crude oil from one central location. All orders are received by mail and indicate the
preassigned customer identification number, desired quantity, proposed delivery date, method of
payment, and shipping terms. Because price fluctuates daily, orders do not indicate a price. Price
sheets are printed daily and details are stored in a permanent disk file. The details of orders are also
maintained in a permanent file.

Each morning the shipping clerk receives a computer printout with details of customers' orders to be
shipped that day. After the orders have been shipped, the shipping details are entered into the
computer, which simultaneously updates the sales journal, perpetual inventory records, accounts
receivable and sales accounts.

216
The details of all transactions, as well as daily updates, are maintained on disks that are available for
Honey to use in performing the audit.

Required:
a. How may Honey use a computerized audit program to perform substantive tests of Babe's sales
records in their machine-readable form? Do not discuss accounts receivable and inventory.
b. After Honey performs these tests with the assistance of the computer, what other auditing
procedures should Honey perform to complete the examination of Babe's sales record?

Exercise 5

The following are audit procedures in the sales and collection cycle.
1. Examine a sample of shipping documents to determine if each has a sales invoice number
included on it.
2. Discuss with the sales manager whether any sales allowances have been granted after the
statement of financial position date that may apply to the current period.
3. Add the columns on the aged trial balance and compare the total with the general ledger
4. Observe whether the controller make an independent comparison of the total in the general
ledger with the trial balance of accounts receivable.

Required:
a. For each procedures, identify the applicable type of audit evidence.
b. For each procedures, identify which of the following it is:
1) Test of control
2) Substantive test of transactions
3) Analytical procedure
4) Test of details of balances
c. For those procedures you identified as a test of control or substantive test of transactions, what
internal control objective of objectives are being satisfied?
d. For those procedures you identified as a test of details of balance, what audit objectives or
objectives are being satisfied?

217
Problem

An improper cutoff of transaction around year-end occurs when journal entries are record in the wrong
year. In case, you are to determine the effects of various cutoff misstatement relating to recording cash
receipts received on accounts receivable and the recording of credit sales. To effectively consider the
effect of an improper cutoff, it is helpful to consider the underlying journal entries

Type of Transaction Proper Journal Entry (Entries)

Cash receipts on an Cash 3,000.00
account receivable Accounts Receivable
3,000.00
Credit sale- periodic inventory Accounts receivable 2,000.00
system Sales 2,000.00
Credit sale- perpetual inventory Accounts receivable 2,000.00
system Sales
Cos of Goods Sold 2,000.00
Inventory 1,300.00
1,300.00

An example of a possible improper cutoff is to “close” the cash receipts journal on December 30 and
included December 31 ). As a result, cash is understated by P3,000, while accounts receivable is
overstated by P3,000 for the year just ended. The effect of closing the sales journal depend upon
whether a periodic inventory or perpetual inventory system is in use. The effects of “leaving open”
journals past year-end and dating January entries as of December may be determined in a similar
manner.

Required:

Assume that the client made the following actual credit sales and received cash receipts as follows
after 12/29/20X8:

Sales Cost of Goods Sold Cash Receipts

(Receivable Collected)
12/30/X8 P 1,000 P 600 P 4,000
12/31/X8 2,000 1,300 3,000
1/1/X9 3,500 2,200 2,500
1/2/X9 2,900 2,900 3,200

218
Determine the overstatements and understatements that would result from the following situations.
Assume that each situation is independent of one another. As an illustration, situation 1 has been
solved for you. To simplify the problem, in the case of perpetual inventory, assume that the year-end
inventory count did not identify and correct the misstatement(s).

Situation Cash Acct. Rec Inventory CGS Sales Income

1. Square Inc. left the cash receipts journal open P2,500 (o) P2,500 (u)
after year-end for an extra day and included
January 1 cash receipts in the December 31totals.
The company uses a periodic inventory system.
What effect would this have in 20X8?

2. Square Inc. closed the cash receipts journal

at12/29 and reported the last two days of cash
receipts in January of 20X9. The company usesa
periodic inventory system. What effect would
this have on 20X8?

3. Square Inc. left the sales journal open after

year-end for an extra day and included January
1sales in the December 31 totals. The company
uses a periodic inventory system. What effect
would this have on 20X8?

4. Square Inc. left the sales journal open after

year-end for an extra day, and included January
1sales in the December 31 totals. The company
uses a perpetual inventory system. What effect
would this have on 20X8?

5. Square Inc. closed the sales journal at 12/29 and

reported the two last days' sales in January
of20X9. The company uses a perpetual inventory
system. What effect would this have on 20X8?

6. Square Inc. left both the sales journal and the

cash receipts journal open through January 2and
reported the first two days' transactions in
December of 20X8. The company uses a periodic
inventory system. What effect would this have
on 20X8?

Note: The Substantive Tests of Details of Balances of the Principal Accounts affect by the
Revenue and Collection Cycle are covered in …
Chapter 11 - Audit of Cash Balances
Chapter 12 - Audit of Trade Receivable, Allowances for
Doubtful Accounts and Sales

219
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
EXPENDITURE CYCLE

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Enumerate and describe the steps involved in auditing the

expenditure cycle

2. Describe the nature and the major classes of transactions in the

expenditure cycle.

3. Explain the process analyzing and recording transactions in the

expenditure cycle, i.e., purchase, purchase adjustments and cash
disbursements transactions as well as the corresponding accounts,
documents and records used.

4. Apply the risk assessment and risk response phases of the audit
process, i.e., test of controls and substantive tests of transactions in
the expenditure cycle.

220
CHAPTER 7
AUDIT OF THE EXPENDITURE CYCLE

INTRODUCTION

This chapter covers the explanation of the expenditure (or acquisitions and disbursements) cycle and
the internal control environment and objectives pertaining thereto. Then, consideration is given to
internal controls over the expenditure transactions and to the study and evaluation of controls over
these two classes of transactions.

The following activities should be undertaken by the auditor in relation to the audit of the
expenditure cycle:

1. Diagram the flow of transaction is a typical expenditure cycle, the specific accounts affected
and the elements of control within the cycle.

2. Relate the effect of controls on the assertions embodied in the financial statement

3. Determine the essential features of internal control over the transactions in the expenditure
cycle.

4. Prepare an audit program to gather evidence regarding compliance with control procedures that
reduce control risk.

5. Evaluate effectiveness of controls and perform the substantive tests of transactions to gather
evidence to determine whether financial statement assertions are materially correct on accounts
affected by the expenditure cycle

6. Design tests of details of account balances and analytical procedures to satisfy balance-related
audit objectives.

Steps 1 to 5 are discussed in this chapter while Step no. 6 is covered in Chapters 11 and 13.

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NATURE OF THE EXPENDITURE CYCLE

Basic Considerations

The expenditure cycle involves the activities associated with the acquisition and payment of goods
and services, plant assets and labor. For a trading concern, the major classes of transactions in this
cycle are:

1. Acquisition of goods and services

2. Cash disbursements
3. Purchase returns and allowances and purchase discounts

For a manufacturing firm, production cycle transactions and inventory warehousing transactions are
included in the expenditure cycle in addition to the above-mentioned major classes of transactions.

This chapter does not include the acquisition of all plant and intangible assets, short-term or
long-term securities, the issuance and redemption of long-term debt and the issuance or requisition
of a company's share capital. These transactions are considered to be part of the investing and
financing cycles, the audit of which are tackled in Chapters 9 and 10.

Transactions in the expenditure cycle often affect more financial statement accounts than the other
cycles combined. On the statement of financial position, the expenditure cycle impacts on all current
assets, except marketable securities and receivables, all plant and intangible assets, and many current
liabilities. Transactions in this cycle involve major expenses reflected in the Income Statements such
as salaries and wages, taxes, utilities, advertising, repairs and other expenses manufacturing costs (if
applicable).

Typical accounts included in the acquisition and payment cycle are shown by T- accounts in Figure
7-1. Note the large number of accounts affected by this cycle. To keep the illustration manageable,
only the control accounts are shown for the three major categories of expenses used by most
companies. For each control account, examples of the subsidiary expense accounts are also given.
Because of the large number of accounts in the cycle, it is not surprising that it often takes more time
to audit the acquisition and payment cycle than any other.

Figure 7-1 shows that every transaction is either debited or credited to accounts payable. Because
many companies make acquisitions directly by check or through petty cash, the figure is an
oversimplification. We assume that cash disbursement transactions are processed in the same manner
as all others.

222
Figure 7-1 : Accounts in theAquisition and Payment Cycle
Raw material Merchandise
Cash in Bank purchases inventory

Accounts payable
Purchase return Cash Acquisitions of Property, plant and
and allowances disbursements goods & services equipment
Purchase
returns &
allowances
Purchase
Purchase discounts discounts Prepaid expenses
Selling expenses
Subsidiary accounts
Commisions
Travel expenses
Manufacturing Delivery expenses Administrative
Expense control Repairs expense control
Account Advertising account
Subsidiary accounts Subsidiary accounts
Repair & Supplies
Maintenance Officers' travel
Taxes Legal
Supplies Auditing fees
Freight in taxes
Utilities

223
PROCESSING EXPENDITURE TRANSACTIONS

Summary of Business Functions in the Expenditure Cycle and Related Documents and
Records

The acquisition and payment cycle involves the decisions and processes necessary for obtaining the
goods and services for operating a business. The cycle typically begins with the initiation of a
purchase requisition by an authorized employee who needs the goods or services and ends with
payment for the benefits received. Although the discussion that follows deals with a small
manufacturing company that makes tangible products for sale to third parties, the same principles
apply to a service company, a government unit, or any other type of organization.

There are four business functions shown in the third column of Figure 7-2. These functions occur
in every business in the recording of the three classes of transactions in the acquisition and payment
cycle. Observe that the first three business functions are for recording the acquisition of goods and
services on account and the last process if for recording the cash disbursements for payments to
vendors. Processing purchase returns and allowances and purchase discounts are also business
functions in the cycle, but these are not separately shown on Figure 7-2 because the amounts are not
significant for most companies.

This section explains the four business functions in Figure 7-2 and describes typical documents
and records for each function. These documents and records are shown in the fourth column of
Figure 7-2. It is essential to understand the business functions and documents and records in a
company before assessing control risk and designing test of controls and substantive tests of
transactions.

