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Chapter 4
Accounts Receivable
Sales
1) Receivable is recorded in the A/R control account in the general ledger and in A/R subsidiary ledger
2) Periodically, an independent person should reconcile these two records
Collection of Cash Receipts
1) When payment is received from customer, receivable is eliminated
Uncollectible Receivables
1) Aging schedule is prepared and sent to credit department for use in carrying out its collection program
2) At some point, uncollectible receivables should be written off
3) Controls for writing off include proper authorization by treasurer and recordkeeping
4) The auditor observes the preparation of the aging schedule as part of the study of internal control
Sales Returns
1) Returned goods examined to ensure they correspond with the reason for return before credit is given
2) Serially numbered receiving report may be used as a sales return slip
3) Once return is approved, the related receivable is eliminated
Sales discounts
1) Discount procedures and records should be reviewed to ensure that discounts are properly given and recorded
Cash Receipts
1. Collection of Cash Receipts
1) Incoming mail must be opened by a person who does not have access to the accounts receivable ledger
2) The receipts should be listed in detail with one copy and the actual receipts sent to cashier for bank deposit
3) Another copy sent to accounts receivable department for entry in the accounts receivable subsidiary records
4) Third copy sent to accounting department for entry in general ledger accounts receivable control account
5) Accounts receivable department should match bank deposit ticket with remittance advices
6) Cash registers or lock boxes should be used as safeguards
***Treasury makes deposit if no cashier!
Order &Credit Department Authority
Warehouse & Shipping Department Custody
Billing/Accounts Receivable Department Record Keeping
Accounting Department Record Keeping
Mailroom Department Custody
Cashier / Treasurer Department Custody
Accounts Receivable Department Record Keeping
Accounting Department Record Keeping
Must review pages A4-7 to A4-9
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Cut-off
Accounts Receivable:
o Review accounts receivable schedule for accuracy and collectability
o Confirmation
Follow up on error reports (Rights and Obligations)
Confirm receivables
o Adequacy of Uncollectible Accounts
Subjective judgment = Risk
Calculate the adequacy of allowance for uncollectible accounts
Aging schedule of accounts receivable should be constructed
Tests of adequacy of allowance relate to the FS assertion of Valuation and Allocation
Test credit approval
Audit Procedures regarding Cash Receipts: see below
Expenditure: Includes purchases, payables, and cash disbursements
Trace up Biggest concern is understatement of expenses and liabilities
Purchases:
Purchase Requisition
1) Starting of purchasing cycle
2) Department in need of asset or services sends a properly approved, serially numbered requisition to purchasing dept
Purchase Orders
1) Consider the relevance of the time and quantity of the request
2) Obtain competitive bids from various suppliers to make sure that the best price is obtained
3) Issue order after proper approval
4) It is best if the purchase orders are pre-numbered
5) Multiple copies sent to the requisitioning dept, the vendor, the receiving department, and accounting department
6) If order is cancelled, all copies should be recalled and filed
Receipt of Goods or Services
1) They received their copy from the purchasing department, preferably it should be a blind copy
2) If blind copy, then receiving dept is forced to count the goods upon arrival
3) A receiving report is prepared and forwarded to the accounting department
4) Goods are forwarded to the requisitioning department
Accounts Payable:
Has three functions: record the payable, approve the invoice for payment, and record the payment after it is paid by treasurer
Recording the payable
o A/P = approval of bill
o They received their copy from the purchasing department
o Receiving report is compared with the purchase order and vendor`s invoice as to quantity
o Comparison is made to prevent payment of charges for goods in excess of those ordered/received
o Records the goods received in inventory and records a payable
Approving Invoice for Payment and Recording Payment
o Indicate the debit and credit
o Accounting department approves invoice by matching the invoice, purchase order, receiving report, and requisition
o Confirm invoice amount is correct and reflects any purchase discounts before approving it for payment
Cash Disbursements:
Best if invoices paid by check
The functions of approving the payment and signing the checks should be segregated
Approved voucher (invoice, purchase order, receiving report, and requisition) prepared by A/P are received by treasurer
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Treasurer prepares, signs, and mails the checks and cancels all supporting documents after payment
Paid vouchers are returned to accounting dept for posting of payment and filing of documents
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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 detect kiting!
