Becker CPA Review Auditing 4 Class Notes

AUDITING 4 CLASS NOTES

I.

AUDITING 4
The main concepts of Auditing 4 are the procedures used to test financial statement balances
and transactions (i.e., substantive testing), audit documentation, and audit evidence.
A.

B.

TRANSACTION CYCLES
1.

Transaction cycles include cycles for revenue, expenditures, payroll and personnel,
inventory and production, property, plant, and equipment, investments, and other
liabilities.

2.

For each of these cycles, the auditor wants to answer two crucial questions:
a.

Are controls operating effectively?

b.

Have transactions, balances, and disclosures been recorded properly in

accordance with GAAP?

3.

In the textbook you will see each transaction cycle presented in three ways: in written
sentences, as a flowchart, and in a chart. Pay attention to the division of
responsibilities as shown in the flowcharts, and how the auditor might test the
controls shown in the charts.

4.

It is the company's responsibility to properly segregate duties and implement

effective controls. The auditor's responsibility is to evaluate those controls, decide
whether or not to rely on them, and to determine the nature, extent, and timing of
substantive audit procedures.

5.

For each transaction cycle, be aware of whether the account being examined is an
asset/revenue or a liability/expense. This usually dictates whether the assertion of
existence or the assertion of completeness is being tested.
a.

For assets/revenues, the focus is often on whether the account actually exists
(i.e., making sure the accounts are not overstated).

b.

For liabilities/expenses, the focus is often on whether the items were actually
recorded (i.e., making sure the accounts are not understated).

6.

If a flowchart is presented on the examination, it will typically present various

departments (showing segregation of duties), as well as show how a particular
transaction starts with a source document (e.g., a sales order) and is processed to
ultimate inclusion in the financial statements.

7.

In evaluating each transaction cycle, the auditor should determine whether

management has implemented sound internal control (i.e., the auditor should see
evidence of PAID TIPS).

REVENUE CYCLE
The revenue cycle includes sales, accounts receivable, and cash receipts.
1.

Emphasis is on the existence assertion, as there is often a motivation to overstate

revenue and receivables.

2.

Another important assertion is valuation. Obtaining credit approval, preparing an

aging schedule, and the allowance for doubtful accounts relate to this assertion.

3.

Proper segregation of duties is also important (pay attention to the responsibilities

assigned to each department).

4.

Confirmation is a generally accepted auditing procedure. Confirmations provide

evidence of existence, not valuation.

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Becker CPA Review Auditing 4 Class Notes

C.

EXPENDITURE CYCLE
The expenditure cycle includes purchases, accounts payable, and cash disbursements.

D.

E.

1.

The specific assertion typically addressed in the expenditure cycle is completeness,

as expenses and payables may be understated.

2.

Know the duties performed in each department (purchasing, receiving, accounts

payable, and the treasurer) for proper segregation of duties.

3.

Know how an auditor would typically search for unrecorded liabilities.

CASH
1.

Be familiar with the controls surrounding cash receipts (lockbox, restrictive

endorsements, etc.).

2.

Proper segregation of duties is also important (pay attention to the roles played by
each department involved in the collection of cash receipts).

3.

Be familiar with lapping and kiting, and how to prevent/detect such schemes.

4.

The primary assertion tested is existence. Cash confirmations, bank statements,

bank reconciliations, and transfer schedules all relate to this assertion.

AUDIT DOCUMENTATION
1.

The auditors must create audit documentation, also called working papers. Audit
documentation serves as the primary record of the work performed, and provides
support for the opinion rendered on the financial statements.

2.

Audit documentation belongs to the auditor be aware of the confidentiality issues

surrounding audit documentation.

3.

Be aware of the specific requirements surrounding audit documentation (e.g., it

should meet the "experienced auditor" requirement, reconcile the accounting
records to the financial statements, demonstrate compliance with fieldwork
standards, identify who performed and who reviewed the work, etc.).

4.

Be aware of the factors that affect the quantity, type, and content of audit
documentation.

5.

Understand what matters would be considered significant audit findings, and how
such matters should be documented (i.e., finding, action taken, conclusion reached).

6.

Know what sorts of things are typically included in audit documentation, and know the
difference between the permanent file and the current file.

7.