Typically, the accounts affected by the expenditure cycle are:

1. Purchases
2. Accounts and notes payable-trade
3. Purchase returns and allowances
4. Cash in bank (credit for cash disbursements)
5. Purchase discount
6. Inventories (merchandise; finished goods; raw materials; goods in process)
7. Manufacturing and operating expenses (selling and administrative) requiring cash
payments.

224
Figure 7-2 Classes of Transactions, Accounts, Business Functions, and Related Documents
and Records for the Acquisition and Payment Cycle

Classes of Business Documents and

Transactions Accounts Functions Records

Acquisitions Inventory (1) Processing purchase Purchase

Property, plant & equip. orders requisition
Prepaid expenses Purchase order
Leasehold
improvements
Accounts payable
Manufacturing
expenses
Selling expenses
Administrative
expenses

(2) Receiving goods and Receiving report

services
(3) Recognizing the Acquisition journal
liability Summary
acquisitions
report
Vendor’s invoice
Debit memo
Voucher
Accounts payable
master file
Accounts payable
trial balance
Vendor’s statement

Cash Cash in bank (from (4) Processing and Check

disbursements cash disbursements) recording cash Cash disbursements
Accounts payable disbursements journal
Purchase discounts

225
Documents Used in the Expenditure Cycle and their Audit Significance

Documents Audit Significance

Purchase Requisition
A prenumbered document that originates in the
inventory stockroom or an operating department
A purchased requisition provides evidence
and indicates to the purchasing department that
that the purchasing department was
goods should be ordered. A requisition
authorized to initiate a purchase.
describes the items, specifies the quantity
needed, and indicates the requester.
Purchase order
A prenumbered document recording the
description, quantity, and related information A purchase order contains the signature of
for goods and services the company intends to the employee who authorized a purchase
purchase. This document is frequently used to from a vendor.
services.
Receiving report
A prenumbered document prepared at the time
This report is prepared within the entity
tangible goods are received that indicates the
and provides evidence that goods were
description of goods, the quantity received, the
received.
date received, and other relevant data.
Vendor's invoice
A document that indicates the description and
This document is created externally and
quantity of goods and services received, price,
provides evidence about a purchase of
including freight, cash discount terms, and date
goods or services.
of the billing.
Debit memo
A prenumbered document indicating a
reduction in the amount owed to a vendor
because of returned goods or an allowance
granted.
Voucher
A prenumbered document to establish a formal
means of recording and controlling acquisitions
A voucher provides documentation or the
prepared by a payables clerk for each payment.
recording of a transaction.
A vendor’s invoice, a receiving report, and a
purchase order are attached to it.
Check
A check that has been presented for
A prenumbered written authorization to a bank payment is referred to as paid or canceled
to transfer funds to the payee. Checks are used check. A paid check provides evidence
as a means of payment. about payments that an entity has made,
such as date, payee, and amount.

226
Vendor’s statement
A statement prepared monthly by the vendor Vendor’s statements may be used to
indicating the beginning balance, acquisitions, determine that all transactions recorded on
returns and allowances, payments to the vendor, the statements have been recorded in the
and ending balance. books.

Accounting Records Involved in the Expenditure Cycle

Purchased journal

A journal for recording purchased transactions.

Cash disbursement transaction file / journal

A file for recording the individual payments made by check. It contains the total cash paid, the
debit to accounts payable at the amount the transaction was recorded in the acquisition
transaction file, discount taken, and other debits and credits.

Accounts payable master file / subsidiary ledger

A file for recording individual acquisitions, cash disbursements, and acquisition returns and
allowances for each vendor.

Cost Accounting Records

These records in a manufacturing company are used to summarize transactions affecting Raw
Materials, Goods in Process, Finished Goods, Labor Costs and Manufacturing Overhead.

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AUDIT OF THE EXPENDITURE CYCLE

PHASE I-RISK ASSESSMENT

I. PERFORMING RISK ASSESSMENT PROCEDURES IN THE ACQUISITION

AND PAYMENT CYCLE

As part of performing risk assessment procedures, the auditor obtains information that is
useful in assessing the risk of material misstatement. This includes information about
inherent risks at the financial statement level (for example, the client’s business and
operational risks, financial reporting risks) and at the account and assertion levels, fraud
risks including feedback from audit team brainstorming sessions, strengths and
weaknesses in internal control, and results from preliminary analytical procedures.

Once the risks of material misstatement have been identified, the auditor then determines
how best to respond to them as part of the audit opinion formulation process.

Identifying Inherent Risks

Inventory is usually material, complex and subject to manipulation. Given the large
number of inventory-related fraud that have been perpetrated, auditors should exercise
particularly high levels of professional skepticism in audits of inventory and cost of goods
sold accounts.

 A great variety (diversity) of items exists in inventory.

 Inventory accounts typically experience a high volume of activity.
 Inventory accounts may be valued according to various accounting valuation
methods.
 Identifying obsolete inventory and applying the lower of cost or market principle to
determine valuation are difficult tasks.
 Inventory are easily transportable.
 Because inventory often includes a variety of types of products, the auditor must
possess and apply significant knowledge about the business in order to address
obsolescence and valuation questions.
 Individuals involved with the purchase of inventory may have incentives to exploit
weaknesses in the control system to their economic advantage.

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Identifying Fraud Risk Factors

Because of the volume of transactions, as well as the ability to physical move inventory,
the acquisition and payment cycle is often the subject of fraud. Most of the frauds in this
cycle involve overstatement of inventory or assets and understanding of expenses. Many
disbursements frauds involve fictitious purchases or, in some cases, kickbacks on the
purchasing agent.

Examples of fraud in the acquisition and payment cycle include:

 Theft of inventory by the employee

 Inventory shrinkage, which is a reduction in inventory presumed to be due to physical
loss or theft
 Employee schemes involving fictitious vendors as means to transfer payments to
themselves
 Executives recording fictitious vendors as means to transfer payments to themselves.
 Executives recording fictitious inventory or inappropriately recording higher values
for existing inventory by creating false records for items that do not exist (for
example, inflated inventory count sheets and bogus receiving reports or purchase
orders)
 Large manual adjustments to inventory accounts
 Schemes to classify expenses as assets (for example, inappropriately capitalizing
items that are truly current-period expenses)
 Executives misusing travel and entertainment accounts and charging them as
company expenses

229
Figure 7-3 identifies some of the possible fraudulent schemes for manipulating inventory
and cost of goods sold.

Figure 7-3: Approaches for Manipulating Inventory and Cost of Goods Sold

Event Affected Accounts Possible Manipulations

1. Purchase inventory Inventory, accounts payable Under-record purchases
Record purchases in a later
period
Not record purchases

2. Return inventory to Accounts payable, inventory Overstate returns

supplier Record returns in an earlier
period
3. Inventory is sold Cost of goods sold, inventory Record at too low an amount
not record cost of goods sold
nor reduce inventory
4. Inventory becomes Loss on write-down of Not write off or write down
obsolete inventory, inventory obsolete inventory
5. Periodic count of Inventory shrinkage, inventory Overcount inventory (double
inventory quantities counting, etc.)

Identifying Control Risks

Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement in the acquisition and payment cycle accounts, the auditor needs to
understand the controls that the client has designed and implemented to address those
risks. Remember, the auditor is required to gain an overall understanding of internal
controls for both integrated audits and financial statement only audits. Such understanding
is normally gained by means of a walkthrough of the process, inquiry, observation, and
review of the client’s documentations. The auditor considers both entity-wide controls and
transaction controls at the account and assertion levels. This understanding provides the
auditor with a basis for making an initial control risk assessment.

230
Overview of Common Controls in the Requisition Process

Inventory Purchases: Manufacturing Organization

 Written requisitions are made for specific products by the production manager or
stockroom manager.
 Computer-generated requisitions are generated based on current inventory levels and
production plans.

Inventory Purchases: Retail Organization

 Overall authorization to purchase product lines is delegated to individual buyers by

the marketing manager. The authorization is built into the computer as a control. The
limit for individual goods can be exceeded only on specific approval by the marketing
manager.
 Store managers may be granted authority to purchase a limited number of goods. The
store manager’s ability to issue a purchase order may be subject to overall corporate
limits, usually specified in dollars.
 The supplier may have access to the retailer’s inventory database and, by contract,
ship replacement merchandise bases on sales activity and reorder points.

Inventory Purchases: Just-in-Time Manufacturing Process

 An agreement is signed with the supplier whereby the supplier agrees to ship
merchandise (just in time) according to the production schedule set by manufacturer.
Along-term supply contact is negotiated specifying price, quality of products,
estimated quantities, penalties for product shortages or quality problems, and so forth.
Specific purchase orders are not issued; rather, the production plan is communicated
to the supplier with the specified delivery dates. The production plan serves as the
requisition.

Supplies Purchases

 Requisitions are issued by individual departments and sent to the appropriate

department manager for approval.
 Each department may be given a budget for supplies and may have the ability to issue
purchase orders directly for the needed items or may be able to purchase a limited
number of items without a purchase order.

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Performing Preliminary Analytical Procedures

When planning the audit, the auditor is required to perform preliminary analytical procedures.
These procedures can help auditors identify areas of potential misstatements.

The following are examples of possible expected relationships in the acquisition and payment
cycle:

 Assume that the company’s production and pricing strategies have remained the same
during the past year. Gross margin is expected to be stable and consistent with the industry
average.
 Assume that the company has introduced a new product with a low price point and
significant customer demand. Inventory turnover is expected to increase, and days’ sales in
inventory are expected to decrease.
 Assume that the company has invested in a new manufacturing process that results in
significantly less waste and overall increases in efficiency during the production process.
Cost of goods sold is expected to decline, and gross margin is expected to increase.

The following relationships might suggest a heightened risk of fraud in the acquisition or
payment cycle:

 Unexpected increases in gross margin

 Inventory that is growing at a rate greater than sales
 Expenses that are either significantly above or below industry norms
 Unexpected increases in the number of suppliers
 Capital assets that seem to be growing faster than the business and for which there are no
strategic plans
 Expense accounts that have significant credit entries
 Travel and entertainment expense accounts, but no documentation or approval of
expenditures
 Inadequate follow-up to the auditor’s recommendations on needed controls

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PHASE II- RISK RESPONSE

Responding to Identified Risks of Material Misstatement

Once the auditor has developed an understanding of the risks of material misstatement, the
auditor can determine the appropriate audit procedures to perform. Audit procedures should be
proportional to the assessed risks, with areas of higher risk receiving more audit attention and
effort. Responding to identified risks typically involves developing an audit approach that
contains substantive procedures (for example, test of details and, when appropriate, substantive
analytical procedures) and tests of controls, when applicable. The appropriateness and
sufficiency of selected procedures vary to achieve the desired level of assurance for each
relevant assertion. While audit firms may have a standardized audit program for auditing the
acquisition and payment cycle, the auditor should customize the audit program based on the
assessment risk of material misstatement.

