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Transcript of 16-1 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution...
16-1
Chapter 16
Auditing Operations and Completing the Audit
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
16-2
Auditing Operations
Corporate earnings are considered as an extremely important indicator of health and well-being of corporations
Measurement of income is generally regarded as the single most important function of accounting
16-3
Conservatism in the Measurement of Income
Powerful influence on revenue and expenses Important because of subjectivity involved
with accounting estimates Assets – accountants choose lower of two or
more reasonable alternative values Liabilities – higher amount is chosen Results in income statement with a low or
conservative income figure
16-4
Objectives for audit of revenue and expenses
1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to revenues and expenses.
2. Consider internal control over revenues and expenses.
3. Assess the risks of material misstatement of revenues and expenses and design further audit procedures that:
a. Establish the occurrence of recorded revenue and expense transactions.
b. Determine the completeness of recorded revenue and expense transactions.
c. Establish the accuracy of revenue and expense transactions.
d. Verify the cutoff of revenue and expense transactions.
e. Determine that the presentation and disclosure of revenue and expense accounts are appropriate, including the proper classification of amounts and the proper presentation of earnings-per-share data.
16-5
Figure 16-1 Comparative Income Statement Analysis
16-6
Relationships Between Balance Sheet and Income Statement Accounts
Balance Sheet Item Revenue Expenses
Accounts receivable
Notes receivable Securities and investments
Sales Interest, Interest, dividends, gains, investee’s income
Uncollectible accounts Uncollectible notes Losses
Inventories Purchases, cost of goods sold, payroll
Property, plant and equip. Intangible assets Prepaid expenses Accrued liabilities
Rent, gains
Royalties
Depreciation; repairs
Amortization Various expenses Various expenses
Interest-bearing debt Interest
16-7
Misc. Revenue (1 of 2) Mixture of minor items, some nonrecurring and others
received at regular intervals Auditor should analyze account to look for items
improperly recorded as miscellaneous: Collections on previously written-off accounts or notes
receivable Write-offs of old outstanding checks or unclaimed
wages Proceeds from sales of scrap Rebates or refunds of insurance premiums Proceeds from sales of plant assets
16-8
Misc. Revenue (2 of 2)
Auditor should Propose adjusting journal entry to classify
items correctly Perform analytical procedures and investigate
unusual fluctuations• Can detect material amounts of unrecorded
revenue and• Significant misclassifications affecting revenue
16-9
Figure 16-2 Professional Fees Analysis
16-10
16-10
Substantive Tests for Selling, General and Administrative Expenses (1 of 2)
Perform analytical procedures Develop an expectation of the account balance
• Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data and relevant nonfinancial data
Determine the amount of difference from the expectation that can be accepted without investigation• Use estimates of materiality
Compare the company’s account balance with the expected account balance
Investigate significant deviations from the expected account balance
16-11
16-11
Substantive Tests for Selling, General and Administrative Expenses (2 of 2)
Obtain or prepare analyses of selected expense accounts
Examine accounts based on results of analytical procedures
Which accounts? AICPA suggests• Advertising• Research and development• Legal expenses and other professional fees • Maintenance and repairs• Rents and royalties
Obtain or prepare analyses of critical expenses in the income tax return
16-12
Payroll
Importance – typically largest operating cost Payroll fraud had been common and often
substantial but now fraud difficult to conceal because of: Extensive segregation of duties relating to
payroll Use of computers with proper controls for
preparation of payrolls Filing of frequent payroll reports to the
government
16-12
16-13
Segregation of Functions--Payroll
Separate departments should handle: • Employment (personnel)
• Timekeeping
• Payroll preparation and record keeping
• Distribution of pay to employees
16-14
Internal Control over Payroll Documentation
Typical questions Are employees paid by check or direct deposit? Is a payroll bank account maintained on an imprest basis? Are the activities of timekeeping, payroll compilation, payroll
check signing, and paycheck distribution performed by separate departments or employees?
Are all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed?
