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309 terms

audit 4 txt

cpa
STUDY
PLAY
The purpose of audit documentation is to provide:
1. Support for the auditor's report, including evidence that the audit was conducted in
accordance with generally accepted auditing standards.
2. Assistance in planning, conducting, and supervising the audit.
3. Accountability, emphasizing that the audit team is responsible for its work.
4. Information that may be useful for future audits, quality control reviews, or peer
reviews.
Requirements
Audit documentation should:
1. Provide a record of accumulated evidence and the results of audit tests and
procedures;
2. Be prepared in enough detail so that an experienced auditor who has no previous
connection with the audit can understand the audit procedures performed, the evidence
obtained, the conclusions reached, and how the accounting records reconcile with the
financial statements;
3. Demonstrate compliance with the standards of fieldwork by showing that the work
performed was adequately planned and supervised, that a sufficient understanding of
the entity and its environment was obtained, and that sufficient appropriate audit
evidence was obtained to provide a reasonable basis for the opinion;
4. Include identifying characteristics of the specific items tested:
Audit documentation should:
5. Enable reviewers to understand the work performed and the evidence obtained;
6. Include documentation of departures from mandatory GAAS requirements, including
justification for the departure and how appropriate alternative procedures were used to
achieve audit objectives;
7. Identify both the staff who performed the work and the staff who reviewed the work, as
well as the dates associated with each;
8. Contain proper indexing and cross-referencing; and
9. Indicate proper identification of client, purpose, and period covered.
Retention and Completion
1. Report Release Date
The "report release date" is defined as the date on which the auditor grants the client
permission to use the report. Often, this is the date on which the report is delivered to
the client.
Retention and Completion
2. Document Retention
a. SAS Rules (nonissuers)
Auditing standards require that audit documentation be retained for at least five
years from the report release date.
b. PCAOB Rules (issuers)
The PCAOB requires auditors of public companies to keep audit documentation
for seven years from the report release date.
Retention and Completion
3. Documentation Completion Date
The auditor is granted a certain window of time following the report release date in
which to assemble the final audit documentation file. The end of this window is referred
to as the "documentation completion date." After this date, existing documentation
must not be deleted, and additions to the audit documentation must be documented as
such.
a. SAS Rules (nonissuers)
Auditing standards require the final audit documentation file to be assembled
within 60 days following the report release date.
b. PCAOB Rules (issuers)
The PCAOB defines the documentation completion date as 45 days following the
report release date, and requires preparation of an "engagement completion
document" identifying all significant findings and issues. Also, under PCAOB
standards, if work is performed by another auditor, the office issuing the report
must obtain, review, and retain certain audit documentation from the other
auditor.
Retention and Completion
4. Safekeeping of Audit Documentation
Reasonable precautions should be established for the safekeeping of audit
documentation, as it is the proof that a professional audit was performed. The SOX Act
of 2002 imposes tough penalties for failure to retain audit documentation or for the
destruction of records.
a. The auditor shouid estabiish appropriate controls for audit documentation to
protect its integrity, prevent unauthorized changes, etc.
D. Nature and Extent of Audit Documentation
Audit documentation may be in paper form, electronic form, or other media. Oral
explanations alone are insufficient, but may be used for clarification of information included in
the audit documentation.
The specific quantity, type, and content of audit documentation are based on the auditor's
judgment. In determining the nature and extent of documentation for a specific area, the
auditor should consider:
1. The risk of material misstatement;
2. The extent to which judgment was required in performing the work and evaluating the
results;
3. The nature of the specific auditing procedure;
4. The significance of the evidence obtained;
5. The nature and extent of any problems identified; and
6. The need to document conclusions that may not be obvious.
Specific Contents
The form and content of audit documentation can vary, but it should be designed to meet the
circumstances of the particular engagement. Generally, audit documentation wili consist of a
permanent or continuous audit file and a current file.
Specific Contents
1. Permanent (Continuous) File
The permanent file includes audit documentation that has a continuing interest from
year to year (such as contracts, pension plans, ieases, stock options, bylaws, articles of
incorporation, minutes of meetings, bond indentures, and internal information).
Specific Contents
2. Current File
The current file contains all audit documentation applicable to the year under audit, and
generally includes the following audit documentation;
a. The audit plan (audit program).
b. Financial statements and the auditor's report.
c. Working trial balance, adjusting journal entries, and reclassification entries.
d. Letters of confirmation and representation (e.g., letters from attorneys, a
management representation letter, and confirmation responses).
e. Analyses, worksheets, issues memoranda, and schedules or commentaries
prepared or obtained by the auditor. Note that related accounts, such as notes
receivable and interest income, are often analyzed together.
f. Abstracts or copies of entity documents, such as contracts or agreements
examined to evaluate the accounting for significant transactions.
g. Summaries of significant audit findings or issues (see below), actions taken, and
conclusions reached.
h. Records of tests of controls and substantive tests that include identification of
specific items selected for testing (i.e., the source from which the items were
selected and specific selection criteria).
Significant Audit Findings
Audit documentation should include significant audit findings, actions taken, and
conclusions reached. Significant audit findings include matters that:
a. Are related to the selection and application of accounting principles (and the
consistency with which they are applied), especially those involving complex or
unusual transactions, or estimates and uncertainties.
b. Are related to possible material misstatements in the financial statements.
c. Suggest a need to revise the auditor's previous risk assessment.
d. Cause significant difficulty in applying necessary audit procedures, or indicate
the need for significant revision of planned audit procedures.
e. May result in modification to the auditor's standard report.
f.Result in audit adjustments or corrections identified by the auditor that are
material, either individually or when aggregated.
Rule 301 of the Code of Professional Conduct states
that "a member in public
practice shall not disclose any confidential client information without the specific consent of
the client." The auditor should adopt reasonable procedures to maintain confidentiality and
prevent unauthorized access to audit documentation.
There are several situations in whic1. The risk of material misstatement: greater risk implies more evidence will be required.
2. The quality of audit evidence: less audit evidence may be reqUired when that evidence
is of higher quality.h
audit documentation can be provided to someone else without the client's permission:
1. If audit documentation is used as part of a voluntary quality review program under the
auspices of the AICPA or state society of CPAs.
2. If audit documentation is subpoenaed by a court.
3. If audit documentation is needed as part of an official investigation being conducted by
the AICPA, a state CPA society, or under State Board of Accountancy authorization.
4. If audit documentation is needed to respond to an official inquiry made by the AiCPA, a
state CPA society, or a State Board of Accountancy (i.e., for the CPA's defense).
Audit evidence is gathered throughout
the audit when performing:
(i) Risk assessment procedures
(ii) Tests of controls
(iii) Substantive procedures
(iv) Other audit procedures
The third standard of fieldwork states:
"The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to
afford a reasonable basis for an opinion regarding the financial statements under audit. "
The auditor's decision regarding the sufficiency of evidence is influenced by:
1. The risk of material misstatement: greater risk implies more evidence will be required.
2. The quality of audit evidence: less audit evidence may be reqUired when that evidence
is of higher quality.
Reliability of Evidence
Reliability of audit evidence is dependent on the circumstances under which it is
gathered. Reliability of evidence is also influenced by its source and nature.
a. Auditor's Direct Personal Knowledge
Any evidence obtained directly by the auditor (i.e., through observation, physical
examination, inspection, or recalculation) provides more persuasive evidence
than evidence obtained indirectly.
b. External Evidence
External evidence obtained from independent sources outside the enterprise
provides greater assurance of reliability than internally generated evidence.
There are two types of external evidence:
(1) Evidence sent directly to an independent auditor; and
(2) Evidence received and held by the client.
c. Importance of Effective Controls
Internal evidence generated within the enterprise is not as reliable as external
evidence, but strong, effective internal controls improve reliability. Internal
evidence includes purchase orders, sales orders, general ledgers, and
management reports.
d. Documentary Evidence
Audit evidence in documentary form is more reliable than oral evidence, and
original documentation is more reliable than photocopies or faxes. Oral evidence
consists of statements made by clients concerning the procedures involved in a
given transaction, often resulting in the explanation of an account balance. Oral
evidence is the least reliable form of evidence.
e. Consistency of Evidence
When audit evidence obtained from different sources is consistent, a greater
degree of assurance is provided.
f. Information Produced by the Client
If the auditor intends to use information produced by the client, evidence must be
obtained about the accuracy and completeness of such information.
PASS KEY
Memorize the following hierarchy of audit evidence (from most reliable to least reliable):
1. Auditor's direct personal knowledge
2. External evidence
3. Internal evidence
4. Oral evidence
2. Relevance of Evidence
Evidence must relate to the financial statement assertion(s) under
consideration. For example, accounts receivable confirmations are relevant to the
existence of receivables, not to their valuation, because a customer can confirm that a
receivable exists, but this does not necessarily imply that the customer has the intent or
the ability to pay.
D. Evaluation of Audit Evidence
The evaluation of audit evidence must take into consideration the achievement of audit
objectives. The auditor must be unbiased in this evaluation, considering all evidence
regardless of whether it conflicts with the financial statements.
If the auditors have doubts about a material assertion, they are required to gather sufficient
evidence to eliminate the doubt or they must express a qualified opinion or disclaimer of
opinion.
Substantive procedures consist of:
(i) Tests of details applied to transactions, balances, and disclosures, and
(ii) Substantive analytical procedures.
Tests of Details
Tests of details consist of audit procedures used to gather evidence to support the account
balances as reflected in the financial statements. Tests of details are performed on ending
balances, the details of transactions, or a combination of the two. If an account has a high
turnover rate with many transactions occurring during the year, the auditor generally will
concentrate testing on the ending balance.
Tests of Details
For example, during an audit of the sales revenue account, the auditor uses procedures to
substantiate the ending balance while also performing extensive procedures on samples of
transactions and related accounts (e.g., cash receipts and accounts receivable).
Examples of Substantive Procedures
The auditor may test the details supporting transactions, balances, and disclosures
through inspection, observation, inquiry, confirmation, recalculation, reperformance,
Analytical Procedures
Analytical procedures are evaluations of financial information made by a study of plausible
relationships among both financial and nonfinancial data, and they generally involve
comparisons of recorded amounts to independent expectations developed by the auditor.
Ratios, percentages, comparisons of actual to budget, and other comparisons may be used
analytical procedures:
Phase: Planning
Requirement: Required
To assist the auditor in understanding the entity and its
environment.
Used for risk measurement to alert the auditor to problem
areas requiring attention. This serves a vital planning
function.
analytical procedures:
Phase:Substantive procedures Requirement: Not required
As a substantive test to obtain audit evidence about specific management assertions related to account balances or
transactions.
The evidence is circumstantial and generally additional
corroborating evidence (such as documentation) must be
obtained.
analytical procedures:
Phase: Final review
Requirement: Required
To assist the auditor in the final review of the overall
reasonableness of account balances.
ANALYTICAL PROCEDURES
1. Comparisons of Financial Data
Analytical procedures generally include a review of the current and prior year's financial
statements and the current year's budget. Comparisons are made between the current
year's actual and budgeted financial statements, and between the current year's actual
and prior year's actual financial statements. Comparisons are also made within the
current year's financial statements for Internal consistency. For example, net income
on the income statement should agree with the increase in retained earnings on the
statement of retained earnings.
Auditor Expectations
The auditor also develops independent expectations for comparison to recorded
amounts. These expectations may be developed based on:
a. Financial information for comparable prior periods;
b. Anticipated results from budgets and forecasts;
c. Relationships among data within the current period;
d. Industry norms; and
e. Relationships of financial data with nonfinancial information.
Efficiency and Effectiveness of Analytical Procedures
The efficiency and effectiveness of analytical procedures in detecting potential
misstatements depends, among other things, on the following four factors.
a. Nature of the Assertion Being Tested
b. Plausibility and Predictability of the Data Relationship
c. Availability and Reliability of Data Used to Develop the Expectation
d. Precision of the Expectation
Efficiency and Effectiveness of Analytical Procedures
a. Nature of the Assertion Being Tested
Analytical procedures are most effective and efficient for assertions in which
potential misstatements are not apparent from an examination of the detailed
evidence or when such detail is unavailable.
Efficiency and Effectiveness of Analytical Procedures
b. Plausibility and Predictability of the Data Relationship
In order to use analytical procedures as a substantive test, the auditor must have
a clear understanding of the relationships among data. It is possible that data
may appear to be related when in fact they are not, and failure to properly
understand such situations may lead to erroneous conclusions.