The auditor may develop an audit program that consists of first performing limited tests of
operating effectiveness of control, then performing limited to moderate substantive analytical
procedures, and finally performing extensive substantive tests of details. Because of the high
risk, the auditor will want to obtain a great deal of evidence directly from tests of details. In
contrast, consider a client where the auditor has assessed the risk of material misstatement
related to the existence of inventory as low, and believes that the client has implemented
effective controls in this area. For this client, the auditor will likely perform tests of controls,
gain a high level of assurance from substantive analytical procedures such as a reasonableness
test, and then complete the substantive procedures by performing tests of details at a limited
level.

233
AUDITING ACQUISITION TRANSACTIONS

This section covers the following areas:

I. Evaluation and Obtaining Evidence About Internal Control Operating Effectiveness

in the Acquisition Cycle
II. Tests of Controls over Acquisition Transactions
III. Illustrative Audit Program for Acquisition Transactions
IV. Substantive Tests of Acquisition Transactions

Typically, the acquisition transactions involve the following business activities.

a. Processing purchase orders

b. Receiving goods and services
c. Recognizing the liability
d. Cash disbursements

Figure 7-4 shows a flowchart of the manual system for executing acquisition and purchases
transactions. While Figure 7-5 shows the flowchart of purchase returns.

234
Figure 7-4:
4: Purchases Flowchart
Figure 7-5: Purchase Returns
I. Evaluation and Obtaining Evidence About Internal Control Operating Effectiveness
in the Acquisition Cycle

For integrated audits, the auditor will test the operating effectiveness of important controls
as of the client’s year end. If the auditor wants to rely on controls for the financial
statement audit, the auditor will test the operating effectiveness of those controls
throughout the year.

Figure 7-6 illustrates an internal control questionnaire for acquisition of goods and
services that may be used in obtaining evidence on the operating effectiveness in the
acquisition cycle.

Figure 7-6: Internal Control Questionnaire for Acquisition

Cycle: Expenditure Class of Transactions: Acquisitions
Yes No NA Remarks
Executing
1. Is there separation between
authority, recording, and
custody of merchandise /
supplies purchases?
2. Are steps taken to ensure the
best price for merchandise?
3. Is immediate control
established over
merchandise received from
vendors?
4. Are receiving reports made
out after an independent
count?
5. Is a signed receipt obtained
form storeroom on delivery
of goods by receiving?
6. Are purchase orders,
receiving reports, and
vendors’ invoices matched
in preparing vouchers?
7. Are vouchers internally
verified for accuracy?
8. Are vouchers approved by
authorized personnel?
9. Are daily voucher
summaries prepared and
agreed to vouchers issued?

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Recording
1. Are all issued vouchers accounted for in
journalizing?
2. Are voucher register entries reviewed for
reasonableness?
3. Are unpaid voucher file and perpetual inventory
records independently maintained?
4. Are there periodic independent reconciliations of
control accounts and subsidiary records?
Custody
1. Are goods stored in locked areas with restricted
access?
2. Are there periodic independent comparisons of
inventory records with goods on hand?

II. Test of Controls over Acquisition Transactions

For integrated results, the auditor will test the operating effectiveness of important controls
as the client’s year end. If the auditor wants to rely on controls for the financial statement
audit, the auditor will test the operating effectiveness of those controls throughout the year.

The following assertions relate to acquisitions transactions.

General Specific
1. Existence or occurrence 1. Recorded acquisitions are for items that
were acquired.
2. Completeness 2. Acquisition that occurred are recorded.
3. Rights and obligations 3. Recorded acquisitions are the entity’s
purchases and liabilities.
4. Valuation or allocation 4. Acquisitions are recorded for the proper
amounts.
5. Presentation and disclosure 5. Acquisitions are recorded to result in
presentation and disclosure in accordance
with PAS / PFRS.

In many instances, more than one control is required to ensure the validity of an assertion.
Because specific controls may vary with the client, the tests of controls discussed in this
section should be viewed as illustrative only.

238
The following sections present the controls an entity should have to ensure the propriety of
each assertion and the tests an auditor might perform to determine the effectiveness of the
controls on acquisitions transactions.

Discussion:

A. Existence or Occurrence: Recorded acquisitions are for items that were acquired.

Controls Tests of Controls

1. Acquisitions should be approved by 1. Auditor should examine the approval
authorized personnel. Approval of signature.
acquisition is evidenced by signature on the
purchase order.
2. A voucher should be prepared for the 2. To test this control, the auditor
purchase of goods. This should be supported observes the procedure and
by properly executed purchase requisition, examines the file of documents. If
purchase order, receiving report, and the entity does not prepare vouchers,
vendor’s invoice. the auditor should review the entries
in the purchases journal and examine
the documents underlying them for
authenticity and reasonableness.
3. The check signer should examine the 3. The auditor can examine
supporting documentation and cancel the cancellations on the documents to
documents, making them “paid” or writing test this control. If an entity does not
the date and number of the check on the effectively cancel supporting
document. documents, the auditor should be
concerned that duplicate payment
may have been made and should
scan the voucher register for
multiple entries of similar amounts.

B. Completeness: Acquisitions that occurred are recorded.

4. Prenumbered receiving reports should be 4. To test this control the auditor

used and accounted for to determine that should observe the procedure and
liability is recorded for all goods received. account for the numerical sequence
of the receiving report.
5. Vouchers are prenumbered and accounted for 5. The auditor should observe
as they are entered in the voucher registered. procedure and account for the
numerical sequence of the voucher.

239
C. Rights and Obligations: Recorded acquisitions are the entity’s purchases and
liabilities.

6. Receiving reports should be prepared by 6. To test this control, the auditor should
persons having access only to a blind observe that the procedure is being
copy of purchase order details. Requiring performed.
a purchase order for the recording of all
acquisitions will preclude recording
consigned goods as well as goods
ordered for personal use of employees.

D. Valuation or Allocation: Acquisitions are recorded in the proper amounts.

7. Invoice amounts are verified by a clerk 7. The auditor should examine the voucher
by reference to the purchase orders and for signature indicating performance.
receiving reports. Mathematical
accuracy of the invoice is also
rechecked.

E. Presentation and Disclosure: Acquisitions are recorded to results in presentation and

disclosure in accordance with PAS/PFRS.

8. Require employees to use a chart of 8. Auditor should examine the chart of

accounts that adequately describes accounts. Also, he or she should examine
accounts to be debited. Account coding the signature of employee performing
is assigned by one person and checked the checking or verification.
by another.

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III. Illustrative Audit Program For Tests Of Controls: Acquisition Transactions

The following audit program summarizes the audit procedures that auditors may use to test
controls on acquisitions transactions.

Happy Sounds Corporation

Test of Controls: Acquisitions
December 31, 20X7

Done
WP
Audit Procedures Ref By Date
1. For a sample of purchases, examine the related purchase
requisition and purchase order.
2. For a sample of purchases, trace the transaction to the voucher
register and the perpetual inventory records maintained in stores.
3. Check vendor invoice for mathematical accuracy.
4. Trace posting from the voucher register to the general ledger.

Possible errors that may result due to control weaknesses over acquisitions transactions follow:

Internal Control
Weaknesses or Factors That
Increase the Risk of the Examples of Fraud / Error Description of Possible
Misstatement Errors or Misstatement
1. Documentation of 1. A purchase order is 1. Unauthorized purchases;
purchase transactions, made for goods that Payments made to
incomplete and have not been vendors for goods and
inadequate; ineffective authorized or requested. services not authorized.
controls for matching
purchase requisitions
with purchase orders.
2. Ineffective controls for 2. Goods are ordered but 2. Misappropriation of
matching invoices with delivered to an goods purchases.
receiving documents inappropriate address
before disbursements are and stolen.
authorized.

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3. Inadequate segregation 3. A bookkeeper prepared 3. Inaccurate recording of a
of duties of records a check to himself and purchase or
keeping and preparing records it as having been disbursements.
cash disbursements, or issued to a major
check signer does not supplier.
review and cancel
supporting documents.
4. Ineffective controls for 4. A purchase is recorded 4. Duplicate recording or
review and cancellation when an invoice is purchases.
of supporting documents received from a vendor
by the check signer. and recorded again
when a duplicate
invoice is sent by the
vendor.
5. Accounting manuals not 5. Purchase of 5. Error in recording
used. merchandise purchase transactions.
erroneously recorded as
purchase of equipment.

6. Creditors’ statements not 6. Creditor is paid twice 6. Undetected errors in

examined for possible when bookkeeper fails recording purchases
errors. to reconcile postings in transactions.
the AP subsidiary ledger
with creditor’s
statement of account.
7. Ineffective board of 7. Purchases journal 7. Late (early) recording of
directors, audit “closed early” with this cost purchases - “cutoff
committee, or internal period’s purchases problems”.
audit function; top recorded as having
management action not occurred in subsequent
conducive to ethical period.
conduct; undue pressure
to meet earnings target.

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IV. Substantive Tests Of Acquisition Transactions

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine that 1. Examine underlying
recorded purchases are documents for
for items that were authenticity and
acquired. reasonableness. Scan
voucher register for large
or unusual items. Inspect
acquired property, plant
and equipment. Trace
inventory purchased to
perpetual records, scan
voucher register for
duplicate payment.
II. Completeness B. To determine that 2. Trace a sequence of
purchases that occurred receiving reports to
are recorded. entries in the voucher
register. Test cutoff.
Account for a sequence
of entries in the voucher
register.
III. Rights and Obligations C. To determine that 3. Trace from invoices to
purchases are the perpetual inventory
entity’s acquisitions and records. Examine
liabilities. vendor’s invoices to
determine that goods
were purchased.
IV. Valuation or Allocation D. To determine that 4. Recomputed invoices
purchases are recorded and compare invoice
for the proper amount. price to purchase order.