Are employee time reports approved by supervisors? Is the payroll bank account reconciled monthly by an employee
having no other payroll duties?
16-15
Audit Program for Payroll (1 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures:a. Compare names and wage or salary rates to records maintained by the
human resources department.
b. Compare time shown on payroll to time cards and time reports approved by supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by employees.
e. Test extensions and footings of payroll.
16-16
Audit Program for Payroll (2 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures (continued):f. Compare total of payroll with total of payroll checks issued.
g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
h. If wages are paid in cash, compare receipts obtained from employees with payroll records.
i. If wages are paid by check, compare paid checks with payroll and compare endorsements to signatures on withholding tax exemption certificates.
j. If wages are paid by direct deposit, compare listing of employee payments with payroll and direct deposit authorizations.
k. Observe the use of time clocks by employees reporting for work and investigate time cards not used.
16-17
Substantive Procedures for Payroll
16-18
Audit of Statement of Cash Flows
Amounts are audited in conjunction with the audit of balance sheet and income statement accounts
Presentation and disclosure important audit objective is important Operating Investing Financing
16-19
Audit Procedures Completed Near the End of Field Work
Search for unrecorded liabilities Review the minutes of meetings Perform final analytical procedures Perform procedures to identify loss
contingencies Perform the review for subsequent events Obtain the representation letter Schedule an exit conference Review total misstatements and materiality Prepare management & accounting letters
16-20
E.g. Loss Contingencies Litigation Income tax disputes Accommodation endorsements and other guarantees of
indebtedness Accounts receivable sold or assigned with recourse Environmental issues Commitments (e.g. purchase or sales commitment at
fixed prices; must be disclosed if material; booked when causing an adverse position)
General risk contingencies (e.g. natural disasters, competition, strikes, raw material shortages; these should not be disclosed)
16-21
Loss Contingencies
Loss contingencies should be booked in the financial statement amounts when BOTH:
It is probable that a loss had been sustained before the balance sheet date
The amount of the loss can be reasonably estimated Loss contingencies should be disclosed in the
notes to the financial statements when it is at least reasonably possible that a loss has been sustained
Loss contingencies need not be disclosed when the possibility of loss is remote
16-22
Litigation
Most common loss contingency – pending or threatened litigation Letter of inquiry to client’s legal counsel
• Evidence of pending and threatened litigation; disclosure of any unpaid billings due to lawyers
• Unasserted claims - need to be disclosed if probable and reasonably possible
SAS 12• Auditors should obtain from management a list
describing and evaluating threatened or pending litigation
16-23
Audit Procedures for Loss Contingencies
1. Review the minutes of directors’ meetings to the date of completion of fieldwork.
2. Send letter of inquiry to client’s lawyer
3. Send confirmation letters to financial institutions to request information on contingent liabilities of the company.
4. Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts receivable.
5. Review reports and correspondence from regulatory agencies to identify potential assessments or fines.
6. Obtain a representation letter from the client indicating that all liabilities known to officers are recorded or disclosed.
NOTE: General risk contingencies do not have to be disclosed (e.g. natural disasters, competition, strikes, raw material shortages, etc.)
16-24
Responsibility for Subsequent Events
16-25
Procedures to Identify Subsequent Events
Review latest available financial statements and minutes of the board and selected committees
Inquiry about matters dealt with at meetings for which minutes are not available
Inquiry of management Obtain lawyer’s letter Obtain representations from management
16-26
Obtain Representation Letter
Purpose is to have the client’s principal officers acknowledge that they are primarily responsible for the fairness of the financial statements
Dated as of the date of the audit report Not a substitute for application of
necessary audit procedures
16-27
Misstatements
Known misstatements Specific misstatements identified during the
course of the audit Likely misstatements
Due to extrapolation from audit evidence or differences in accounting estimates
Evaluation Material misstatements must be corrected
• Quantitative and qualitative factors
16-28
Qualitative Materiality Factors
Likely to be material when: Arise from an item capable of precise measurement (e.g., the amount of a
sale) rather than from an estimate (e.g., the amount in the allowance for doubtful accounts).