Purposes of bank confirmation: verify year-end balances, info on actual loans and contingent liabilities, discounted
notes, pledged collateral, and guarantee or security agreements
Risks to Consider
1. Incentives/Pressures:
a. Pressure to overstate revenues to achieve EPS targets
b. Pressure to overstate sales and/or receivables tin order to improve the balance sheet and liquidity ratios
c. Pressure to understate liabilities in order to improve balance sheet and liquidity ratios
2. Potential Misstatements:
a. Recording fictitious sales (existence assertion)
b. Holding open the sales journal to include next year`s sales (improper cut-off)
c. Shipping goods that were not ordered at or near year-end (goods are generally returned in the following period)
d. Failure to record payments
3. Other Potential Problems:
a. Errors increased due to high volume of transactions
b. Theft of cash collections sales adjustments may be used to conceal thefts of cash collections
c. Omission existing sales and purchases may not be recorded (completeness assertion)
Audit Documentation Supports auditors opinion
-known as working papers
-principal record of audit procedures performed, evidence obtained, and conclusions reached
-belong to the CPA
Purpose:
Support for the auditors report, including evidence that the audit was conducted in accordance with GAAS
Assistance in planning, conducting, and supervising the audit
Accountability, emphasizing that the audit team is responsible for its work
Information that may be useful for future audits, quality control reviews, or peer reviews
Requirements:
Audit documentation should indicate that accounting records are in compliance with the FS
Record of evidence and results of audit tests and procedures
Details of audit procedures performed, the evidence obtained, the conclusions reached, and how the accounting records reconcile with
FS
Demonstrate compliance with the standards of fieldwork by showing that work performed was adequately planned and supervised,
sufficient understanding of the entity and its environment was obtained, and sufficient appropriate audit evidence was obtained
Retention:
Audit Documentation: the property of independent auditor (may be useful to client, but it is auditors property)
Report Release Date: the date on which the auditor grants client permission to use the report. Usually is the date on which the report is
delivered to the client
o Private companies: retain documents for five years
o Public companies: retain documents for seven years per PCAOB
Documentation Completion Date: the time following the report release date in which to assemble final audit documentation file
o Private companies: audit documentation must be filed within 60 days following the report release date
o Public companies: audit documentation must be filed within 45 days following the report release date per PCAOB
Requires preparation of engagement completion document
Safekeeping of Audit Documentation: establish appropriate controls for audit documentation to protect its integrity, prevent
unauthorized changes, etc
Nature and Extent of Audit Documentation:
may be in paper form, electronic form, or other media
oral evidence alone is not sufficient, but may be used for clarification of information
specific quantity, type, and content of audit documentation are based on the auditors judgment, and should consider:
o risk of material misstatement Objective of detailed substantive testing is to detect material misstatement
o extent to which judgment was required in performance and evaluation
o nature of specific auditing procedure
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Specific Contents:
Permanent (continuous) File:
o Include continuing interest from year to year (such as contracts, pension plans, leases, stock options, bylaws, articles of
incorporation, minutes of meetings, bond indentures, and internal information
Current File: documentation applicable to the year under audit
o Audit plan (audit program)
o FS and auditors report
o Working trial balance, adjusting journal entries, and reclassification entries
o Letters of confirmation and representation (attorneys, management representation letter, confirmation responses)
o Analyses, worksheets, schedules or commentaries.
o Abstracts or copies of entity documents, such as contracts or agreements
o Summaries of significant audit findings, actions taken, conclusions reached
o Records of tests of controls and substantive tests
Significant Audit Findings:
Selection and application of accounting principles (consistency, complexity, unusual transactions, estimates, uncertainties)
Possible material misstatements in FS
Suggest a need to revise the auditors previous risk assessment
Cause significant difficulty in applying necessary audit procedures or significant revision of planned audit procedures
May result in modification to the auditors standard report
Tickmarks:
Use tickmarks, or symbols indicating the work that has been performed
Confidentiality:
Must obtain permission to disclose audit documentation. EXCEPT the following without clients permission:
o If documentation used as part of voluntary quality review program under the auspices of AICPA or state society of CPAs
o If documentation is subpoenaed by a court
o If documentation is part of an official investigation being conducted by the AICPA, state CPA society, or under state statutes
o Your defence team: Lawyers/Court, Insurance Company, Expert Witness
Audit Evidence:
All the information auditor uses to arrive at the conclusions of the audit opinion (written, electronic, observable assets or activities).
