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returns and allowances—can materially overstate net earnings.
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Cutoff misstatements can occur for sales, sales returns and allowances, and cash
receipts. For each one, auditors require a threefold approach to determine the
reasonableness of cutoff:
1. Decide on the appropriate criteria for cutoff.
2. Evaluate whether the client has established adequate procedures to ensure a
reasonable cutoff.
3. Testwhether the cutoff was correct.
Sales Cutoff Most merchandising and manufacturing clients record a sale based on
shipment of goodscriterion. However, some companies record invoices at the time title
passes, which can occur before shipment (as in the case of custom-manufactured
goods), at the time of shipment, or subsequent to shipment. For the correct measure -
ment of current period income, the method must be in accordance with accounting
standards and consistently applied.
The most important part of evaluating the client’s method of obtaining a reliable
cutoff is to determine the procedures in use. When a client issues prenumbered shipping
documents sequentially, it is usually a simple matter to evaluate and test cutoff.
Moreover, the segregation of duties between the shipping and the billing function also
enhances the likelihood of recording transactions in the proper period. However, if
shipments are made by company truck, if the shipping records are unnumbered, and if
shipping and billing department personnel are not independent of each other, it may be
difficult, if not impossible, to be assured of an accurate cutoff.
When the client’s internal controls are adequate, auditors can usually verify the
cutoff by obtaining the shipping document number for the last shipment made at the
end of the period and comparing this number with current and subsequent period
recorded sales. As an illustration, assume the shipping document number for the last
shipment in the current period is 1489. All recorded sales before the end of the period
528 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
EARLY REVENUE Faced with declining sales for its traditional equipment was recorded at the beginning of the
product lines, Xerox prematurely recognized lease, but revenues from servicing and financing
RECOGNITION
revenues to meet market expectations, according were recognized over the life of the lease
BOOSTS PROFITS to charges filed by the SEC. The SEC stated that contract. According to the SEC complaint, Xerox
Xerox accelerated the recognition of equipment took a number of actions to shift servicing and
revenue to increase revenues by over $3 billion financing revenue to the value of the equipment,
and pre-tax earnings by approximately $1.5 billion so that more of the revenue could be recognized
over the period 1997 through 2000. The early immediately.
revenue recognition and other actions to increase The SEC alleged that these actions were set
earnings were significant, representing 37 percent by the “tone at the top” and ordered six senior
of reported pre-tax earnings for the fourth executives to pay over $22 million in penalties
quarters of 1997 and 1998. Without these actions and disgorgement of profits from their actions.
to increase earnings, the SEC charged that Xerox Without admitting or denying the allegations
would have fallen short of market earnings made in the SEC complaint, Xerox agreed to pay
expectations for almost every reporting period a $10 million fine, at that time the largest ever for
from 1997 through 1999. a public company.
A primary issue was how Xerox accounted for
Sources: 1. Securities and Exchange Commission
lease revenue. The revenue in Xerox’s leasing
Accounting and Auditing Enforcement Release No.
arrangements represented three components: the 1542 (April 11, 2002); 2. Securities and Exchange
value of the equipment, servicing over the life of Commission Press Release 2003-70 (June 5, 2003)
the lease, and financing. The revenue from the (www.sec.gov).
should bear a shipping document number preceding number 1490, and no sales
recorded and shipped in the subsequent period should have a bill of lading numbered |
1489 or lower. An auditor can easily test this by comparing recorded sales with the
related shipping documents for the last few days of the current period and the first few
days of the subsequent period.
Sales Returns and Allowances ACuptoaffgAocc ouPntDinFg s tanEdnardhs arenquciree thrat sales
returns and allowances be matched with related sales if the amounts are material. For
example, if current period shipments are returned in the subsequent period, the sales
return should appear in the current period. (The returned goods should be treated as
current period inventory.) For most companies, however, sales returns and allowances
are recorded in the accounting period in which they occur, under the assumption of
approximately equal, offsetting amounts at the beginning and end of each accounting
period. This approach is acceptable as long as the amounts are not material. Some
companies establish a reserve, similar to the allowance for uncollectible accounts, for
the expected amount of returns in the subsequent period.
When the auditor is confident that the client records all sales returns and allow -
ances promptly, the cutoff tests are simple and straightforward. The auditor can
examine supporting documentation for a sample of sales returns and allowances
recorded during several weeks subsequent to the closing date to determine the date of
the original sale. If auditors discover that the amounts recorded in the subsequent
period are significantly different from unrecorded returns and allowances at the
beginning of the period under audit, they must consider an adjustment. For example, a
company may experience an increase in sales returns when it launches a new product.
In addition, if the internal controls for recording sales returns and allowances are
evaluated as ineffective, a larger sample is needed to verify cutoff.
Cash Receipts CutoffFor most audits, a proper cash receipts cutoff is less important
than either the sales or the sales returns and allowances cutoff because the improper
cutoff of cash affects only the cash and the accounts receivable balances, not earnings.
Nevertheless, if the misstatement is material, it can affect the fair presentation of these
accounts, especially when cash is a small or negative balance.
It is easy to test for a cash receipts cutoff misstatement (often called holding the cash
receipts book open) by tracing recorded cash receipts to subsequent period bank
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 529
deposits on the bank statement. If a delay of several days exists, that could indicate a
cutoff misstatement.
To some degree, auditors may also rely on the confirmation of accounts receivable
to uncover cutoff misstatements for sales, sales returns and allowances, and cash
receipts. However, it is often difficult to distinguish a cutoff misstatement from a
normal timing difference due to shipments and payments in transit at year end. For
example, if a customer mails and records a check to a client for payment of an unpaid
account on December 30 and the client receives and records the amount on January 2,
the records of the two organizations will be different on December 31. This is not a
cutoff misstatement, but a timing difference due to the delivery time. It may be difficult
for the auditor to evaluate whether a cutoff misstatement or a timing difference
occurred when a confirmation reply is the source of information. This type of situation
requires additional investigation, such as inspection of supporting documents.
Accounts Receivable Accounting standards require that companies state accounts receivable at the amount
Is Stated at that will ultimately be collected. The realizable value of accounts receivable equals
Realizable Value gross accounts receivable less the allowance for uncollectible accounts. To calculate the
allowance, the client estimates the total amount of accounts receivable that it expects to
be uncollectible. Obviously, clients cannot predict the future precisely, but it is |
necessary for the auditor to evaluate whether the client’s allowance is reasonable,
considering all available facts. To assist with this evaluation, the auditor often prepares
an audit schedule that analyzes the allowance for uncollectible accounts, as illustrated
in Figure 16-4. In this example, the analysis indicates that the allowance is understated.
This can be the result of the client failing to adjust the allowance or economic factors.
Note that the potential understatement of the reserve was signaled by the analytical
procedures in Table 16-3 (p. 525) for Hillsburg Hardware.
To begin the evaluation of the allowance for uncollectible accounts, the auditor
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reviews the results of the tests of controls that are concerned with the client’s credit
policy. If the client’s credit policy has remained unchanged and the results of the tests
of credit policy and credit approval are consistent with those of the preceding year, the
change in the balance in the allowance for uncollectible accounts should reflect only
changes in economic conditions and sales volume. However, if the client’s credit policy
or the degree to which it correctly functions has significantly changed, auditors must
take great care to consider the effects of these changes as well.
Auditors often evaluate the adequacy of the allowance by carefully examining the
noncurrent accounts on the aged trial balance to determine which ones have not been
paid subsequent to the balance sheet date. The size and age of unpaid balances can then be
compared with similar information from previous years to evaluate whether the amount
of noncurrent receivables is increasing or decreasing over time. Auditors also gain insights
into the collectibility of the accounts by examining credit files, discussions with the credit
manager, and review of the client’s correspondence file. These procedures are especially
important if a few large balances are noncurrent and are not being paid on a regular basis.
Auditors face two shortcomings in evaluating the allowance by reviewing individual
noncurrent balances on the aged trial balance. First, the current accounts are ignored in
establishing the adequacy of the allowance, even though some of these amounts will
undoubtedly become uncollectible. Second, it is difficult to compare the results of the
current year with those of previous years on such an unstructured basis. If the accounts
are becoming progressively uncollectible over several years, this fact can be overlooked.
To avoid these two shortcomings, clients can establish a history of bad debt write-offs
over a period of time as a frame of reference for evaluating the current year’s allowance.
For example, a client might calculate that 2 percent of current accounts, 10 percent of 30-
to 90-day accounts, and 35 percent of all balances over 90 days ultimately become
uncollectible. Auditors can apply these percentages to the current year’s aged trial balance
totals and compare the result with the balance in the allowance account. Of course, the
530 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
FIGURE 16-4 Analysis of Allowance for Uncollectible Accounts for Hillsburg
HardwareCo.
Hillsburg Hardware Co. Schedule B-4 Date
Analysis of Allowance for Uncollectible Accounts Prepared by TW 1/8/12
12/31/11 Approved by SB 1/10/12
Estimated Estimated
A/R A/R Balance Allowance Required
Category 12/31/11 Percentage Allowance
0–30 days $14,217,156 ✓ 3% (cid:5) $ 426,515
31–60days 2,869,366 ✓ 6% (cid:5) 172,162
61–90days 1,408,642 ✓ 15% (cid:5) 211,296
91–120 days 1,038,926 ✓ 25% (cid:5) 259,732
Over 120 662,710 ✓ 40% (cid:5) 265,084
Total $20,196,800 $1,334,789
Recorded Allowance $1,240,000 TB
Difference $ 94,789
✓ — Traced to aged accounts receivable trial balance.
(cid:5)— Allowance percentages are consistent with prior year, and appear reasonable
based on historical loss percentages documented in permanent file.
TB— Agreed to trial balance.
Conclusion: Recorded allowance appears understated based on aging analysis. Approximate |
amount of$95,000 not consideredmaterial. Include on Summary of Possible Misstatements
schedule on A-3. (See Figure 24-6 on page 773.)
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auditor has to verify the appropriateness of the percentages used and be careful to modify
the calculations for changed conditions.
Bad Debt Expense After the auditor is satisfied with the allowance for uncollectible
accounts, it is easy to verify bad debt expense. Assume that:
• The beginning balance in the allowance account was verified as a part of the
previous audit.
• The uncollectible accounts written off were verified as a part of the substantive
tests of transactions.
PUT IT Sears, Roebuck & Co. was enjoying a remarkable continue making payments on their accounts.
turnaround in earnings in 1996. However, most of However, many of these agreements were not
ON THE CARD
the increase in profits was attributable to interest filed in the bankruptcy cases, which meant the
on Sears credit card balances. In the early 1990s, company was collecting on unenforcea ble agree -
Sears added more than 17 million new credit card ments for debt that no longer legally existed. As a
customers. However, many of these new customers result of a federal investigation, Sears was forced
were not good credit risks, and they tended to carry to pay a $60 million fine and set aside $475 million
high balances. As a result, in 1997, Sears had to in reserves to cover complaints over its debt
increase its allowance for credit card delinquencies collection practices. After continuing struggles
to $393 million, a 44 percent increase. with write-offs, Sears sold its credit card business
Unfortunately, the delinquencies were only to Citigroup in 2003.
part of the problem. Many of these delinquent
customers also filed for bankruptcy. In fact, by Sources: Adapted from 1. Robert Berner, “The
Struggle in Store for Sears,” BusinessWeek(July 24,
1997 Sears was a creditor in more than one-third
2003); 2. John McCormick, “The Sorry Side of
of all bankruptcies filed in the United States. Sears
Sears,”Newsweek(February 22, 1999), pp. 36–39.
aggressively sought reaffirmation agreements 3. De’AnnWeimer, “Put the Comeback on My Card,”
with these customers, in which they pledged to BusinessWeek(November 10, 1997), pp. 118–119.
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 531
• The ending balance in the allowance account has been verified by various
means.
Bad debt expense is then simply a residual balance that can be verified by recal -
culation.
The Client Has Rights The client’s rights to accounts receivable ordinarily cause no audit problems because the
to Accounts Receivable receivables usually belong to the client. In some cases, however, a portion of the
receivables may have been pledged as collateral, assigned to someone else, factored, or
sold at discount. Normally, the client’s customers are not aware of the existence of such
matters, so the confirmation of receivables will not bring them to light. To uncover
instances in which the client has limited rights to receivables, the auditor may review the
minutes, discuss with the client, confirm with banks, examine debt contracts for
evidence of accounts receivable pledged as collateral, and examine correspondence files.
Accounts Receivable Tests of the four presentation and disclosure-related audit objectives are generally done
Presentation as part of the completion phase of the audit. However, some tests of presentation and
and Disclosure disclosure are often done with tests to meet the balance-related audit objectives. For
example, when testing sales and accounts receivable, the auditor must understand and
evaluate the appropriateness of the client’s revenue recognition policy to determine
whether it is properly disclosed in the financial statements. The auditor must also decide
whether the client has properly combined amounts and disclosed related party
information in the statements. To evaluate the adequacy of the presentation and
disclosure, the auditor must have a thorough understanding of accounting standards and |
presentation and disclosure requirements.
An important part of the evaluation involves deciding whether the client has
separated material amounts requiring separate disclosure in the statements. For example,
receivables from officers and affiliated companies must be segregated from accounts
receivable from customers if the amounts are material. Similarly, under SEC require-
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ments, companies must disclose sales and assets for different business segments
separately. The proper aggregation of general ledger balances in the financial statements
also requires combining account balances that are not relevant for external users of the
statements. If all accounts included in the general ledger were disclosed separately on
the statements, most statement users would be more confused than enlightened.
CONFIRMATION OF ACCOUNTS RECEIVABLE
OBJECTIVE 16-4 Confirmation of accounts receivable was a recurring concept in our discussion about
designing tests of details of balances for accounts receivable. The primary purpose of
Obtain and evaluate accounts
accounts receivable confirmation is to satisfy the existence, accuracy, and cutoff
receivable confirmations.
objectives.
Confirmations are one of the eight types of audit evidence introduced in Chapter7.
A confirmation is a direct written response from a third party in paper or electronic
form, and they are considered to be highly reliable evidence because they are received
directly from third parties. Although an oral response provides audit evidence, it is not
considered a confirmation.
Auditing Standards U.S. auditing standards indicate that auditors should use external confirmations for
Requirements material accounts receivable. Confirmation may not be appropriate in the following
circumstances:
1. The auditor considers confirmations ineffective evidence because response rates
will likely be inadequate or unreliable. In certain industries, such as hospitals,
response rates to confirmations are very low.
2. The combined level of inherent risk and control risk is low and other substantive
evidence can be accumulated to provide sufficient evidence. If a client has
532 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
effective internal controls and low inherent risk for the sales and collection
cycle, the auditor should often be able to satisfy the evidence requirements by
tests of controls, substantive tests of transactions, and analytical procedures.
If the auditor decides not to confirm accounts receivable, the justification for doing
so must be documented in the audit files. While U.S. auditing standards require the use
of confirmations for accounts receivable in most circumstances, international auditing
standards suggest, but do not require their use. This is one of the few notable difference
between requirements of U.S. and international audit standards.
In performing confirmation procedures, the auditor must first decide the type of Types of Confirmation
confirmation to use.
Positive Confirmation A positive confirmation is a communication addressed to
the debtor requesting the recipient to confirm directly whether the balance as stated on
the confirmation request is correct or incorrect. Figure 16-5 (p. 534) illustrates a
positive confirmation in the audit of Hillsburg Hardware Co. Notice that this con -
firmation is for one of the largest accounts on the aged trial balance in Figure 16-3
(p.527).
A blank confirmation form is a type of positive confirmation that does not state
the amount on the confirmation but requests the recipient to fill in the balance or
furnish other information. Because blank forms require the recipient to determine the
information requested, they are considered more reliable than confirmations that
include balance information. Blank forms are rarely used in practice because they often
result in lower response rates.
An invoice confirmation is another type of positive confirmation in which an
individual invoice is confirmed, rather than the customer’s entire accounts receivable |
balance. Many customers use voucher systems that allow them to confirm individual
invoices but not balance informationA. Aps aa rgesuolt , thPe DuseF o f inEvoniche caonnfircmeatirons may
improve confirmation response rates. Invoice confirmations also result in fewer timing
differences and other reconciling items than balance confirmations. However, invoice
confirmations have the disadvantage of not directly confirming ending balances.
Sales to major customers often involve special terms or side-agreements for the
return of goods that may affect the amount and timing of revenue to be recognized
from the sale. When this has been identified as a significant risk, positive confirmations
often request the customer to confirm the existence of any special terms or side-
agreements between the client and customer.
Negative Confirmation Anegative confirmationis also addressed to the debtor but
requests a response only when the debtor disagrees with the stated amount. Figure 16-6
(p. 535) illustrates a negative confirmation in the audit of Hillsburg Hardware Co. that
has been attached to a customer’s monthly statement.