V. Presentation and E. To determine that 5. Check accuracy of

Disclosure purchases are recorded accounts on invoices by
to result in presentation reference to chart of
and disclosure in accounts.
accordance with
PAS/PFRS.

243
Discussion of Audit Procedures

1. Examine underlying documents for authenticity and reasonableness. Scan voucher

register for large or unusual items. Inspect acquired property, plant and equipment.
Trace inventory purchased to perpetual records. Scan voucher register for duplicate
payments.

To test the existence of acquisitions transactions in the voucher register, an auditor should
examine for selected transactions, the underlying documents — the voucher, purchase
order, receiving report, and vendor's invoice. The auditor should also physically inspect
additions to fixed assets to substantiate their existence and trace inventory purchases to
perpetual records. The auditor can scan the voucher register as well as files of check copies
to them for possible duplicate payments of invoices.

2. Trace a sequence of receiving reports to entries in the voucher register. Test cutoff.
Account for sequence of entries in the voucher register.

The auditor may select a sequence of receiving reports and vouchers to determine that
entries have been made for them in the voucher register or purchases journal. He / She can
perform a cut-off test at year-end to as certain that all acquisitions occurring during he year
have been recorded.

3. Trace from invoices to perpetual inventory records. Examine vendor's invoices to

determine that goods were purchased.

The auditor should examine supporting documents to as certain that goods were not
received on consignment, that the goods were not delivered to another location, simply
that the ordered goods were received. These supporting documents include the voucher,
vendor's invoice, receiving report, purchase order, and purchase requisition.

4. Recomputed invoices and compare invoice price to purchase order.

To ensure that acquisitions are recorded for proper amounts, auditor may select a sample
of transactions and examine the purchase requisition trace the price to the purchase order;
compare the quantity on the invoice with the quantity in the receiving report and
recalculate the invoice total. The auditor might also choose to perform the substantive
testing of prices paid by tracing prices in published catalogs at the time of the purchase.

244
5. Check accuracy of accounts on invoices by reference to chart of accounts.

Auditors can review documents underlying entries in the voucher register to determine
whether the invoice was correctly coded and will be properly presented and disclosed in
the financial statements. This procedure can be performed simultaneously with substantive
tests of valuation.

AUDIT OF CASH DISBURSEMENTS

This section covers the following areas:

I. Evaluation and Obtaining Evidence About Internal Control over Cash Disbursements
Transactions
II. Tests of Controls over Cash Disbursements Transactions
III. Illustrative Audit Program for Cash Disbursements Transactions
IV. Substantive Tests of Cash Disbursements Transactions

Typically, the cash disbursement transactions involve the following business activities.

a. Recording of transactions in a voucher register with appropriate supporting

documents such as purchase order and receiving report.

b. Submission of approved vouchers and supporting papers and unsigned check to the
Finance Department.

c. Release of checks signed by authorized signatories.

d. Recording of checks issued.

Figure 7-7 shows a flowchart for processing cash disbursements.

245
Figure 7-7:
7: Cash Disbursement Processing
I. Evaluation and Obtaining Evidence about Internal Control over Casb Disbursements
Transactions

Figure 7-8: Internal Control Questionnaire for Cash Disbursements Transactions

Cycle: Expenditure Class of Transactions: Cash Disbursements

Yes No NA Remarks
Executing
1. Are all disbursements (except for petty cash) made
by checks?
2. Are imprinted and renumbered checks used?
3. Is a check-protection device used in printing the
check amount?
4. Is each check supported by an approved voucher?
5. Is supporting documentation mutilated after
payment?
6. Are two signatures required on each check?
7. Does last check signer mail the check and
remittance advice?
8. Are there prohibitions against issuing checks to cash
or bearer?
9. Is the signing of blank checks prohibited?
10. Is daily summary of checks prepared and
agreed to checks issued?

Recording
1. Are accounting personnel prohibited from
signing checks?
2. Are daily summaries of checks compared with check
register totals?
3. Are checks recorded in numerical
sequence?

Custody
1. Are there periodic independent reconciliations of
bank accounts?

247
II. Test of Controls over Cash Disbursements Transactions

Auditors are interested in the effect of controls in the financial statements assertions
embodies in the cash disbursements. Auditors address the following assertions when
testing cash disbursements:
General Specific
1. Existence or occurrence 1. Recorded cash disbursements occurred.
2. Completeness 2. All cash disbursements made are recorded
3. Rights and obligations 3. All cash disbursements made are for
obligations of the entry.
4. Valuation or Allocation 4. Debits to various accounts and credits to cash
are valued at proper amounts.
5. Presentation and disclosure 5. Cash disbursements are recorded to result in
presentation and disclosure inaccordance
with PAS / FRS.

The following sections present the controls an entity should have to ensure the propriety of
each assertion and the tests an auditor might perform to determine the effectiveness of the-
controls on cash disbursement transactions.

Discussion:

a. Existence or Occurrence: Recorded cash disbursements occurred.

Controls Tests of Controls

1. Authorized individual signs and mails 1. The auditor may inquire of the check
promptly the checks after reviewing signer and employees who work with
documentation. him or her about whether this procedure
is followed. The auditor may also
observe if the procedure is being
followed.
2. A review should be made by a person not 2. The auditor may inquire about whether
responsible for handling disbursements this procedure is being followed or may
to determine that checks are processed on examine the outstanding checks list to
a timely basis. determine that checks are being
processed promptly.

248
b. Completeness: All cash disbursements made are recorded.

3. Checks should be prenumbered and 3. To test this control, the auditor should
accounted for to ensure that all checks observe whether employee who prepares
that were written are entered in the the check register accounts for the
check register. sequence of the checks.

4. Employee who does not handle cash 4. He auditor observes that the employee
disbursements and cashreceipts. who prepares the reconciliation does not
handle cash receipts or disbursements. In
addition, the auditor inspects the
reconciliation.

c. Rights and Obligations: All cash disbursements made for obligations of the entity.

5. Check signer who is independent of 5. The auditor tests this control by inquiring
voucher preparation should examine the about the segregation of duties; and
supporting documentation before signing observing whether separation really
checks to determine that the payment is exists. He / She can also inquire about the
for an obligation of the entity. check signer's procedures for reviewing
documents in support of cash
disbursement and may observe the check
signer performing these procedures.

d. Valuation and Allocation: Debits to various accounts and credits to cash are valued at
proper amounts.

6. Amounts (including discounts taken) and 6. To test this control, the auditor should
calculations on vendors' invoices are observe the procedure. He / She can
independently verified. Employee signs examine signatures on paid invoices.
the voucher after verification is done.

249
e. Presentation and Disclosure: Cash disbursements are recorded to result in presentation
and disclosure in accordance with PAS / PFRS.

7. Chart of accounts adequately describes 7. The auditor can test this control by
accounts to be used, and account coding observing the procedure, he can also
is assigned by one person and checked by examine the signatures of the employees
another. performing the review account coding.

III. Illustrative Audit Program For Tests of Controls:

Cash Disbursements Transactions

In summary, typical audit procedures employed by the auditor in testing disbursement for
the period under consideration include the following:

Happy Sounds Corporation

Test of Controls: Cash Disbursements
December 31, 20X7

Done
Audit Procedures WP
Ref
By Date

1. Prove the arithmetical accuracy of the cash disbursements

record and trace postings to the general ledger.

2. Compare paid bank checks with the cash disbursement records.

3. Account for all check.

4. Reconcile recorded disbursements with the bank statement.

5. Examine supporting documents.

6. Review cash disbursements records for unusual items.

250
Possible errors that may result due to control weaknesses over payments to vendors
follows:

Internal Controls
Weaknesses or Factors Examples of Fraud/Error Description of Possible
That Increase the Risk of Errors or Misstatement
the Misstatement

1. Inadequate segregation 1. A bookkeeper prepares a 1. Inaccurate recording of a

of duties of records check to himself and purchase or
keeping and preparing records it as having been disbursement.
cash disbursement, or issued to a major
check signer does not supplier.
review and cancel
supporting documents.
2. Ineffective controls for 2. A disbursement is made 2. Inaccurate recording of a
matching invoices with to pay an invoice for purchase or
receiving documents goods that have not been disbursement.
before disbursements are received.
authorized.
3. Ineffective accounting 3. Disbursement is for 3. Inaccurate recording of a
coding procedures may travel and entertainment purchase or
result from incompetent are improperly included disbursement.
accounting personnel, with merchandise
inadequate chart of purchases.
accounts, or no controls
over the posting process.
4. Ineffective controls for 4. A purchase is recorded 4. Duplicate recording and
review cancellation of when an invoice is payment of purchases.
supporting documents received from a vendor
by the check signer. and recorded again when
a duplicate invoice is
sent by the vendor.
5. Ineffective control over 5. In conjunction with 5. Unrecorded
record keeping for and unrecorded (but disbursements.
access to cash. deposited) cash receipts,
an employee writes and
cashes an unrecorded
check for the identical
amount.

251
IV. Substantive Tests Of Transactions: Cash Disbursements

ASSERTIONS AUDIT OBJECTIVES AUDIT PROCEDURES

I. Existence or Occurrence A. To determine that 1. Examine paid checks for
recorded ash appropriate endorsements.
disbursements occurred. Examine documents
underlying payments.

II. Completeness B. To determine that all cash 2. Reconcile cash

disbursements made are disbursements per books
recorded. with cash disbursements
per the bank. Prepare or
test bank reconciliation.

III. Rights and Obligations C. To determine that all cash 3. Examine underlying
disbursements made were documents.
the entity’s obligations.

IV. Valuation or Allocation D. To determine that debits 4. Recalculate invoices paid.

to various accounts and
credits to ash are valued at
proper amounts.

V. Presentation and E. To determine that cash 5. Check accuracy of

Disclosure disbursements accounts on invoices by
transactions are recorded reference to chart of
to result in presentation accounts.
and disclosure in
accordance with PAS /
PFRS.

252
DISCUSSION OF AUDIT PROCEDURES

Examining Documents Underlying Cash Disbursements

Auditors examine the documents underlying cash disbursements such as receiving reports,
purchase order, purchase requisitions, and vendors' invoice for consistency with each other and
with the entry in the cash disbursements journal. Approvals on these documents provide
evidence that the transaction occurred and that the payment was the entity's debt. Checks with
appropriate endorsements which have been paid by the bank provide evidence about the
existence of the transactions. The auditor likewise recomputes the discount taken to verify
proper valuation of cash disbursement transactions. Accuracy of accounts charged may also be
verified by the auditor by reference to the chart of accounts.