It must be obtained to support auditor conclusions with respect to risk assessment, test of controls, and substantive testing.
Auditor should have access to all pertinent accounting data and corroborating evidential matter, otherwise it is a scope limit.
Underlying accounting records consists of records of initial entries and any supporting records. Example: checks, records of EFT, invoices,
contracts, ledgers, journal entries, and worksheets. The auditor tests the accounting records through analytical procedures and substantive
tests, such as retracing procedural steps, recalculation, and reconciliation. Auditor tests the accounting records through analytical
procedures and substantive tests, such as retracing procedural steps, recalculation, and reconciliation.
Corroborating Evidence includes meeting minutes, confirmations, industry analysts reports, data about competitors, and information
obtained through observation, inquiry, and inspection. Provides additional support and gives validity to the recorded accounting data.
Evidence in Electronic Form auditor should consider the time during which info exists or is available in determining the NET of audit
procedures.
Third Standard of Fieldwork: 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
Objective is to detect material misstatement in financial statements
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Audit evidence must persuade the auditor that the ending balances in the FS are fairly presented. Audit provides reasonable assurance
regarding the fairness of the FS. Auditor is not a guarantor, and must rely on evidence that is persuasive, rather than conclusive.
Cost benefit may be a valid reason for performing only certain procedures, cost alone or difficulty in obtaining evidence is not a valid basis
for omitting a procedure for which there is no appropriate alternative.
Sufficiency of audit evidence: Must be Valid and Relevant
Amount of evidence gathered directly affects the level of detection risk (risk that auditors evidence gathering procedures will not be
sufficient to support the FS assertions.
Auditors decision regarding the sufficiency of evidence is influenced by: (Evaluate Management assertions)
1. Risk of material misstatement: greater risk implies more evidence will be required
2. Quality of audit evidence: less audit evidence may be required when that evidence is of higher quality
Evidence Hierarchy:
A Auditor observation and knowledge
E External Evidence
I Internal Evidence
O Oral Evidence
Evidence must relate to the FS assertion under consideration.
Evaluation of audit evidence must take into consideration and achievement of audit objectives.
Substantive procedures consist of:
Test of details (as applied to transactions, balances, and disclosures)
Substantive analytical procedures
These tests are designed to substantiate the validity of management assertions regarding the FS.
Tests of details:
Procedures used to gather evidence to support the account balances
Tests of details are performed on ending balances, the details of transactions, or a combination of the two
Example: account has high turnover rate with many transactions, auditor will concentrate more on the ending balance total.
o Auditor must be satisfied that internal control is strong!
Alternative approach: test the details of transactions. This approach is used when the account being substantiated has relatively few
transactions occurring during the year.
Combination of both: when auditing sales revenue account, auditor might use procedures to substantiate the ending balance while also
performing extensive procedures on samples of transactions and related accounts
Example 2: test the details supporting FS amounts and disclosures through inspection, observation, inquiry, confirmation, recalculation,
reperformance, etc.
Analytical Procedures:
Evaluations of financial information made by a study of financial and nonfinancial data
Comparisons (Ratios, percentages, actual to budget) of recorded amounts to independent expectations developed by auditor.
Must use analytical procedures in planning and overall review, and may use analytical procedures as substantive tests
Analytical procedure in planning: Required. Purpose: to assist the auditor in planning the NET of auditing procedures. Used for risk
measurement to alert the auditor to problem areas requiring attention. Vital planning function.
Analytical procedure in final review: Required. Purpose: to assist the auditor in final review of overall reasonableness of account balances.
Substantive procedures: Not Required. Purpose: as 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 generally include a review of the current and prior years FS and current years budget.