A positive confirmation is more reliableevidence because the auditor can perform
follow-up procedures if a response is not received from the debtor. With a negative
confirmation, failure to reply must be regarded as a correct response, even though the
debtor may have ignored the confirmation request.
Offsetting the reliability disadvantage, negative confirmations are less expensive to
send than positive confirmations, and thus more can be distributed for the same total
cost. Negative confirmations cost less because there are no second requests and no
follow-up of nonresponses.
The determination of which type of confirmation to use is an auditor’s decision,
and it should be based on the facts in the audit. Auditing standards state that it is
acceptable to use negative confirmations only when allof the following circum stances
are present:
1. The auditor has assessed the risk of material misstatement as low and has
obtained sufficient appropriate evidence regarding the design and operating
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 533
FIGURE 16-5 Positive Confirmation
HILLSBURGHARDWARE CO.
Gary, Indiana
January 5, 2012
Atwater Brothers
19 South Main Street
Middleton, Ohio 36947
To Whom It May Concern:
In connection with an audit of our financial statements, please confirmdirectly to our
auditors
BERGER & ANTHONY, CPAs
Gary, Indiana
the correctness of the balance ofyour account with us as of December 31, 2011, as shown
below.
This is not a request for payment; please do not sendyour remittance to our auditors.
Your prompt attention to this request will be appreciated. An envelope is enclosedfor your
reply.
Erma Swanson, Controller
BERGER & ANTHONY, CPAs
Gary, Indiana
The balance receivable from us of$210,389 as of December 31, 2011, is correct except
as noted below:
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Date By
effectiveness of controls relevant to the assertion being tested by the con -
firmation procedure.
2. The population of items subject to negative confirmation procedures is made
up of a large number of small, homogenous account balances, transactions, or
other items.
3. The auditor expects a low exception rate.
4. The auditor reasonably believes that recipients of negative confirmation
requests will give the requests adequate consideration. For example, if the
response rate to positive confirmations in prior years was extremely high or if
there are high response rates on audits of similar clients, it is likely that
recipients will give negative confirmations reasonable consideration as well.
Typically, when negative confirmations are used, the auditor puts considerable
emphasis on the effectiveness of internal controls, substantive tests of transactions, and
analytical procedures as evidence of the fairness of accounts receivable, and assumes
that the large majority of the recipients will provide a conscientious reading and
response to the confirmation request. |
Negative confirmations are often used for audits of hospitals, retail stores, banks,
and other industries in which the receivables are due from the general public. Auditors
may use a combination of negative and positive confirmations by sending the latter to
accounts with large balances and the former to those with small balances.
534 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
FIGURE 16-6 Negative Confirmation
AUDITOR’S ACCOUNT CONFIRMATION
Please examine this statement carefully. If it does NOT agree with your records,please report any
exceptionsdirectly to our auditors
BERGER & ANTHONY, CPAs
Gary, Indiana
who are conducting an audit of our financial statements as of December 31, 2011. An addressed
envelope is enclosedforyour convenience in replying.
Do not send your remittance to our auditors.
The auditor’s choice of confirmation falls along a continuum, starting with the use
of no confirmations in some circumstances, to using only negatives, to using both
negatives and positives, to using only positives. The primary factors affecting the
auditor’s decision are the materiality of total accounts receivable, the number and size
of individual accounts, control risk, inherent risk, the effectiveness of confirmations as
audit evidence, and the availability of other audit evidence.
The most reliable evidence from confirmations is obtained when they are sent as close Timing
to the balance sheet date as possible. This permits the auditor to directly test the
accounts receivable balance on the financial statements without making any inferences
about the transactions taking place between the confirmation date and the balance
sheet date. However, as a means of completing the audit on a timely basis, it is often
necessary to confirm the accounts at an interim date. This is permissible if internal
controls are adequate and can provide reasonable assurance that sales, cash receipts,
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and other credits are properly recorded between the date of the confirmation and the
end of the accounting period. The auditor is likely to consider other factors in making
the decision, including the materiality of accounts receivable and the auditor’s
exposure to lawsuits because of the possibility of client bankruptcy and similar risks.
If the decision is made to confirm accounts receivable before year-end, the auditor
typically prepares a roll-forward schedule that reconciles the accounts receivable balance
at the confirmation date to accounts receivable at the balance sheet date. In addition to
performing analytical procedures on the activity during the intervening period, it may
be necessary to test the transactions occurring between the confirmation date and the
balance sheet date. The auditor can accomplish this by examining internal documents
such as duplicate sales invoices, shipping documents, and evidence of cash receipts.
Sample Size The major factors affecting sample size for confirming accounts receivable Sampling Decisions
fall into several categories and include the following:
• Tolerable misstatement
• Inherent risk (relative size of total accounts receivable, number of accounts,
prior-year results, and expected misstatements)
• Control risk
• Achieved detection risk from other substantive tests (extent and results of sub -
stan tive tests of transactions, analytical procedures, and other tests of details)
• Type of confirmation (negatives normally require a larger sample size)
Selection of the Items for Testing Some type of stratificationis desirable with most
confirmations. In a typical approach to stratification for selecting the balances for
confirmation, an auditor considers both the dollar size of individual accounts and the
length of time an account has been outstanding. In most audits, the emphasis should
be on confirming larger and older balances because these are most likely to include a
significant misstatement. But it is also important to sample some items from every
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 535 |
material segment of the population. In many cases, the auditor selects all accounts
above a certain dollar amount and selects a random sample from the remainder.
Management may refuse to allow the auditor to send confirmation requests to
certain customers. The auditor must inquire about the reason for the client’s request,
which is often due to litigation or negotiations between the client and customer. The
auditor should obtain evidence to evaluate the reasonableness of the client’s request,
and evaluate whether the request indicates a potential fraud risk or increased risk of
material misstatement.
Verification of The auditor should perform procedures to verify the addresses or email addresses used
Addresses and for confirmation. For example, auditors should consider performing additional
Maintaining Control procedures when the address is a post office box, or an email address is inconsistent
with the customer’s Web site address.
For confirmations sent by mail, the auditor must maintain control of the con -
firmations until they are returned from the customer. The client may assist with
preparing the confirmations, but the auditor must be responsible for mailing the
confirmation outside the client’s office. A return address must be included on all
envelopes to make sure that undelivered mail is received by the CPA firm. Similarly,
self-addressed return envelopes accompanying the confirmations must be addressed
for delivery to the CPA firm’s office. These procedures are designed to ensure that
responses will be received directly by the auditor.
Follow-Up on It is inappropriate to regard confirmations mailed but not returned by customers as
Nonresponses significant audit evidence. For example, nonresponses to positive confirmations do not
provide audit evidence. Similarly, for negative confirmations, the auditor should not
conclude that the recipient received the confirmation request and verified the informa -
tion requested. Negative confirmations do, however, provide some evidence of the
existence assertion.
WAhepn apogsitoive cPonDfirFm atEionns harae unsecd,e aruditing standards require follow-up
procedures for confirmations not returned by the customer. It is common to send second
and some times even third requests for confirmations. Even with these efforts, some
customers do not return the confirmation, so it is necessary to follow up with alternative
procedures. The objective of alternative procedures is to determine by a means other
than con firmation whether the nonconfirmed account existed and was properly stated at
the confirmation date. For any positive confirmation not returned, auditors can examine
the following documentation to verify the existence and accuracy of individual sales
transactions making up the ending balance in accounts receivable:
Subsequent Cash Receipts Evidence of the receipt of cash subsequent to the con -
firmation date includes examining remittance advices, entries in the cash receipts records,
or perhaps even subsequent credits in the accounts receivable master file. On the one
hand, the examination of evidence of subsequent cash receipts is a highly useful alterna -
tive procedure because it is reasonable to assume that a customer would not have made a
payment unless it was an existing receivable. On the other hand, payment does not
establish whether an obligation existed on the date of the confirmation. In addition,
auditors should take care to match each unpaid sales transaction with evidence of its
subsequent payment as a test for disputes or disagreements over individual outstanding
invoices.
Duplicate Sales Invoices These are useful in verifying the actual issuance of a sales
invoice and the actual date of the billing.
Shipping Documents These are important in establishing whether the shipment was
actually made and as a test of cutoff.
Correspondence with the Client Usually, the auditor does not need to review
correspondence as a part of alternative procedures, but correspondence can be used to
disclose disputed and questionable receivables not uncovered by other means. |
536 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
FALSE AUDIT Confirmations are normally considered highly vendors and pressured them to return false con-
reliable evidence because they come from firmation letters to the auditors. In two separate
CONFIRMATIONS
independent third parties. However, in some complaints, the SEC charged 16 individuals who
HIDE FRAUD AT cases customers have colluded with audit clients were employees of or agents for vendors that
and returned false audit confirmations. Such was supplied U.S. Foodservice.
U.S. SUBSIDIARY
the case at U.S. Foodservice, Inc., a U.S. subsidiary
Sources: 1. Securities and Exchange
of Royal Ahold, a company headquartered in The
Commission Accounting and Auditing Enforce-
Netherlands. The SEC complaints charged that
ment Release No. 2341, November 2, 2005
U.S. Foodservice inflated promotional allowances
(www.sec.gov/litigation); 2. Securities and
from vendors by at least $700 million for fiscal Exchange Commission Accounting and Auditing
years 2001 and 2002 in order to meet earnings Enforcement Release No. 2167, January 13,
targets. U.S Foodservice personnel contacted 2005 (www.sec.gov/litigation).
The extent and nature of the alternative procedures depend primarily on the
materiality of the nonresponses, the types of misstatements discovered in the con -
firmed responses, the subsequent cash receipts from the nonresponses, and the
auditor’s conclusions about internal control.
It is normally desirable to account for all unconfirmed balances with alternative
procedures even if the amounts are small, as a means of properly generalizing from the
sample to the population. Another acceptable approach is to assume that nonresponses
are 100 percent overstatement amounts.
When the confirmation requests are returned by the customer, the auditor must Analysis of Differences
determine the reason for any reported differences. In many cases, they are caused by
timing differences between the client’s and the customer’s records. It is important to
distinguish between timing differences and exceptions, which represent misstatements
of the accounts receivable balance. The most commonly reported types of differences
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Payment Has Already Been Made Reported differences typically arise when the
customer has made a payment before the confirmation date, but the client has not
received the payment in time for recording before the confirmation date. Such
instances should be carefully investigated to determine the possibility of a cash receipts
cutoff misstatement, lapping, or a theft of cash.
Goods Have Not Been Received These differences typically result because the client
records the sale at the date of shipment and the customer records the acquisition when
the goods are received. The time that the goods are in transit is often the cause of
differences reported on confirmations. These should be investigated to determine the
possibility of the customer not receiving the goods at all or the existence of a cutoff
misstatement on the client’s records.
The Goods Have Been Returned The client’s failure to record a credit memo could
have resulted from timing differences or the improper recording of sales returns and
allowances. Like other differences, these must be investigated.
Clerical Errors and Disputed Amounts The most likely types of reported
differences in a client’s records are when the customer states that there is an error in the
price charged for the goods, the goods are damaged, the proper quantity of goods was
not received, and so forth. These differences must be investigated to determine whether
the client is in error and the amount of the error.
In most instances, the auditor will ask the client to reconcile the difference and, if
necessary, will communicate with the customer to resolve any disagreements. Naturally,
the auditor must carefully verify the client’s conclusions on each significant difference.
When all differences have been resolved, including those discovered in performing Drawing Conclusions |
alternative procedures, the auditor must reevaluate internal control. Each client
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 537
misstatement must be analyzed to determine whether it was consistent or inconsistent
with the original assessed level of control risk. If a significant number of misstatements
occurred that are inconsistent with the assessment of control risk, it is necessary to
revise the assessment and consider the effect of the revision on the audit. Auditors of
public companies must also consider implications for the audit of internal control over
financial reporting.
It is also necessary to generalize from the sample to the entire population of accounts
receivable. Even though the sum of the misstatements in the sample may not significantly
affect the financial statements, the auditor must consider whether the population is likely
to be materially misstated. Generalizing from the sample to the population can be done
using nonstatistical or statistical sampling techniques and is discussed in Chapter 17.
The auditor should always evaluate the qualitative nature of the misstatements
found in the sample, regardless of the dollar amount of the estimated population
misstatement. Even if the estimated misstatement is less than tolerable misstatement
for accounts receivable, the misstatements found in a sample can be symptomatic of a
more serious problem.
The final decision about accounts receivable and sales is whether sufficient
appropriate evidence has been obtained through tests of controls and substantive tests
of transactions, analytical procedures, cutoff procedures, confirmation, and other
substantive tests to justify drawing conclusions about the correctness of the stated
balance.
DEVELOPING TESTS OF DETAILS AUDIT PROGRAM
OBJECTIVE 16-5 We use Hillsburg Hardware Co. to illustrate the development of audit program pro -
cedures for tests of details in the sales and collection cycle, which serves as the
Design audit procedures Apago PDF Enhancer
summary of this chapter. The determination of these procedures is based on the tests of
for the audit of accounts
receivable, using an evidence controls and substantive tests of transactions, as illustrated in Chapters 14 and 15, and
planning worksheet as a the analytical procedures described earlier in this chapter.
guide. Fran Moore, the audit senior, prepared the evidence-planning worksheet in Figure
16-7 as an aid to help her decide the extent of planned tests of details of balances. The
source of each of the rows is as follows:
• Tolerable misstatement. The preliminary judgment of materiality was set at
$442,000 (approximately 6 percent of earnings from operations of $7,370,000).
She allo cated $265,000 to the audit of accounts receivable (see page 255).
• Acceptable audit risk.Fran assessed acceptable audit risk as medium because the
company is publicly traded, but is in good financial condition, and has high
management integrity. Although Hillsburg is a publicly traded company, its
stock is not widely held or extensively followed by financial analysts.
• Inherent risk. Fran assessed inherent risk as medium for existence and cutoff
because of concerns over revenue recognition identified in auditing standards.
Fran also assessed inherent risk as medium for realizable value. In past years,
the client made audit adjustments to the allowance for uncollectible accounts
because it was found to be understated. Inherent risk was assessed as low for all
other objectives.
• Control risk. Control risk assessments for each audit objective are the same as
those in Figure 15-6 on page 499. (Recall that results of tests of controls and
substantive tests of transactions in Chapter 15 were consistent with the auditor’s
initial control risk assessments, except for the accuracy and realizable value
objectives for sales.)
• Substantive tests of transactions results.These results were also taken from Figure
15-6. (Recall from Chapter 15 that all results were acceptable except for the
accuracy and cutoff objectives for sales.) |
538 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Acceptable audit risk Medium Medium Medium Medium Medium Medium Medium Medium
Inherent risk Low Medium Low Low Low Medium Medium Low
Control risk— Not
Sales Low Medium Low High Low Medium High applicable
Control risk— Not Not
Cash receipts Low Medium Low Low Low Low applicable applicable
Control risk—
None None None None None None None Low
Additional controls
Substantive tests
Good Good Good Fair Good Unacceptable Not Not
of transactions—
results results results results results results applicable applicable
Sales
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Substantive tests
Good Good Good Good Good Good Not Not
of transactions—
results results results results results results applicable applicable
Cash receipts
Analytical
procedures
Planned detection
risk for tests of
details of balances
Planned audit
evidence for tests of
details of balances
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 539
ni-eit
liateD
ecnetsixE
ssenetelpmoC
ycaruccA
noitacifissalC
ffotuC
eulav
elbazilaeR
sthgiR
FIGURE 16-7 Evidence-PlanningWorksheet to Decide Tests of Details of Balances for Hillsburg Hardware
Co. — Accounts Receivable
Good Good Good Good Good Good Unacceptable Not
results results results results results results results applicable
High Medium High Medium High Low Low High
Low Medium Low Medium Low High High Low
Tolerable misstatement $265,000
• Analytical procedures.See Tables 16-2 and 16-3 (both on page 525).
• Planned detection risk and planned audit evidence. These two rows are decided
for each objective based on the conclusions in the other rows.
Table 16-4 (p. 540) shows the tests of details audit program for accounts receivable,
by objective, and for the allowance for uncollectible accounts. The audit program
reflects the conclusions for planned audit evidence on the evidence-planning work -
sheet in Figure 16-7.
Table 16-5 (p. 541) shows the audit program in a performance format. The audit
pro cedures are identical to those in Table 16-4 except for procedure 2, which is an
analytical procedure. The numbers in parentheses are a cross reference between the
two tables.
TABLE 16-4 Balance-Related Audit Objectives and Audit Program for Hillsburg Hardware Co. — Sales and
Collection Cycle (Design Format)
Balance-Related Audit Objective Audit Procedure
Accounts receivable in the aged trial balance agree Trace 10 accounts from the trial balance to accounts on master file (6).
with related master file amounts, and the total is
Foot two pages of the trial balance, and total all pages (7).
correctly added and agrees with the general ledger
(detail tie-in). Trace the balance to the general ledger (8).