Reconciling Cash Disbursements per Books to Cash Disbursements per Bank

The auditors may prepare a proof of cash which reconciles cash disbursements as recorded on
the bank with cash disbursement recorded by the bank.

Preparing or Testing Reconciliation

The auditors can prepare a bank reconciliation or test a bank reconciliation prepared by the
client for an interim period. When preparing the bank reconciliation, the auditor should receive
the bank sentence directly from the bank. If the bank statement has been opened by the client's
employees, the auditor generally compares the individual entries on it with the documents
returned by the bank and looks for erasures, changes or other irregularities on the statement.
REVIEW QUESTIONS AND PROBLEMS

Questions

1. Describe the processing of transactions in the expenditure cycle.

2. Identify major risks of misstatements in the expenditure cycle.

3. Identify the financial statement assertions for acquisitions transactions.

4. When an entity's controls are ineffective for payments, what potential misstatements
could arise in the financial statements?

5. Compare a vendor's statement to a vendor's invoice and describe how an auditor

might use each.

6. Give two reasons audit work on cash is likely to be more extensive than might appear
to be justified by the relative amount of the balance sheet figure for cash.

7. Among the departments of J-R Company are a purchasing department, receiving

department, accounting department, and finance department. If you were preparing a
flowchart of a voucher system to be installed by the company, in which department
would you show
a. The assembling of the purchase order, receiving report, and vendor's invoice to
determine that these documents are in agreement?
b. The preparation of a check?
c. The signing of a check?
d. The mailing of a check to the payee?
e. The cancellation of the voucher and supporting documents?

8. During your audit small manufacturing firm, you find numerous checks for large
amounts drawn payable to the treasurer and charged to the Miscellaneous Expense
account. Does this require any action by the auditor? Explain.

9. During your reconciliation bank of accounts in an audit, you find that a number of
checks for small amounts have been outstanding for more than a year. Does this
situation call for any action by the auditor? Explain.

254
10. Explain the objectives of each of the following audit procedures for cash:
a. Obtain a cutoff bank statement subsequent to the balance sheet date.
b. Compare paid checks returned with the bank statement to the list of outstanding
checks in the previous reconciliation.
c. Trace all bank transfers during the last week of the audit year and the first week
of the following year.
d. Investigate any checks representing large or unusual payments to related parties.

Multiple Choice Questions

1. An auditor usually examines receiving reports to support entries in the

a. Voucher register and sales returns journal.
b. Sales journal and sales returns journal.
c. Voucher register and sales journal.
d. Check register and sales journal.

2. An internal control questionnaire indicates that an approved receiving report is

required to accompany every check request for payment of merchandise. Which of
the following procedures provides the greatest assurance that this control is operating
effectively?
a. Select and examine canceled checks, and ascertain that the related receiving
reports are dated no earlier than the checks.
b. Select and examine canceled checks, and ascertain that the related receiving
reports are dated no later than the checks.
c. Select and examine receiving reports, and ascertain that the related canceled
checks are dated no earlier than the receiving reports.
d. Select and examine receiving reports, and ascertain that the related canceled
checks are dated no later than the receiving reports.

3. The accounts payable department receives the purchase order to accomplish all the
following except
a. Comparing the invoice price to the purchase order price.
b. Ensuring that the purchase had been properly authorized.
c. Ensuring that the goods had been received by the party requesting them.
d. Comparing the quantity ordered to the quantity purchased.
4. For effective internal control, which of the following individuals should be
responsible for mailing signed checks?
a. Receptionist
b. Treasurer
c. Accounts payable clerk
d. Payroll clerk

5. If internal control is properly designed, the same employee should not be permitted to
a. Sign checks and cancel supporting documents.
b. Receive merchandise and prepare a receiving report.
c. Prepare disbursement vouchers and sign checks.
d. Initiate a request to order merchandise and approve merchandise ordered.
6. In a properly designed accounts payable system, a voucher is prepared after the
invoice, purchase order, requisition, and receiving report have been verified. The next
step in the system is to
a. Cancel the supporting documents.
b. Enter the check amount in the check register.
c. Approve the voucher for payment.
d. Post the voucher amount to the expense ledger.

Exercises

Exercise 1

Henry Martin is responsible for preparing checks, recording cash disbursements, and
preparing bank reconciliations for Star Corporation. While reconciling the October bank
statement„ Martin noticed that several checks totaling P9,370 had been outstanding for
more than one year. Concluding that these checks would never be presented for payments,
Martin prepared a check for P9,370 payable to himself, forged the treasurer's signature,
and cashed the cheek. Martin made no entry in the accounts for this disbursement and
attempted to conceal the theft by destroying the forged check and omitting the
long-outstanding checks from subsequent bank reconciliations.

Required:
1. Identify the weaknesses in Star Corporation's internal control.
2. Explain several audit procedures that might disclose the fraudulent disbursement.

256
Exercise 2

You are the auditor in charge of the audit of Circle Corporation. In the audit of
investments, you have just been given the following list of securities held by Circle
Corporation at December 31, 20X3.

CIRCLE CORPORATION
Schedule of Marketable Securities
December 31, 20X3

Market Value December 31

10,000 shares of Diamond Corp. P599,100

6,000 shares of Square Corp. 216,500

8,000 shares of Rectangle Corporation (not publicly traded)

400 line Corporation 7.5% Convertible Bonds 555,000

Required:

1. Identify the potential audit problems that may be indicated by the schedule.
2. To value the shares of Rectangle Corporation, management has employed a
securities, valuation firm. Explain the audit considerations involved in auditing the
value developed by the valuation firm.

Exercise 3

Items a through l represent possible errors and fraud that you suspect may be present at
Rex Company. The accompanying List of Auditing Procedures represents procedures that
the auditor would consider performing to gather evidence concerning possible errors and
fraud. For each item, select one or two procedures, as indicated, that the auditor most likely
would perform to gather evidence in support of that item. The procedures on the list may
be selected once, more than once, or not at all.

LIST OF AUDITING PROCEDURES

A. Compare the details of the cash receipts L. Examine the entity's shipping documents
journal entries with the details of the to verify that the merchandise that
corresponding daily deposit slips. produced the receivable was actually sent
B. Scan the debits to the fixed asset accounts to the customer.
and vouch selected amounts to vendors' M. Inspect the entity's correspondence files
invoices and management's for indications of customer disputes for
authorization. evidence that certain shipments were on
consignment.
C. Perform analytical procedures that N. Perform edit checks of data on the
compare documented authorized pay payroll transaction tapes.
rates to the entity's budget and forecast. O. Inspect payroll check endorsements for
D. Obtain the cutoff bank statement and similar handwriting.
compare the cleared checks to the year- P. Observe payroll check distribution on a
end bank reconciliation. surprise basis.
E. Prepare bank transfer schedule. Q. Vouch data in the payroll register to
F. Inspect the entity's deeds to its real estate. documented authorized pay rates in the
G. Make inquiries of the entity's attorney human resources department’s files.
concerning the details of real estate R. Reconcile the payroll checking account
transactions. and determine if there were unusual time
H. Confirm the terms of borrowing lags between the issuance and payment
arrangements with the lender. of payroll checks.
I. Examine selected equipment repair S. Inspect the file of prenumbered vouchers
orders and supporting documentation to for consecutive numbering and proper
determine the propriety of the charges. approval by an appropriate employee.
J. Send requests to confirm the entity's T. Determine that the details of selected
accounts receivable on a surprise basis at prenumbered vouchers match the related
an interim date. vendors' invoices.
K. Send a second request for confirmation U. Examine the supporting purchase orders
of the receivable to the customer and and receiving reports for selected paid
make inquiries of a reputable credit vouchers.
agency concerning the customer's
creditworthiness.

Possible Misstatements Due to Errors and Fraud

a. The auditor suspects that a kitting scheme exists because an accounting department
employee who can issue and record checks seems to be leading an unusually
luxurious lifestyle.(Select only 1 procedure.)
b. An auditor suspects that the controller wrote several checks and recorded the cash
disbursements just before year-end but did not mail the checks until after the first
week of' the subsequent year. (Select only 1 procedure.)
c. The entity borrowed funds from financial institution. Although the transaction was
properly recorded, the auditor suspects that the loan created a lien on the entity's real
estate that is not disclosed in its financial statements. (Select only 1 procedure.)
d. The auditor discovered an unusually large receivable from one of the entity's new
customers. The auditor suspects that the receivable may be fictitious because the
auditor has never heard of the customer and because the auditor's initial attempt to
confirm the receivable has been ignored by the customer. (Select only 2 procedures.)
e. The auditor suspects that fictitious employees have been placed on the payroll by the
entity's payroll supervisor, who has access to payroll records and to the paychecks.
(Select only 1 procedure.)
f. The auditor suspects that selected employees of the entity received unauthorized
raises from the entity's payroll supervisor, who has access to payroll records. (Select
only 1 procedure.)
g. The entity's cash receipts of the first few days of the subsequent year were properly
deposited in its general operating account after the year-end. However, the auditor
suspects that the entity recorded the cash receipts in its books during the last week of
the year under audit. (Select only 1 procedure.)
h. The auditor suspects that vouchers were prepared and processed by an accounting
department employee for merchandise that was either ordered nor received by the
entity. (Select only 1 procedure.)
i. The details of invoices for equipment repairs were not clearly identified or explained
to the accounting department employees. The auditor suspects that the bookkeeper
incorrectly recorded the repairs as fixed assets. (Select only 1 procedure.)
j. The auditor suspects that a lapping scheme exists because an accounting department
employee who has access to cash receipts also maintains the accounts receivable
ledger and refuses to take any vacation or sick days. (Select only 2 procedures.)
k. The auditor suspects that the entity is inappropriately increasing the cash reported in
its balance sheet by drawing a check on one account and not recording it as an
outstanding check on that account and simultaneously recording it as a deposit in a
second account. (Select only 1 procedure.)
l. The auditor suspects that the entity's controller has overstated sales and accounts
receivable by recording fictitious sales to regular customers in the entity's books.
(Select only 2 procedures.)