Efficiency and Effectiveness of Analytical Procedures
c. Availability and Reliability of Data Used to Develop the Expectation
Data used by the auditor to develop expectations should be both readily available
and reliable. Reliability of data is enhanced if it is obtained from external rather
than internal sources, obtained from independent internal sources (i.e., unrelated
to those who are responsible for the amount being audited), generated under
effective internal controls, audited previously, and obtained from a variety of
sources.
Efficiency and Effectiveness of Analytical Procedures
d. Precision of the Expectation
More precise expectations are more effective in detecting misstatements. An
expectation is more precise when it is developed at a sufficiently detailed level,
and when there is effective identification and consideration of factors that
significantly influence the relationship.
Documentation Requirements
When an analytical procedure is used as the principal substantive test of a significant
financial statement assertion, the auditor is required to document the:
a. Auditor's expectation.
b. Factors considered in the development of the expectation.
c. Results of the comparison of the expectation to recorded amounts.
d. Additional audit procedures performed in response to significant unexplained
differences.
e. Results of such additional procedures.
Ratio Analysis
In performing analytical procedures, recorded amounts are compared to expectations
developed by the auditor. The auditor may also choose to compare ratios developed from
recorded amounts to expected ratios developed by the auditor.
Investigation of Significant Differences
Analytical review procedures may indicate a possible material misstatement, and therefore
the auditor should investigate any significant differences or unusual items that arise. The
auditor should reconsider the manner in which the expectation was developed, make
inquiries of management, and if necessary, expand audit procedures. If no adequate
explanations can be obtained, the auditor should obtain sufficient appropriate evidence about
the related assertion by performing alternative substantive procedures
Limitations of Analytical Procedures
Analytical review comparisons are based on expected plausible relationships among data.
Differences do not necessarily indicate errors or fraud, but simply indicate the need for further
investigation. Changes in an account, changes in accounting principle, and inherent
differences between industry norms and the client all contribute to fluctuations in expected
amounts.
TESTS OF DETAILS
Directional Testing
Directional testing refers to testing either forward or backward. Tracing forward from source
documents to journal entries provides evidence of completeness. Vouching backward from
journal entries to source documents provides evidence of existence.
PASS KEY
Many exam questions require the candidate to determine which assertion is being tested by a specific audit
procedure. Remember that if a test starts with items in the accounting records, the proper assertion is most
likely to be existence - the auditor searches for evidence indicating that the item truly exists and has not been
created by management.
On the other hand, if a test starts with source documents, it is most likely related to
the completeness assertion, since the goal is probably to make sure all transactions (as identified by the
source documents) have been included in the accounting records
PASS KEY
Candidates should try to use proper auditing terminology. If a question asks for audit procedures, words such
as foot, crossfoot, inquire, vouch, examine, inspect, review, confirm, analyze, recalculate, reconcile, observe,
and trace should be used.
tooting, Cross footing, and Recalculation
An auditor may verify the mathematical accuracy of statements and schedules by
adding down (footing), adding across (crossfooling), or recomputing amounts. For
example, the auditor may substantiate the valuation of financial accounts and the
allocation of items such as depreciation, amortization, and accruals by recomputing
those items.
2. Inquiry
Inquiry consists of requesting information from knowledgeable parties both internally
(e.g., managers and supervisors) and externally (e.g., attorneys and bankers).
Examples include inquiries about pending litigation or pledged or obsolete inventories.
Inquiry is used extensively throughout most audits. However, inquiry alone is generally
considered insufficient and therefore should be used in conjunction with other audit
procedures. in using inquiry, the auditor should:
a. Consider the specific characteristics (knowledge, objectivity, qualifications, etc.)
of the person to whom the inquiry is directed.
b. Ask appropriate questions.
c. Evaluate the response and take appropriate action (e.g., following up with
additional inquiry, modifying planned audit procedures, etc.)
3. vouching
Vouching is directional testing in which the auditor examines support for what has been
recorded in the records and statements, going from the financial statements back to
supporting documents. The objective of vouching is to gather evidence regarding
possible overstatement errors (the existence or occurrence assertions).
4. examination I Inspection
The auditor may inspect or examine records, documents, or tangible assets. Records
or documents may be internal or external, and may be in paper or electronic form.
Inspection or examination generally provides evidence about the existence assertion,
rather than about ownership, rights, obligations, or valuation. Examination may also
provide evidence of the terms of contracts, loans, and commitments.
5. confirmation
Confirmation is a specific type of inquiry that involves obtaining representations from
independent third parties about account balances and transactions or events.
Confirmations are controlled by the auditor in that the auditor selects the parties to be
contacted, prepares and mails the confirmation requests, and receives the responses
directly from the third parties. Examples include bank confirmations of the amount on
deposit or of a loan outstanding, or a confirmation from a customer regarding the
existence of a receivable balance at a certain date.
6. analytical Procedures
Analytical procedures consist of evaluations of financial information made by a study of
meaningful relationships among data, to help highlight unusual fluctuations that could
be the result of errors or fraudulent omissions or overstatements. Scanning may also
be considered an analytical procedure, as the auditor uses professional judgment to
search for large, significant, or unusual items in the accounting records.
7. Re performance
Reperformance occurs when an auditor independently performs procedures or controls
that were originally performed as part of an entity's internal control.
8. Reconciliation
Reconciliation substantiates the existence and valuation of accounts. It involves
comparing financial amounts from two independent sources for agreement, such as
reconciling the physical inventory count with the perpetual inventory records. Other
examples include reconciling the cash balance per the books with the balance per
bank, and reconciling lead schedules to general ledger amounts.
9. Observation
Observation occurs when an auditor looks at a process or procedure performed by
others. For example, at the beginning of an audit, the auditor may tour the client's
facilities to gain an understanding of the client's business, or the auditor may observe
the client's employees taking a physical inventory to obtain firsthand knowledge
regarding ending inventory.
10. Tracing
As with vouching, tracing is directional testing. However, tracing is looking for
coverage in the opposite direction from vouching. Tracing starts with the source
documents and traces forward to provide assurance that the event is being given
proper recognition in the books and records. The objective of tracing is to gather
evidence regarding possible understatement errors (the completeness assertion).
11. Cut-off review
The auditor should perform a cut-off review of year-end transactions, especially
inventory, cash, purchases, sales, and accruals.
12. Auditing related accounts simultaneously
Certain accounts can be audited simultaneously, such as:
a. Long-term liabilities and interest expense
b. Capital additions to plant and equipment and repairs and maintenance expense
c. Investments and dividend and interest income
13. Representation letter
At the conclusion of fieldwork, the independent auditor must obtain a management
representation letter from the client.
14. Subsequent events review
The auditor is required to perform certain procedures for the period after the balance
sheet date up to the date of the auditor's report. Evidence not available at the close of
the period often becomes available before the auditors complete their fieldwork and
write their report. For example, the bankruptcy of the auditor's client's customer shortly
after the balance sheet date indicates that the financial strength of the customer had
probably deteriorated before year-end.
Review of Relevant Assertions
As described in Auditing and Attestation 3, the main assertions relevant to the audit of
account balances, transactions, and presentation and disclosure are:
1. Account Balances (eVER)
When audit procedures relate to asset, liability, and equity account balances, the most relevant assertions are
a. completeness
b. Valuation allocation and accuracy
c. Existaence and occurrence
d. rights and obligations.
a. completeness
All assets, liabilities, and equity interests that should have been recorded have
been recorded.
b. valuation, allocation and accuracy
Assets, liabilities, and equity interests are recorded fairly and at appropriate
amounts, and any resulting valuation or allocation adjustments are appropriately
recorded.
c. existence and occurrence
Assets, liabilities, and equity interests exist.
d. Rights and obligations
The entity holds or controls the rights to assets and liabilities are the obligations
of the entity.
I
Transactions and Events (COVEU)
When testing transactions, the most relevant assertions are:
a. Completeness
b. Cut-off
C. valuation allocation and accuracy
d. existence and occurrence
e. understandability and classification
Presentation and Disclosure (CVRU)
When testing financial statement disclosures, the most relevant assertions are:
a. completeness
b. valuation allocation and accuracy
c. Rights and obligations and occurrence
d. understandability and classification
Assertion:
Completeness
1. Tracing of transactions forward, starting from source documents through their
accounting recognition and ultimately to the financial statements. Note that
this directional test is the opposite of vouching (the directional test for the
existence/occurrence assertion).
2. Analytical review procedures. The auditor should consider how certain items
might be omitted from the account balance, such as unrecorded liabilities or
omissions of pledged assets.
3. Observation of processes and procedures.
Assertion:
cut-off
1. Cut-off procedures to analyze transactions before and after year end for
proper accounting period recognition.
Assertion:
Valuation, Allocation and accuracy
1. Inspection of documentation supporting transactions.
2. Footing and cross-footing of schedules.
3. Independent recalculation. Examples would be aging of accounts receivable
to substantiate the value of the allowance account, or the recalculation of
depreciation charges. A prime area for recalculation are estimates made by
the client.
4. Reconciliation of supporting schedules to general ledger line items.
Assertion:
Existence and Occurrence
1. Confirmation of accounts with third parties.
2. Observation, inspection, and examination of assets, processes, and
procedures. (These provide very persuasive forms of eVidence.)
3. Vouching of transactions from financial statements back to supporting
documents.
Assertion:
Rights and obligations
1. Inspection of documentation supporting transactions, inspection of contracts,
etc.
Assertions:
Understandability and classification
1. Inspection of documentation supporting transactions.
2. Review of all related disclosures for compliance with GAAP.
3. Inquiry of management regarding disclosures for the account and for related
accounts.
TRANSACTION CYCLES
cycle: revenue
Includes sales revenues, receivables, and cash receipts
TRANSACTION CYCLES
cycle: Expenditure
Includes purchases, payables, and cash disbursements
TRANSACTION CYCLES
cycle: Inventory
Includes perpetual inventory, physical counts, and manufacturing costs
TRANSACTION CYCLES
cycle:
Investments
Includes investments in debt and equity and the income received from investments
TRANSACTION CYCLES
cycle: Property, Plant, and equipment
Includes acquisitions and disposals and related depreciation expense
TRANSACTION CYCLES
cycles: Payroll and personnel
Includes payroll (salaried and hourly) and personnel functions
TRANSACTION CYCLES
cycles: financing
Includes debt and equity financing, repayments to borrowers, interest expense, and
dividends
Pass key
Know these mf'ing transaction cycles
REVENUE CYCLE
A. Fraud Risk
As stated in the discussion of fraud risk i, there should be a
presumption in every audit that there is the risk of material misstatement due to revenue
recognition fraud. Common revenue frauds include:
1. Early revenue recognition.
2. Holding the books open past the close of the accounting period.
3. Fictitious sales.
4. Failure to record sales returns.
5. Side agreements used to alter sales terms and conditions to induce customers to
accept goods and services they otherwise do not need.
6. Channel stuffing achieved by convincing distributors to purchase more inventory than
they can sell in the near term.
Another common fraud related to the revenue cycle is the overstatement of receivables,
achieved by overstating balances, reporting fictitious balances, or understating the allowance
for uncollectible accounts.
B. Internal Control - Sales
Under strong internal control, segregation of the functions in a sales transaction should exist
as follows:
1. Preparation of the Sales Order
The sales function begins with the receipt of a customer purchase order by the sales
department. If it is determined that the order can be filled, a serially numbered sales
order is prepared and sent to the credit department for approval.
Internal Control - Sales
2. Credit Approval
The credit department determines whether or not the customer may receive goods on
open account. If the order is approved, a copy of the approved sales order is sent to
the shipping department, the billing department, and the accounting department.
Internal Control - Sales
3. Shipment
In the shipping department, a serially numbered bill of lading is prepared and a copy is
sent to the customer. The goods are shipped, and at this point a receivable arises.
Internal Control - Sales
4. Billing
The billing department prepares a serially numbered sales invoice. Shipping
documents, sales orders, and invoices are compared to assure that all shipments were
based on valid customer orders and were properly billed. Prices and discounts are
applied to the invoice, and necessary extensions and footings are computed. The
invoice is then sent to the customer and to the accounts receivable department.