The accounts receivable on the aged trial balance exist Confirm accounts receivable, using positive confirmations. Confirm all amounts
(existence). over $100,000 and a nonstatistical sample of the remainder (10).
Perform alternative procedures for all confirmations not returned on the first or
second request (11).
Review accounts receivable trial balance for large and unusual receivables (1).
Existing accounts receivable are included in the aged Trace five accounts from the accounts receivable master file to the aged trial
trial balance (completeness). balance (9).
Accounts receivable in the trial balance are Confirm accounts receivable, using positive confirmations. Confirm all amounts
accurate (accuracy). over $100,000 and a nonstatistical sample of the remainder (10).
Perform alternative procedures for all confirmations not returned on the first or
second request (11).
Review accounts receivable trial balance for large and unusual receivables (1).
Accounts receivable on the aged trial balance are Review the receivables listed on the aged trial balance for notes and related
correctlyclassified (classification). party receivables (3).
Inquire of management whether there are any related party notes or long-term
receivables included in the trial balance (4).
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Transactions in the sales and collection cycle are Select the last 20 sales transactions from the current year’s sales journal and |
recorded in the proper period (cutoff). the first 20 from the subsequent year’s and trace each to the related
shipping documents, checking for the date of actual shipment and the
correct recording (14).
Review large sales returns and allowances before and after the balance sheet
date to determine whether they are recorded in the correct period (15).
Accounts receivable is stated at realizable value Trace 10 accounts from the aging schedule to the accounts receivable master
(realizable value). file to test for the correct aging on the trial balance (6).
Foot the aging columns on the trial balance and total the pages (7).
Cross-foot the aging columns (7).
Discuss with the credit manager the likelihood of collecting older accounts.
Examine subsequent cash receipts and the credit file on all accounts over
90 days and evaluate whether the receivables are collectible (12).
Evaluate whether the allowance is adequate after performing other audit
procedures for collectibility of receivables (13).
The client has rights to accounts receivable on the trial Review the minutes of the board of directors meetings for any indication of
balance (rights). pledged or factored accounts receivable (5).
Inquire of management whether any receivables are pledged or factored (5).
Note: The procedures are summarized into a performance format in Table 16-5on page 541. The numbers in parentheses after the procedures refer to Table 16-5.
540 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
TABLE 16-5 Test of Details of Balances Audit Program for Hillsburg Hardware
Co. — Sales and Collection Cycle (Performance Format)
1. Review accounts receivable trial balance for large and unusual receivables.
2. Calculate analytical procedures indicated in carry-forward audit schedules (not included) and
follow upon any significant changes from prior years.
3. Review the receivables listed on the aged trial balance for notes and related party receivables.
4. Inquire of management whether there are any related party, notes, or long-term receivables
included inthe trial balance.
5. Review the minutes of the board of directors meetings and inquire of management to determine
whether any receivables are pledged or factored.
6. Trace 10 accounts from the trial balance to the accounts receivable master file for aging and the
balance.
7. Foot two pages of the trial balance for aging columns and balance and total all pages and cross-
foot the aging.
8. Trace the balance to the general ledger.
9. Trace five accounts from the accounts receivable master file to the aged trial balance.
10. Confirm accounts receivable, using positive confirmations. Confirm all amounts over $100,000 and
anonstatistical sample of the remainder.
11. Perform alternative procedures for all confirmations not returned on the first or second request.
12. Discuss with the credit manager the likelihood of collecting older accounts. Examine subsequent
cash receipts and the credit file on all larger accounts over 90 days and evaluate whether the
receivables are collectible.
13. Evaluate whether the allowance is adequate after performing other audit procedures for
collectibility ofreceivables. Apago PDF Enhancer
14. Select the last 20 sales transactions from the current year’s sales journal and the first 20 from the
subsequent year’s and trace each to the related shipping documents, checking for the date of
actual shipment and the correct recording.
15. Review large sales returns and allowances before and after the balance sheet date to determine
whether they are recorded in the correct period.
ESSENTIAL TERMS
Accounts receivable balance-related audit Blank confirmation form––a letter,
objectives––the eight specific audit objec - addressed to the debtor, requesting the
tives used by the auditor to decide the recipient to fill in the amount of the
appropriate audit evidence for accounts accounts receivable balance; it is con-
receivable sidered a positive confirmation
Aged trial balance—a listing of the Cutoff misstatements—misstatements
balances in the accounts receivable master that take place as a result of current period |
file at the balance sheet date broken down transactions being recorded in a subsequent
according to the amount of time passed period, or subsequent period transactions
between the date of sale and the balance being recorded in the current period
sheet date Invoice confirmation––a type of positive
confirmation in which an individual
Alternative procedures––the follow-up of
invoice is confirmed, rather than the cus -
a positive confirmation not returned by
tomer’s entire accounts receivable balance
the debtor with the use of documenta -
tion evidence to determine whether the Negative confirmation––a letter, addressed
recorded receivable exists to the debtor, requesting a response only
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 541
if the recipient disagrees with the amount in accounts receivable that will ultimately
of the stated account balance be collected
Positive confirmation––a letter, addressed
to the debtor, requesting that the recipi - Timing difference––a reported dif-
ent indicate directly on the letter whether ference in a confirmation from a debtor
the stated account balance is correct or that is determined to be a timing
incorrect and, if incorrect, by what amount difference between the client’s and
Realizable value of accounts receivable–– debtor’s records and therefore not a
the amount of the outstanding balances misstatement
REVIEW QUESTIONS
16-1 (Objective 16-1)Distinguish among tests of details of balances, tests of controls, and
substantive tests of transactions for the sales and collection cycle. Explain how the tests of
controls and substantive tests of transactions affect the tests of details of balances.
16-2 (Objective 16-1)Cynthia Roberts, CPA, expresses the following viewpoint: “I do not
believe in performing tests of controls and substantive tests of transactions for the sales and
collection cycle. As an alternative, I send a lot of negative confirmations on every audit at
an interim date. If I find a lot of misstatements, I analyze them to determine their cause. If
internal controls are inadequate, I send positive confirmations at year-end to evaluate the
amount of misstatements. If the negative confirmations result in minimal misstatements,
which is often the case, I have found that the internal controls are effective without bother-
ing to perform tests of controls and substantive tests of transactions, and the confirmation
requirement has been satisfied at the same time. In my opinion, the best test of internal
controls is to go directly to third parties.” Evaluate her point of view.
16-3 (Objective 16-2)List five analytical procedures for the sales and collection cycle. For
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each test, describe a misstatement that could be identified.
16-4 (Objective 16-3)Identify the eight accounts receivable balance-related audit objec -
tives. For each objective, list one audit procedure.
16-5 (Objective 16-3)Which of the eight accounts receivable balance-related audit objec-
tives can be partially satisfied by confirmations with customers?
16-6 (Objective 16-3)State the purpose of footing the total column in the client’s accounts
receivable trial balance, tracing individual customer names and amounts to the accounts
receivable master file, and tracing the total to the general ledger. Is it necessary to trace each
amount to the master file? Why?
16-7 (Objective 16-3)Distinguish between accuracy tests of gross accounts receivable and
tests of the realizable value of receivables.
16-8 (Objective 16-3)Explain why you agree or disagree with the following statement: “In
most audits, it is more important to test carefully the cutoff for sales than for cash receipts.”
Describe how you perform each type of test, assuming documents are prenumbered.
16-9 (Objective 16-4)Evaluate the following statement: “In many audits in which accounts
receivable is material, the requirement of confirming customer balances is a waste of time
and would not be performed by competent auditors if it were not required by auditing
standards. When internal controls are excellent and there are a large number of small |
receivables from customers who do not recognize the function of confirmation, it is a
meaningless procedure. Examples include well-run utilities and retail stores. In these
situations, tests of controls and substantive tests of transactions are far more effective than
confirmations.”
16-10 (Objective 16-4)Distinguish between a positive and a negative confirmation and
state the circumstances in which each should be used. Why do CPA firms sometimes use a
combination of positive and negative confirmations on the same audit?
542 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
16-11 (Objective 16-4)Under what circumstances is it acceptable to confirm accounts
receivable before the balance sheet date?
16-12 (Objective 16-4) State the most important factors affecting the sample size in
confirmations of accounts receivable.
16-13 (Objective 16-4) Discuss whether email responses and oral responses are confir -
mations. How can an auditor verify the addresses for confirmations sent by mail, and
confirmations sent electronically?
16-14 (Objective 16-4)In Chapter 15, one of the points brought out was the need to obtain
a representative sample of the population. How can this concept be reconciled with the
statement in this chapter that the emphasis should be on confirming larger and older
balances because these are most likely to contain misstatements?
16-15 (Objective 16-4)Define what is meant by alternative procedures in the confirmation
of accounts receivable and explain their purpose. Which alternative procedures are the
most reliable? Why?
16-16 (Objective 16-4) Explain why the analysis of differences is important in the
confirmation of accounts receivable, even if the misstatements in the sample are not
material.
16-17 (Objective 16-4) State three types of differences that might be observed in the
confirmation of accounts receivable that do not constitute misstatements. For each, state
an audit procedure that will verify the difference.
16-18 (Objective 16-1)What is the relationship of each of the following to the sales and
collection cycle: flowcharts, assessing control risk, tests of controls, and tests of details of
balances?
16-19 (Objective 16-3)Describe accounting requirements for proper recording of sales
returns and allowances.
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MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
16-20 (Objective 16-2)The following questions concern analytical procedures in the sales
and collection cycle. Choose the best response.
a. As a result of analytical procedures, the auditor determines that the gross profit
percentage has declined from 30% in the preceding year to 20% in the current year.
The auditor should
(1) express a qualified opinion due to inability of the client company to continue as a
going concern.
(2) evaluate management’s performance in causing this decline.
(3) require footnote disclosure.
(4) consider the possibility of a misstatement in the financial statements.
b. After a CPA has determined that accounts receivable have increased as a result of slow
collections in a “tight money” environment, the CPA will be likely to
(1) increase the balance in the allowance for bad debt account.
(2) review the going concern ramifications.
(3) review the credit and collection policy.
(4) expand tests of collectibility.
c. In connection with his review of key ratios, the CPA notes that Pyzi had accounts
receivable equal to 30 days’ sales at December 31, 2010, and to 45 days’ sales at
December 31, 2011. Assuming that there have been no changes in economic
conditions, clientele, or sales mix, this change most likely will indicate
(1) a steady increase in sales in 2011.
(2) an easing of credit policies in 2011.
(3) a decrease in accounts receivable relative to sales in 2011.
(4) a steady decrease in sales in 2011.
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 543
16-21 (Objective 16-4) The following questions deal with confirmation of accounts
receivable. Choose the best response.
a. The negative form of accounts receivable confirmation request is useful exceptwhen |
(1) internal control surrounding accounts receivable is considered to be effective.
(2) a large number of small balances are involved.
(3) the auditor has reason to believe the persons receiving the requests are likely to
give them consideration.
(4) individual account balances are relatively large.
b. The return of a positive confirmation of accounts receivable without an exception
attests to the
(1) collectibility of the receivable balance.
(2) accuracy of the receivable balance.
(3) accuracy of the aging of accounts receivable.
(4) accuracy of the allowance for uncollectible accounts.
c. In confirming a client’s accounts receivable in prior years, an auditor found that there
were many differences between the recorded account balances and the confirmation
responses. These differences, which were not misstatements, required substantial time
to resolve. In defining the sampling unit for the current year’s audit, the auditor will
most likely choose
(1) individual overdue balances. (3) small account balances.
(2) individual invoices. (4) large account balances.
16-22 (Objective 16-3)The following questions concern audit objectives and management
assertions for accounts receivable. Choose the best response.
a. When evaluating the adequacy of the allowance for uncollectible accounts, an auditor
reviews the entity’s aging of receivables to support management’s balance-related
assertion of
(1) existence. (3) valuation and allocation.
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(2) completeness. (4) rights and obligations.
b. Which of the following audit procedures will best uncover an understatement of sales
and accounts receivable?
(1) Test a sample of sales transactions, selecting the sample from prenumbered
shipping documents.
(2) Test a sample of sales transactions, selecting the sample from sales invoices
recorded in the sales journal.
(3) Confirm accounts receivable.
(4) Review the aged accounts receivable trial balance.
c. The confirmation of customers’ accounts receivable rarely provides reliable evidence
about the completeness assertion because
(1) many customers merely sign and return the confirmation without verifying
details.
(2) recipients usually respond only if they disagree with the information on the
request.
(3) customers may not be inclined to report understatement errors in their accounts.
(4) there is likely to be reliable third party evidence available.
DISCUSSION QUESTIONS AND PROBLEMS
16-23 (Objective 16-3)The following are common tests of details of balances for the audit
of accounts receivable:
1. Obtain a list of aged accounts receivable, foot the list, and trace the total to the
general ledger.
2. Trace 35 accounts to the accounts receivable master file for name, amount, and age
categories.
544 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
3. Examine and document cash receipts on accounts receivable for 20 days after the
engagement date.
4. Request 25 positive and 65 negative confirmations of accounts receivable.
5. Perform alternative procedures on accounts not responding to second requests by
examining subsequent cash receipts documentation and shipping reports or sales
invoices.
6. Test the sales cutoff by tracing entries in the sales journal for 15 days before and after
the balance sheet date to shipping documents, if available, and/or sales invoices.
7. Determine whether any accounts receivable have been pledged, discounted, sold,
assigned, or guaranteed by others.
8. Evaluate the materiality of credit balances in the aged trial balance.
For each audit procedure, identify the balance-related audit objective or objectives it Required
partially or fully satisfies.
16-24 (Objective 16-3)The following misstatements are sometimes found in the sales and
collection cycle’s account balances:
1. The accounts receivable trial balance total does not equal the amount in the general
ledger.
2. Several accounts receivable in the accounts receivable master file are not included in
the aged trial balance.
3. One account receivable in the accounts receivable master file is included on the aged |
trial balance twice.
4. A shipment made in the subsequent period is recorded as a current period sale.
5. The allowance for uncollectible accounts is inadequate because of the client’s failure
to reflect depressed economic conditions in the allowance.
6. Several accounts receivable are in dispute as a result of claims of defective mer-
chandise.
7. The pledging of accounts receivable to the bank for a loan is not disclosed in the
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financial statements.
8. Goods shipped and included in the current period sales were returned in the
subsequent period.
9. Long-term interest-bearing notes receivable from affiliated companies are included
in accounts receivable.
a. For each misstatement, identify the balance-related audit objective to which it Required
pertains.
b. For each misstatement, list an internal control that should prevent it.
c. For each misstatement, list one test of details of balances audit procedure that the
auditor can use to detect it.
16-25 (Objective 16-3)The following are audit procedures in the sales and collection cycle:
1. Add the columns on the aged trial balance and compare the total with the general
ledger.
2. Examine a sample of shipping documents to determine whether each has a sales
invoice number included on it.
3. Examine a sample of customer orders and see if each has a credit authorization.
4. Compare the date on a sample of shipping documents a few days before and after the
balance sheet date with related sales journal transactions.
5. Discuss with the sales manager whether any sales allowances have been granted after
the balance sheet date that may apply to the current period.
6. Observe whether the controller makes an independent comparison of the total in the
general ledger with the trial balance of accounts receivable.
7. Compare the date on a sample of shipping documents throughout the year with
related duplicate sales invoices and the accounts receivable master file.
8. Compute the ratio of allowance for uncollectible accounts divided by accounts
receivable and compare with previous years.
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 545
Required a. For each procedure, identify the applicable type of audit evidence.
b. For each procedure, identify which of the following it is:
(1) Test of control (3) Analytical procedure
(2) Substantive test of transactions (4) Test of details of balances
c. For those procedures you identified as a test of control or substantive test of trans -
actions, what transaction-related audit objective or objectives are being satisfied?
d. For those procedures you identified as a test of details of balances, what balance-
related audit objective or objectives are being satisfied?
16-26 (Objective 16-3)The following are the eight balance-related audit objectives, six tests
of details of balances for accounts receivable, and seven tests of controls or substantive tests
of transactions for the sales and collection cycle:
Balance-Related Audit Objective
Detail tie-in Classification
Existence Cutoff
Completeness Realizable value
Accuracy Rights
Test of Details of Balances, Test of Control, or Substantive Test of Transactions Audit Procedure
1. Confirm accounts receivable.
2. Review sales returns after the balance sheet date to determine whether any are
applicable to the current year.