Note: The Substantive Tests of Details of Balances of the Principal Accounts affected by the
Expenditure Cycle are covered in …

Chapter 11 — Audit of Cash Balances

Chapter 13 — Audit of Inventories, Cost of Sales and Trade Payables

259
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
EXPENDITURE CYCLE …
CONTINUED

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Explain the nature and activities involved in the

 Production cycle
 Inventory warehousing
 Payroll transaction

2. Identify the documents and accounting records used in these transactions.

3. Apply the risk assessment and risk response phases, i.e., test of controls and
substantive tests of transactions to the above mentioned transactions.
CHAPTER 8

AUDIT OF THE EXPENDITURE CYCLE, CONTINUED

AUDIT OF PRODUCTION CYCLE TRANSACTIONS

I. NATURE OF THE PRODUCTION CYCLE

The production cycle involves the conversion of raw materials into finished goods. It includes
production planning and control of the types and quantities of products to be manufactured, the
inventory levels (raw materials, finished goods) to be maintained, and the activities pertaining
to the manufacturing process. This cycle interfaces with both the revenue and expenditure
cycles.

Figure 8-1 shows a flowchart that identifies and describes the principal components of internal
control over production.

Documents Used in Production Activities and their Audit Significance

Documents Audit Significance

Production Order
A prenumbered form used to instruct a quantity of Records approval for production
a particular product. personnel to procedure products.
Bill of Materials
A list of raw material components required to Indicates components to be used in
produce a product. producing a product.
Materials Requisition
A prenumbered form used to request and approve Records approval to issue materials to
the issuance of materials from inventory production.
Materials Requisition Summary
A form that summarizes the materials Records materials used in any given
requisitioned by job or by process, for a period period and is the basis for assigning costs
such as a day, a week, or a month. to an account.
Cost Accumulation Report
A form that accompanies goods as they are transferred Records cost of raw materials
through production. As additional costs are incurred, the placed in production.
costs are recorded on the report.

Labor Ticket
A prenumbered form on which time worked on job is Record the specific activity of a
recorded. laborer and is the basis for
assigning costs to an accounts.
Labor Ticket Summary
A form that summarizes the daily labor tickets by job or Records labor used in production
by process. on any given day.
Completed Production Report
A report that summarizes costs for cost control purposes Provides a basis for inventory
and for determining the amount of cost to assign to valuation.
goods remaining in the production process.

Accounting Records Involved in Production Activities

General Journal

The journal in which entries not entered in a special journal, such as the transfer of raw
materials to work in process, are made.

Subsidiary Ledgers / Share Cards

Subsidiary ledgers are maintained for raw materials, work in process, finished goods, and
manufacturing overhead. Each subsidiary ledger includes a group of detailed records. For
example, a subsidiary ledger for raw materials includes a record for each type of material.

This chapter discussed the audit of the inventory and warehousing cycle. Because of the
difficulties associated with establishing the existence and valuation of inventories, the cycle is
often the most time-consuming and complex part of the audit. The cycle is also unique because
many of the tests of the inputs to the cycle are tested as part of the audit of other cycles. Tests
performed as part of the inventory and warehousing cycle focus on the cost accounting records,
physical observation, and tests of the pricing and compilation of the ending inventory balance.

262
Figure 8-1:
1: Production Flowchart

Note: Circled numbers denote sequence in which functions are performed.

Figure 8-2: Interrelationship of Various Audit Tests
II. EVALUATION OF INTERNAL CONTROL OVER PRODUCTION
TRANSACTIONS

A questionnaire that may be used in gathering information about prescribed controls over
manufacturing transactions is shown in Figure 8-3.

Figure 8-3: Internal Control Questionnaire for Production Transactions

Cycle: Expenditure Class of Transactions: Production

Yes No NA Remarks
Executing
1. Are production orders prenumbered and
the numerical sequence checked for
missing document?
2. Are production orders prepared by
authorized persons?
3. Are bills of materials and manpower
needs forms prepared by authorized
persons?
4. Are bills of materials and manpower
needs forms prenumbered and the
numerical sequence checked for missing
document?
5. Are issue slips prenumbered and the
numerical sequence checked for missing
document?
6. Are material requisitions and job time
tickets reviewed by the production
supervisor after the foremen prepares
them?
7. Are the weekly materials-used reports
and direct labor reviewed by the
production supervisor after preparation
by the foreman?
8. Are completed production reports
prepared?
9. Is a quality control report issued on
finished work?
10. Do routing tickets accompany the
transfer of goods?
11. Is receipt obtained from transferee when
goods are transferred?

265
Recording
1. Are standard costs used? If so, are they
reviewed and revised periodically?
2. Does the accounting manual give
instructions for proper classification of
cost accounting transactions?
3. Are summary entries for direct materials
and direct labor reviewed and approved
by the cost accounting supervisor?
4. Is there verification of correct
application of overhead job cost sheets?
5. Is there segregation of functions between
general accounting and cost accounting?
6. Are there periodic reconciliations of
work in process and finished goods with
subsidiary records?
Custody
1. Is work in process tagged during
production?
2. Are finished goods stored in locked
warehouses?
3. Are perpetual finished goods records
periodically compared with goods on
hand?

III. TESTS OF CONTROLS: PRODUCTION TRANSACTIONS

Controls related to production transactions are important to auditors because they affect
the assertions embodied in the financial statements. Auditors perform one or more audit
procedures to test the assertions, including the following:

General Specific
1. Existence or occurrence 1. Recorded production transactions occurred.

2. Completeness 2. All production transactions that occurred

are recorded.
3. Valuation or allocation 3. Production transactions are recorded for the
proper amounts.
4. Presentation and disclosure 4. Production transactions are recorded to
result in presentation and disclosure in
accordance with PAS / PFRS.

266
DISCUSSION:

The following sections present the controls an entity should have to ensure the propriety of each
assertion, and the tests an auditor might perform to determine the effectiveness of the controls
on production transactions.

A. Existence or Occurrence: Recorded production transactions occurred.

Controls Tests of Controls

1. A material requisition should be prepared 1. To test this control, the auditor should
by operating personnel and signed by a observe separation of duties and examine
warehouse custodian when goods are approval signatures.
transferred to production. Requiring
materials to be completed by two persons
— one who releases raw materials and
another who accepts responsibility for
merchandise — provides evidence that a
transaction exists. Properly completed
materials requisitions should be on file in
accounting, where an employee accounts
for their sequence.
2. Labor tickets bearing a signature 2. The auditor should examine labor ticket.
indicating that work was actually
performed should be the basis in
recording labor.

B. Completeness: All production transactions that occurred are recorded.

3. Production orders are prenumbered and 3. To test this control the auditors should
accounted for to determine that all observe the procedure and account for a
production is recorded. numerical sequence of production orders.
4. Materials requisitions are prenumbered 4. The auditor should observe the procedure
and accounted for by an accounting clerk. and account for numerical sequence of
materials requisitions.
5. Time charged on labor ticket is 5. The auditor,could observe if a clerk
reconciled to employee time cards. reconciles the time charged on completed
labor tickets to the total hours for which
production workers are paid.

267
C. Valuation or Allocation: Production transactions are recorded for the proper amount.

6. Value for transactions are based on a bill 6. To test this control, the auditor should
of materials, approved ticket and rates for trace the amounts to the bill of materials
labor, and predetermined overhead rates. time cards and overhead rates assigned
costs may then be traced to authorized
price lists and underlying schedules.
7. Overapplied or underapplied overhead is 7. The auditor should observe the signature
reviewed periodically, and rates are indicating that the overhead rate has been
adjusted as necessary. reviewed.

D. Presentation and Disclosure: Transactions are recorded to result in presentation and

disclosure in accordance with PAS / PFRS.

8. The chart of accounts should adequately 8. The auditor should examine the chart of
describe the accounts to be used; and accounts and examine the signature of
account coding is independently the employee performing the procedure.
checked.

IV. AUDIT PROGRAM FOR TESTS OF CONTROLS OVER PRODUCTION

TRANSACTIONS

Happy Sounds Corporation

Tests of Controls: Production
December 31, 20X7

WP `
Audit Procedures Ref By Date
1. Select a sample of production orders.
a. Determine if production order was authorized.
b. Match to bill of materials and manpower
needs.
c. Trace bills of materials to material requisitions,
material issue slips, materials-used reports, and
into job cost sheets.
d. Trace manpower needs to job time sheets,
labor reports and into job cost sheets.
2. Select a sample of issue slips from the raw materials
stores file.
a. Determine if a matching requisition is
available for every issue slip.
b. Trace to materials-used reports into job cost
sheet.
3. Select a sample of clock timecards from the payroll
file. Trace a job time tickets, labor reports, and into
job cost time sheets.

268
4. Select a sample open and dosed job cost sheets.
a. Recalculate all costs entered.
b. Vouch labor costs to job tickets and reports.
c. Compare labor reports to summary of payroll.
d. Vouch material costs to issue slips and
materials-used reports.
e. Compare materials-used reports to material
requisitions and bill of materials.
f. Vouch overhead charges to overhead analysis
schedules.
g. Trace selected overhead amounts from analysis
schedules to cost allocations and to invoices of
accounts payable vouchers.
5. Reconcile the open job cost sheets to work-in
process inventory control account.
6. Select a sample of transfers from work-in process
and trace to
a. Transfers to finished goods perpetual records
comparing unit costs and quantities.
b. Summary transfer entries in general ledger
control accounts.
7. Select a sample of transfers from finished goods and
trace to
a. Shipping documents comparing quantities and
unit costs, coordinating with tests of sales in
the revenue / receipt cycle.
b. Summary of cost of sales and sales entries.

The foregoing test of controls may reveal the following weaknesses and possible errors:

Control Weakness Possible Errors

1. Persons recording inventory cost flows, 1.
maintaining inventory records, a. Errors in recording inventory cost
determining overhead application rates, flows.
setting standard costs, or costing physical b. Errors in costing inventory and cost
inventory not competent to do so. of sales.
2. Inadequate documentation of inventory c. Errors in perpetual inventory
movements. records.
3. Lack of rigorous cost accounting system, 2.
as evidenced by a. Unauthorized issuance of materials.
a. Absence of journal entries recording b. Inaccurate inventory records.
cost flows. 3.
b. Failure to incorporate standard costs a. Inventory recording errors.
and variance analysis into the b. Errors in calculating and recording
accounting system. cost of sales.
c. Failure to maintain detailed c. Failure to promptly locate and
manufacturing overhead ledger. correct unfavorable variances.
d. Failure to use standard journal
entries in costing monthly
production.