Internal Control - Sales
5. Accounting
The sale is entered into the sales journal, and a receivable is recorded.
Internal Control - Accounts Receivable
1. sales
A receivable is recorded in the accounts receivable control account in the general
ledger and in the accounts receivable subsidiary ledger. Periodically, an independent
person should reconcile these two records.
Internal Control - Accounts Receivable
2. Collection of Cash receipts
When payment is received from the customer, the receivable is eliminated.
Internal Control - Accounts Receivable
3. Uncollectible Receivables
An aging schedule is prepared and sent to the credit department for use in carrying out
its collection program. At some point, uncollectible receivables should be written off.
Controls for writing off receivables include proper authorization (by the treasurer) and
recordkeeping. Without proper control, amounts subsequently collected easily could be
misappropriated by employees.
Internal Control - Accounts Receivables
4. Sales Returns
Returned goods must be examined to ensure that they correspond with the reason for
return before credit is given. A serially numbered receiving report may be used as a
sales return slip. Once the return is approved, the related receivable is eliminated.
Credit memos should not be prepared by individuals who coilect or receive cash
payments on accounts receivable; to do so wouid be an inadequate segregation of
duties.
Internal Control - Accounts Receivables
5. Sales Discounts
Sales discount procedures and records should be reviewed to ensure that discounts
are properly given and recorded. This ensures that receivables are not overstated
Internal Control - Cash Receipts
1. Collection of Cash Receipts
Incoming mail must be opened by a person who does not have access to the accounts
receivable ledger. The receipts should be listed in detail with one copy and the actual
receipts sent to the cashier to prepare the bank deposit, another copy sent to the
accounts receivable department for entry in the accounts receivable subsidiary records,
and a third copy sent to the accounting department for entry in the general ledger
accounts receivable control account.
Substantive Procedures Related to the Revenue Cycle
1. Auditing Accounts Receivable
a. Completeness
The auditor should obtain an aged trial balance of accounts receivable and trace
the total to the general ledger control account.
Auditing Accounts Receivable
Valuation, Allocation, and Accuracy
The auditor should examine the results of confirmations and test the adequacy of
the allowance for uncollectible accounts (see the discussion of Accounting
Estimates presented later in this lecture).
Auditing Accounts Receivable
Existence and Occurrence
The auditor should confirm a sample of accounts receivable (see the discussion
of accounts receivable confirmations below).
PASS KEY
Existence is generally a more relevant assertion than completeness when auditing the revenue
cycle because the risk that accounts receivable and sales will be overstated (existence) is high
while the risk that accounts receivable and sales will be understated (completeness) is low.
Rights and Obligations
The auditor should review bank confirmations and debt agreements for liens on
receivables. The auditor should also inquire of management and review debt
agreements and board minutes for evidence that accounts receivable have been
factored or sold.
Auditing Sales Transactions
The following tests of details may also be performed as tests of controls or dual-purpose
tests. The cut-off procedure is performed most often as a substantive
procedure.
Auditing Sales Transactions
a. Completeness
The auditor should trace a sample of shipping documents to the corresponding
sales invoices and to the sales journal and accounts receivable subsidiary
ledger.
Auditing Sales Transactions
b. Cut-off
The auditor should compare a sample of sales invoices from shortly before and
after year-end with the shipment dates and with the dates the sales were
recorded in the sales journal. The auditor should also analyze the record of
sales returns after year-end.
Auditing Sales Transactions
c.Valuation, Allocation, and Accuracy
The auditor should compare prices and terms on a sample of sales invoices with
authorized price lists and terms of trade to determine whether sales are recorded
at the appropriate amount.
Auditing Sales Transactions
d. existence and occurrence
The auditor should vouch a sample of sales transactions from the sales journal to
the sales invoice back to the customer order and shipping documents.
Auditing Sales Transactions
e. Understandability and Classification
The auditor should examine a sample of sales invoices for proper classification
into the appropriate revenue accounts.
Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to accounts
receivable and sales have been included in the notes to the financial statements.
Revenue cycle disclosures include:
1. Revenue recognition method(s).
2. Revenue by reportable segment.
3. Related party revenues and receivables.
4. Receivables by type (trade, officer/employee, affiliates) and term (shortterm
and long-term).
5. Pledged or discounted receivables.
Auditing Presentation and Disclosure
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to accounts
receivable and sales to determine whether the information is accurate and
presented at the appropriate amounts.
Auditing Presentation and Disclosure
c. Rights and Obligations and Occurrence
The auditor should determine whether any receivables have been pledged,
assigned or discounted and, if so, determine if disclosure is required. The
auditor should compare disclosures to other audit evidence to ensure that all
disclosed information related to accounts receivable and sales has occurred.
Auditing Presentation and Disclosure
d. Understandability and Classification
The auditor should read all accounts receivable and sales related disclosures to
ensure that they are understandable.
Accounts Receivable Confirmations
The auditor should review the accounts receivable schedule for accuracy and collectability. Confirmation is considered a required generally accepted auditing procedure unless:
(I)receivables are immaterial,
(ii) confirmation would be ineffective, or
(iii) inherent and control risks are very low and evidence provided by other procedures is sufficient to reduce audit risk to an acceptably low level. If confirmations are not sent, the auditor must document how omission of this procedure was overcome.
1. Positive Confirmations
Positive confirmations are those where the auditor requests a response from the
recipient. Generally, the auditor sends (to the client's customer) a confirmation stating
the amount owed. The customers are requested to return a statement to the auditor
indicating whether they agree with the amount, or providing information about any
exceptions. Positive confirmations should be used when there are large individual
accounts, expected errors, or items in dispute, and when internal control is weak.
Note that positive confirmations may also be "blank," which means that the recipient is
requested to fill in the balance. Blank forms provide a greater degree of assurance
(since the recipient cannot simply sign off without actually checking the balance) but
may also result in lower response rates because a greater effort is required for
response.
How should correspondences received electronically be confirmed.
verified by calling the sender, The sender should also be requested to mail the original
confirmation directly to the auditor.
2. Negative Confirmations
The auditor may send to a sample of customers another type of confirmation in which
an answer is requested only if the amount stated is incorrect.
Negative confirmations
should be used when:
a. The combined assessed level of inherent and control risk is low;
b. A large number of small account balances are being confirmed; and
c. There is no reason to expect that recipients of the requests will ignore them.
Negative confirmations are somewhat less effective than positive confirmations
because lack of a response does not provide explicit verification of the existence of the
receivable.
3. Confirmation Exceptions
Confirmation exceptions occur when there is a disparity between the amount of the
receivable recorded in the client's accounting records and the amount of the receivable
confirmed by the client's customer. For confirmation exceptions, the auditor should
determine whether the exception is due to a timing difference or a misstatement.
a. Timing Differences
Timing differences occur when there is a delay in the recording of the transaction
by the client or their customer. For example, an entity may correctly record a
receivable on December 31 when the goods are shipped to the customer, but the
customer may not record the payable until the goods are received on January 5.
This is not a misstatement.
b. Misstatements
A confirmation exception would be indicative of misstatement if the exception is
due to any of the following errors or frauds:
(1) Fictitious sale
(2) Misappropriation of cash
(3) Goods sent to the wrong customer
(4) Invoice sent to the wrong customer
(5) Payment applied to the wrong customer account
(6) Incorrect price or quantity charged to the customer
4. Confirmation Non-responses
Non-responses should be followed up with second (and sometimes third) requests.
The client may be asked to intervene. The auditor may also perform alternative
procedures, such as inspecting shipping documents or reviewing subsequent cash
receipts, when confirmation responses are not received. Alternative procedures may
not be necessary if a 100% overstatement of the accounts receivable from the nonresponding
customers would be immaterial, as long as there is no unusual pattern to
the non-responses.
Internal Control - Purchases\
1. Purchase Requisition
The purchase requisition starts the purchasing cycle. The department in need of the
asset or services sends a properly approved, serially numbered requisition to the
purchasing department. The requisitioning department should not have the authority to
actually place the purchase order. This would indicate a weakness in internal control.
Internal Control - Purchases
Purchase Orders
The purchasing department should place the order only after giving proper
consideration to the time to order and the quantity to order. The purchasing
department should also obtain competitive bids from various suppliers to make sure
that the best price is obtained. The purchase order is issued only after proper
approval. For internal control purposes, it is best that prenumbered purchase orders be
used.
Purchase Orders
There should be multiple copies that will be sent to
(i) the requisitioning department;
(ii) the vendor;
(iii) the receiving department; and
(iv) the accounting
department. If the purchase order is canceled, all copies should be recalled and filed
so that every purchase order number is accounted for.
Purchase
Receipt of Goods or Services
The copy of the purchase order sent to the receiving department serves as an
authorization to accept the goods when they arrive. It is preferable that the copy not
indicate the quantity ordered. Thus, the receiving department is forced to count the
goods upon arrival. A receiving report is prepared by this department and forwarded to
the accounting department. The goods are forwarded to the requisitioning department.
Internal Control - Accounts Payable
The accounting department has three functions:
(i) to record the payable;
(ii) to approve the
invoice for payment; and
(iii) to record the payment after it is paid by the Treasurer
Accounts Payable
1. Recording the Payable
The copy of the purchase order sent to the accounting department notifies them that
there will be a future cash disbursement. The receiving report is compared with the
purchase order and the vendor's invoice as to quantity to prevent payment of charges
for goods in excess of those ordered and received. The accounting department
records the goods as received in inventory, and records a payable.
Accounts Payable
2. Approving Invoice for Payment and Recording Payment
When the invoice arrives, the accounting department approves it by matching the
invoice, purchase order, receiving report, and (sometimes) the requisition. When
payment is made, the payable is reversed. The accounting department should ensure
that the invoice amount is correct, and that it accurately reflects any purchase
discounts, before approving it for payment.
Internal Control - Cash
It is best for internal control purposes to pay invoices by check. For effective internal control,
the functions of approving the payment and signing the checks should be segregated.
Approved voucher packets (matched invoice, purchase order, receiving report, and
requisition) prepared by the accounting department (Accounts Payabie) are received by the
Treasurer, who prepares, signs, and mails the checks and cancels all supporting documents
after payment. Paid vouchers are returned to the accounting department for posting of the
payment and filing of the documents.
Substantive Procedures Related to the Expenditure Cycle
1. Auditing Accounts Payable
a. Completeness
The auditor should perform the following procedures:
(1) Agree the accounts payable listing to the general ledger.
(2) Obtain a sample of vendor statements and agree to the vendor accounts.
(3) Perform a Search for Unrecorded Liabilities
The auditor should select cash disbursements made subsequent to yearend
and examine the supporting documentation (e.g., receiving reports,
vendor invoices, etc.). The auditor looks for items that should have been
recorded at the balance sheet date, but were not.
PASS KEY
For accounts payable, completeness and accuracy are generally more relevant than
existence and rights and obligations because the risk of understatement is higher than
the risk of overstatement.
Auditing Accounts Payable:
Valuation, Allocation, and Accuracy
The auditor should perform the following procedures:
(1) Obtain the accounts payable listing, foot the listing, and agree the listing to
the general ledger.
(2) Obtain a sample of vendor statements and agree the amounts to the
vendor accounts.
(3) Review the results of accounts payable confirmations
Auditing Accounts Payable:
c. Existence and Occurrence
The auditor should vouch selected amounts from the accounts payable listing to
the voucher packages. The auditor may also confirm accounts payable.
Auditing Accounts Payable:
(1) Accounts Payable Confirmations
Accounts payable confirmations are not required because good external
evidence to support accounts payable is generally available. However,
confirmations of accounts payable may be sent when internal control is
weak, when there are disputed amounts, or when monthly vendor
statements are not available. Typically, vendors with small or zero
balances would be selected for confirmation.
The major limitation of accounts payable confirmations is that they may
only be sent to recorded liabilities.
If a material error were present in
accounts payable, it would most likely involve unrecorded liabilities; as
such, no record would exist. On the other hand, unrecorded liabilities
generally surface eventually, as when unpaid vendors stop delivering
goods.
Auditing Accounts Payable:
d. Rights and Obligations
The auditor should review a sample of voucher packages for the presence of the
purchase requisition, purchase order, receiving report and vendor invoice to
verify that the accounts payable are owed by the entity.