3. Compare dates on shipping documents and the sales journal throughout the year.
4. Perform alternative procedures for nonresponses to confirmation.
5. Examine sales transactions for related party or employee sales recorded as regular sales.
6. Examine duplicate sales invoices for consignment sales and other shipments for
which title has not passed.
7.ATrapcea a gsamop le Pof DaccFou ntEs fnromh tahen acccoeunrts receivable master file to the aged trial
balance.
8. Trace recorded sales transactions to shipping documents to determine whether a
document exists.
9. Examine duplicate sales invoices for initials that indicate internal verification of
extensions and footings.
10. Trace a sample of shipping documents to related sales invoice entries in the sales
journal. |
11. Compare amounts and dates on the aged trial balance and accounts receivable
master file.
12. Trace from the sales journal to the accounts receivable master file to make sure the
information is the same.
13. Inquire of management whether there are notes from related parties included with
trade receivables.
RReeqquuiirreedd a. Identify which procedures are tests of details of balances, which are tests of controls,
and which are substantive tests of transactions.
b. For each balance-related audit objective, identify which test of details of balances and
test of controls or substantive test of transactions partially satisfy the balance-related
objective.
16-27 (Objective 16-3)Niosoki Auto Parts sells new parts for foreign automobiles to auto
dealers. Company policy requires that a prenumbered shipping document be issued for
each sale. At the time of pickup or shipment, the shipping clerk writes the date on the
shipping document. The last shipment made in the fiscal year ended August 31, 2011, was
recorded on document 2167. Shipments are billed in the order that the billing clerk receives
the shipping documents.
For late August and early September, shipping documents are billed on sales invoices as
follows:
546 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Shipping Document No. Sales Invoice No.
2163 5437
2164 5431
2165 5432
2166 5435
2167 5436
2168 5433
2169 5434
2170 5438
2171 5440
2172 5439
The August and September sales journals have the following information included:
SALES JOURNAL — AUGUST 2011
Day of Month Sales Invoice No. Amount of Sale
30 5431 $ 726.11
30 5434 4,214.30
31 5432 419.83
31 5433 1,620.22
31 5435 47.74
SALES JOURNAL — SEPTEMBER 2011
Day of Month Sales Invoice No. Amount of Sale
1 5437 $2,541.31
1 5436 106.39
1 5438 852.06
2 5440 1,250.50
2 5439 646.58
a. What are the accounting requirements for a correct sales cutoff? Required
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b. Which sales invoices, if any, are recorded in the wrong accounting period? Prepare an
adjusting entry to correct the financial statement for the year ended August 31, 2011.
Assume that the company uses a periodic inventory system (inventory and cost of
sales do not need to be adjusted).
c. Assume that the shipping clerk accidentally wrote August 31 on shipping documents
2168 through 2172. Explain how that will affect the correctness of the financial
statements. How will you, as an auditor, discover that error?
d. Describe, in general terms, the audit procedures you would follow in making sure that
cutoff for sales is accurate at the balance sheet date.
e. Identify internal controls that will reduce the likelihood of cutoff misstatements. How
would you test each control?
16-28 (Objective 16-4)Dodge, CPA, is auditing the financial statements of a manufacturing
company with a significant amount of trade accounts receivable. Dodge is satisfied that the
accounts are correctly summarized and classified and that allocations, reclassifications, and
valuations are made in accordance with GAAP. Dodge is planning to use accounts receivable
confirmation requests to obtain sufficient appropriate evidence as to trade accounts receivable.
a. Identify and describe the two forms of accounts receivable confirmation requests and Required
indicate what factors Dodge will consider in determining when to use each.
b. Assume that Dodge has received a satisfactory response to the confirmation requests.
Describe how Dodge can evaluate collectibility of the trade accounts receivable.
c. What are the implications to a CPA if during an audit of accounts receivable some of
a client’s trade customers do not respond to a request for positive confirmation of
their accounts?
d. What auditing steps should a CPA perform if there is no response to a second request
for a positive confirmation?*
*AICPA adapted.
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 547
16-29 (Objectives16-2, 16-3) The Albring Company sells electronics equipment, and has
grown rapidly in the last year by adding new customers. The audit partner has asked you to |
evaluate the allowance for doubtful accounts at December 31, 2011. Comparative
information on sales and accounts receivable is included below:
Year Ended Year Ended
12/31/11 12/31/10
Sales $ 12,169,876 $ 10,452,513
Accounts Receivable 1,440,381 1,030,933
Allowance for doubtful accounts 90,000 75,000
Bad debt charge-offs 114,849 103,471
Accounts Receivable:
0–30 days $ 897,035 $ 695,041
30–60 days 254,269 160,989
60–90 days 171,846 105,997
Over 90 days 117,231 68,906
TOTAL $ 1,440,381 $ 1,030,933
Required a. Identify what tests of controls and substantive tests of transactions you recommend be
performed before conducting your analysis of the allowance for doubtful accounts.
b. Perform analytical procedures to evaluate whether the allowance is fairly stated at
December 31, 2011. Assume tolerable misstatement for the allowance account is
$15,000.
16-30 (Objective 16-4) You have been assigned to the confirmation of aged accounts
receivable for the Blank Paper Company audit. You have tested the aged trial balance and
selected the accounts for confirming. Before the confirmation requests are mailed, the
controller asks to look at the accounts you intend to confirm to determine whether he will
permit you to send them.
He Arevpieawsg thoe l istP anDd Finf orEmsn yhoua thnat chee dores not want you to confirm six of the
accounts on your list. Two of them are credit balances, one is a zero balance, two of the other
three have a fairly small balance, and the remaining balance is highly material. The reason he
gives is that he feels the confirmations will upset these customers because “they are kind of
hard to get along with.” He does not want the credit balances confirmed because it may
encourage the customer to ask for a refund.
In addition, the controller asks you to send an additional 20 confirmations to customers
he has listed for you. He does this as a means of credit collection for “those stupid idiots
who won’t know the difference between a CPA and a credit collection agency.”
RReeqquuiirreedd a. Is it acceptable for the controller to review the list of accounts you intend to confirm?
Discuss.
b. Discuss the appropriateness of sending the 20 additional confirmations to the customers.
c. What additional procedures should be performed if the auditor agrees with the
client’s request not to send confirmations to the six customers.
16-31 (Objective 16-4)You have been assigned to the first audit of the Chicago Company
for the year ending March 31, 2011. Accounts receivable were confirmed on December 31,
2010, and at that date the receivables consisted of approximately 200 accounts with
balances totaling $956,750. Fifty of these accounts with balances totaling $650,725 were
selected for confirmation. All but 10 of the confirmation requests have been returned; 24
were returned without any exceptions, 6 had minor differences that have been cleared
satisfactorily, and 10 confirmations had the following information and comments:
1. We are sorry, but we cannot answer your request for confirmation of our account as
the PDQ Company uses an accounts payable voucher system and can only confirm
individual invoices.
2. The balance of $1,050 was paid on December 28, 2010.
3. The balance of $7,750 was paid on January 5, 2011.
4. The balance of $2,975 was paid on December 13, 2010.
548 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
5. We do not owe you anything at December 31, 2010, as the goods, represented by
your invoice dated December 30, 2010, number 25050, in the amount of $11,550,
were received on January 5, 2011, on FOB destination terms.
6. An advance payment of $2,500 made by us in November 2010 should cover the two
invoices totaling $1,350 shown on the statement attached.
7. This confirmation was returned as undeliverable by the post office.
8. We are contesting the propriety of this $12,525 charge. We think the charge is excessive.
9. We do not owe this balance as our agreement with the company allows us to return
any unsold goods without penalty. Amount okay. As the goods have been shipped to |
us on consignment, we will remit payment upon selling the goods.
10. Your credit memo dated December 5, 2010, in the amount of $440 cancels the
balance above.
a. Indicate which of these confirmation responses likely represent timing differences. Required
b. Which of the ten confirmation responses likely represent a misstatement? Explain why
the response indicates a misstatement.
c. For each of the 10 confirmation responses, indicate the procedures you would
perform to determine whether the exception is a misstatement or has been
appropriately recorded by the client.*
16-32 (Objectives 16-3, 16-5)The following are various changes in audit circumstances.
Audit Circumstance
1. Analytical procedures indicated a significant slowing in accounts receivable turnover.
2. The client entered into sales contracts with new customers that differ from the
client’s standard sales contracts.
3. The client had a significant increase in sales near year-end.
4. Accounts receivable confirmations were ineffective due to a very low response rate in
the prior year audit.
5. The client began experiencing an increase in returns due to product changes that
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6. You found several pricing errors in your substantive tests of transactions for sales.
7. In performing substantive test of transactions for cash receipts, you found that
receipts were promptly recorded in customer accounts, but there were delays in
depositing the receipts at the bank.
8. The client entered into a new loan agreement with the bank. Accounts receivable are
pledged as collateral for the loan.
9. The client did not reconcile the accounts receivable subsidiary records with the
accounts receivable balance in the general ledger on a regular basis.
Match each change in audit circumstance with the most likely test of details of balances Required
response. Each response is used once.
a. Expand testing of sales returns after year-end and compare the level of returns with
the prior year.
b. Send positive confirmations that include requests for information on side agreements
and special terms.
c. Increase the number of accounts traced from the accounts receivable trial balance to
the accounts receivable subsidiary records.
d. Expand the review of cash receipts after year-end to evaluate the collectibility of
accounts receivable.
e. Increase the sample size for sales cutoff testing for sales recorded before year-end.
f. Send a confirmation to the bank confirming amounts pledged as collateral under loan
agreements.
g. Increase the sample size for positive confirmations of accounts receivable.
h. While at the client’s premises at year-end, obtain information on the last few cash
receipt at year-end for cash receipts cutoff testing.
*AICPA adapted.
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 549
i. Perform alternative procedures to test the existence and accuracy of accounts receivable
instead of sending positive confirmations.
16-33 (Objective 16-4)In the confirmation of accounts receivable for the Reliable Service
Company, 85 positive and no negative confirmations were mailed to customers. This
represents 35% of the dollar balance of the total accounts receivable. Second requests were
sent for all nonresponses, but there were still 10 customers who did not respond. The
decision was made to perform alternative procedures on the 10 unanswered confirmation
requests. An assistant is requested to conduct the alternative procedures and report to the
senior auditor after he has completed his tests on two accounts. He prepared the following
information for the audit files:
1. Confirmation request no. 9
Customer name—Jolene Milling Co.
Balance—$3,621 at December 31, 2011
Subsequent cash receipts per the
accounts receivable master file: January 15, 2012—$1,837
January 29, 2012—$1,263
February 6, 2012—$1,429
2. Confirmation request no. 26
Customer name—Rosenthal Repair Service
Balance—$2,500 at December 31, 2011
Subsequent cash receipts per the
accounts receivable master file February 9, 2012—$500 |
Sales invoices per the accounts receivable
master file (I examined the duplicate invoice) September 1, 2011—$4,200
Required a. If you are called on to evaluate the adequacy of the sample size, the type of confirma-
tion used, and the percent of accounts confirmed, what additional information will
you need?
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b. Discuss the need to send second requests and perform alternative procedures for non-
responses.
c. Evaluate the adequacy of the alternative procedures used for verifying the two non -
responses.
CASE
16-34 (Objectives 16-1, 16-3, 16-4, 16-5)You are auditing the sales and collection cycle for
the Smalltown Regional Hospital, a small not-for-profit hospital. The hospital has a
reputation for excellent medical services and deficient record keeping. The medical people
have a tradition of doing all aspects of their job correctly, but because of a shortage of
accounting personnel, there is not time for internal verification or careful performance. In
previous years, your CPA firm has found quite a few misstatements in billings, cash
receipts, and accounts receivable. As in all hospitals, the two largest assets are accounts
receivable and property, plant, and equipment.
The hospital has several large loans payable to local banks, and the two banks have told
management that they are reluctant to extend more credit, especially considering the modern
hospital that is being built in a nearby city. In the past, county taxes have made up deficits, but
in the past year, the county has also been incurring deficits because of high unemployment.
In previous years, your response from patients to confirmation requests has been
frustrating at best. The response rate has been extremely low, and those who did respond
did not know the purpose of the confirmations or their correct outstanding balance. You
have had the same experience in confirming receivables at other hospitals.
You conclude that control over cash is excellent and the likelihood of fraud is extremely
small. You are less confident about unintentional errors in billing, recording sales, cash
receipts, accounts receivable, and bad debts.
550 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
a. Identify the major factors affecting client business risk and acceptable audit risk for Required
this audit.
b. What inherent risks are you concerned about?
c. In this audit of the sales and collection cycle, which types of tests are you likely to
emphasize?
d. For each of the following, explain whether you plan to emphasize the tests and give
reasons:
(1) Tests of controls (3) Analytical procedures
(2) Substantive tests of transactions (4) Tests of details of balances
INTEGRATED CASE APPLICATION —
PINNACLE MANUFACTURING: PART VII
16-35 (Objectives 16-2, 16-3, 16-4)Parts III, V, and VI of this case study dealt with obtaining
an understanding of internal control and assessing control risk for transactions affecting
accounts payable of Pinnacle Manufacturing. In Part VII, you will design analytical
procedures and design and perform tests of details of balances for accounts payable.
Assume that your understanding of internal controls over acquisitions and cash
disbursements and the related tests of controls and substantive tests of transactions
support an assessment of a low control risk. The listing of the 519 accounts making up the
accounts payable balance of $12,969,686 at December 31, 2011 is included under the
Pinnacle link on the textbook Web site.
a. List those relationships, ratios, and trends that you believe will provide useful infor - Required
mation about the overall reasonableness of accounts payable. You should consider
income statement accounts that affect accounts payable in selecting the analytical
procedures.
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b. Study Table 19-5 (p. 647) containing balance-related audit objectives and tests of details
of balances for accounts payable to be sure you understand each procedure and its
purpose. Prepare an audit program for accounts payable in a performance format,
using the audit procedures in Table 19-5. The format of the audit program should be |
similar to Table 16-5 (p. 541). Be sure to include a sample size for each procedure.
c. Assume for requirement b that (1) assessed control risk had been high rather than low
for each transaction-related audit objective, (2) inherent risk was high for each
balance-related audit objective, and (3) analytical procedures indicated a high
potential for misstatement. What would the effect have been on the audit procedures
and sample sizes for requirement b?
d. Confirmation requests were sent to a stratified sample of 51 vendors listed in Figure
16-8 (p. 552). Confirmation responses from 45 vendors were returned indicating no
difference between the vendor’s and the company’s records. Figure 16-9 (pp. 553–554)
presents the six replies that indicate a difference between the vendor’s balance and
the company’s records. The auditor’s follow-up findings are indicated on each reply.
Prepare an audit schedule similar to the one illustrated in Figure 16-10 (p. 555) to
determine the misstatements, if any, for each difference. The audit schedule format
shown in Figure 16-10 can be downloaded using the Pinnacle link on the textbook
Web site. The exception for Fiberchem is analyzed as an illustration. Assume that
Pinnacle Manufacturing took a complete physical inventory at December 31, 2011,
and the auditor concluded that recorded inventory reflects all inventory on hand at
the balance sheet date. Include the balances confirmed without exception as one
amount on the schedule for each stratum, and total the schedule columns.
e. Estimate the total misstatement in the income statement, not just the misstatem ents
in the sample, based on the income statement misstatements you identified in
requirement d. The total misstatement should include a projected misstatement and
an estimate for sampling error. Hint: See pages 257–258 for guidance on calculating
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 551
FIGURE 16-8 Pinnacle Manufacturing Sample of Accounts Payable Selected
for Confirmation — December 31, 2011
High-Volume Items (>$250,000)
1. American Press $ 340,767.94
2. Clean-O-Rama, Co. 317,668.63
3. Fiberchem 793,049.89
4. Rufus Austin Antiques 400,046.08
5. Todd Machinery 531,073.93
6. Welburn Manufacturing 388,836.07 $2,771,442.54
Large Balance Items ($50,001–$250,000)
1. A& M Sandler Inc. $ 81,348.54
2. American Baby/USTC 75,432.73
3. Beach & Hoover Refining 76,408.79
4. Bearing Drives Co. 73,017.24
5. Burton Martin 78,682.54
6. Cable Sys./Ind. Traf. Cons. 71,288.95
7. Eddie Ventura, Inc. 60,255.55
8. Fiberoptics 60,102.78
9. Finish Metals Inc. 60,769.71
10. Freeman Furniture–Attn A/P 130,493.51
11. GP Chambers Co. 64,125.44
12. Godwin Drug Co. 84,331.05
13. Holy Family Hospital 117,916.83
14. Las Flores Designs Inc. 88,644.92
15. Lean Corp. 67,985.23
16. MacDonald Svc. Corporation 147,943.95
17. McCoys Inc. 67,936.32
18. Metadyne Corp. 85,432.51
19. Micron Power Systems 136,071.37
20. Mobil Oil 93,210.48
21. National Elevator & Mach. Co. 76,921.40
22. Norris Industries 88,314.64
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23. R& B Products 80,092.46
24. Remington Supply 123,411.24
25. Safety Envelope Co. 223,950.34
26. Scandec USA Inc. 65,942.94
27. The Dutton Company 63,882.02
28. The Haberdashery Co. 71,869.16
29. University of California 80,624.95
30. ZZZZ Bank Adjustments 64,471.21 $2,660,878.80
Items $50,000 and less
1. Advent Sign Mfg. Co. $ 51,750.00
2. B&K Mfg. Co. Inc. 42,668.50
3. Bellco 42,710.74
4. Boston Shoecase Co. 52,174.50
5. Dynamic Metal Products 36,546.05
6. Everhart Co. 47,519.14
7. Fuller Travel 32,470.11
8. Good House Home Video Inc. 46,472.67
9. Harrah’s Metals, Inc. 51,279.85
10. J C Licht Co.—Glendale Hts. 53,228.47
11. Liberty Lighting 46,802.78
12. Long Beach Lawn Service 48,488.96
13. Premier Whirlpool Bath 6,550.33
14. Quaker Transanalysis 50,363.69
15. Tower International 37,299.55 $ 646,325.34
TOTAL TESTED $6,078,646.68
the point estimate. Note that the misstatements should be projected separately for
each stratum. You will need to determine the size of each stratum using the accounts |
payable listing. Use your judgment to estimate sampling error, considering the size of
the population and the amounts tested.