Auditor develops independent expectations for comparison to recorded amounts. Example:
a) Financial information for comparable prior periods
b) Anticipated results from budgets and forecasts
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Income statement has more predictable relationships than the balance sheet
Accounts with management discretion are less predictable
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Reading pertinent information, such as the minutes of board of directors meetings, shareholder meetings, and management
committee meetings
Assertion
Completeness
P
A
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Classification
Occurrence
Allocation and Valuation
R
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Understandability and
Classification
Procedure
Tracing
Analytical Review
Observation
Cut-off Procedures
Inspection
Footing
Inspection
Vouching
Independent recalculation
Reconciliation
Inspection
Confirmation
Observation, inspection, and examination
Review
Inquiry of management
Inventory and Production: Includes perpetual inventory, physical counts, and manufacturing costs
Inventory Internal Control Segregate the following duties:
1. Purchasing
2. Receiving
3. Storage (custody)
4. Shipping
Observation of beginning and ending physical inventory counts is required by GAAP. When physical inventory count is impossible, must use
alternative procedures.
If internal control is strong and inventories are well-kept perpetual inventories, then physical counts may be performed before, during, or
after the end of the audit period. If control risk is high, then observation should be performed at year-end.
= This is timing of the Nature, Extent, and Timing
*Should observe all inventory held in public warehouses if inventory is significant. Otherwise, confirmation of such is sufficient.
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Existence
Client Physical
Inventory Report List
Completeness
Existence
Completeness
Company Pre-Numbered
Inventory Tags
Accuracy
Auditor should confirm that consigned inventory on hand is excluded from physical inventory count
Related accounts: inventories, purchases, sales, sales returns and allowances, COGS
Examine purchase invoices and receiving reports for several days before and after year-end
Examine sales invoices and compare them to shipping documents for several days before and after year-end
Determine whether inventory adheres to lower of cost or market principles and whether it is pledged or subject to liens
Examine vendor invoices, direct labor rates, and test the computation of standard overhead rates
RM: Raw Material
DL: Direct Labor
FOH: Factory Overhead: applied consistently and using GAAP
Accounts Receivable Confirmations
Positive Confirmations request response from the recipient (may be blank)
Best type of confirmation for large accounts, expect errors and disputes, weak internal controls
Blank confirmations: greater degree of assurance, but may also result in lower response rate
Non-responses should be followed up with second/third requests, and ask client to intervene
May perform alternative procedures when confirmation responses are not received
Provide evidence regarding existence and rights and obligations, NOT provide valuation or completeness
Negative confirmations recipient is asked to respond only if amount stated is incorrect
Not as good as positive
Used when low control risk, small balances, expect customer attention
Accounts Payable Confirmations Not Required
Positive confirmations and generally blank
Objective: determine if A/P are understated
Confirmations of A/P sent when weak internal control
Vendors with small or zero balances would be selected, b/c were looking for understated liabilities and expenses
Unrecorded liabilities surface when unpaid vendors stop delivering goods
Search for unrecorded liabilities: 1. Subsequent events, 2. Post balance sheet review
Long-term Investments auditor must determine:
i.
GAAP is consistently applied
ii.
Gains and losses are accurately computed and disclosed
iii.
Investment income is properly reported
iv.
Valuation is fairly stated and disclosed
v.
Investments exists and owned by client
Segregation of duties: 1 person authorizes purchase/sale, another person asks as custodian, and third person maintains records
Control risk:
1. Proper authorization and approval
2. Reconciliations to ensure accuracy
3. Continuous monitoring and review
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Confirmation of EXISTENCE and RIGHTS & OBLIGATIONS Request from custodian for securities to confirm
Independent calculations should be made to determine the validity of recorded gains or losses from security sales and of discount and
premium amortization. Recalculation should be made to determine the accuracy of recorded dividend and interest income. Analytical
procedures may also be used to test the reasonableness of dividend and interest income
Management representation letter required!
Review board minutes slope limitation if denied access
Payroll and Personnel: Includes payroll (salaried and hourly) and personnel functions
Segregation of duties
Authorization to Employ and Pay ARC Function of HR to hire new employees
Supervision ARC All pay base data (hours, time off, etc) should be approved by immediate supervisor
Timekeeping and Cost Accounting ARC Data on which pay is based 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.