Auditing Purchase Transactions:
a. Completeness
b. Cut-off
a. Completeness
The auditor should trace a sample of vouchers to the purchase journal.
b. Cut-off
The auditor should compare dates on a sample of vouchers with the dates the
transactions were recorded in the purchase journal. The auditor should also
examine purchases before and after year-end to determine if they were recorded
in the proper period.
Auditing Purchase Transactions:
c. Valuation, Allocation, and Accuracy
d. Existence and Occurrence
e. Understandability and Classification
c. Valuation, Allocation, and Accuracy
The auditor should recompute the mathematical accuracy of a sample of vendor
invoices.
d. Existence and Occurrence
The auditor should test a sample o
f vouchers for authorization
and the presence of the receiving report.
e. Understandability and Classification
The auditor should verify the account classification of a sample of purchases.
3. Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to accounts
payable and purchases have been included in the notes to the financial
statements.
3. Auditing Presentation and Disclosure
a. Completeness
Required disclosures include:
1.Payables by type (trade, officer/employee, affiliates) and term (short-term
and long-term).
2.Purchase contracts and purchase commitments.
3. Related party purchases and payables.
4. Expenses by segment.
3. Auditing Presentation and Disclosure
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to accounts
payable and purchases to determine whether the information is accurate and
presented at the appropriate amounts.
CASH
A. Fraud Risk
Cash is an area with high fraud risk, especially when internal control is weak. Lapping and
kiting are two common cash fraud schemes.
1. Lapping
The theft of cash is often concealed by failing to account for cash receipts. The most
common of these methods is known as lapping. Lapping involves withholding and not
recording current receipts of cash or checks. The unrecorded receipt is covered by
applying a subsequent receipt to the previously unrecorded account.
a. How to Prevent and Detect Lapping
Safeguards against lapping include independent comparison of recorded cash
receipts with funds actually deposited, separation of incoming receipts from
subsidiary accounts receivable remittance advices, comparison of the details of
bank deposits and the details of remittance credits, provision of timely
statements, and confirmation of customer balances. One of the best methods to
guard against lapping is use of a "lock box" system.
2. Kiting
Kiting occurs when a check drawn on one bank is deposited in another bank and no
record is made of the disbursement in the balance of the first bank. Kiting may be used
to cover a cash shortage or to pad a company's cash position.
a. How to Detect Kiting
To detect kiting effectively, the cash deposits in transit at the end of a period and
the paid checks returned with the bank statements of the next period must be
examined. This is accomplished by preparing a bank transfer schedule. A bank
transfer schedule compares the dates checks are drawn (on the disbursing bank
account) to the dates checks are deposited (in the receiving bank account).
Kiting is indicated when the date stamped by the receiving bank on the rear of
the returned (paid) check precedes the date on which the disbursement was
recorded.
B. Internal Control
Control procedures and tests of controls related to cash receipts and cash disbursements
were covered above in the discussions of the revenue cycle and the expenditure cycle.
Segregation of duties is a key control over cash. Proper segregation of duties demands that
close consideration be given to check-writing authority. Separation of cash handling,
recordkeeping, and reconciliation of bank statements should exist, as well as separation of
petty cash activities. Good internal control for cash would include the use of a voucher
system for cash disbursements
Substantive Procedures Related to Cash
1. Auditing the Ending Cash Balance
a. Completeness, Valuation and Allocation, Existence
The primary audit procedures performed to test the existence, completeness and
valuation of the ending cash balance are the bank confirmation and the audit of
the year-end bank reconciliation.
(1) Bank Confirmation
The standard bank confirmation should be sent to all banks with whom the
client has done business during the year, regardless of whether there is a
year-end balance to confirm. This is done because the bank confirmation,
in addition to verifying year-end balances, also provides evidence about
actual loans and contingent liabilities, discounted notes, pledged collateral,
and guarantee or security agreements. A sample bank confirmation is
shown below.
(2) Bank Reconciliation
The year-end bank reconciliation for every account should be tested by:
(a) Footing the bank reconciliation and the list of outstanding checks.
(b) Agreeing the balance per the books to the general ledger.
(c) Agreeing the balance per the bank confirmation to the balance per
the bank on the bank reconciliation.
(d) Agreeing deposits in transit and outstanding checks to the cut-off
bank statement. The cut-off bank statement is obtained by the
auditor from the bank and covers the first ten to fifteen days of the
period after year-end. Reconciling items should generally clear
during the ten to fifteen day period. Any item that does not clear
should be investigated.
Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that ali required disclosures related to cash have been
included in the notes to the financial statements. Required disclosures related to
cash include:
1. Policy defining cash and cash equivalents.
2. Restrictions on cash, including sinking fund requirements.
3. Compensating balance requirements.
INVENTORY CYCLE
A. Internal Control
Internal control over inventory purchases and sales was covered in the sections on the
revenue cycle and expenditure cycle. For inventory held by the entity, proper internal control
includes adequate safeguarding of inventory and proper segregation of duties.
The following duties should be segregated:
INVENTORY CYCLE
A. Internal Control
1. Purchasing
Serially numbered, properly approved purchase orders should be prepared and issued
to the accounting and receiving departments
INVENTORY CYCLE
A. Internal Control
2. Receiving
The receiving department is solely responsible for the receipt of goods. This
department is responsible for verification of quantities received, detection of damaged
goods, preparation of a receiving report, and delivery of goods received to the
warehouse department. The receiving department should receive a copy of the
purchase order with the amounts blackened out.
INVENTORY CYCLE
A. Internal Control
3. Warehouse
4. Shipping
3. Warehouse
This department acts as custodian for the verified quantity of goods received.
4. Shipping
The shipping department is responsible for shipment of goods after authorization (in the
form of an approved sales order from the credit department).
Substantive Procedures Related to Inventory
1. Auditing the Ending Inventory Balance (inventory observation)
The observation of the beginning and ending physical inventory counts is a required
generally accepted auditing procedure. The observation and related procedures
provide evidence regarding the existence, completeness, and valuation of ending
inventory. An auditor who is not present to observe the physical inventory must use
alternative procedures to justify any opinion expressed.
PASS KEY
Candidates sometimes believe that "inventory observation" implies that the auditor counts the client's inventory. This is not the case - the client counts the inventory, and the auditor simply observes. The auditor may make test counts of certain items, but generally the auditor would not count the client's '"
entire inventory.
INVENTORY CYCLE
a. completeness
In conjunction with the inventory observation, the auditor should test the physical
inventory report by tracing test counts to the report, thereby verifying its
completeness. The auditor should also trace from a sample of prenumbered
inventory tags to the physical inventory report sheets to test the completeness of
the inventory report sheets.
INVENTORY CYCLE
b. Valluation, allocation and accuracy.
The auditor should perform the following procedures:
(1) Test the mathematical accuracy of the inventory report and reconcile it to
the general ledger inventory accounts.
(2) Inquire about obsolete or damaged goods, scan the perpetual records for
slow-moving items, and be alert during the inventory observation for
damaged goods or signs of obsolescence.
(3) Examine vendor invoices, review direct labor rates, test the computation of
standard overhead rates, and examine standard cost variance analyses.
(4) Perform inventory price tests for a sample of inventory items to determine
whether the inventory is valued appropriately.
INVENTORY CYCLE
c. Existence and Occurrence
The primary purpose of the observation of the client's inventory count is to
establish the existence of inventory. During the observation, the auditor should
verify the existence of a sample of items in the physical inventory report by
locating and performing test counts of the items.
INVENTORY CYCLE
d. Rights and Obligations
The auditor should ascertain that consigned inventory on hand is excluded from
the physical inventory count, whereas consigned goods in the hands of
customers are included in inventory balances.
Auditing Inventory Transactions
Inventory purchases and sales should be audited as part of the audits of the revenue
cycle and the expenditure cycle, as described previously.
Inventory cycle
Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to inventory have
been included in the notes to the financial statements. Inventory disclosures
include:
1.Cost method (LIFO, FIFO, weighted average) and valuation method (net
realizable value or lower of cost or market).
2.Raw materials, work-in-process, and finished goods inventory balances.
3.Consigned inventory.
4.Pledged or assigned inventory.
5. Significant losses from inventory write-downs or purchase commitments.
6. Warranty obligations.
Inventory cycle: b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to inventory
to determine whether the information is accurate and presented at the
appropriate amounts.
Inventory cycle:
c. Rights and Obligations and Occurrence
auditor should determine that inventory-related obligations have been
properly disclosed by inquiring of management and reviewing loan agreements
and minutes for evidence that inventory has been pledged or assigned. The
auditor should also inquire about warranty obligations. The auditor should
compare disciosures to other audit evidence to ensure that all disclosed
information related to inventory has occurred.
Inventory cycle:
d. Understandability and Classification
The auditor should read all inventory related disclosures to ensure that they are
understandable. The auditor should review inventory records for proper
classification between raw materials, work in process, and finished goods.
VI. INVESTMENT CYCLE
Sufficient audit evidence must be obtained by the auditor for investments in debt and equity. These
types of investments may be in the form of debt and equity investments, derivative investments,
and loan and advance accounts.
VI. INVESTMENT CYCLE
A. Internal Control
Internal control over investments requires strong segregation of duties. One person (or, more
commonly, the board of directors) should authorize the purchase or sale, another person
should act as custodian (preferably an independent third-party custodian, who has no direct
contact with entity employees, or joint control by two company officials), and a third person
should maintain the detailed record of investments.
Investments not held by an independent third party custodian should be kept in a safe deposit
box.
VI. INVESTMENT CYCLE
B. Substantive Procedures Related to Investments
Substantive tests of details related to the investment cycle generally focus on the ending
balance in the investment accounts and presentation and disclosure. Analytical procedures
are used to test the reasonableness of related gains and losses and investment income.
VI. INVESTMENT CYCLE
1. Auditing the Ending Investment Balances
a. Completeness
If the entity has a high volume of material investment transactions, the auditor
should search for unrecorded purchases of securities by examining transactions
for a few days after year-end. The auditor should also confirm securities held by
the third party custodian or count securities on hand to determine that all
securities have been recorded, although these are primarily tests of existence.
VI. INVESTMENT CYCLE
b.Valuation and Allocation
The auditor should perform the following procedures:
(1) Obtain and foot a listing of investments by category (trading, available for
sale, held-to-maturity, derivative, and equity method) and agree the totals
to the general ledger.
(2) Obtain evidence corroborating the quoted year-end fair value by comparing
assigned values to prices published by various sources or obtained from a
third party, such as an independent broker-dealer or appraiser.
(3) Recalculate the ending values of investments not reported at fair value,
including investments classified as held-to-maturity and accounted for
using the equity method.
(4) Determine whether there has been any permanent impairment in the value
of individual securities.
A4-44
2.
(5) Assess the reasonableness and appropriateness of assumptions, market
variables, and valuation models, and of any decline in fair value.
VI. INVESTMENT CYCLE
c. Existence
(1) Confirmation
...Confirmations should be requested from the custodian for securities that
are in the possession of third parties. It is also advisable to send
confirmations to the broker-dealer and to counterparties concerning any
unsettled transactions.
VI. INVESTMENT CYCLE
c. Existence
(2) Examination of Securities on Hand
An examination of the securities on hand should be made to coincide with
the examinations of other liquid assets, such as cash. This procedure
prevents the concealment of theft by making it impossible for one asset to
serve as a substitute for another (i.e., to conceal a stolen asset). The face
of the instrument should be examined to determine if ownership is correctly
recorded.
VI. INVESTMENT CYCLE
d. Rights and Obligations
The confirmation of securities and the count of securities on hand provide
evidence of the entity's ownership of investments. Additionally, the auditor may
examine broker's advices for a sample of securities purchased during the year to
verify the entity's ownership.
VI. INVESTMENT CYCLE
Auditing Investment Transactions
a. Completeness
The auditor should perform analytical procedures testing the reasonableness of
dividend and interest income to determine that all investment income has been
recorded.
VI. INVESTMENT CYCLE
Auditing Investment Transactions
b. Cut-off
A cut-off review should be performed to ensure that purchases, sales, and
investment income were recorded in the proper period.
VI. INVESTMENT CYCLE
Auditing Investment Transactions
c. Valuation, Allocation, and Accuracy
Independent calculations should be made to determine the validity of recorded
gains or losses from security sales and of discount and premium amortization. In
addition, a recalculation should be made to determine the accuracy of recorded
dividend and interest income. Investment income from dividends may be
recalculated by comparing recorded income with dividend records produced by
investment advisory services such as Moody's.