552 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
f. Estimate the total misstatement in accounts payable in the same way you did for the
income statement in requirement e. Hint: A misstatement caused by the failure to
record an FOB origin purchase is an understatement of accounts payable and inven-
tory and has no effect on income.
g. What is your conclusion about the fairness of the recorded balance in accounts payable
for Pinnacle Manufacturing as it affects the income statement and balance sheet? How
does this affect your assessment of control risk as being low for all transaction-related
audit objectives? Assume you decided that tolerable misstatement for accounts
payable as it affects the income statement is $250,000.
FIGURE 16-9 Replies to Requests for Information
STATEMENT FROM FIBERCHEM
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
Invoice No. Date Amount Balance Due
8312 11-22-11 $300,000.00 $300,000.00
8469 12-02-11 178,000.00 478,000.00
8819 12-18-11 315,049.89 793,049.89(1)
9002 12-30-11 32,500.00(2) 825,549.89
Auditor’s notes:
(1) Agrees with accounts payable listing.
(2) Goods shipped FOB Fiberchem’s plant on December 31, 2011;
arrived at Pinnacle Manufacturing on January 4, 2012.
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STATEMENT FROM MOBIL OIL
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
Invoice No. Date Amount Balance Due
DX14777 12-23-11 $9 3,210.48 $ 9 3,210.48(1)
DX16908 12-29-11 3 7,812.00(2) 131,022.48
Auditor’s notes:
(1) Agrees with accounts payable listing.
(2) Goods shipped FOB Pinnacle Manufacturing on December 29, 2011;
arrived at Pinnacle Manufacturing on January 3, 2012.
STATEMENT FROM NORRIS INDUSTRIES
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
Invoice No. Date Amount Balance Due
14896 12-27-11 $ 88,314.64 $ 88,314.64(1)
15111 12-28-11 1 17,296.00(2) 205,610.64
Auditor’s notes:
(1) Agrees with accounts payable listing.
(2) Goods received December 30, 2011; recorded on January 2, 2012.
(Figure 16-9 continued on next page)
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 553
FIGURE 16-9 Replies to Requests for Information(Cont.)
STATEMENT FROM REMINGTON SUPPLY
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
Invoice No. Date Amount Balance Due
141702 11-11-11 $23,067.00 $ 23,067.00
142619 11-19-11 12,000.00 35,067.00
142811 12-04-11 7 ,100.00 42,167.00
143600 12-21-11 27,715.24 69,882.24
144927 12-29-11(2) 53,529.00 123,411.24(1)
Auditor’s notes:
(1) Agrees with accounts payable listing.
(2) Goods shipped FOB Pinnacle Manufacturing on December 29, 2011; arrived at
Pinnacle Manufacturing on January 4, 2012.
STATEMENT FROM ADVENT SIGN MFG. CO.
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
First progress billing per contract $51,7 50.00(1)
Secondprogress billing per contract 7,5 0 0 . 0 0 (2)
Total due $59,250.00
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Auditor’s notes:
(1) Agrees with accounts payable listing.
(2) Progress payment due as of December 31, 2011, per contract for construction
of new custom electric sign; sign installation completed on January 15, 2012.
STATEMENT FROM FULLER TRAVEL
Pinnacle Manufacturing
Detroit, MI
Amounts due as of December 31, 2011:
Invoice No. Date Amount Balance Due
84360110 12-04-11 $9,411.63(2) $ 9,411.63
84360181 12-12-11 9,411.63(2) 18,823.26
84360222 12-21-11 7,100.00(1) 25,923.26
84360291 12-26-11 13,646.85(2) 39,570.11
Auditor’s notes:
(1) Paid by Pinnacle Manufacturing on December 28, 2011; payment in transit at year-end.
(2) The total of these items of $32,470.11 agrees with accounts payable listing.
554 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
FIGURE 16-10 Pinnacle Manufacturing Analysis of Trade Accounts Payable — December 31, 2011
Misstatement in
Related Accounts
Books Timing Misstatement Other Balance Income
Balance Amount Over (Under) Difference: in Accounts Sheet Statement |
per Confirmed Amount No Payable Misstatement Misstatement Brief
Vendor Books by Vendor Confirmed Misstatement o/s (u/s)* o/s (u/s)* o/s (u/s)* Explanation
Key Accounts (>$250,000)
F.O.B. Origin
error:
Dr. Inv.
Fiberchem $793,049.89 $825,549.89 $(32,500.00) $(32,500.00) $(32,500.00) Cr. A/P
Accounts in stratum $50,001–$250,000
Accounts in stratum less than or equal to $50,000
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* o/s = overstatement u/s = understatement
Chapter 16 / COMPLETING THE TESTS IN THE SALES AND COLLECTION CYCLE: ACCOUNTS RECEIVABLE 555
ACL PROBLEM
16-36 (Objective 16-3)This problem requires the use of ACL software, which is included in
the CD attached to the text. Information about installing and using ACL and solving this
problem can be found in Appendix, pages 838–842. You should read all of the reference
material preceding the instructions for “Quick Sort” before locating the appropriate
command to answer questions a-f. For this problem use the Metaphor_Trans_All file in
ACL Demo, which is a file of outstanding sales invoices (each row represents an invoice
transaction). The suggested command or other source of information needed to solve the
problem requirement is included at the end of each question.
a. Determine the total number of invoices (read the bottom of the Metaphor_Trans_All
file screen) and total unpaid invoices outstanding (NEWBAL) for comparison to the
general ledger. (Total Field)
b. How many of the invoices included a finance charge (FINCHG) and what was the
total amount of the finance charges? (Filter, Count Records, and Total Field)
c. Determine and print accounts receivable outstanding from each customer and total
the amount for comparison to part a (Note: remove the filter from step b first).
(Summarize and Total Field) Which customer number has the largest balance due?
d. What is the largest and smallest account balance outstanding? (Quick Sort)
e. For the account with the largest balance, prepare and print an aging of the account
from the transaction file using the statement date labeled “STMTTDT.” Use the aging
date as of 4/30/2003 and “NEWBAL” as the subtotal field. (Filter and Age)
f. To better decide the customers to select for confirmation you decide to stratify
customer balances into two intervals after excluding all balances less than $5,000. How
many balances are greater than $5,000? Print the output. (Filter and Stratify)
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INTERNET PROBLEM 16-1: REVENUE RECOGNITION
In recent years, several high-profile incidents of improper revenue recognition attracted
the attention of the business media. The SEC has also expressed concerns about the
number of instances of improper revenue recognition identified by SEC staff. One revenue
issue involves “bill and hold” sales. In a bill and hold transaction, a customer agrees to
purchase the goods, but the seller retains physical possession until the customer requests
shipment to designated locations. Normally, such an arrangement does not qualify as a sale
because delivery has not occurred. Under certain conditions, however, when a buyer has
made a firm purchase commitment and has assumed the risks and rewards of the
purchased product, but is unable to accept delivery because of a compelling business
reason, bill and hold sales may qualify for revenue recognition. Read the SEC guidance on
revenue recognition (www.sec.gov/interps/account/sabcodet13.htm) to answer the following
questions:
Required a. What does the SEC indicate are the four basic criteria for determining whether
revenue is realized or realizable?
b. A customer of your audit client, Henson LLC, made a formal written request to
establish a bill and hold arrangement in November 2011, an arrangement which is
typical in the industry. The customer’s written request outlines a delivery schedule
that will begin in February 2012. As of November 2011, the product to be shipped in
February is already complete and ready for shipment. Because the sale was completed
in 2011, your audit client would like to record the bill and hold the transaction
described as a sale in 2011. You do not recall noticing any inventory held in a separate |
area of the client’s warehouse during the December 31, 2011 inventory observation. In
making your determination regarding the timing of the revenue recognition, what
criteria has the SEC determined to be important?
556 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
17
C H A P T E R
AUDIT SAMPLING
FOR TESTS OF
LEARNING OBJECTIVES
DETAILS OF BALANCES
After studying this chapter,
you should be able to
17-1 Differentiate audit sampling for
Both Statistical And Nonstatistical Sampling tests of details of balances and
for tests of controls and
Are Acceptable Under Auditing Standards,
substantive tests of transactions.
But Whichever Is Used, It Must Be Done Right
17-2 Apply nonstatistical sampling to
tests of details of balances.
Bob Lake was the manager on the audit of Images, Inc., a specialty retailer
that had shops throughout the Midwest. Images appealed to upscale work- 17-3 Apply monetary unit sampling.
ing women and offered its own credit card. Images’ accounting was done 17-4 Describe variables sampling.
centrally. Transactions were captured online and sales and accounts receiv- 17-5 Use difference estimation in tests
able files were maintained on a database. of details of balances.
Bob Lake’s firm encouraged the use of statistical sampling in its practice and
provided a traini ng program for the development of a statistical coordinator
for each office. The coordinator in Bob’s office was Barbara Ennis. Bob believed that sales transactions and accounts
receivable confirmation tests should be done using statistical sampling and asked Barbara to help design and oversee
the statistical aspects of this testing.
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Barbara developed a program for the design of confirmation audit procedures as part of doing tests of details of bal-
ances for accounts receivable. Her work included determining sample sizes. She left the program with Bob to carry out
and said that she would be available to help evaluate the results after the tests were performed.
When all the confirmation replies were received or alternative procedures were completed several weeks later, Bob
called Barbara to do the statistical evaluation. Much to his dismay, he found out that Barbara had left the firm, and
worse, there was no statistically trained person to take her place. Bob was under a lot of pressure to get the job com-
pleted and decided to make the statistical calculations himself. Based on his calculations, he concluded that the poten-
tial misstatement was large, but not material, so Bob concluded the objectives of the confirmation tests had been met.
The next year Images, Inc.’s earnings declined sharply, partially because of large write-offs of accounts receivable. The
stock price dropped sharply and a class action suit was filed, naming Bob’s firm among the defendants. An outside
expert was brought in to review the audit docum entation. The expert redid all of Bob’s work and found errors in the sta-
tistical calculations. The expert calculated that the misstatement in accounts receivable, based on the auditor’s sample,
was significantly more than a material amount. Bob’s firm settled the suit for $3.5 million.
In Chapter 16, we moved into phase III of the audit process by examining analytical procedures and tests of details
of balances for accounts receivable. We will now continue with phase III by determining sample size and items to
select from the population for the audit of accounts receivable. Although the concepts in this chapter deal with
accounts receivable, they apply to the audit of many other account balances.
As the story about the audit of Images, Inc. demonstrates, auditors must correctly use sampling to avoid making
incorrect conclusions about a population. While both statistical and nonstatistical audit sampling methods are used
extensively for tests of details of balances, auditors must decide which method to use, depending on their
preference, experience, and knowledge about statistical sampling. This chapter should help you make correct
inferences about populations using either statistical or nonstatistical methods. |
Before starting the study of this chapter, we suggest you refer to Figure 13-9 on page 425 to be sure you
understand where we are in the audit process. At this stage, all items in phases I and II will have been completed
before auditors determine sample size and items to select from the population. Also, the auditor will have
completed substantive analytical procedures and designed audit procedures for tests of details of balances, as
covered in Chapter 16 (part of phase III). The auditor cannot perform the audit procedures for tests of details of
balances until first deciding sample size and items to select from the population.
COMPARISONS OF AUDIT SAMPLING FOR TESTS OF
DETAILS OF BALANCES AND FOR TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS
OBJECTIVE 17-1 Most of the sampling concepts for tests of controls and substantive tests of trans -
actions, which were discussed in Chapter 15, apply equally to sampling for tests of
Differentiate audit sampling
details of balances. In both cases, an auditor wants to make inferences about the entire
for tests of details of balances
population based on a sample. Both sampling and nonsampling risks are therefore
and for tests of controls and
substantive tests of important for tests of controls, substantive tests of transactions, and tests of details of
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transactions. balances. To address sampling risk, auditors can use either nonstatistical or statistical
methods for all three types of tests.
The main differences among tests of controls, substantive tests of transactions, and
tests of details of balances are in what the auditor wants to measure.
Type of Test What it Measures
Tests of controls •The operating effectiveness of internal controls
Substantive tests of transactions •The operating effectiveness of internal controls
•The monetary correctness of transactions in the accounting
system
Tests of details of balances •Whether the dollar amounts of account balances are
materially misstated
Auditors perform tests of controls and substantive tests of transactions:
• To determine whether the exception rate in the population is sufficiently low
• To reduce assessed control risk and thereby reduce tests of details of balances
• For larger public companies, to conclude that the control is operating effectively
for purposes of auditing internal control over financial reporting
Unlike for tests of controls and substantive tests of transactions, auditors rarely use
rate of occurrence tests in tests of details of balances. Instead, auditors use sampling
methods that provide results in dollar terms. There are three primary types of
sampling methods used for calculating dollar misstatements in account balances
addressed in this chapter: nonstatistical sampling, monetary unit sampling, and variables
sampling.
558 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
NONSTATISTICAL SAMPLING
There are 14 steps required in audit sampling for tests of details of balances. These steps OBJECTIVE 17-2
parallel the 14 steps used for sampling for tests of controls and substantive tests of
Apply nonstatistical sampling
trans actions, although the objectives differ. As an auditor, you need to understand how
to tests of details of balances.
audit sampling for tests of details of balances both resembles and differs from audit
sampling for tests of controls and substantive tests of transactions. The primary
differences in applying audit sampling for tests of details of balances are indicated in
italics.
Steps—Audit Sampling for Tests of
Steps—Audit Sampling for Tests of Controls and Substantive Tests of
Details of Balances Transactions (see p. 486)
Plan the Sample Plan the Sample
1. State the objectives of the audit test. 1. State the objectives of the audit test.
2. Decide whether audit sampling 2. Decide whether audit sampling
applies. applies.
3. Define a misstatement. 3. Define attributes and exception
conditions.
4. Define the population. 4. Define the population.
5. Define the sampling unit. 5. Define the sampling unit.
6. Specify tolerable misstatement. 6. Specify the tolerable exception rate. |
7. Specify acceptable risk of incorrect 7. Specify acceptable risk of assessing
acceptance. control risk too low.
8. Estimate misstatements in the 8. Estimate the population exception
population. rate.
9. Determine the initial sample size. 9. Determine the initial sample size.
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Select the Sample and Select the Sample and
Perform the Audit Procedures Perform the Audit Procedures
10. Select the sample. 10. Select the sample.
11. Perform the audit procedures. 11. Perform the audit procedures.
Evaluate the Results Evaluate the Results
12. Generalize from the sample to 12. Generalize from the sample to the
the population. population.
13. Analyze the misstatements. 13. Analyze the exceptions.
14. Decide the acceptability of the 14. Decide the acceptability of the
population. population.
Auditors sample for tests of details of balances to determine whether the account balance State the Objectives
being audited is fairly stated. The population of 40 accounts receivable in Table 17-1 of the Audit Test
(p. 560), totaling $207,295, illustrates the application of nonstatistical sampling. An
auditor will do tests of details of balances to determine whether the balance of $207,295
is materially misstated. Typically, tolerable misstatement defines a material misstatement.
