Chapter 16. Auditing Operations and Completing the Audit. McGraw-Hill/Irwin. Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 16 Auditing Operations and Completing the Audit McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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 16-2

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 16-3

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 earningsper-share data. 16-4

Figure 16-1 Comparative Income Statement Analysis 16-5

16-6 Relationships Between Balance Sheet and Income Statement Accounts Balance Sheet Item Revenue Expenses Accounts receivable Notes receivable Securities and investments Inventories Property, plant and equip. Intangible assets Prepaid expenses Accrued liabilities Interest-bearing debt Sales Interest, Interest, dividends, gains, investee s income Rent, gains Royalties Uncollectible accounts Uncollectible notes Losses Purchases, cost of goods sold, payroll Depreciation; repairs Amortization Various expenses Various expenses Interest

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 16-7

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 16-8

Figure 16-2 Professional Fees Analysis 16-9

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 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

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

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? 16-14

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. 16-15

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. 16-16

Substantive Procedures for Payroll 16-17

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 16-18

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

Loss Contingencies Loss contingencies should be reflected in the financial statement amounts when: 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 16-20

Litigation Most common loss contingency pending or threatened litigation Letter of inquiry to client s legal counsel Evidence of pending and threatened litigation 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 16-21

Other Contingencies Income tax disputes Accommodation endorsements and other guarantees of indebtedness Accounts receivable sold or assigned with recourse Environmental issues Commitments General risk contingencies 16-22

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. 16-23

Responsibility for Subsequent Events 16-24

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 16-25

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 16-26

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 16-27

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. 16-28

16-29 Total Likely Misstatement Overstatements (Understatements) W/P ref. Current Assets Noncurrent Assets Current Liabilities Noncurrent 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) 11,215 4,486 Projected Misstatements C-5 Overstatement of accounts receivable (confirmation results) 30,000 12,000 30,000 (12,000) 30,000 12,000 Other Estimated Misstatements C- 10 Understatement of allowance for uncollectible accounts 5,000 2,000 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.

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 16-31

Reporting on Other Information with the Financial Statements 16-32

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.

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 16-34

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