VI. INVESTMENT CYCLE
Auditing Investment Transactions
d. Existence and Occurrence
The analytical procedures performed to test the reasonableness of dividend and
interest income provide evidence of the existence of investment income.
VI. INVESTMENT CYCLE
Auditing Investment Transactions
e. Understandability and Classification
The auditor should examine a sample of investment transactions to determine
that the transactions were recorded in the proper accounts. For example,
unrealized gains and losses on available-for-sale securities should be recorded
in other comprehensive income, while unrealized gains and losses on trading
securities should be recorded in earnings.
VI. INVESTMENT CYCLE
3. Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to investments
have been included in the notes to the financial statements. Specifically, the
auditor should determine whether all required marketable security and derivative
disclosures have been made.
VI. INVESTMENT CYCLE
3. Auditing Presentation and
Disclosure
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to
investments to determine whether the information is accurate and presented at
the appropriate amounts.
VI. INVESTMENT CYCLE
3. Auditing Presentation and
Disclosure
c. Rights and Obligations and Occurrence
The auditor should inquire of management and review loan agreements, minutes
and other documents to determine whether investments have been pledged as
collateral. The auditor should compare disclosures to other audit evidence to
ensure that all disclosed information related to investments has occurred.
VI. INVESTMENT CYCLE
3. Auditing Presentation and
Disclosure
d. Understandability and Classification
The auditor should read required disclosures for understandability, and review
and evaluate the methods used to account for, classify, and value securities.
VI. INVESTMENT CYCLE
(1) Marketable Securities
Trading and available-for-sale securities over which the investor has no significant influence should be carried at fair value, and held-to-maturity securities should be carried at amortized cost. The auditor should inquire of management and obtain written representation concerning management's intent and ability with respect to holding versus selling
securities.
Investment cycle:
(2) Equity Method Investments
For investments using the equity method, the auditor should examine the
audited financial statements of the investee. The auditor should inquire of
management regarding the entity's abiiity to exercise significant influence
over investments to determine whether investments have been properly
ciassified.
Investment cycle:
(3) Derivatives
An entity may invest in derivatives to hedge against risks, such as the risk
associated with fluctuating prices. Under these circumstances, generally
accepted accounting principles specify that, in order to qualify for hedge
treatment, the entity must demonstrate and disciose a number of
transaction features, including risk exposure. The auditor would therefore
need to examine the contracts to evaluate the character of the hedge and
the degree to which losses should be recognized in the determination of
income, as well as to determine the appropriate character of any
disciosures.
PROPERTY, PLANT, AND EQUIPMENT CYCLE
Property, plant, and equipment includes all tangible assets with service lives greater than one year that are used in the operation of a business. The major transactions associated with these assets are purchases, repairs and maintenance, depreciation, disposal, revaluation
Property, plant and equipment:
A. Internal Control
The internal control for property, plant, and equipment includes the controls in both the revenue and expenditure cycles as well as the foliowing special controls:
1. Acquisition
special requisition form is generated for acquisitions. This form inciudes a
description. reason for acquisition, amount to be charged, and probable cost, and it
should be approved by top management. Acquisitions are tied to the capital budget,
which the board of directors usually approves. Variances from this budget should be
promptly investigated. The board of directors should also approve acquisitions of
assets over a certain amount, regardless of whether these assets are purchased or
constructed
Property, plant and equipment:
A. Internal Control
2. Subsidiary Ledgers
Detailed information concerning each asset is kept in the subsidiary ledger. Usually
such information as the asset's description, identification number, location, acquisition
date, cost, depreciation method, and amount of depreciation can be found in this
ledger.
Property, plant and equipment:
A. Internal Control
3. Physical Security
Fixed assets should have identification plates. The serial number on the plate should
be listed in the control account. Physical controls to safeguard assets from theft,
destruction, or unauthorized disposition should also be in place, including periodic
physical inspection of plant and equipment.
Property, plant and equipment:
A. Internal Control
4. Written Policies
Written depreciation policies and records should be maintained. Specific capitalization
policies are also necessary to prevent misstatement of revenue and expenses.
Property, plant and equipment:
A. Internal Control
5. Disposition
Retirements of assets should be documented on a sequentially numbered work order
containing evidence of proper authorization and the reason for retirement. This asset
retirement order form is the basis for recording any cash received and for removing the
asset and its accumulated depreciation from the subsidiary ledger. There should be a
proper segregation of duties between authorization and custody (i.e., those who
authorize a disposal should not be permitted to actually dispose of the asset).
B. Substantive Procedures Related to Property, Plant and Equipment
1. Auditing the Ending Property, Plant, and Equipment Balance
a. Completeness
The auditor should obtain and foot the fixed asset schedule and agree the total to
the general ledger, obtain and foot a schedule of additions and dispositions of
fixed assets and agree amounts to the fixed asset schedule, and select a sample
of actual fixed assets and trace to the fixed assets subsidiary ledger.
1. Auditing the Ending Property, Plant, and Equipment Balance
b. Valuation and Allocation
The auditor should recalculate accumulated depreciation for reasonableness.
The auditor should also evaluate fixed assets for impairment by examining the
entity's documented impairment analysis, indentifying circumstances that could
indicate that the book value of fixed assets is not recoverable, and reperforming
the entity's impairment analysis to determine whether recorded impairment
losses are reasonable. If the entity uses IFRS, the auditor should verify the
reasonableness of any fixed asset revaluations.
1. Auditing the Ending Property, Plant, and Equipment Balance
c. Existence
The auditor should vouch additions to the fixed asset accounts by examining
internal documents (such as the asset requisition form), by examining external
evidence (such as invoices), and by inspecting the actual asset. The auditor
should also consider selecting older fixed assets from the subsidiary ledgers and
then trying to locate those assets, as a means of testing for unrecorded
retirements.
1. Auditing the Ending Property, Plant, and Equipment Balance
d. Rights and Obligations
The auditor should examine invoices, deeds, and title documents to confirm
ownership of fixed assets.
2. Auditing Property, Plant, and Equipment Transactions
The following tests of details can be performed as dual-purpose tests.
a. Completeness
Trace a sample of fixed asset purchase requisitions to receiving reports and the
fixed asset subsidiary ledger. The auditor should also review the related repair
and maintenance expense accounts to test for completeness of asset additions.
The auditor is looking for items recorded as repairs that would more properly
have been capitalized.
PASS KEY
The examiners sometimes try to trick the candidates with questions about the repairs and
maintenance account. Keep in mind that the auditor often reviews this account in order to
locate items that should have been capitalized.
2. Auditing Property, Plant, and Equipment Transaction
b. Cut-off
Review fixed asset purchases and dispositions from shortly before and after
year-end for recording in the proper period.
2. Auditing Property, Plant, and Equipment Transaction
c. Valuation, Allocation, and Accuracy
Depreciation expense should be recalculated for reasonableness and conformity
with GAAP. Gains and losses and the charge-off of accumulated depreciation for
fixed assets sold or retired should be tested for reasonableness. Revaluation
losses and surplus should be recalculated.
2. Auditing Property, Plant, and Equipment Transaction
d. Existence and Occurrence
The auditor should vouch a sample of purchases to the receiving report and
vendor invoice and a sample of dispositions to the asset retirement form and
other supporting documentation.
2. Auditing Property, Plant, and Equipment Transaction
e. Understandability and Classification
The auditor should examine a sample of significant charges to repairs and
maintenance expense for items that should have been capitalized (also a
completeness test) and should review lease transactions for proper classification
as operating or capital.
PPE
3. Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to fixed assets
have been included in the notes to the financial statements. Required
disclosures include:
1. Depreciation methods and useful lives.
2. Depreciation expense for the period.
3. Balance of each class of capital assets by nature or function.
4. Accumulated depreciation allowances by class or in total.
5. Liens and mortgages.
6. Capital and operating lease information.
PPE
3. Auditing Presentation and Disclosure
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to fixed
assets to determine whether the information is accurate and presented at the
appropriate amounts.
PPE
3. Auditing Presentation and Disclosure
c. Rights and Obligations and Occurrence
The auditor should inquire of management and review loan agreements, minutes
and other documents to determine whether fixed assets have been pledged as
collateral. The auditor should compare disclosures to other audit evidence to
ensure that all disclosed information related to fixed assets has occurred.
PPE
3. Auditing Presentation and Disclosure
d. Understandability and Classification
...
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
The most significant payroll and personnel cycle risks are the creation of fictitious employees
and the falsification of hours worked.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
1. Service Organizations
As discussed in Auditing 3, many entities use service organizations to process payroll
transactions. The service organization's services are considered to be part of a user
entity's information system when those services affect the initiation, execution,
processing, or reporting of the user company's transactions. In such cases, the
controls placed in operation by the service organization are considered to be part of the
user organization's information system.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
2. Segregation of Duties
There should be a proper segregation of duties as follows:
a. Authorization to Employ and Pay
It is the function of the human resources department to hire new employees (on
the basis of requisitions from user departments) and to maintain the personnel
records containing hire date, department, salary, and position.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
2. Segregation of Duties
Supervision
Timekeeping and Cost Accounting
Supervision
All pay base data (hours, absences, time off, etc.) should be approved by an
employee's immediate supervisor.
Timekeeping and Cost Accounting
Data on which pay is based, such as hours worked or jobs completed, should be
accumulated independent of any other function.
Where there are employees who are paid by the hour, it is advisable to use time
clocks. Each department supervisor should compare the job time tickets with
employee clock cards that have been signed by the employee. Salaried
employees should prepare time sheets, which also require supervisory approval.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
2. Segregation of Duties
Payroll Check Preparation
The payroll department computes salary based on information received, for
example, total hours worked for hourly employees. This department is
responsible for issuing the unsigned payroll checks that are later signed by the
treasurer.
PASS KEY
Remember that the payroll department is a recordkeeping department, not a custodial
department. While employees in this department compute salaries, create the payroll register,
and prepare unsigned checks, they should not have the authority to initiate changes in hours or
rates, nor should they have the ability to sign checks.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
2. Segregation of Duties
Check Distribution
The payroil checks should be distributed by a person who has no other payroil
function. In larger corporations, this individual is often referred to as the
paymaster.
The employees should be required to show some form of identification before
receiving their paychecks.
The internal auditing department periodically compares the personnel files with
the payroli files. This is to help ensure that only authorized payments have been
made in the proper amounts to appropriate personnel.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
3. control Procedures
a. prenumbering
b. authorization
a. time cards, checks and payroll change documents should be pre-numbered and accounted for .
b. Authorization
Transactions should be initiated with proper authority.
(1) New hires should be properly documented.
(2) Pay rates should be authorized at the appropriate level.
(3) Deduction authorizations should be obtained from the employee.
(4) The personnel department should authorize ail changes to the payroil
master file.
(5) The personnel department should keep personnel files on each employee.
(6) Terminations should be properly documented.
(7) Time cards (time clock) should be used to record time worked.
(8) Authorized signatures should be required on all payroll checks.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
3. control Procedures
c. independent check to maintain asset accountability.
(1) Calculation of payroll amounts should be internally verified.
(2) Account classification of payroll transactions should be internally verified.
(3) The accounting department should prepare a voucher for the amount of
the payroll based upon input from the payroll department.
(4) A bank reconciliation of the imprest payroll account should be prepared by
an individual independent of custody or recordkeeping functions.
(5) Unclaimed payroll checks should be returned to an independent individual
for follow up.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
3. control Procedures
d. documentation
e. timely and appropriate performance reviews.
d. documentation
(1) All changes to payroll should be supported by authorized change
documents.
(2) Hours worked should be documented by approved time records.
e. timely and Appropriate Performance Reviews
(1) Employees handling cash disbursements should be bonded. Bonding is a
form of insurance that guarantees payment to an employer if a financial
loss occurs due to theft by an employee.
(2) Personnel should be rotated to different functions.
(3) Budgetary controls should be used to enhance internal control.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
3. control Procedures
f. information processing controls
g. physical controls for safeguarding assets
f. (1) General and application controls should be in place to ensure that payroll
transactions are valid, properly authorized, and completely and accurately
recorded. For example, hours worked should be compared to
predetermined minimums and maximums (a range test), or perhaps to
prior periods (a reasonableness test).
g. (1) There should be no unauthorized access to IT programs and data.