As stated in Chapter 15, “Audit sampling applies whenever the auditor plans to reach Decide Whether
conclusions about a population based on a sample.” Although auditors commonly Audit Sampling Applies
sample in many accounts, in some situations sampling does not apply. For the
population in Table 17-1, the auditor may decide to audit only items over $5,000 and
ignore all others because the total of the smaller items is immaterial. Similarly, if the
auditor is verifying fixed asset additions and finds many small additions and one
extremely large purchase of a building, the auditor may decide to ignore the small
items entirely. In either case, the auditor has not sampled.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 559
TABLE 17-1 Illustrative Accounts Receivable Population
Population Item Recorded Amount
Population Item Recorded Amount (cont.) (cont.)
1 $ 1,410 21 $ 4,865
2 9,130 22 770
3 660 23 2,305
4 3,355 24 2,665
5 5,725 25 1,000
6 8,210 26 6,225
7 580 27 3,675
8 44,110 28 6,250
9 825 29 1,890
10 1,155 30 27,705
11 2,270 31 935
12 50 32 5,595
13 5,785 33 930
14 940 34 4,045
15 1,820 35 9,480
16 3,380 36 360
17 530 37 1,145
18 955 38 6,400
19 4,490 39 100
20 17,140 40 ___8__,4_3_5_
$ 207,295
Define a Misstatement BecauAse pauaditg saom plPingD foFr tesEts nofh daetanilsc ofe bralances measures monetary misstate -
ments, a misstatement exists whenever a sample item is misstated. In auditing accounts
receivable, any client misstatement in a customer balance included in the auditor’s
sample is a misstatement.
Define the Population In tests of details of balances, the population is defined as the items making up the
recorded dollar population. The recorded population of accounts receivable in Table
17-1 consists of 40 accounts totaling $207,295. Most accounting populations that
auditors sample will, of course, include far more items totaling a much larger dollar
amount. The auditor will evaluate whether the recorded population is overstated or
understated.
Stratified Sampling For many populations, auditors separate the population into
two or more subpopulations before applying audit sampling. This is called stratified
sampling, where each subpopulation is a called a stratum. Stratification enables the
auditor to emphasize certain population items and deemphasize others. In most audit
sampling situations, including confirming accounts receivable, auditors want to
emphasize the larger recorded dollar values, so they define each stratum on the basis of
the size of recorded dollar values.
By examining the population in Table 17-1, you can see that there are different
ways to stratify the population. Assume that the auditor decided to stratify as follows:
No. in Dollars in
Stratum Stratum Criteria Population Population
1 >$15,000 3 $ 88,955 |
2 $5,000–$15,000 10 71,235
3 <$5,000 _2_7_ ___4_7_,1_0_5_
40 $207,295
560 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
There are many alternative ways to stratify this population. One example is to have
four strata (make stratum 3 items between $2,000 and $5,000, and add a fourth
stratum for items less than $2,000).
For nonstatistical audit sampling in tests of details of balances, the sampling unit is Define the
almost always the items making up the account balance. For example, for the accounts Sampling Unit
receivable in Table 17-1 the sampling unit will be the customer number. Auditors can
use the items making up the recorded population as the sampling unit for testing all
audit objectives except completeness. If auditors are concerned about the completeness
objective they should select the sample from a different source, such as customers or
vendors with zero balances. Accordingly, the sampling unit for a completeness test will
be customers with zero balances.
Auditors use tolerable misstatement, as discussed in Chapter 9, for determining sample Specify Tolerable
size and evaluating results in nonstatistical sampling. The auditor starts with a Misstatement
preliminary judgment about materiality and uses that total in deciding tolerable
misstatement for each account. The required sample size increases as the auditor’s
tolerable misstatement decreases for the account balance or class of transactions.
For all statistical and nonstatistical sampling applications, auditors risk making Specify
incorrect quantitative conclusions about the population. This is always true unless the Acceptable Risk of
auditor tests 100 percent of the population. Incorrect Acceptance
Acceptable risk of incorrect acceptance (ARIA)is the amount of risk an auditor is
willing to take of accepting a balance as correct when the true misstatement in the
balance exceeds tolerable misstatement. ARIA measures the auditor’s desired assurance
for an account balance. For greater assurance in auditing a balance, auditors will set
ARIA lower. (Note that ARIA is the equivalent term to ARACR (acceptable risk of
assessing control risk too low) for tests of controls and substantive tests of trans -
actions.) Like for ARACR, ARIA caAn pbea segt oqu anPtitDatiFve ly E(sunchh aas 5n%c oer 1r0%), or
qualitatively (such as low, medium or high).
There is an inverse relationship between ARIA and required sample size. If, for
example, an auditor decides to reduce ARIA from 10 percent to 5 percent, the required
sample size will increase. Stated differently, if the auditor is less willing to take risk, a
larger sample size is needed.
An important factor affecting the auditor’s decision about ARIA is assessed control
risk in the audit risk model. When internal controls are effective, control risk can be
reduced, permitting the auditor to increase ARIA. This, in turn, reduces the sample size
required for the test of details of the related account balance.
You need to understand how ARACR and ARIA interact to affect evidence
accumulation. You already know from earlier chapters that tests of details of balances
for monetary misstatements can be reduced if auditors find internal controls effective
after assessing control risk and performing tests of controls. The effects of ARACR and
ARIA are consistent with that conclusion. If the auditor concludes that internal
controls are likely to be effective, preliminary control risk can be reduced. A lower
control risk requires a lower ARACR in testing the controls, which requires a larger
sample size. If controls are found to be effective, control risk can remain low, which
permits the auditor to increase ARIA (through use of the audit risk model), thereby
requiring a smaller sample size in the related substantive tests of details of balances.
Figure 17-1 (p. 562) shows the effect of ARACR and ARIA on substantive testing when
controls are not considered effective and when they are considered effective.
In addition to control risk, ARIA is directly affected by acceptable audit risk and |
inversely affected by other substantive tests already performed (or planned) for the
account balance. If auditors reduce acceptable audit risk, they should also reduce
ARIA. If analytical procedures indicate that the account balance is likely to be fairly
stated, ARIA can be increased. In other words, analytical procedures are evidence
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 561
FIGURE 17-1 Effect of ARACR and ARIA on Substantive Testing
Controls Not Controls
Considered Effective Considered Effective
Control risk (cid:3) 100% Reduce
control risk
ARACR (cid:3) 100% Reduce ARACR
Perform no Perform
tests of controls tests of controls
Use low ARIA Use high ARIA*
Perform extensive Perform limited
substantive testing substantive testing
*Assumes tests of controls results were satisfactory, which permits control risk
to remain low.
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supporting the account balance, meaning auditors require smaller sample sizes in tests
of details of balances to achieve the desired acceptable audit risk. The same conclusion
is appropriate for the relationship among substantive tests of transactions, ARIA, and
sample size for tests of details of balances. The various relationships affecting ARIA are
summarized in Table 17-2.
Estimate The auditor typically makes this estimate based on prior experience with the client and
Misstatements by assessing inherent risk, considering the results of tests of controls, substantive tests
in the Population of transactions, and analytical procedures already performed. The planned sample size
increases as the amount of misstatements expected in the population approaches
tolerable misstatement.
TABLE 17-2 Relationship Among Factors Affecting ARIA, Effect on ARIA, and Required Sample Size for
Audit Sampling
Effect on
Factor Affecting ARIA Example Effect on ARIA Sample Size
Effectiveness of internal controls Internal controls are effective (reduced control risk). Increase Decrease
(control risk)
Substantive tests of transactions No exceptions were found in substantive tests of Increase Decrease
transactions.
Acceptable audit risk Likelihood of bankruptcy is low (increased Increase Decrease
acceptable audit risk).
Analytical procedures Analytical procedures are performed with no Increase Decrease
indications of likely misstatements.
562 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
When using nonstatistical sampling, auditors determine the initial sample size by Determine the
considering the factors we’ve discussed so far. Table 17-3 summarizes these factors, Initial Sample Size
including the effect of changing each factor on sample size. It shouldn’t be surprising that
considering all of these factors requires considerable judgment. To help auditors make
the sample size decision, they often follow guidelines provided by their firm or some
other source. Figure 17-2 (p. 564) presents a grid for combining these factors and a
formula for computing sample size based on the AICPA Audit Sampling Auditing Guide.
Assume an auditor applied this formula to the population in Table 17-1 (p. 560) and
that tolerable misstatement is $15,000. The auditor decided to eliminate from the
recorded population the three items making up the first stratum because they exceed
tolerable misstatement. These three individually material accounts will be tested
separately. The remaining population to be sampled is $118,340, which is the combined
amount of stratum 2 and 3. Further, assume that the combined assessed inherent and
control risk is moderate and that there is a moderate risk that substantive tests of
transactions and substantive analytical procedures will not detect a material
misstatement. Based on the grid, the required assurance factor is 1.6, and the computed
sample size will be 13 [($118,340/$15,000) x1.6 = 12.6].
When auditors use stratified sampling, they must allocate sample size among the
strata, typically allocating a higher portion of the sample items to larger population
items. In the example from Table 17-1, the auditor must test all items in stratum 1, |
which is not audit sampling. They decided to allocate the sample size of 13 to seven
from stratum 2 and six from stratum 3.
For nonstatistical sampling, auditing standards permit the auditor to use any of the Select the Sample
selection methods discussed in Chapter 15. The auditor will make the decision after
considering the advantages and disadvantages of each method, including cost con -
siderations.
For stratified sampling, the auditor selects samples independently from each
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stratum. In our example from Table 17-1, the auditor will select seven sample items
from the 10 population items in stratum 2 and six of the 27 items in stratum 3.
TABLE 17-3 Factors Influencing Sample Sizes for Tests of Details of Balances
Conditions Leading to Conditions Leading to
Factor Smaller Sample Size Larger Sample Size
Control risk (ARACR)—Affects acceptable risk Low control risk High control risk
of incorrect acceptance
Results of other substantive procedures related to the Satisfactory results in other related Unsatisfactory results in other
same assertion(including analytical procedures substantive procedures related substantive procedures
and other relevant substantive tests)—Affect
acceptable risk of incorrect acceptance
Acceptable audit risk—Affects acceptable risk of High acceptable audit risk Low acceptable audit risk
incorrect acceptance
Tolerable misstatement for a specific account Larger tolerable misstatement Smaller tolerable misstatement
Inherent risk—Affects estimated misstatements Low inherent risk High inherent risk
in the population
Expected size and frequency of misstatements— Smaller misstatements or lower Larger misstatements or higher
Affect estimated misstatements in the population frequency frequency
Dollar amount of population Smaller account balance Larger account balance
Number of items in the population Almost no effect on sample size Almost no effect on sample size
unless population is very small unless population is very small
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 563
FIGURE 17-2 Formula for Computing Nonstatistical Tests of Details of Balances
Sample Size Based on AICPA Audit Sampling Formula
Population’s recorded amount*
(cid:5) Assurance factor (cid:2) Sample size
Tolerable misstatement
Select the appropriate assurance factor as follows:
Risk That Other Substantive Procedures
Assessed Will Fail to Detect a Material Misstatement
Inherent and Slightly Below
Control Risk Maximum Maximum Moderate Low
Maximum 3.0 2.7 2.3 2.0
Slightly below maximum 2.7 2.4 2.0 1.6
Moderate 2.3 2.1 1.6 1.2
Low 2.0 1.6 1.2 1.0
*Individual items exceeding tolerable misstatement are tested individually and subtractedfrom
the population for this calculation.
Perform the To perform the audit procedures, the auditor applies the appropriate audit procedures
Audit Procedures to each item in the sample to determine whether it contains a misstatement. In the
confirmation of accounts receivable, auditors send the sample of positive confirma -
tions in the manner described in Chapter 16 and determine the amount of misstatement
in each account confirmed. For nonresponses, they use alternative procedures to deter -
mine the misstatements.
Referring to our example from Table 17-1 on page 560 again, assume an auditor
sends first and second requests for confirmations and performs alternative procedures.
Also assume the auditor reaches the following conclusions about the sample after
reconcAilipnga algl tiomi ngP dDiffeFre ncEes:nhancer
Dollars Audited
Stratum Sample Size Recorded Value Audited Value Client Misstatement
1 3 $ 88,955 $ 91,695 $ (2,740)
2 7 43,995 43,024 971
3 _6_ __1__3_,_1_0_5_ __1__0_,_9_4_7_ __2__,1_5__8_
Total 16 $146,055 $145,666 $ 389
Generalize from The auditor must generalize from the sample to the population by (1) projecting mis -
the Sample to the statements from the sample results to the population and (2) considering sampling
Population and Decide error and sampling risk (ARIA). In our example, will the auditor conclude that
the Acceptability of accounts receivable is overstated by $389? No, the auditor is interested in the population |
the Population results, not those of the sample. It is therefore necessary to project from the sample to
the population to estimate the population misstatement.
The first step is to calculate a point estimate. The point estimate can be calculated
in different ways, but a common approach is to assume that misstatements in the
unaudited population are proportional to the misstatements in the sample. That
calculation must be done for each stratum and then totaled, rather than combining the
total misstatements in the sample. In our example, the point estimate of the misstate -
ment is calculated by using a weighted-average method, as shown below.
Client Misstatement Recorded
÷ Recorded Value Book Value Point Estimate
Stratum of the Sample x for the Stratum = of Misstatement
1 $(2,740)/$88,955 $88,955 $(2,740)
2 $ 971 /$43,995 71,235 1,572
3 $ 2,158 /$13,105 47,105 __7_,7__5_7_
Total $ 6,589
564 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
The point estimate of the misstatement in the population is $6,589, indicating an
overstatement. The point estimate, by itself, is not an adequate measure of the popu -
lation misstatement, however, because of sampling error. In other words, because the
estimate is based on a sample, it will be close to the true population misstatement, but
it is unlikely to be exactly the same. Whenever the point estimate ($6,589 in the
example) is less than tolerable misstatement ($15,000 in the example), the auditor
must consider the possibility that the true population misstatement is greater than the
amount of misstatement that is tolerable in the circumstances. This must be done for
both statistical and nonstatistical samples.
An auditor using nonstatistical sampling cannot formally measure sampling error
and therefore must subjectively consider the possibility that the true population
misstatement exceeds a tolerable amount. Auditors do this by considering:
1. The difference between the point estimate and tolerable misstatement (this is
called calculated sampling error)
2. The extent to which items in the population have been audited 100 percent
3. Whether misstatements tend to be offsetting or in only one direction
4. The amounts of individual misstatements
5. The sample size
In our example, suppose that tolerable misstatement is $40,000. In that case, the
auditor may conclude it is unlikely, given the point estimate of $6,589, that the true
population misstatement exceeds the tolerable amount (calculated sampling error is
$33,411).
Suppose that tolerable misstatement is $15,000 (as it was in the example), only
$8,411 greater than the point estimate. In that case, the auditor will consider other
factors. If the larger items in the population were audited 100 percent (as was done
here), any unidentified misstatements will be restricted to smaller items. If the
misstatements tend to be offsettingA apnda arge orel atiPveDly Fsm alEl inn shizea, tnhec auedirtor may
conclude that the true population misstatement is likely to be less than the tolerable
amount. Also, the larger the sample size, the more confident the auditor can be that the
point estimate is close to the true population value. In this example, when sample size
is considered large, auditors will be more willing to accept that the true population
misstatement is less than tolerable misstatement. However, if one or more of these
other conditions differs, auditors may judge the chance of a misstatement in excess of
the tolerable amount to be high and the recorded population unacceptable.
Even if the amount of likely misstatement is not considered material, the auditor
must wait to make a final evaluation until the entire audit is completed. The estimated
total misstatement and estimated sampling error in accounts receivable must be
combined with estimates of misstatements in all other parts of the audit to evaluate the
effect of all misstatements on the financial statements as a whole.
It is essential for auditors to evaluate the nature and cause of each misstatement found Analyze the |
in tests of details of balances. For example, suppose that when the auditor confirmed Misstatements
accounts receivable, all misstatements resulted from the client’s failure to record
returned goods. The auditor will determine why that type of misstatement occurred so
often, the implications of the misstatements on other audit areas, the potential impact
on the financial statements, and its effect on company operations. The same approach
is followed for all misstatements.
The auditor must do misstatement analysis to decide whether any modification of
the audit risk model is needed. In the preceding paragraph, if the auditor concluded
that the failure to record the returns resulted from a breakdown of internal controls, it
might be necessary to reassess control risk. That in turn will probably cause the auditor
to reduce ARIA, which will increase planned sample size. As we discussed in Chapter 9,
revisions of the audit risk model must be done with extreme care because the model is
intended primarily for planning, not evaluating results.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 565
Action When a When the auditor concludes that the misstatement in a population may be larger than
Population Is Rejected tolerable misstatement after considering sampling error, the population is not
considered acceptable. At that point, an auditor has several possible courses of action.