Payroll Check Preparation ARC Payroll department computes salary based on information received (ex. Hours x pay). Responsible
for issuing unsigned payroll checks that are later signed by the treasurer.
Check Distribution ARC Treasury signs checks and distributes, known as paymaster.
Control Procedures:
P Prenumbering: time cards, checks, and payroll change documents
A Authorization:
I Independent Check to Maintain Asset Accountability:
o Accting dept prepares a voucher for amount of payroll based upon input from payroll dept
o Bank reconciliation of the imprest payroll account prepared by individual independent of custody or recordkeeping
functions.
o Unclaimed payroll checks should be returned to an independent individual for follow up
D Documentation: all changes to payroll should have authorized change documents. Hours worked be documented by approved
time records = Payroll register
T Timely and Appropriate Performance Reviews:
I Information Processing Controls:
P Physical Controls for Safeguarding Assets: treasurer should sign the payroll checks. An imprest payroll account be used
S Segregation of duties:
o Authorization: operating dept and personnel dept
o Recordkeeping: payroll dept
o Custody (payroll checks): treasurer should sign and distribute checks
See chart on pg. A4-43
Property, Plant, and Equipment: includes acquisitions and disposals and related depreciation expense
Acquisition: a special requisition form is generated for acquisitions, includes description, reason for acquisition, amount, cost, and approval.
Acquisitions are tied to capital budget, which board of directors approve. Board of directors should approve acquisitions.
Detailed information concerning each asset is kept in the subsidiary ledger. (i.e. description, ID #, location, date, cost, depreciation method,
amount of depreciation)
Fixed assets should have identification plates. Serial number on plate should be listed in control account. Physical controls to safeguard
assets from theft be in place.
Written depreciation policies and records be maintained. Specific capitalization policies are also necessary to prevent misstatement of
revenue and expenses.
Retirements of assets should be documented on sequentially numbered work order. Helps in assessing cash and removing asset and
depreciation from subsidiary ledger.
Auditor should vouch down (existence and support) for additions to fixed asset accounts.
Review retirements and recalculate any gains and losses thereon.
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Review repair and maintenance expense accounts to test for completeness of asset additions. This would be to locate items that should
have been capitalized.
Perform cut-off tests to determine whether purchase/sale was recorded in proper period
Confirm the purchase/sale was properly authorized
Determine if appropriate controls are in place to safeguard fixed assets and prevent theft or destruction
Recalculate depreciation
Alert for evidence indicating a lien on assets, such as a missing insurance policy.
Liabilities
Examine notes payable, comparing terms and authorization of indebtedness to board approval. Interest expense should be computed
independently.
Investments / Long-term debt:
1. GAAP is consistently applied
2. Interest expense is properly reported
3. Valuation is fairly stated
4. All debt has been recorded
5. For LTD, compare interest expense with bond payable amount
Contingencies:
1. Review bank confirmations for hidden bank loans, discounted drafts, guarantee of notes
2. Discuss long-term purchase commitments
3. Review the status of long-term leases
4. Review status of tax returns for open years
5. Send inquiry letter to clients attorneys
6. Discuss sales contracts
7. Review the interim FS after year-end
8. Review minutes from board of directors and shareholder meetings
9. Obtain client representation letter
Owners Equity
Examine all shares of treasury stock and reconcile the number of shares stated in treasury stock account. Transactions should be traced to
accounting records (cash accounts) and to authorization in board meeting minutes
Stock transactions should be vouched to supporting documentation (cash receipts, minutes)
All stock issuances, dividend declarations, treasury stock purchases must be authorized by board of directors.
Articles of incorporations should be in the permanent audit file.
If client uses a stock transfer agent, third-party confirmations should be used to provide evidence. If client uses stock certificate book, then
examine the stubs for proper recording.
Consider whether any appropriations of retained earnings are necessary. Auditor focuses on evaluating the presentation and disclosure of
FS. classification and understandability
Audit Evidence: Miscellaneous Items
Related Party Transactions
Related Party Transactions Valuation and Accuracy make sure properly recorded and dkisclosed
Related parties may include reporting entitys affiliates, principal owners, management, and members of their immediate families.
Related party transaction is not considered to be an arms length transaction.
Objective: properly disclosed in accordance with GAAP.
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