(2) Unsigned checks should be locked up.
(3) The treasurer should sign the payroll checks. An imprest payroll account
should be used.
PAYROLL AND PERSONNEL CYCLE
A. Internal Control
3. control Procedures
h. segregation of duties
(1) Authorization: operating department and personnel department.
(2) Recording: payroll department.
(3) Custody (payroll checks): treasurer should sign and distribute checks.
PAYROLL AND PERSONNEL CYCLE
5. Internal Control Evaluation
The auditor should evaluate whether internal controls provide reasonable assurance
that only valid employees are being paid. that payment is for the actual hours worked.
and that the correct rate of pay is used. The following procedures should be
performed:
a.Compare the personnel records for each department with the actual time cards
and the employees actually working in each department:
b.Observe payroll distribution on a surprise basis to ensure that all personnel being
paid are actually employed by the company;
c.Observe the use of time clocks and investigate time cards not used; and
d.Test transfers and underlying employee authorizations if direct deposit is used.
PAYROLL AND PERSONNEL CYCLE Substantive Procedures Related to Payroll and Personnel
1. Auditing the Payroll Accrual
When internal control over payroll is effective, the auditor generally focuses substantive
procedures on the valuation assertion. Tests related to completeness, existence and
rights and obligations are generally performed only when the entity's internal control
over payroll cannot be relied upon.
Substantive Procedures Related to Payroll and Personnel
1. Auditing the Payroll Accrual
a. completeness
b. valuation and allocation
a. Completeness
The auditor should test the completeness of the payroll accrual when performing
the search for unrecorded liabilities.
b. Valuation and Allocation
The auditor should recalculate any year-end payroll accrual and compare the
calcUlated amount to the reported accrual.
Substantive Procedures Related to Payroll and Personnel
1. Auditing the Payroll Accrual
c. Existence
d. Rights and Obligations
c. Existence
The auditor should vouch amounts from the client's calculation of the payroll
accrual to supporting documentation.
d. Rights and Obligations
The auditor should examine supporting documentation to verify that the payroll
accrual is an obligation of the entity.
Substantive Procedures Related to Payroll and Personnel
2. Auditing Payroll Transactions
The following tests of details can be performed as dual-purpose tests.
a. Completeness
b. Cut-off
a. Completeness
Trace a sample of time cards to the payroll register.
b. Cut-off
Trace a sample of time cards from before and after year-end to the payroll report
to determine whether the transactions were recorded in the proper period.
Substantive Procedures Related to Payroll and Personnel
2. Auditing Payroll Transactions
c. Valuation, Allocation, and Accuracy
The auditor should test the accuracy and valuation of payroll expense by
performing the following procedures:
(1) Compare total recorded payroll with total payroll checks issued;
(2) Test extensions and footings of payroll;
(3) Verify pay rates and payroll deductions with employee records from
personnel;
(4) Recalculate gross and net pay on a test basis;
(5) Compare payroll costs with standards or budgets;
(6) Recompute the mathematical accuracy of a sample of paychecks.
Substantive Procedures Related to Payroll and Personnel
2. Auditing Payroll Transactions
d. existence and occurrence
e. understandability and classification
d.
Existence and Occurrence
Vouch time on payroll summaries by selecting a sample of payroll register entries
and comparing to time cards and approved time reports. From a sample of
payroll transactions, the auditor should find the related employee to verify the
existence and current employment status.
e. Understandability and Classification
The auditor should examine a sample of paychecks for classification into the
proper expense accounts.
Substantive Procedures Related to Payroll and Personnel
3. Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to payroll have been included in the notes to the financial statements. Required disclosures include:
1. Pension and post-retirement benefit disclosures.
2. Stock-based compensation disclosures.
3. Deferred compensation and profit-sharing plans.
Substantive Procedures Related to Payroll and Personnel
3. Auditing Presentation and Disclosure
b. Valuation, Allocation, and Accuracy
c. Rights and Obligations and Occurrence
d. Understandability and Classification
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to payroll to
determine whether the information is accurate and presented at the appropriate
amounts.
c. Rights and Obligations and Occurrence
The auditor should inquire about accruals for proper disclosure. The auditor
should compare disclosures to other audit evidence to ensure that all disclosed
information related to payroll has occurred.
d. Understandability and Classification
The auditor should also read required disclosures for understandability.
FINANCING CYCLE
The financing cycle includes an entity's debt and equity.
A. Internal Control Over Debt
An entity's internal control over debt should include the following:

1.Adequate documentation of all financing agreements.
2.Authorization of new financing by the board of directors or management.
3. Detailed records of long-term debt, including interest and principal payments and the amortization of premiums and discounts.
FINANCING CYCLE
The financing cycle includes an entity's debt and equity.
B. Internal Control Over EquityAll stock issuances, dividend declarations, and treasury stock purchases must be authorized by the board of directors. Evidence of these events should be duly recorded in the minutes of
board meetings.
Many large entities use a stock transfer agent who ensures that stock issuances comply with the articles of incorporation, prepares stock certificates, and maintains records of shares authorized, issued, and outstanding. If a stock transfer agent is not used, then the entity should implement the following controls:
1. An officer of the entity should be responsible for ensuring that stock transactions
comply with the articles of incorporation and regulatory requirements and should
maintain the stock certificate book. To ensure proper segregation of duties, the
individual who maintains the stock certificate book should have no accounting
responsibilities.
2. There should be a periodic independent reconciliation of the stock certificate book with
the number of shares outstanding.
FINANCING CYCLE
C. Substantive Procedures Related to Debt
1. Auditing the Ending Debt Balance
a. Completeness
The auditor should review board minutes for evidence of new debt, obtain new
debt agreements, and trace all new debt contracts to the financial statements.
The auditor should obtain a listing of all debt and agree the total to the general
ledger. Any debt disclosed on the standard bank confirmation should be traced
to the debt agreements and the financial statements. Notes and bonds shouid
be confirmed directly with creditors. The auditor should inquire of management
regarding new debt and any off-balance sheet financing transactions.
FINANCING CYCLE
C. Substantive Procedures Related to Debt
1. Auditing the Ending Debt Balance
b. Valuation and Allocation
c. Existence
d. Rights and Obligations
b. Valuation and Allocation
The auditor should examine new debt agreements to determine whether they
were recorded at the proper amount. The auditor should recompute any interest
payable and recompute the amortization of premiums or discounts.
c. Existence
The auditor should confirm notes or bonds directly with creditors.
d. Rights and Obligations
The auditor should examine note and bond agreements to verify that they are the
obligations of the entity.
FINANCING CYCLE
C. Substantive Procedures Related to Debt
2. AUditing Debt Transactions
The folloWing tests of details can be performed as dual-purpose tests.
a. Completeness
b. cutoff
a. Completeness
The auditor should examine new debt agreements and the board minutes for
evidence of new agreements. The auditor should review interest expense for
payments to debt holders not included in the debt listing. The auditor should
examine lease agreements for proper classification as operating or capital.
b. cutoff
the auditor should review debt activity shortly before and after year end to ensure the transactions were reported in the proper period
FINANCING CYCLE
C. Substantive Procedures Related to Debt
2. Auditing Debt Transaction
d. Existence and Occurrence.
e. Understandability and Classification
d. Existence and Occurrence
The auditor should verify the existence of new debt by reviewing the board
minutes for evidence of new agreements and then inspecting the agreements.
e. Understandability and Classification
The auditor should examine the due dates of notes and bonds to determine
whether the debt should be classified as short-term or long-term.
FINANCING CYCLE
C. Substantive Procedures Related to Debt
3. Auditing Presentation and Disclosure
a. Completeness
The auditor should ensure that all required disclosures related to debt have been
included in the notes to the financial statements. Required disclosures include:
1. Details of maturity dates, interest rates, call and conversion privileges, and
assets piedged as security.
2. Future sinking fund payments and maturities for each of the next five
years.
3. Restrictive loan covenants.
FINANCING CYCLE
C. Substantive Procedures Related to Debt
3. Auditing Presentation and Disclosure
b. Valuation, Allocation, and Accuracy
c. Rights and Obligations and Occurrence
d. Understandability and Classification
b. Valuation, Allocation, and Accuracy
The auditor should read the footnotes and other information related to debt to
determine whether the information is accurate and presented at the appropriate
amounts.
c. Rights and Obligations and Occurrence
The auditor should compare disciosures to other audit evidence to ensure that all
disclosed information related to debt has occurred.
d. Understandability and Classification
The auditor should also read required disclosures for understandability.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
...When auditing equity, the auditor is primarily concerned about completeness, valuation, and
existence and occurrence. The auditor should also focus on evaluating classification and
understandability.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
1. Completeness
If the client uses a stock transfer agent, third-party confirmations should be used to
provide evidence of the completeness of shares authorized, issued, and outstanding,
as well as to provide evidence of the individual transactions.
If a client does not use a stock transfer agent, the primary source of evidence of
completeness is the stock certificate book.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
1. Completeness
The auditor should ensure that all required disclosures related to equity have been included in the notes to the financial statements. Required equity disclosures include:
a. Number of shares authorized, issued, and outstanding.
b. Rights and privileges of securities, including dividend and liquidation
preferences, participation rights, call prices and dates, conversion or exercise
prices or rates and pertinent dates, sinking-fund requirements, unusual voting
rights, and significant contracts to issue additional shares.
c. Stock option plans.
d. Restrictions on retained earnings and dividends.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
2. Valuation
The auditor may recompute the value assigned to stock transactions during the period.
The auditor should also analyze the retained earnings account from inception (or since
the last audit) and should review the propriety of any direct entries to retained earnings.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
3. Existence and Occurrence
Existence and occurrence can be tested by vouching transactions recorded during the
current period to board minutes. The stock transfer agent confirmation and the
inspection of the stock certificate book also provide evidence of existence.
FINANCING CYCLE
D. Substantive Procedures Related to Owners' Equity and Treasury Stock
4. Understandability and Classification
The auditor should determine whether there are restrictions on retained earnings
resulting from loans, agreements, or state laws. The auditor should also inquire of
management regarding any appropriations of retained earnings. Restrictions and
appropriations must be properly disclosed.
I. RELATED PARTY TRANSACTIONS
A. Auditor's Responsibility
When auditors are performing an examination of financial statements, they are responsible
for identifying any related party transactions encountered during the course of the audit and
for determining whether the transactions are given proper disclosure in the financial
statements. Related parties may include the reporting entity's affiliates, principal owners,
management, and members of their immediate families.
I. RELATED PARTY TRANSACTIONS
B. Accounting for Related Party Transactions
Except for very routine transactions, it generally isn't possible to determine whether a
transaction would have taken place in exactly the same manner if the parties weren't related.
Therefore, a related party transaction is not considered to be an arm's-length transaction.
For this reason, the substance of a related party transaction may be very different from its
form, and GMP requires that such transactions be disclosed.
I. RELATED PARTY TRANSACTIONS
C. Audit Objectives
The auditor's primary concern with related party transactions is that they are properly
disclosed in accordance with GMP. The auditor must determine the existence of related
parties, identify and examine related party transactions, and verify that disclosure is
adequate.
I. RELATED PARTY TRANSACTIONS
D. Determining the Existence of Related Parties
Application of specific procedures regarding material transactions with related parties may
include:
1. Evaluating the company's procedures for identifying and accounting for related party
transactions, and obtaining a conflict of interest statement from the client.
2. Asking management for the names of all related parties and inquiring whether any
transactions occurred during the period.
3. Reviewing the reporting entity's filings with the SEC and other regulatory agencies
concerning the names of officers and directors who occupy management or
directorship positions in other businesses.
4. Reviewing material transactions (especially investment transactions) for related party
evidence.
5. Reviewing prior years' audit documentation or inquiring of the predecessor auditor.
I. RELATED PARTY TRANSACTIONS
1. Identifying Related Party Transactions
The auditor should provide the names of known related parties to the audit staff. In addition, related party transactions may be identified by reviewing board minutes, SEC filings, and confirmations. The auditor should remain alert for the following items, which may be indicative of a related party transaction.
a. Compensating balance arrangements (which may be maintained by or for related
parties).
b. Loan guarantees.
c. Unusual, nonrecurring transactions near year-end.
d. Transactions based on terms that differ significantly from market terms.
e. Nonmonetary exchanges.