Understand what tickmarks are and how they are used.

8.

Know the terms "report release date" (the date on which the auditor grants
permission to use the report) and "documentation completion date" (the date by
which final documentation must be assembled).

9.

a.

Nonissuers: documentation completion date = report release date + 60 days

b.

Issuers: documentation completion date = report release date + 45 days

Retention requirements: 5 years for audits of nonissuers; 7 years for audits of

issuers.

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Becker CPA Review Auditing 4 Class Notes

F.

G.

AUDIT EVIDENCE
1.

The third standard of fieldwork relates to audit evidence, stating that "sufficient
appropriate audit evidence" must be obtained.

2.

Audit evidence consists of underlying accounting data and corroborating evidence

know what is included in each of these terms.

3.

Sufficiency refers to the quantity of audit evidence, and judgments about sufficiency
are affected by the risk of material misstatement and the quality of the evidence.

4.

Evidence is appropriate if it is both reliable and relevant. Know what each of these
terms mean, and know that the reliability of evidence is improved when it is external,
received directly by the auditor, generated under strong controls, evidenced by
documentation, and consistent with information from other sources.

5.

If evidence exists in electronic form, the auditor must consider when and for how long
it will be available.

6.

Audit evidence is obtained through performance of audit procedures. The mnemonic

FIVE CARROTS may be used as a memory aid for various audit procedures.

SUBSTANTIVE TESTING
1.

Substantive testing consists of tests of details and analytical procedures.

2.

Tests of details consist of audit procedures applied to ending balances, the details of
transactions, or a combination of the two.

3.

Analytical procedures involve studying relationships among data, and usually involve
comparison of recorded amounts to auditor expectations.

4.

H.

a.

Know that analytical procedures are required during planning and as an overall
review, but are optional with respect to substantive testing.

b.

Be aware of the factors that improve the efficiency and effectiveness of

analytical procedures used as substantive procedures (e.g., analytical
procedures are more appropriate when there are predictable relationships
involved).

c.

Be aware of the specific documentation requirements when analytical

procedures are used as substantive tests.

The term "directional testing" refers to the direction of an audit test.

a.

If the auditor starts from original source documents and traces forward to the
accounting records, this tests the assertion of completeness. This helps the
auditor identify understatement errors.

b.

If the auditor starts from the accounting records and vouches backwards to the
original source documents, this tests the assertion of existence or
occurrence. This helps the auditor identify overstatement errors.

INVENTORY
1.

Safeguarding of assets and segregation of duties are of primary importance for

inventory know which duties should be properly segregated.

2.

Inventory observation is generally required (or acceptable alternative procedures

must be applied). Test counts should be utilized.

3.

Cutoff testing of purchases and sales should be performed.

4.

Valuation relates to the original cost of inventory, the existence of obsolete or

damaged goods, and the proper application of lower of cost or market principles.

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Becker CPA Review Auditing 4 Class Notes

I.

J.

ACCOUNTS RECEIVABLE
1.

Confirmation of accounts receivable is generally required (know the exceptions to this

rule).

2.

There are two forms of confirmation, positive and negative. Know the definitions of
each, and know when it is appropriate to use each type. Also know what blank
confirmations are and the pros and cons of using them.

3.

Remember that electronic confirmation responses must be verified, and nonresponses must be followed up with either second requests or alternative
procedures.

ACCOUNTS PAYABLE
1.

The auditor is primarily concerned with an understatement of liabilities (completeness

assertion).

2.

Accounts payable confirmations are not required, as good external evidence

surrounding payables typically exists.
a.

K.

L.

M.

If confirmations are used, small or zero balances would be selected for

confirmation.

LONG-TERM INVESTMENTS
1.

Long-term investments include stocks, bonds, and derivatives.

2.

Audit objectives include determining whether: GAAP has been consistently applied,
classification and valuation are properly determined and disclosed, investments exist
and are owned by the company, gains and losses are accurately computed and
disclosed, and investment income is properly reported.

3.

Audit procedures may include confirmation, observation, cutoff testing, review of

board minutes, and recalculation.

PAYROLL AND PERSONNEL

1.

Segregation of duties is a key concern. Know which departments are responsible for
authorization (operating managers and personnel), recordkeeping (payroll), and
custody (treasurer).