Take No Action Until Tests of Other Audit Areas Are Completed Ultimately,
the auditor must evaluate whether the financial statements taken as a whole are
materially misstated.If offsetting misstatements are found in other parts of the audit,
such as in inventory, the auditor may conclude that the estimated misstatements in
accounts receivable are acceptable. Of course, before the audit is finalized, the auditor
must evaluate whether a misstatement in one account may make the financial
statements misleading even if there are offsetting misstatements.
Perform Expanded Audit Tests in Specific Areas If an analysis of the misstate -
ments indicates that most of the misstatements are of a specific type, it may be desirable
to restrict the additional audit effort to the problem area. For example, if an analysis of
the misstatements in confirmations indicates that most of the misstatements result from
failure to record sales returns, the auditor can make an extended search of returned
goods to make sure that they have been recorded. However, care must be taken to evaluate
the cause of all misstatements in the sample before a conclusion is reached about the
proper emphasis in the expanded tests. Problems may exist in more than one area.
When auditors analyze a problem area and correct it by proposing an adjustment
to the client’s records, the sample items that led to isolating the problem area can then
be shown as “correct.” The point estimate can now be recalculated without the
misstatements that have been “corrected.” (This is only true when the error can be
isolated to a specific area. Errors must generally be projected to the population being
sampled, even if the client adjusts for the error.) With the new facts in hand, the auditor
will also have to reconsider sampling error and the acceptability of the population.
Increase the Sample Size When the auditor increases the sample size, sampling error
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is reduced if the rate of misstatements in the expanded sample, their dollar amounts,
PARTNER Anicom was a national distributor of wire and $14,354,505 out of $98,182,737 in accounts
cable products. Anicom officers and employees receivable. The audit team could not confirm
CHARGED WITH
engaged in improper earnings management $1,152,965 of the $14,354,505 tested, resulting in
FAILURE TO techniques that inflated Anicom’s revenues by an error rate of 8%. Projecting this error rate over
over $38 million and net income by over $20 the entire accounts receivable population indicates
ADEQUATELY
Action When million from the first quarter of 1998 through the a potential misstatement of $7,854,619, which |
PROJECT AND first quarter of 2000, including extensive improper was material to Anicom’s financial statements.
a Population
revenue recognition. Anicom recogn ized over 66 However, the audit partner did not expand the
Is RejectedEVALUATE
fictitious sales transactions to at least 38 different confirmation procedures or subject the potentially
SAMPLE ERRORS customers. Most of the fictitious sales transactions misstated accounts receivable balances to further
were created just prior to quarter-end, when it testing. Further, the audit firm performed alterna -
was clear that Anicom would not meet its revenue tive procedures for 17 of the 20 balances for which
goals. These end-of-the-quarter sales transa ctions confirmation responses were not received. The
were either entirely fictitious or potential orders auditors tested only $2,746,487, or 28% of the
disguised as sales. $9,817,038 in subsequent cash payments pur-
The partner on the engagement assessed portedly made by customers toward their balances.
Anicom as high-risk because of cash-flow Anicom was delisted by Nasdaq in 2000 and
problems, potential violations of debt covenants, filed for bankruptcy in January 2001. The engage -
and allega tions of improper billing practices. ment audit partner was charged with improper
Despite being aware of these red flags, the professional conduct and violations of the
partner did not design audit proc edures to test Securities Exchange Act of 1934 and prohibited
Anicom’s accounts receivable more extensively from practicing before the SEC.
than originally planned.
The audit firm’s testing of Anicom’s accounts Source: Adapted from Securities and Exchange
receivable included confirming the existence and Commission Accounting and Auditing Enforcement
accuracy of 20 customer balances totaling Release No. 20678, August 11, 2004 (www.sec.gov).
566 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
and their direction are similar to those in the original sample. Therefore, increasing the
sample size may satisfy the auditor’s tolerable misstatement requirements.
Increasing the sample size enough to satisfy the auditor’s tolerable misstatement
standards is often costly, especially when the difference between tolerable misstatement
and projected misstatement is small. Moreover, an increased sample size does not
guarantee a satisfactory result. If the number, amount, and direction of the misstate-
ments in the extended sample are proportionately greater or more variable than in the
original sample, the results are still likely to be unacceptable.
For tests such as accounts receivable confirmation and inventory observation, it is
often difficult to increase the sample size because of the practical problem of “reopening”
those procedures once the initial work is done. By the time the auditor discovers that the
sample was not large enough, several weeks have usually passed.
Despite these difficulties, sometimes the auditor must increase the sample size after
the original testing is completed. It is much more common to increase sample size in
audit areas other than confirmations and inventory observation, but it is occasionally
necessary to do so even for these two areas. When stratified sampling is used, increased
samples usually focus on the strata containing larger amounts, unless misstatements
appear to be concentrated in some other strata.
Adjust the Account Balance When the auditor concludes that an account balance is
materially misstated, the client may be willing to adjust the book value based on the
sample results. In the preceding example, assume the client is willing to reduce book
value by the amount of the point estimate ($6,589) to adjust for the estimate of the mis-
statement. The auditor’s estimate of the misstatement is now zero, but it is still
necessary to consider sampling error. Again, assuming a tolerable misstatement of
$15,000, the auditor must now assess whether sampling error exceeds $15,000, not the
$8,411 originally considered. If the auditor believes sampling error is $15,000 or less, |
accounts receivable is acceptable after the adjustment. If the auditor believes it is more
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than $15,000, adjusting the account balance is not a practical option.
Request the Client to Correct the Population In some cases, the client’s records are
so inadequate that a correction of the entire population is required before the audit can
be completed. For example, in accounts receivable, the client may be asked to correct the
accounts receivable records and prepare the accounts receivable listing again if the
auditor concludes that it has significant misstatements. When the client changes the
valuation of some items in the population, the results must be audited again.
Refuse to Give an Unqualified Opinion If the auditor believes that the recorded
amount in an account is not fairly stated, it is necessary to follow at least one of the
preceding alternatives or to qualify the audit report in an appropriate manner. If the auditor
believes that there is a reasonable chance that the financial statements are materially mis -
stated, it would be a serious breach of auditing standards to issue an unqualified opinion. For
purposes of reporting on internal control, the material misstatement should be considered
a potential indicator of a material weakness in internal control over financial reporting.
MONETARY UNIT SAMPLING
Now that we have discussed nonstatistical sampling, we will move on to statistical OBJECTIVE 17-3
sampling, starting with monetary unit sampling, which is a statistical sampling
Apply monetary unit
methodology developed specifically for use by auditors. Monetary unit sampling
sampling.
(MUS)is the most commonly used statistical method of sampling for tests of details of
balances because it has the statistical simplicity of attributes sampling yet provides a
statistical result expressed in dollars (or another appropriate currency). MUS is also
called dollar unit sampling, cumulative monetary amount sampling, and sampling
with probability proportional to size.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 567
Differences MUS is similar to using nonstatistical sampling. All 14 of the steps must also be
Between MUS performed for MUS, although some are done differently. Understanding those
and Nonstatistical differences is the key to understanding MUS. Let’s examine these differences in detail.
Sampling The Definition of the Sampling Unit Is an Individual Dollar A critical feature
of MUS is the definition of the sampling unit as an individual dollar in an account
balance. The name of the statistical method, monetary unit sampling, results from this
distinctive feature. For example, in the population in Table 17-1 (p. 560), the sampling
unit is 1 dollar and the population size is 207,295 dollars, not the 40 physical units
discussed earlier. (A physical unit is an accounts receivable customer balance, an
inventory item in an inventory listing, and other such identifiable units in a listing.)
By focusing on the individual dollar as the sampling unit, MUS automatically
emphasizes physical units with larger recorded balances. Because the sample is selected
on the basis of individual dollars, an account with a large balance has a greater chance
of being included than an account with a small balance. For example, in accounts
receivable confirmation, an account with a $5,000 balance has a 10 times greater
probability of selection than one with a $500 balance, as it contains 10 times as many
dollar units. As a result, stratified sampling is unnecessary with MUS. Stratification
occurs automatically.
The Population Size Is the Recorded Dollar Population For example, the popu -
lation of accounts receivable in Table 17-1 consists of 207,295 dollars, which is the
population size, not the 40 accounts receivable balances. This is the recorded dollar
amount of accounts receivable.
Because of the method of sample selection in MUS, which is discussed later, it is
not possible to evaluate the likelihood of unrecorded items in the population. Assume,
for example, that MUS is used to evaluate whether inventory is fairly stated. MUS |
cannot be used to evaluate whether certain inventory items exist but have not been
counteAd.p Ifa thge coom pPletDenFess oEbjencthivea isn imcpeortrant in the audit test, and it usually is,
that objective must be satisfied separately from the MUS tests.
Preliminary Judgment of Materiality Is Used for Each Account Instead of
Tolerable Misstatement Another unique aspect of MUS is the use of the pre -
liminary judgment about materiality, as discussed in Chapter 9, to directly determine
the tolerable misstatement amount for the audit of each account. Other sampling
techniques require the auditor to determine tolerable misstatement for each account by
allocating the preliminary judgment about materiality. This is not required when MUS
is used. For example, assume that an auditor decides that the preliminary judgment
about materiality should be $60,000 for the financial statements as a whole. That
materiality amount of $60,000 will be used as tolerable misstatement in all applications
of MUS—inventory, accounts receivable, accounts payable, and so forth.
Sample Size Is Determined Using a Statistical Formula This process is examined
in detail after we have discussed the 14 sampling steps for MUS.
A Formal Decision Rule Is Used for Deciding the Acceptability of the Popula -
tion The decision rule used for MUS is similar to that used for nonstatistical sampling,
but it is sufficiently different to merit discussion. The decision rule is illus trated on
page 576 after the calculation of the misstatement bounds is shown.
Sample Selection Is Done Using PPS Monetary unit samples are samples selected
with probability proportional to size sample selection (PPS). PPS samples can be
obtained by using computer software, random number tables, or systematic sampling
techniques. Table 17-4 provides an illustration of an accounts receivable population,
including cumulative totals that will be used to demonstrate selecting a sample.
Assume that the auditor wants to select a PPS sample of four accounts from the
population in Table 17-4. Because the sampling unit is defined as an individual dollar,
the population size is 7,376, and four random numbers are needed. Assume that the
568 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
auditor uses a computer program to generate the following random numbers from
between 1 and 7,376: 6,586, 1,756, 850, and 6,499.
Auditors have no way to audit these dollars directly so they must associate the
individual dollars with physical units, in this case customer balances. The population
physical unit items that contain these random dollars are determined by reference to the
cumulative total column. Looking again at Table 17-4, they are items 11 (containing
dollars 6,577 through 6,980), 4 (dollars 1,699 through 2,271), 2 (dollars 358 through
1,638), and 10 (dollars 5,751 through 6,576). These four accounts will be audited
because the cumulative total associated with these accounts includes the random dollars
selected, and the result for each physical unit will be used to make statistical inferences.
The statistical methods used to evaluate monetary unit samples permit the
inclusion of a physical unit in the sample more than once. In the previous example, if
the random numbers had been 6,586, 1,756, 850, and 6,599, the sample items would
have been 11, 4, 2, and 11. Item 11 would be audited once but treated as two sample
items statistically, and the sample total would be four items because four monetary units
were involved. If audit tests determine that item 11 included an error, it would count as
two errors in the statistical evaluation.
One problem using PPS selection is that population items with a zero recorded
balance have no chance of being selected with PPS sample selection, even though they
may be misstated. Similarly, small balances that are significantly understated have little
chance of being included in the sample. This problem can be overcome by doing specific
audit tests for zero- and small-balance items, assuming that they are of concern. |
Another problem with PPS is its inability to include negative balances, such as credit
balances in accounts receivable, in the PPS (monetary unit) sample. It is possible to
ignore negative balances for PPS selection and test those amounts by some other means.
An alternative is to treat them as positive balances and add them to the total number of
monetary units being tested. However, this complicates the evaluation process.
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The Auditor Generalizes from the Sample to the Population Using MUS
Techniques Regardless of the sampling method selected, the auditor must generalize
from the sample to the population by (1) projecting misstatements from the sample
results to the population and (2) determining the related sampling error. There are
four aspects in doing so using MUS:
1. Attributes sampling tables are used to calculate the results. Tables, such as the
one on page 505, can be used, replacing ARACR with ARIA.
2. The attributes results must be converted to dollars. MUS estimates the dollar
misstatement in the population, not the percent of items in the population that
TABLE 17-4 Accounts Receivable Population
Population Item Cumulative Total
(Physical Unit) Recorded Amount (Dollar Unit)
1 $ 357 $ 357
2 1,281 1,638
3 60 1,698
4 573 2,271
5 691 2,962
6 143 3,105
7 1,425 4,530
8 278 4,808
9 942 5,750
10 826 6,576
11 404 6,980
12 396 7,376
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 569
are misstated. Therefore, auditors can estimate the rate of population dollars
that contain a misstatement as a way of estimating the total dollar misstatement.
3. The auditor must make an assumption about the percentage of misstatement
for each population item that is misstated. This assumption enables the auditor
to use the attributes sampling tables to estimate dollar misstatements.
4. The statistical results when MUS is used are called misstatement bounds.
These misstatement bounds are estimates of the likely maximum overstate -
ment (upper misstatement bound) and likely maximum understatement
(lower misstatement bound) at a given ARIA. Auditors calculate both an upper
misstatement bound and a lower misstatement bound.
This final step, generalizing from the sample to the population, is essential. General -
ization is different when the auditor finds no misstatements in the sample compared to when
there are misstatements. We will examine generalizing under these two situations next.
Generalizing from Suppose that the auditor is confirming a population of accounts receivable for monetary
the Sample to the correctness. The population totals $1,200,000, and a sample of 100 confirmations is
Population When obtained. Upon audit, no misstatements are uncovered in the sample. The auditor wants
No Misstatements to determine the maximum amount of overstatement and understatement amounts that
Are Found Using MUS could exist in the population even when the sample contains no misstatements. These are
called the upper misstatement bound and the lower misstatement bound, respectively.
Assuming an ARIA of 5 percent, and using the attributes sampling table on page 505,
both the upper and lower bounds are determined by locating the intersection of the
sample size (100) and the actual number of misstatements (0) in the same manner as for
attributes sampling. The CUER of 3 percent on the table represents both the upper and
lower bound, expressed as a percent. Because the sample misstatement rate was 0 percent,
the 3 percent represents an estimate of sampling error.
Based on the sample results and the misstatement bounds from the table, the auditor
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can conclude with a 5 percent sampling risk that no more than 3 percent of the dollar
units in the population are misstated. To convert this percent into dollars, the auditor
must make an assumption about the average percent of misstatement for population
dollars that contain a misstatement. This assumption significantly affects the misstate -
ment bounds. To illustrate this, three sets of example assumptions are examined:
Assumption 1 Overstatement amounts equal 100 percent; understatement amounts |
equal 100 percent; misstatement bounds at a 5 percent ARIA are:
Upper misstatement bound = $1,200,000 x3%x100% = $36,000
Lower misstatement bound = $1,200,000 x3%x100% = $36,000
The assumption is that, on average, those population items that are misstated are
misstated by the full dollar amount of the recorded value. Because the misstatement
bound is 3 percent, the dollar value of the misstatement is not likely to exceed $36,000
(3 percent of the total recorded dollar units in the population). If all the amounts are
overstated, there is an overstatement of $36,000. If they are all understated, there is an
understatement of $36,000.
The assumption of 100 percent misstatements is extremely conservative, especially
for overstatements. Assume that the actual population exception rate is 3 percent. The
following two conditions both have to exist before the $36,000 correctly reflects the
true overstatement amount:
1. All amounts have to be overstatements. Offsetting amounts would have reduced
the amount of the overstatement.
2. All population items misstated have to be 100 percent misstated. There cannot,
for example, be a misstatement such as a receivable balance of $226 recorded as
$262. This would be only a 13.7 percent misstatement (262 – 226 = 36
overstatement; 36/262 = 13.7%).
570 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
In the calculation of the overstatement and understatement misstatement bounds
of $36,000, the auditor did not calculate a point estimate and sampling error (called
precision amount in MUS) in the manner discussed earlier in the chapter. This is
because the tables used include both a point estimate and a precision amount to derive
the upper exception rate. Even though the point estimate and precision amount are not
calculated for MUS, they are implicit in the determination of misstatement bounds
and can be determined from the tables. In this illustration, the point estimate is zero
and the statistical precision is $36,000.
Assumption 2 Overstatement amounts equal 10 percent; understatement amounts
equal 10 percent; misstatement bounds at a 5 percent ARIA are:
Upper misstatement bound = $1,200,000 x3%x10% = $3,600
Lower misstatement bound = $1,200,000 x3%x10% = $3,600
The assumption is that, on average, those items that are misstated are misstated by
no more than 10 percent. If all items were misstated in one direction, the misstatement
bounds will be + $3,600 and –$3,600. The change in assumption from 100 percent to
10 percent misstatements significantly affects the misstatement bounds. The effect is in
direct proportion to the magnitude of the change.