Mask a change in earnings or other trends. Hide a failure to meet analysts’ consensus expectations for the company. Change a loss into income, or vice versa. Concern a particularly important segment or other portion of the registrant’s
business. Affect compliance with regulatory requirements, loan covenants, or other
contractual requirements. Increase management’s compensation. Involve concealment of an unlawful transaction. Are of an amount that management or the auditors believe would affect the
stock’s price.
16-29
Total Likely MisstatementOverstatements
(Understatements)W/P ref. Current
AssetsNoncurrent
AssetsCurrent
LiabilitiesNoncurrent Liabilities
Owners’ Equity
Income before Taxes
Tax Expenses
Uncorrected Known Misstatements
D-8 Overstatement of prepaid expenses
$6,500$2,600
$6,500 (2,600)
$6,500$2,600
F-6 Overstatement of prior years’ depreciation
($10,000)(4,000)
(10,000)4,000
M-4 Unrecorded liabilities (11,215)4,486
11,215(4,486)
11,2154,486
Projected Misstatements
C-5 Overstatement of accounts receivable (confirmation results)
30,00012,000
30,000(12,000)
30,00012,000
Other Estimated Misstatements
C-10
Understatement of allowance for uncollectible accounts
5,0002,000
5,000(2,000)
5,000________ 2,000
Total Likely Misstatements $41,500 ($10,000) $5,871 $25,629 $52,715 $21,086
Amount considered material
$100,000 $125,000 $100,000 $125,000 $200,000 $150,000
16-30
Evaluation Materiality: Considering
Previous Year Uncorrected Misstatements SEC SAB 108 Situation:
$70,000 current year misstatement $60,000 balance sheet carryover from preceding year
If either the $70,000 or the $130,000 total ($70,000 + 60,000) is material to this year, an adjustment must be made.
The current year’s income is decreased by at least $70,000
If the $60,000 is immaterial this year, it will also decrease current year income• If the $60,000 is material this year, prior year financial
statements should be adjusted.
16-31
Review the Engagement
Review of work of audit staff accomplished through review of audit working papers
Typically performed by seniors Review of working papers not completed until
near (of after) completion of fieldwork Partner and manager devote attention to
accounts with higher risk of material misstatement
Second partner review prior to issuance of audit report
16-32
Responsibility for Other Information with the Financial Statements
FASB or GASB-Required Supplementary Information--The auditors have a responsibility to perform limited procedures on the information for compliance with the applicable FASB or GASB Statements and modify their report to indicate when the information is not presented, not appropriately presented, or the auditors were not able to complete the limited procedures.
Other Information in Client-Prepared Documents--The auditors have a responsibility to read the information for inconsistencies with other information known to the auditors and for material misstatements, and to consider modifying their report, withholding the use of their report, or withdrawing from the engagement if the client refuses to revise any misstated information.
Information Accompanying Financial Statements in Auditor-Submitted Documents--The auditors have a responsibility to report on all information in documents prepared or submitted by them.
16-33
Required Communication with Those Charged with Governance
Auditor responsibility under generally accepted auditing standards (e.g., to form and express an opinion, and management’s responsibilities)
An overview of the planned scope and timing of the audit
Significant findings from the audit Qualitative aspects of accounting practices Audit difficulties encountered Uncorrected misstatements Disagreements with management Management consultations with other accountants Auditor independence issues Other issues.
16-34
Post-Audit Responsibilities
Auditor subsequent discovery of facts existing at date of report Advise client to make appropriate disclosure
of the facts to anyone actually or likely to be relying upon the audit report and financial statements
If client refuses to make disclosure, CPA should inform each member of board and notify regulatory agencies
16-35
Subsequent Discovery of Omitted Audit Procedures
Discovered during peer review or other subsequent review of working papers
Assess importance of omitted procedures to their previously issued opinion If omission impairs ability to support issued
opinion and report being relied upon by third parties, attempt to perform omitted procedure or appropriate alternative procedure
16-35