I. RELATED PARTY TRANSACTIONS
2. Examining Related Party Transactions
Once a related party transaction has been identified, the auditor should obtain an
understanding of the business purpose of the transaction and test the amounts to be
disclosed.
I. RELATED PARTY TRANSACTIONS
F. Evaluating Financial Statement Disclosure
For each material related party transaction (except compensation arrangements, expense
allowances, and other similar items in the ordinary course of business), the auditor should
audit the transaction and determine whether it is adequately disclosed in accordance with
GAAP. If management indicates in the financial statements that the transaction was
consummated on arm's-length terms and the auditor believes this statement is
unsubstantiated, the auditor should express a qualified or adverse opinion due to a GAAP
departure.
ACCOUNTING ESTIMATES
A. Defined
An accounting estimate is an approximation of a financial statement element, item, or
account. Estimates are used because either data about past events cannot be accumulated
in a timely, cost-effective manner or because measurement of some accounts is dependent
upon the outcome of future events. It is the responsibility of management to make
reasonable estimates and include them in the financial statements.
ACCOUNTING ESTIMATES
Examples of estimates include:
1. Net realizable values of inventory and accounts receivable;
2. Compensation in stock option plans;
3. Future pension and warranty expenses; and
4. Probability of loss and related amounts due to litigation.
ACCOUNTING ESTIMATES
Auditor's Responsibilities
The auditor has four responsibilities when evaluating estimates:
1. Assess management's written policies and practices regarding the development and
use of estimates.
2. Verify that all material estimates have been developed.
3. Determine that the accounting estimates are reasonable. In evaluating
reasonableness, the auditor focuses on assumptions that are significant to the
estimate, sensitive to variations, deviations from historical patterns, or subjective and
susceptible to misstatement/bias.
4. Ensure that the accounting estimates are properly presented and disclosed in
conformity with GAAP.
ACCOUNTING ESTIMATES
Procedures
In evaluating the reasonableness of an estimate, the auditor must first obtain an
understanding of how management developed its estimate. The auditor would then perform one or a combination of the following procedures:
1. Review and test the procedures used by management to develop the estimate.
2. Develop an independent estimate of the item for comparative purposes.
3. Review sUbsequent events and transactions (occurring prior to the date of the auditor's
report) that corroborate the value of the estimate.
AUDITING FAIR VALUES
A. Fair Value Reporting
Certain assets, liabilities, and specific components of equity are presented or disclosed at fair value in the financial statements.
1. Fair value is defined as the amount at which an asset could be bought or sold (or the
amount at which a liability could be incurred or settled) in a current transaction between
willing parties.
a. Market value (e.g., a published price quotation in an active market) should be
used where possible.
b. Estimates and valuation methods may be used when market values are not
available.
AUDITING FAIR VALUES
A. Fair Value Reporting
2. Fair value measurements may arise from both the initial recording of a transaction and
later changes in value.
a. Changes in fair value measurement may be treated in different ways under
GAAP (e.g., included in net income, reflected in other comprehensive income
and equity, etc.).
AUDITING FAIR VALUES
B. Management's Responsibility
Management is responsible for making fair value measurements and disclosures in
accordance with GAAP.
1.Where market prices are not available, appropriate valuation methods should be used
to estimate fair value.
2.Valuation methods should incorporate assumptions that would be used in the market
when possible.
3.Management should identify and support any significant assumptions used.
AUDITING FAIR VALUES
C. Auditor's Responsibilities
1. The auditor should obtain sufficient competent audit evidence to provide reasonable
assurance that fair value measurements and disclosures are in conformity with GAAP.
The auditor should:
a. Understand the entity's process for determining fair value measurements and
disclosures.
b. Understand relevant controls.
c. Assess the risk of material misstatement of fair value measurements.
d. Evaluate conformity with GAAP.
e. Consider the need for a specialist.
f. Test fair value measurements and disclosures
AUDITING FAIR VALUES
C. Auditor's Responsibilities
continued:
h. Evaluate the sufficiency, competency, and consistency of evidence obtained with
respect to fair value measurements and disclosures.
i. Obtain relevant management representations (e.g., relating to the
reasonableness of significant assumptions, management's intent and ability to
carry out planned courses of action, completeness and adequacy of disclosure,
the effect of subsequent events, etc.).
j. Communicate relevant matters to those charged with governance (e.g., matters
related to particularly sensitive fair value estimates).
AUDITING FAIR VALUES
C. Auditor's Responsibilities
In testing an entity's fair value measurements and disclosures, the auditor may:
1. Determine whether management's significant assumptions provide a reasonable basis
for fair value measurements.
2. Consider management's intent and ability to carry out courses of action that may affect
fair values.
3. Evaluate whether the valuation model is appropriate given the entity's circumstances.
4. Test the underlying data for accuracy, completeness, relevancy, and consistency.
5. Develop independent fair value estimates for corroborative purposes.
6. Review subsequent events and transactions (occurring before the date of the auditor's
report) for evidence regarding fair value measurements at the balance sheet date.
EVALUATING CONTINGENCIES
In performing an audit in accordance with generally accepted auditing standards, the independent auditor must obtain appropriate evidence regarding contingent liabilities.
Contingent liabilities may arise from many sources, including:
(i) Pending and threatened litigation
(ii) Actual or possible claims and assessments
(iii) Guarantees of the indebtedness of others
(iv) Product warranties
(v) Income tax disputes
Under GAAP, contingent liabilities that are probable and can be reasonably estimated must be
accrued and disclosed.
EVALUATING CONTINGENCIES
A. Identifying Contingencies
The auditor should ask management about contingent liabilities, including pending litigation
or possible future litigation and about controls adopted to identify, evaluate, and account for
such items. In conjunction with these inquiries, the auditor should perform the following
procedures:
1. Review the minutes of meetings of stockholders, board of directors, and other
executive committees.
2. Review correspondence and invoices from lawyers.
3. Review contracts, loan agreements, loan guarantees, ieases, and correspondence
from taxing authorities.
4. Review bank confirmations for hidden bank loans, discounted drafts, guarantee of
notes, etc.
5 Discuss long-term purchase commitments with the purchasing agent.
6. Review the status of long-term leases.
7. Discuss sales contracts with the sales manager.
8. Review the interim financial statements after year-end.
9. Obtain a client representation letter.
10. Send an inquiry letter to the client's attorneys.
EVALUATING CONTINGENCIES
Specific Inquiry Into Litigation
If it comes to the auditor's attention that the entity is involved in litigation or is threatened with
litigation, the auditor should inquire regarding:
1.The nature of the matter, including the period of occurrence;
2.The progress of the case to date, including management's intended response;
3.The degree of probability of an unfavorable outcome; and
4.The amount or estimate of potential loss.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
There must be a direct letter of inquiry to the client's attorneys regarding litigation, claims and
assessments. In this letter, management details any pending or threatened litigation matters.
This letter is signed by the client and sent by the auditors to the attorneys.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
1. Response by Attorneys
The attorneys in turn send their replies directly to the independent auditor. In these
replies, attorneys give their evaluation concerning litigation matters within their
knowledge or control.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
2. Limitations on Response
The lawyer's response to the letter of inquiry should include a professional opinion on
the expected outcome of any lawsuit and the likely outcome of any liability, including
court costs.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
2. Limitations on Response
a. "Substantial Attention" Limitation
Lawyers may limit their replies to matters to which they have given substantial
attention. Responses may also be limited to material matters if an understanding
has been reached between the lawyer and the auditor as to what amount would
be considered material.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
2. Limitations on Response
b. Confidentiality Limitation
In some cases, it may be unwise for a lawyer to disclose certain confidential
information. An example of this may be knowledge of a patent violation, if the
disclosure of the violation in the financial statements could bring about a lawsuit.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
3. Refusal to Respond
A lawyer's refusal to respond to a letter of inquiry where the lawyer has devoted
substantial attention to litigation matters is a limitation in the scope of an independent
auditor's examination, sufficient to preclude an unqualified opinion.
EVALUATING CONTINGENCIES
C. Letter of Inquiry to Client's Attorneys
4. Refusal to Permit Inquiry
5. Inherent Uncertainties
4. Refusal to Permit Inquiry
A client's refusal to permit inquiry of the attorneys generally will result in a disclaimer of
opinion.
5. Inherent Uncertainties
In some cases. inherent uncertainties may make it difficult for a lawyer to form
conclusions regarding pending litigation. If the auditor is satisfied that financial
statement disclosure is adequate, no modification to the opinion would be required.
PASS KEY
Note that management is the primary source of information regarding contingencies, including litigation, '-
claims, and assessments. The letter sent to the client's lawyer is simply a means of corroborating information ~
provided by management
Information technology (IT)
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENTS
A. Segregation of Duties
1. In a computerized environment, transaction processing often results in a combination
of functions that are normally separated in a manual environment.
2. The additional risk associated with this (possibly incompatible) concentration of
functions may be mitigated by the implementation of compensating controls.
Information technology (IT)
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENTS
B. Disappearing Audit Trail
1. Paper audit trails are substantially reduced in a computerized environment (particularly
in on-line, real-time systems). If a client processes most of its financial data in
electronic form, without any paper documentation, audit tests should be performed on a
continuous basis.
2. Computer systems should be designed to supply electronic audit trails, which are often
as effective as paper trails.
3. Use of IT may make it more difficult to use physical inspection to identify nonstandard
or unusual transactions or adjustments.
Information technology (IT)
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENTS
C. Uniform Transaction Processing
1. Processing consistency is improved in a computerized environment because clerical
errors (e.g., random arithmetic errors, missed postings, etc.) are virtually eliminated.
2. In a computerized environment, however, there is an increased potential for systematic
errors, such as errors in programming logic (e.g., using the incorrect tax rate).
Information technology (IT)
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENTS
D. Computer-Initiated Transactions
1. Automated transactions are not subject to the same types of authorization as are used
for manual transactions and may not be as well-documented.
2. When information is automatically transferred from transaction processing systems to
financial reporting systems, inadvertent errors are reduced, but unauthorized
interventions may not be evident.
Information technology (IT)
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENT
E. Potential for Increased Errors and Irregularities
Several characteristics of computerized processing act to increase the likelihood that fraud
may occur and remain undetected for long periods of time.
1.The opportunity for remote access to data in networked environments increases the
likelihood of unauthorized access. Therefore, specific controls should exist to ensure
that users can only access and update authorized data elements.
2.Concentration of information in computerized systems means that, if system security is
breached, the potential for damage is much greater than in manual systems.
3.Decreased human involvement in transaction processing results in decreased
opportunities for observation.
4.Errors or fraud may occur in the design or maintenance of application programs.
5. Computer disruptions may cause errors or delays in recording transactions.
DIFFERENCES BETWEEN MANUAL AND COMPUTERIZED (IT) ENVIRONMENT
F. Potential for Increased Supervision and Review
1. Computer systems provide more opportunities for data analysis and review, including
integration of audit procedures in the application programs themseives.
2. Utilization of these opportunities can help mitigate the additional risks associated with a
lack of segregation of duties.
3. In a computerized environment, the increased availability of raw data and management
reports affords greater opportunity for both the client and the auditor to perform
analytical procedures.
EFFECT OF INFORMATION TECHNOLOGY ON EVIDENCE GATHERING
A. Factors to Consider
In selecting the appropriate audit procedures in a computerized environment, the auditor
should consider:
1.The extent of computer utilization in each accounting application,
2.The complexity of the entity's computer operations,
3.The organizational structure of the information technology department,
4.The availability of an audit trail, and
5.The use of computer-assisted audit techniques
Use of an IT Professional
Because some systems depend so heavily on computerized processing, it may be difficult or
impossible for the auditor to access certain information without assistance. If specialized IT
skills are needed, the auditor should seek the help of an IT professional from his or her staff
or from the outside.
1. The auditor should have enough IT-related knowledge to:
a. Communicate audit objectives to the IT professional,
b. Evaluate the sufficiency of the procedures performed, and
c. Evaluate the results of the procedures performed.
2. The CPA's responsibility to guide IT professionals is the same as for other accounting
assistants.
3. The auditor need not personally possess the required level of IT skills.
EFFECT OF INFORMATION TECHNOLOGY ON EVIDENCE GATHERING
C. Auditing Around the Computer
1. When auditing around the computer, the auditor does not directly test the application
program. The auditor tests the input data, processes the data independently, and then
compares the independently determined results to the program results. Emphasis is
on the input and output stages of transaction processing.