2.

Be familiar with the substantive tests an auditor might use to audit payroll. Two of the
most important procedures are:
a.

Analytical procedures, which are used because payroll is generally predictable.

b.

Recalculation of all year-end payroll accruals.

PROPERTY, PLANT, AND EQUIPMENT

1.

If this account does not have a lot of activity, the auditor will likely focus on
transactions.

2.

Large acquisitions are often tied to the capital budget and discussed in the board
minutes.

3.

The auditor should be alert for unrecorded dispositionslook for older items in the
accounting records and see if they are physically present.

4.

Analysis of the repairs and maintenance account is often used to search for asset
additions mistakenly recorded as repairs.

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Becker CPA Review Auditing 4 Class Notes

N.

O.

P.

Q.

R.

S.

OTHER LIABILITIES
1.

Interest expense can be recomputed on a test basis, and it can be compared to

outstanding debt for reasonableness.

2.

The auditor should determine that GAAP has been applied appropriately, and that
debt is properly classified (long-term vs. short term) and valued in the financial
statements.

3.

A loss contingency should be recorded if a loss is probable and can be reasonably

estimated. Be familiar with procedures that may be used to identify contingencies,
such as reviewing bank confirmations.

OWNERS' EQUITY AND TREASURY STOCK

1.

Treasury stock transactions, dividend declarations, and stock issuances should be

traced to the board minutes for authorization.

2.

Activity in the retained earnings account should be analyzed. Typically, there are
only a few transactions affecting this account (e.g., dividends and income).

3.

The auditor's focus is on proper presentation, description, and disclosure in the

financial statements.

RELATED PARTY TRANSACTIONS

1.

Know the responsibilities of management (identifying and disclosing related party

transactions) versus the responsibilities of the auditor (identifying any related party
transactions encountered and verifying proper disclosure).

2.

Be familiar with the audit procedures that might identify a related party transaction.

3.

The auditor is primarily concerned with proper presentation, description, and

disclosure in the financial statements.

ACCOUNTING ESTIMATES
1.

Be familiar with the most common situations in which estimates are used.

2.

Know the auditor's responsibilities: to assess management's procedures, to verify

that material estimates were developed, to ensure that those estimates were
reasonable, and to verify appropriate presentation in accordance with GAAP.

AUDITING FAIR VALUES

1.

Know the definition of fair value, and that fair value measurements can change over
time.

2.

It is management's responsibility to make fair value measurements and disclosures.

The auditor must test fair value measurements and disclosures to determine whether
they are in conformity with GAAP. Be familiar with the procedures the auditor may
use to test fair values.

4.

The auditor is primarily concerned with valuation and with proper presentation,
description, and disclosure in the financial statements.

INQUIRIES REGARDING LITIGATION, CLAIMS, AND ASSESSMENTS

1.

Per GAAS, the auditor is required to obtain audit evidence regarding litigation, claims,
and assessments.

2.

Management provides information about these issues. The auditor sends an external
inquiry to the entity's attorney as a means of corroborating management's
information.

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Becker CPA Review Auditing 4 Class Notes

T.

3.

Be familiar with the topics to be included in an inquiry regarding pending or

threatened litigation.

4.

The lawyer may limit his/her response to material matters, but a refusal to respond is
a scope limitation precluding an unqualified opinion.

5.

If management refuses to permit this inquiry, the auditor will issue a disclaimer of
opinion.

RATIOS
1.

There has been an increased emphasis on ratio analysis in recent exams.

2.

Many of the ratio formulas are provided to you in the Resources section of the
simulations, but you should still be familiar with the definitions, in case any of them
appear in the multiple choice testlets.

3.

You must know not just how to calculate the ratios, but also what each ratio means
(i.e., liquidity ratios, activity ratios, profitability ratios, etc.).

4.

You must also be able to determine what might have caused a change in a particular
ratio from year to year.
a.

If you aren't sure how changing the numerator or the denominator will affect a
ratio, insert numbers and see what happens as you increase or decrease those
numbers.

b.

If given a list of events that might have caused a change in a ratio, think about
the journal entries that go along with the various events listed, and about which
accounts would increase or decrease. Then plug that information into the
formula and see what happens.

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