269
4. Lack of periodic test counts and 4. Undetected inventory shrinkage or
comparison of physical inventory with recording errors.
perpetual records. 5. Undetected errors in recording or posting
5. Failure to agree subsidiary inventory and overhead accounts.
overhead ledgers to controlling accounts
on regular basis.

On the basis of the preliminary evaluation and the results of compliance testing, the auditor
makes a final evaluation of the controls over production transactions. The auditor then
determines the nature, timing and extent of substantive tests to be done on account balances
affected by the production cycle.

V. SUBSTANTIVE TESTS OF TRANSACTIONS: PRODUCTION TRANSACTIONS

Assertions Audit Objectives Audit Procedures

I. Existence of Occurrence A. To determine that 1. For selected transactions,
recorded production examine signed materials
transactions occurred. requisitions, approved
labor tickets, and
allocation of overhead.

II. Completeness B. To determine that all 2.

production transactions a. Account for a
that occurred are sequence of
recorded. production reports.
b. Account for a
sequence of
materials
requisitions.
c. Reconcile time
cards and labor
tickets.
III. Valuation or Allocation C. To determine that 3. Test cost records by
production transactions tracing to underlying
are recorded for the documents, such as bill
proper amounts. of materials, labor
tickets, authorized labor
rates and standard
overhead rates. Review
variances.
IV. Presentation and D. To determine that 4. Check accuracy of
Disclosure production transactions account coding by
are recorded to result in reference to chart of
presentation and accounts.
disclosure in accordance
with PAS / PFRS.

270
DISCUSSION OF AUDIT PROCEDURES

Auditors perform substantive tests of production transactions by examining documents such

as .materials requisitions and labor tickets that support particular transactions; accounting for
the sequence of documents to ascertain that all transactions have been recorded; reviewing and
testing computations on cost accounting records; testing allocations by tracing costs to bills of
materials, labor tickets, authorized labor rates, and overhead rates; verifying mathematical
accuracy; and testing account coding.

AUDIT OF INVENTORY WAREHOUSING

Purchasing and receiving raw materials or goods have been discussed in the acquisitions and
disbursements cycle while the selling of goods has been discussed in the sales and collections
cycle. Warehousing or storage of such materials or goods results in a very significant current
asset for many manufacturing, wholesale, and retail operations.

The transactions included in the warehousing activities are

1. the receipt of goods by the storeroom, and

2. the issuance of goods

I. TESTS OF CONTROLS: INVENTORY WAREHOUSING

Entities store supplies, replacement parts, raw materials, and finished goods. Although the
stored goods may differ, the basic controls and the tests of controls than an auditor
performs similar. Hence, we, discuss here only one example, the storage of raw materials.

Auditors perform one or more audit procedures to test the following assertions related to
inventory warehousing:

General Specific
1. Existence or occurrence 1. Recorded inventory warehousing
transactions occurred.
2. Completeness 2. All inventory warehousing transactions
that occurred are recorded.

271
3. Rights and obligations 3. Inventory warehousing transactions are
for goods that belong to the entity.
4. Valuation or allocation 4. Inventory warehousing transactions are
recorded for the proper amounts.
5. Presentation and disclosure 5. Inventory warehousing transactions are
recorded to result in presentation and
disclosure in accordance with
PAS/PFRS.

DISCUSSION:

A. Existence or Occurrence: Recorded inventory warehousing transactions occurred.

Controls Tests of Controls

1. A copy of a receiving report signed by a 1. Observe separation of duties examine
receiving clerk is used by inventory approval signature receiving report
accounting to record receipt of goods.
2. A materials requisition is prepared and 2. Observe separation of duties and
signed by appropriate operating examine approval signature on materials
personnel. requisition.

B. Completeness:All inventory warehousing transactions that occurred are recorded.

3. Receiving reports and materials 3. Observe procedure and account for a

requisitions are prenumbered and numerical sequence of receiving reports
accounted for by a clerk in inventory to determine that all have been recorded.
accounting.
4. An inventory clerk signs a copy of the 4. Observe procedure. Examine signature
receiving report after counting goods on receiving reports.
transferred to his or her area.
5. Access to inventory is limited to 5. Observe procedures.
personnel responsible for its custody.

272
C. Rights and Obligations: Inventory warehousing transactions are for goods that belong to
the entity

6. Goods received on consignment are 6. Inquire about and observe the procedure.
labeled and separated from goods and
entity owns.

D. Valuation or Allocation: Inventory warehousing transactions are recorded for the proper
amounts.

7. Costs assign to work in process and 7. Inquire about and observe evidence of
finished goods are set by procedures that standards setting, review of standards,
are reviewed and periodically evaluated. and testing of standards.
Mathematical accuracy is tested.

E. Presentation and Disclosure: Inventory warehousing transactions are recorded to result in

presentation and disclosure in accordance with PAS / PFRS.

8. Charts of accounts adequately describes 8. Examines chart of accounts. Examine

accounts to be used, and account coding signature of employee performing check.
is assigned by one person and checked by
another.

II. AUDIT PROGRAM FOR TESTS OF CONTROLS OVER INVENTORY

WAREHOUSING TRANSACTIONS

Happy Sounds Corporation

Tests of Controls: Inventory Warehousing
December 31, 20X7
Done
WP
Audit Procedures Ref By Date
1. For selected transactions recorded in the inventory control
account, examine signed for receiving report.
2. Account for a sequence of receiving reports and requisitions.
Perform records-to-floor and floor-to-records tests.
3. Examine invoice of goods received.
4. Trace allocated costs back to supporting documents. Verify
mathematical accuracy and trace postings.
5. Check accuracy of account on invoices by referring to chart of
accounts.

273
Absence of or inadequate controls over inventory warehousing transactions could result into
the following misstatements and/or irregularities:

1. Fictitious receipts / issues may be recorded.

2. Goods may be received or issued but not recorded.
3. Errors may be recorded in the quantity of goods transferred.
4. Inventory may be misvalued.
5. Goods on consignment may be treated as inventory.
6. Receipt or issue may be charged or credited to wrong accounts.

III. SUBSTANTIVE TESTS OF INVENTORY WAREHOUSING TRANSACTIONS

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine that 1. For selected transactions
recorded inventory recorded in the inventory
warehousing control account, examine
transactions occurred. signed receiving report.
II. Completeness B. To determine that all 2. Account for a sequence
inventory warehousing of receiving reports and
transactions that requisitions. Perform
occurred are recorded. records-to-floor and
floor-to-records tests.
III. Rights and Obligations C. To determine that 3. Examine invoice for
inventory warehousing goods received.
transactions are for
goods that belong to
entity.
IV. Valuation or Allocation D. To determine that 4. Trace allocated costs
allocations are recorded back to supporting
for the proper amounts. documents. Verify
mathematical accuracy
and trace postings.
V. Presentation and E. To determine that 5. Check accuracy of
Disclosure inventory warehousing accounts on invoices by
transactions are recorded referring to chart of
to result in presentation accounts.
and disclosure in
accordance with PAS /
PFRS.

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Discussion of Audit Procedures

The audit procedures described in the preceding schedule are designed primarily to test the
quantities of goods recorded and the prices assigned to goods in the perpetual inventory
records.

Testing Quantities

Inventory records usually include a description of goods, the warehouse location and the
quantity on hand. The auditor may select items from the inventory records, goes to the
warehouse and counts the goods on hand, and determines the accuracy of the inventory records.
The auditor may also examine the related receiving reports and requisitions.

Testing Prices

The prices assigned to inventory should be in accordance with the client's method [e.g., first in,
first out (FIFO), weighted average or specific identification]. To test the accuracy of prices, an
auditor may trade amounts to vendor's invoices, prior year's schedules listing the inventory
value, a standard cost sheet, or a cost of production report.

Tests of the Acquisition and Payment Cycle

When the auditor verifies acquisitions as part of the tests of the acquisition and payment cycle,
evidence is being obtained about the accuracy of raw materials acquired and all manufacturing
overhead costs except labor. These acquisition costs either flow directly into cost of goods sold
or become the most significant part of the ending inventory of raw material, work in process,
and finished. goods. In audits involving perpetual inventory master files, it is common to test
these as part of tests of controls and substantive tests of transactions procedures in the
acquisition and payment cycle. Similarly, if manufacturing costs are assigned to individual jobs
or processes, they are usually tested as a part of the same cycle.

Tests of the Payroll and Personnel Cycle

When the auditor verified labor costs, the same comments apply as for acquisitions. In most
cases, the cost accounting records for direct and indirect labor costs can be tested as part of the
audit of the payroll and personnel cycle if there is adequate advance planning.

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Tests of the Sales and Collection Cycle

Although the relationship is less close between the sales and collection cycle and the inventory
and warehousing cycle than between the two previously discussed, it is still important. Most of
the audit testing in the storage of finished goods as well as the shipment and recording of sales
takes place when the sales and collection cycle is tested. In addition, if standard cost records are
used, it may be possible to test the standard cost of goods sold at the same time that sales tests
are performed.

Tests of Cost Accounting

Tests of cost accounting are meant to verify the controls affecting inventory that were not
verified as part of the three previously discussed cycles. Tests are made of the physical controls,
transfers of raw material costs to work-in process, transfers of costs of completed goods to
finished goods, perpetual inventory master files, and unit cost records.

Physical Inventory, Pricing, and Compilation

In most audits, the underlying assumption testing the inventory and warehousing cycle is that
cost of goods sold is a residual of beginning inventory plus acquisitions of; raw materials, direct
labor, and other manufacturing costs minus ending inventory. When the audit of inventory and
costs of goods sold is approached with this idea in mind, the importance of ending inventory
becomes obvious. Physical inventory, pricing, and compilation are each equally important in
the audit because a misstatement in any one results in misstated inventory and cost of goods
sold.

In testing the physical inventory, it is possible to rely heavily on the perpetual inventory master
files if they have been tested as a part of one or more of the previously discussed tests. In fact,
if the perpetual inventory master files are considered reliable, the auditor can observe and test
the physical count at some time during the year and rely on the perpetual to keep adequate
records of the quantities.