2. Auditing around the computer is often appropriate for simple batch systems with a good
audit trail, and it will result in the same level of confidence as would auditing through
the computer.
3. Risks of auditing around the computer include insufficient, paper-based evidence and
insufficient audit procedures.
EFFECT OF INFORMATION TECHNOLOGY ON EVIDENCE GATHERING
-Computer Assisted Audit Techniques (CAAT)
When using CMTs, emphasis is on the input and processing stages of transaction
processing. In highly automated systems, complex audit trails and the elimination of physical
source documents may mean that CMTs are the only feasible way to complete the audit in a
timely manner. CMTs include:
Computer Assisted Audit Techniques (CAAT)
1. Transaction Tagging
Transaction tagging is a technique the auditor uses to electronically mark (or "tag")
specific transactions and follow them through the client's system.
a. Tagging allows the auditor to test both the computerized processing and the
manual handling of transactions.
Computer Assisted Audit Techniques (CAAT)
2. Embedded Audit Modules
Embedded audit modules are sections of the application program code that collect
transaction data for the auditor.
a. For example, an auditor might want to examine all transactions affecting a
specific account code that are greater than $500.
b. Embedded audit modules are most often built into the application program when
the program is developed, for use in ensuring that controls are operating
effectively.
Computer Assisted Audit Techniques (CAAT)
3. Test Data (test deck)
Test data refers to a technique that uses the application program to process a set of
test data, the results of which are already known. (The client's system is used to
process the auditor's data, off-line, and while under the auditor's controL)
a. The test data contains the types of invalid conditions in which the auditor is
interested (it is not necessary to test all combinations of invalid conditions).
b. An advantage of the test data technique is that the live computer files are not
affected in any way.
Computer Assisted Audit Techniques (CAAT)
4. Integrated Test Facility (fTF)
An integrated test facility (ITF) is similar to the test data approach except that the test
data is commingled with live data. (The client's system is used to process the auditor's
data, on-line.)
a. The test data must be separated from the live data before the reports are
created. This is usually accomplished by processing the test data to dummy
accounts (e.g., a fictitious customer, branch, vendor, etc.).
b. Client personnel are not informed that the test is being run.
Computer Assisted Audit Techniques (CAAT)
Parallel Simulation (reperformance test)
Parallel simulation (reperformance test) is a technique where the auditor re-processes
some or all of the client's live data (using software provided by the aUditor) and then
compares the results with the client's files. (The auditor's system is used to process
the ciient's data.)
a. With controlled processing, the auditor observes an actual processing run and
compares the actual results to the expected results (based on the auditor's
program).
b. With controlled re-processing, the auditor uses an archived copy of the program
in question (generally the auditor's control copy) to re-process transactions. The
results are then compared to the results from the normal processing run.
(Differences indicate that there have been changes to the program.)
(1) Source code comparison programs are programs that compare two
versions of software to determine if they match. This type of software can
be used to look for unauthorized program changes.
Programs to accomplish parallel processing can be specifically developed for the
application, bought as a packaged program or utility, or produced by a
generalized audit software package.
Generalized Audit Software Packages (GASPs)
Generalized audit software packages (GASPs) allow the auditor to perform tests of controls
and substantive tests directly on the client's system. The auditor first defines the client's
system (to the GASP) and then specifies the tests and selections that should be made. The
GASP generates the programs necessary to interrogate the files and extract and analyze the
data.
1. Tasks Typically Performed by GASPs
a. Examining transactions for control compliance.
b. Selecting items meeting specified criteria.
c. RecalcUlating amounts and totals.
d. Reconciling data from two separate files.
e. Performing statistical analysis on transactions.
Advantages of Using GASPs
a. GASPs allow the auditor to sample and test a much higher percentage of
transactions, which results in a more reliable audit.
b. GASPs require little technical knOWledge.
c. After the initial use, GASPs can significantly reduce audit time without sacrificing
quality.
Advantages of Using a Computer
1. Automatic performance of math on all documents, which reduces errors.
2. Automatic cross-referencing of amounts by linking each lead schedule to the working
trial balance and to the financial statements. (This saves considerable time in posting
adjusting journal entries.)
3. Automatic preparation of financial statements, tax return schedules, and consolidating
schedules (all of which save time preViously spent typing them, and which make late
changes easier to implement).
4. Reduction in required supervisory review time.
a. Computer printout is more legible than most handwriting.
b. Once the reliability of the software has been confirmed, less time is required to
review and prove such things as footings, postings, ratio calculations, and cross
references.
Advantages of Using a Computer
5.Automatic performance of certain analytical review procedures, such as:
a. Computing account differences from one year to the next, and
b. Computing the percentage increase or decrease in each account.
6. Enhanced client service-the client's personnel can benefit from:
a. No longer needing to manually prepare schedules that are now permanently in
the computer,
b. More legibie adjusting journal entry listings,
c. Enhanced analytical information, and
d. The ability to review a draft of the financial statements while the auditors are still
in the field.
7. Improved morale and productivity for the audit team, as less time is spent on tedious
clerical tasks (such as preparing lead schedules, endlessly posting columns of figures,
etc.).
Disadvantages
The primary disadvantage of auditing with a computer is that audit documentation may not
contain readily observable details of calculations.
A. Evaluation of Audit Findings
The auditor must evaluate the materiality of all misstatements found during the audit.
1. The size of a misstatement is often evaluated in comparison to a relevant financial
base, such as net income, gross sales, gross margin, total assets, or total liabilities.
2. The auditor must consider the effects, both individually and in the aggregate, of
uncorrected misstatements (both known and likely).
3. As the aggregate of known and likely misstatements approaches the materiality level,
the auditor should consider the risk that the addition of undetected misstatements could
cause materiality levels to be exceeded.
A. Evaluation of Audit Findings
4. Prior period misstatements may affect the financial statements of the current period.
5. Qualitative considerations sometimes may cause an otherwise immaterial
misstatement to be deemed material.
a. The specific circumstances surrounding an entity may lead to situations in which
misstatements that do not exceed materiality limits are still likely to influence the
economic decisions of users.
A. Evaluation of Audit Findings
b. Misstatements are more likely to be considered material if they:
(1) Affect trends in profitability or mask a change in a trend, or change a loss
into income (or vice versa).
(2) Affect the entity's compliance with loan covenants, contracts, or regulatory
provisions.
(3) Increase management compensation, indicate a pattern of management
bias, or involve fraud or an illegal act.
(4) Affect significant financial statement elements, such as those involving
recurring earnings (as opposed to those involving nonrecurring items).
(5) Can be objectively determined, as opposed to including an element of
subjectivity.
A. Evaluation of Audit Findings free of material misstatement
B. Communication to Management
All misstatements, other than those considered trivial, must be communicated to
management.
1. In this communication, the auditor should:
a. Distinguish between known and likely misstatements.
b. Request management to review the situation and make appropriate corrections.
2. The auditor should reevaluate the amount of likely misstatement remaining, if any, after
management has made adjustments.
3. If management does not correct some or all of the known and likely misstatements, the
auditor should consider the implications on the auditor's report.
A. Evaluation of Audit Finding free of material misstatements
C. Documentation Requirements
The auditor should document the following items:
1. Planning levels of materiality and tolerable misstatement, the basis for those levels,
and any subsequent changes.
2. Known and likely misstatements that were corrected by management.
3. A summary of uncorrected misstatements (both known and likely), the auditor's
conclusion regarding whether such misstatements cause the financial statements to be
materially misstated, and the basis for this conclusion.
a. Documentation of uncorrected misstatements should include:
(1) Separate identification of known and likely misstatements.
(2) The aggregate effect on the financial statements.
REVIEWING THE WORK OF OTHERS
A. Documentation Requirements
Audit documentation should include:
1. Who performed the work and the date the work was completed.
2. Who reviewed the audit documentation and the date of the review.
IV. ENGAGEMENT QUALITY REVIEW
PCAOB standards require an engagement quality review and concurring approval of audit report
issuance for all audits of issuers and for each engagement to review the interim financial
statements of an issuer. Many firms also require engagement quality reviews for nonissuer audits.
A. Engagement Quality Reviewer
An engagement quality review is performed by a partner who is not otherwise associated with
the engagement. The engagement quality reviewer must be competent, independent,
objective and act with integrity.
B. Engagement Quality Review Process
Under PCAOB standards, the engagement quality reviewer is required to hold discussions
with the engagement partner and other members of the engagement team and review theaudit documentation in order to evaluate the significant judgments made by the engagement
team and the overall conclusion reached on the engagement. The engagement quality reviewer should do the following:
1. Evaluate the significant judgments related to engagement planning, including the firm's
prior experience with the client, risks identified related to the client, and judgments
about materiality.
2. Evaluate the engagement's team assessment of and responses to significant risks,
including fraud risk.
3. Evaluate significant judgments about materiality, corrected and uncorrected
misstatements, and control deficiencies.
4. Review the evaluation of the firm's independence in relation to the engagement.
5. Review the engagement completion document and confirm that there are no
unresolved matters.
The engagement quality reviewer should do the following:
6. Review the financial statements, management's report on internal control, and the engagement report.
7. Read other information to be filed with the SEC and determine whether appropriate
action has been taken with respect to material inconsistencies or material
misstatements of fact.
8. Evaluate the consultations, documentation, and conclusions related to difficult or
contentious matters.
9. Evaluate communications with management, the audit committee, and regulatory
bodies.
10. Evaluate whether engagement documentation indicates that the engagement team responded appropriately to significant risks and whether such documentation supports
the conclusions reached by the engagement team.
Concurring Approval of Issuance
Under PCAOB standards, the firm cannot give the client permission to use the engagement
report until the engagement quality reviewer provides concurring approval of issuance. The
engagement quality reviewer may provide concurring approval of issuance only if there are
no significant engagement deficiencies.
A significant engagement deficiency exists when:
1.The engagement team failed to obtain sufficient appropriate evidence.
2.The engagement team reached an inappropriate overall conclusion.
3.The engagement report is not appropriate for the circumstances.
4.The firm is not independent of the client.
PASS KEY
Ratio questions on the auditing exam may require a simple ratio calculation, an interpretation of what the ratio
means, or an analysis of the effects of a change. Sometimes, when both the numerator and denominator are
affected by a given change, the final result (increase or decrease) is not easy to determine. The best way to answer
questions like these is to make up numbers and plug them into the ratio formula.
A. Liquidity Ratios
B. Activity Ratios
C. Profitability Ratios
A. Liquidity Ratios
Liquidity ratios are measures of a firm's short-term ability to pay maturing obligations.
B. Activity Ratios
Activity ratios are measures of how effectively an enterprise is using its assets.
C. Profitability Ratios
Profitability ratios are measures of the success or failure of an enterprise for a given time
period.
D. Investor Ratios
E. Long-term Debt.Paying Ability Ratios (coverage ratios)
D. Investor Ratios
Investor ratios are measures that are of interest to investors.
E. Long-term Debt.Paying Ability Ratios (coverage ratios)
Coverage ratios are measures of security for long-term creditors/investors.
LIMITATIONS OF RATIOS
Although ratios are easy to compute, they depend entirely on the reliability of the data on which
they are based (e.g., on estimates and on historical costs).
Other limitations include:
(i) Dissimilar business units may make analysis difficult.
(ii) Inflation can reduce comparability of balance sheet items.
(iii) Manipulation of ratios by management can occur.
(iv) The choice of different generally accepted accounting principles can affect ratios and reduce
comparability.
(v) Generalizations are difficult to make.
(vi) Ratios may use accounting data (e.g., fixed assets) that do not reflect fair values.
A. Common Size Analysis
Common size financial statements are used to compare a company's performance with the
performance of other smaller or larger companies, or with its own performance over time. To
draft a common size balance sheet, simply divide each balance by the total assets. The
result is each balance sheet component expressed as a percentage of the whole, with total
assets representing 100%. Similarly, to draft a common size income statement, simply divide
each income statement amount by the total revenue. Common size financiai statements can
be compared to industry norms or to industry leaders.
B. Analysis of Industry Statistics
Ratio analysis is useful when comparing to norms in an industry. Benchmarking may be
performed against competitors or industry leaders.
C. Trend Analysis
Ratio analysis can be used to analyze trends over time.