When testing the unit costs, it is also possible to rely, to some degree, on the tests of the cost
records made during the substantive tests of transactions. The existence of standard cost records
is also useful for the purpose of comparison with the actual unit costs. If the standard costs are
used to represent historical cost, they must be tested for reliability.
AUDIT OF PAYROLL TRANSACTIONS

I. NATURE OF PAYROLL TRANSACTIONS

Payroll transactions involve the events and activities relative to executive and employee
compensation. This class of transactions includes salaries of personnel, wage earners
(factory workers), sales persons' commission, bonuses to executives, payroll taxes,
pensions and profit sharing plans and other employees' fringe benefits. The primary errors
or irregularities that may occur are a padded payroll and misappropriation of unclaimed
paychecks. The auditor should therefore adopt procedures that will enable him enable him
to detect such occurrences.

Documents Used in the Payroll and Personal Cycle and their Audit Signature

Documents Audit Significance

Time Card
Prenumbered record for each employee Provides evidence about the validity of the
indicating the number of hours worked each hours an employee is paid for working.
day during a pay period. Many entities use a
time clock that automatically records a
starting and stopping time.

Deduction Authorization
A form that employee sign to authorize their Indicates that the employee authorized an
employer to withhold taxes and various amount to be withheld from a paycheck for a
optional payments from their paychecks. specific purpose.

Certification of Taxes Withheld

A report prepared every year for each Indicates that taxes withheld were reported to
employee to report the gross amount of the various taxing authorities.
earnings, income taxes withheld, and Social
Security taxes withheld. Copies are submitted
to employees for filing with their tax returns to
the Bureau of Internal Revenue and to other
government taxing authorities as required.
Labor Ticket
A prenumbered from on which time worked Records the specific activity of a laborer.
on a job is recorded.

Labor Ticket Summary

A form that summarizes the daily labor tickets Records labor used in production on any
by job or by process. given day.

Payroll Tax Returns

Forms the entity files with governmental Provide evidence that amounts withheld have
agencies reporting wages and taxes withheld. been paid to the appropriate authorities

Other Personnel Records

Employment applications Provide evidence that employees exist.
Reports on reference checks Provide evidence that employees exist.
Authorizations for employment Provide evidence that employees work for
entity.
Authorizations for pay or pay changes Provide evidence that pay rate is approved.
Performance-evaluation reports Provide evidence that employees exist.
Records of sick and vacation days Provide evidence in testing accrued payroll.

Accounting Records in the Payroll and Personnel Cycle

Payroll Register

Includes a list of each payroll check, along with gross pay, amounts withheld, and net pay. The
payroll register, sometimes called a payroll journal, is a book of original entry. Totals for each
payroll are posted to general ledger accounts.

Employee Earnings Records

Includes for each employee for each pay period the date, check number, gross amount,
deductions, and net pay. The record includes the gross earnings and deductions for the year to
date and may include other data, such as the number of hours worked during each payroll
period.

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Labor Distribution Journal

Report in which, based on an account code, salaries and wages are allocated to particular
accounts, such as direct or indirect labor or other functions within the entity.

II. EVALUATION OF INTERNAL CONTROL OVER PAYROLL TRANSACTIONS

The methodology to be used by the auditor in evaluating internal control for payroll
transactions will include inquiry, observation and review or documentation.
Questionnaires may be accomplished to document the results of his evaluation. Figure 8-4
shows the questionnaire applicable to Payroll Transactions.

III. TESTS OF CONTROLS: PAYROLL

Auditors are interest in internal controls because of their effect on financial statement
assertions. The following financial statement assertions apply to payroll transactions.

General Specific
1. Existence or occurrence 1. Recorded payroll transactions occurred.
2. Completeness 2. All payroll earned by employees is
recorded.
3. Rights and obligations 3. Recorded payroll transactions are for
services received.
4. Valuation or allocation 4. Payroll transactions are recorded for the
proper amounts.
5. Presentation and disclosure 5. Payroll transactions are recorded to result
in presentation and disclosure in
accordance with PAS / PFRS.

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Figure 8-4:
4: Payroll Flowchart
Figure 8-5: Internal Control Questionnaire for Payroll Transactions

Cycle Expenditure Class of Transactions: Payroll

Executing Yes No NA Remarks

1. Are hiring authorized by personnel
department?
2. Are names of newly hires and terminated
employees reported in writing to the payroll
department?
3. Are wage rates determined by contract or
approved by a personnel officer?
4. Are time cards or piecework reports
prepared by the employee approved by his or
her supervisor?
5. Is a time clock or other electromechanical
system used?
6. Is there internal verification of payroll
checks with payroll register data?
7. Are payroll checks signed and distributed by
treasurer's office personnel?
8. Are payroll tax returns reconciled to
employees earnings records?

Recording
1. Are personnel who journalize payroll
transactions independent of those who
prepare and pay the payroll?
2. Are changes in employee earnings records
reconciled?

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DISCUSSION:

The following sections present the controls and entity should have to ensure the propriety of
each assertion and tests an auditor might perform to determine the effectiveness of the controls
on payroll transactions.

A. Existence or Occurrence: Recorded payroll transactions occurred.

Controls Tests of Controls

1. Personnel department officials authorize 1. To. test this control, the auditor should
the addition of an employee to the payroll observe the procedures followed by the
or any changes in employees' status (such personnel department. The auditor can
as promotion or termination) or pay rates. examine written approvals for selected
payrolls.
2. One employee should review the details 2. The auditor should observe this
of the payroll and sign the payroll checks procedure being followed specifically,
and another employee should distribute the separation of duties.
the checks. Neither employee should be
in personnel, payroll accounting or a
supervisory position in operations.
3. Using time cards and requiring a 3. To test this control, an auditor would
supervisor’s approval of total hours observe is being followed.
entered on time cards.

B. Completeness: All payroll earned by employees is recorded.

4. Use prenumbered checks accounted for 4. To test this control, an auditor would
in the bank reconciliation. Require an observe whether reconciliations are
employee not involved in the preparation routinely prepared by a person not
of payroll to reconcile the payroll bank involved with payroll activities.
account.

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C. Rights and Obligations: Recorded payroll transactions are for services received.

5. Employees are required to record the 5. The auditor should observe whether the
time they work, using a time clock. procedure is being followed. The auditor
Employees are not allowed to time in for should examine signature on card.
each other.
6. Supervisors should review and approve 6. The auditor should observe the
each employee’s time card, functioning of this control.

D. Valuation or Allocation: Payroll transactions are recorded for the proper amount.

7. Payroll calculations should be verified 7. The auditor should examine payroll

for accuracy. In a manual accounting register for signature indicating
system, this is done by recalculation. In a verification.
computerized system, programmed
controls and checks as well as control and
hash totals, ensures clerical accuracy.
8. Control totals of hours worked are 8. To test this control, an auditor examines
verified independently of payroll the worksheet that documents the
accounting and compared to the hours for comparison.
which payment is recorded.

E. Presentation and Disclosure: Payroll transactions are recorded to result in presentation

and disclosure in accordance with PAS / PFRS,

9. An employee should use a chart of 9. The auditor should examine the payroll
accounts in assigning codes for labor summary for the signature indicating that
charges. Another employee would this procedure is being followed.
checks the work of the employee who
assigned the codes and then signs or
initials the work.

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IV. AUDIT PROGRAM FOR TESTS OF CONTROLS OVER PAYROLL
TRANSACTIONS

HAPPY SOUNDS CORPORATION

Tests of Controls: Payroll
December 31, 20X7

Done
Audit Procedures WP
Ref By Date
1. Review the payroll journal, general ledger, and payroll earnings
records for large or unusual amounts.
2. Compare cancelled checks with payroll journal for name,
amount, and date.
3. Examine cancelled checks for proper endorsement.
4. Compare cancelled checks with personnel records.
5. Reconcile the disbursements in the payroll journal with the
disbursements on the payroll bank statement.
6. Prove the bank reconciliation.
7. Recomputed hours worked from time cards.
8. Compare pay rates with union contract, approval by board of
directors, or other source.
9. Recomputed gross pay.
10. Checks with holdings by reference to tax tables and
authorization forms in personnel file.
11. Recomputed net pay.
12. Compare cancelled check with payroll journal for amount.
13. Compare classification with charts of accounts or procedures
manual.
14. Review time card for employee department and job ticket for
job assignment, and trace through to labor distribution.
15. Compare date of recorded check in the payroll journal with date
on cancelled checks and time cards.
16. Compare date on check with date the check cleared the bank.
17. Tests clerical accuracy by footing the payroll journal and
tracing postings on the general ledger and the payroll master
file.

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The test of controls over payroll transactions may reveal the following weaknesses and possible
errors.

Controls Weakness Possible Errors

1. Lack of care in calculating payroll and 1. Errors in calculating gross pay,
failure to review and check calculations. deductions, net pay and payroll taxes.
2. Incompetent personnel assigned in the 2. Errors in calculating gross pay,
calculation of payroll, with holding taxes deductions, net pay and payroll taxes.
or reconciliation of payroll bank
accounts.
3. Standard journal entries not drafted for 3. Errors in recording payroll and payroll
monthly payroll entries. taxes.
4. Journal entries to records payroll and 4. Errors in recording payroll and payroll
payroll taxes not reviewed for taxes.
correctness.
5. Inadequate separation of duties among 5. Payroll padding.
timekeeping, personnel, production,
payroll accounting, and check
distribution.

V. SUBSTANTIVE TESTS OF TRANSACTIONS: PAYROLL TRANSACTIONS

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine that 1. Checks the personnel
recorded payroll records to ascertain
transactions occurred. whether the persons paid
were actually employed
during the pay period
tested.
2. Observe actual payroll
distribution.
3. Investigate the
company’s method
handling of unclaimed
pay.
II. Completeness B. To determine that all 4. Trace the payroll tested
payroll earned by to summaries, trace
employees is recorded. postings to summary
totals to the general
ledger and to subsidiary
ledgers, and checks the
propriety of the
accounting distribution.

285
III. Rights and Obligations C. To determine that 5. Examine the canceled
recorded payroll employee payroll checks
transactions are for for propriety. If
services received. employees are paid in
cash, examine receipts
signed by them to
determine that payments
have, in fact, been, made
to the proper party.
IV. Valuation or Allocation D. To determine that 6. Checks the recorded pay
payroll transactions are against the original