Assumption 3 Overstatement amounts equal 20 percent; understatement amounts
equal 200 percent; misstatement bounds at a 5 percent ARIA are:
Upper misstatement bound = $1,200,000 x3%x20% = $7,200
Lower misstatement bound = $1,200,000 x3%x200% = $72,000
The justification for a larger percent for understatements is the potential for a
larger misstatement in percentage terms. For example, an accounts receivable recorded
at $20 that should have been recorded at $200 is understated by 900 percent [(200 –
20)/20], whereas one that is recorded at $200 that should have been recorded at $20 is
overstated by 90 percent [(200 –20)/200].
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Items containing large understatement amounts may have a small recorded value
as a result of those misstatements. As a consequence, because of the mechanics of
MUS, few of them will have a chance of being selected in the sample. For this reason,
some auditors select an additional sample of small items to supplement the monetary
unit sample when understatement amounts are an audit concern.
Appropriate Percent of Misstatement Assumption The appropriate assumption
for the overall percent of misstatement in those population items containing a
misstatement is an auditor’s decision. The auditor must set these percentages based on
professional judgment in the circumstances. In the absence of convincing information
to the contrary, most auditors believe that it is desirable to assume a 100 percent |
amount for both overstatements and understatements unless there are misstatements
in the sample results. This approach is considered highly conservative, but it is easier to
justify than any other assumption. In fact, the reason upper and lower limits are called
misstatement bounds when MUS is used, rather than maximum likely misstatement or
the commonly used statistical term confidence limit, is because of widespread use of
that conservative assumption. Unless stated otherwise, the 100 percent misstatement
assumption is used in this chapter and problem materials.
So far, we have assumed the samples contain no misstatements. What happens, however, Generalizing When
if misstatements are found? We will use the example from the preceding section but Misstatements
assume there are five misstatements instead of none. The misstatements are shown in Are Found
Table 17-5 (p. 572).
The four aspects of generalizing from the sample to the population we discussed
earlier still apply, but their use is modified as follows:
1. Overstatement and understatement amounts are dealt with separately and then
combined. First, initial upper and lower misstatement bounds are calculated
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 571
TABLE 17-5 Misstatements Found
Recorded Audited Misstatement
Accounts Accounts ÷
Customer Receivable Receivable Recorded
No. Amount Amount Misstatement Amount
2073 $ 6,200 $ 6,100 $ 100 .016
5111 12,910 12,000 910 .07
5206 4,322 4,450 (128) (.03)
7642 23,000 22,995 5 .0002
9816 8,947 2,947 $6,000 .671
separately for overstatement and understatement amounts. Next, a point esti -
mate of overstatements and understatements is calculated. The point estimate of
understatements is used to reduce the initial upper misstatement bound, and the
point estimate of overstatements is used to reduce the initial lower misstatement
bound. The method and rationale for these calculations will be illustrated by
using the four overstatement and one understatement amounts in Table 17-5.
2. A different misstatement assumption is made for each misstatement, including zero
misstatements.When there were no misstatements in the sample, an assumption
was required as to the average percent of misstatement for the population items
misstated. The misstatement bounds were calculated showing several different
assumptions. Now that misstatements have been found, auditors can use
available sample information in determining the misstatement bounds. The
misstatement assumption is still required, but it can be modified based on this
actual misstatement data.
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Where misstatements are found, a 100 percent assumption for all misstate -
ments is not only exceptionally conservative, it is inconsistent with the sample
results. A common assumption in practice, and the one followed in this book,
is that the actual sample misstatements are representative of the population
misstatements. This assumption requires the auditor to calculate the percent
that each sample item is misstated (misstatement ÷ recorded amount) and apply
that percent to the population. The calculation of the percent for each mis -
statement is shown in the last column in Table 17-5. As we will explain shortly,
a misstatement assumption is still needed for the zero misstatement portion of
the computed results. For this example, a 100 percent misstatement assumption
is used for the zero misstatement portion for both overstatement and under -
statement misstatement bounds.
3. The auditor must deal with layers of the computed upper exception rate
(CUER) from the attributes sampling table.Auditors do this because different
TABLE 17-6 Percent Misstatement Bounds
Increase in Precision
Number of Upper Precision Limit Resulting from
Misstatements Limit from Table Each Misstatement (Layers)
0 .03 .03
1 .047 .017
2 .062 .015
3 .076 .014
4 .090 .014
572 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
TABLE 17-7 Illustration of Calculating Initial Upper and Lower Misstatement
Bounds
Unit Misstatement
Number of Upper Precision Recorded Misstatement Bound Portion |
Misstatements Limit Portion* Value Assumption (Columns 2 x3x4)
Overstatements
0 .030 $1,200,000 1.0 $36,000
1 .017 1,200,000 .671 13,688
2 .015 1,200,000 .07 1,260
3 .014 1,200,000 .016 269
4 ._0_1_4_ 1,200,000 .0002 ______3_
Upper precision limit .090
Initial misstatement bound $51,220
Understatements
0 .030 $1,200,000 1.0 $36,000
1 ._0_1_7_ 1,200,000 .03 ____6_1_2_
Lower precision limit .047
Initial misstatement bound $36,612
*ARIA of 5%. Sample size of 100.
misstatement assumptions exist for each misstatement. Layers are calculated
by first determining the CUER from the table for each misstatement and then
calculating each layer. Table 17-6 shows the layers in the attributes sampling
table for the example at hand, using an ARIA of 5% and the attributes sampling
table on page 505. (The layers were determined by reading across the table for
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a sample size of 100, from the 0 through 4 exception columns.)
4. Misstatement assumptions must be associated with each layer.The most common
method of associating misstatement assumptions with layers is to conservatively
associate the largest dollar misstatement percents with the largest layers. Table
17-7 shows this association. For example, the largest misstatement was .671 for
customer 9816. That misstatement is associated with the layer factor of .017, the
largest layer where misstatements were found. The portion of the upper
precision limit related to the zero misstatement layer has a misstatement
assumption of 100 percent, which is still conservative. Table 17-7 shows the
calculation of misstatement bounds before consideration of offsetting amounts.
The upper misstatement bound was calculated as if there were no understate -
ment amounts, and the lower misstatement bound was calculated as if there
were no overstatement amounts.
Most MUS users believe that this approach is overly conservative when there are
offsetting amounts. If an understatement amount is found, it is logical and reasonable
that the bound for overstatement amounts should be lower than it would be had no
understatement amounts been found, and vice versa. The adjustment of bounds for
offsetting amounts is made as follows:
1. A point estimate of misstatements is made for both overstatement and under -
statement amounts.
2. Each bound is reduced by the opposite point estimate.
The point estimate for overstatements is calculated by multiplying the average
overstatement amount in the dollar units audited times the recorded value. The same
approach is used for calculating the point estimate for understatements. Our example
shows one understatement amount of 3 cents per dollar unit in a sample of 100. The
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 573
TABLE 17-8 Illustration of Calculating Adjusted Misstatement Bounds
Unit
Number of Misstatement Sample Recorded Point
Misstatements Assumption Size Population Estimate Bounds
Initial overstatement bound $51,220
Understatement amount
1 .03 100 $1,200,000 $ 360 ____(_3_6_0_)
Adjusted overstatement bound $50,860
Initial understatement bound $36,612
Overstatement amounts
1 .671
2 .07
3 .016
4 ._0_0_0_2_
Sum .7572 100 $1,200,000 $9,086 __(_9_,0__8_6_)
Adjusted understatement bound $27,526
understatement point estimate is therefore $360 (.03/100 x $1,200,000). Similarly,
the overstatement point estimate is $9,086 [(.671 + .07 + .016 + .0002)/100 x
$1,200,000].
Table 17-8 shows the adjustment of the bounds that follow from this procedure:
• The initial upper bound of $51,220 is reduced by the estimated most likely
under statement amount of $360 to an adjusted bound of $50,860.
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• The initial lower bound of $36,612 is reduced by the estimated most likely over -
statement amount of $9,086 to an adjusted bound of $27,526.
Given the methodology and assumptions followed, the auditor concludes that
there is a 5 percent risk that accounts receivable is overstated by more than $50,860, or
understated by more than $27,526.
It should be noted that if the misstatement assumptions are changed, the misstate -
ment bounds will also change. The method used to adjust the bounds for offsetting |
amounts is only one of several in use. The method illustrated here is taken from Leslie,
Teitlebaum, and Anderson.1
Table 17-9 shows the seven steps followed in the calculation of the adjusted mis -
statement bounds for monetary unit sampling when there are offsetting amounts. The
calculation of the adjusted upper misstatement bound for the four overstatement
amounts in Table 17-5 on page 572 is used to illustrate.
Decide the After the misstatement bounds are calculated, the auditor must decide whether the
Acceptability of the population is acceptable. To do that, a decision ruleis needed. The decision rule for MUS
Population Using MUS is as follows: If both the lower misstatement bound (LMB) and upper misstatement
bound (UMB) fall between the understatement and overstatement tolerable misstate -
ment amounts, acceptthe conclusion that the book value is not misstated by a material
amount. Otherwise, conclude that the book value is misstated by a material amount.
This decision rule is illustrated in Figure 17-3 (p. 576). The auditor should
conclude that both the LMB and UMB for situations 1 and 2 fall completely within
both the understatement and overstatement tolerable misstatement limits.
Therefore, the auditor concludes that the population is not misstated by a material
1D. A. Leslie, A. D. Teitlebaum, and R. J. Anderson, Dollar Unit Sampling: A Practical Guide for Auditors, Toronto,
Copp, Clark and Pitman, 1979.
574 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
TABLE 17-9 Summary of Steps to Calculate Adjusted Misstatement Bounds
Calculation for Overstatements in
Steps to Calculate Adjusted Misstatement Bounds Tables 17-5 (p. 572), 17-7 (p. 573), and 17-8
1. Determine misstatement for each sample item, Table 17-5;
keeping overstatements and understatements four overstatements
separate.
2. Calculate misstatement per dollar unit in each Table 17-5;
sample item (misstatement/recorded amount). .016, .07, .0002, .671
3. Layer misstatements per dollar unit from highest Table 17-7;
to lowest, including the percent misstatement 1.0, .671, .07, .016, .0002
assumption for sample items not misstated.
4. Determine upper precision limit from attributes Table 17-7;
sampling table and calculate the percent mis- Total of 9.0% for four misstatements;
statement bound for each misstatement (layer). calculate five layers
5. Calculate initial upper and lower misstatement Table 17-7;
bounds for each layer and total. Total of $51,220
6. Calculate point estimate for overstatements Table 17-8;
and understatements. $360 for understatements
7. Calculate adjusted upper and lower misstatement Table 17-8;
bounds. $50,860 adjusted overstatement
amount. For situations 3, 4, and 5, either LMB or UMB, or both, are outside tolerable
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misstatements. Therefore, the population book value will be rejected.
Assume that the auditor in our example had set a tolerable misstatement amount
for accounts receivable of $40,000 (overstatement or understatement). As previously
shown, the auditor selected a sample of 100 items, found five misstatements, and
calculated the lower bound to be $27,526 and the upper bound to be $50,860.
Application of the decision rule leads the auditor to the conclusion that the population
should not be accepted because the upper misstatement bound is more than tolerable
misstatement of $40,000.
Tolerablemisstatement Tolerable misstatement
($40,000) $40,000
($27,526) $50,860
LMB UMB
When one or both of the misstatement bounds lie outside the tolerable misstatement Action When a
limits and the population is not considered acceptable, the auditor has several options. Population Is Rejected
These are the same as the ones already discussed for nonstatistical sampling on pages
566–567.
Our overview of MUS included the step for determining sample size, but we have Determining Sample
waited until now to discuss the method for making that calculation, because you first Size Using MUS
needed to understand average misstatement assumptions. The method used to
determine sample size for MUS is similar to that used for physical unit attributes |
sampling, using the attributes sampling tables. By this point, you have studied the five
things necessary for calculating sample size using MUS.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 575
FIGURE 17-3 Illustration of the Auditor’s Decision Rule for MUS
(cid:4)Tolerable Misstatement $0 Misstatements (cid:5)Tolerable Misstatement
LMB UMB
#1
LMB UMB
#2
LMB UMB
#3
LMB UMB
#4
LMB UMB
#5
Materiality The preliminary judgment about materiality is normally the basis for
the tolerable misstatement amount used. If misstatements in non-MUS tests are
expected, tolerable misstatement will be materiality less those amounts. Tolerable
misstatement may be different for overstatements or understatements. For this
example, tolerable misstatement for both overstatements and understatements is
$100,000.
Assumption of the Average Percent of Misstatement for Population Items
That Contain a Misstatement Again, there may be a separate assumption for the
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upper and lower bounds. This is also an auditor judgment. It should be based on the
auditor’s knowledge of the client and past experience, and if less than 100 percent is
used, the assumption must be clearly defensible. For this example, 50 percent is used
for overstatements and 100 percent for understatements.
Acceptable Risk of Incorrect Acceptance ARIA is an auditor judgment and is
often reached with the aid of the audit risk model. It is 5 percent for this example.
Recorded Population Value The dollar value of the population is taken from the
client’s records. For this example, it is $5 million.
Estimate of the Population Exception Rate Normally, the estimate of the popula -
tion exception rate for MUS is zero, as it is most appropriate to use MUS when no
misstatements, or only a few, are expected. When misstatements are expected, the total
dollar amount of expected population misstatements is estimated and then expressed
as a percent of the population recorded value. In this example, a $20,000 overstatement
amount is expected. This is equivalent to a .4 percent exception rate. To be conserva -
tive, a .5 percent expected exception rate is used.
These assumptions are summarized as follows:
Tolerable misstatement (same for upper and lower) $100,000
Average percent of misstatement assumption, overstatements 50%
Average percent of misstatement assumption, understatements 100%
ARIA 5%
Accounts receivable—recorded value $5 million
Estimated misstatement in accounts receivable $ 20,000
The sample size is calculated as follows:
576 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Upper Bound Lower Bound
Tolerable misstatement 100,000 100,000
Average percent of misstatement assumption ÷________.5_0_ ÷_______1_.0_0_
200,000 100,000
Recorded population value ÷_5__,0_0_0__,0_0_0_ ÷_5__,0_0_0__,0_0_0_
Tolerable exception rate 4% 2%
Estimated population exception rate (EPER) .5% 0
Sample size from the attributes table (p. 504)
5% ARACR, 4% and 2% TER, and .5% and 0% EPER 117 149
Because only one sample is taken for both overstatements and understatements,
thelargerof the two computed sample sizes is used, in this case 149 items. In auditing
the sample, if auditors find any understatement amounts, the lower bound will exceed
the tolerable limit because the sample size is based on no expected misstatements.
Conversely, several overstatement amounts might be found before the tolerable limit
for the upper bound is exceeded. When concerned about finding an unexpected
misstatement that would cause the population to be rejected, the auditor can guard
against it by arbitrarily increasing sample size above the amount determined by the
tables. In this illustration, the auditor might use a sample size of 200 instead of 149.
Relationship of the Audit Risk Model to Sample Size for MUS The audit risk
model for planning was introduced in Chapter 9 and covered in subsequent chapters as:
AAR
PDR =
IR× CR
(See pages 261–263 for description of the terms.)
Chapter 16 discussed how the auditor reduces detection risk to the planned level
by performing substantive tests of trAanpsaactigonos, subPstDanFtiv e aEnanlyhticaal pnrocceedurres, and |
tests of details of balances. MUS is used in performing tests of details of balances.
Therefore, auditors need to understand the relationship of the three independent
factors in the audit risk model, plus analytical procedures and substantive tests of
transactions, to sample size for tests of details of balances.
Table 17-2 on page 562 shows that four of these five factors (control risk, substan -
tive tests of transactions, acceptable audit risk, and substantive analytical procedures)
affect ARIA. ARIA in turn determines the planned sample size. The other factor,
inherent risk, affects the estimated population exception rate directly.
MUS appeals to auditors for at least four reasons: Audit Uses
1. MUS automatically increases the likelihood of selecting high dollar items from of Monetary
the population being audited. Auditors make a practice of concentrating on Unit Sampling
these items because they generally represent the greatest risk of material
misstatements. Stratified sampling can also be used for this purpose, but MUS
is often easier to apply.
2. MUS often reduces the cost of doing the audit testing because several sample
items are tested at once. For example, if one large item makes up 10 percent of
the total recorded dollar value of the population and the sample size is 100, the
PPS sample selection method is likely to result in approximately 10 percent of
the sample items from that one large population item. Naturally, that item
needs to be audited only once, but it counts as a sample of 10. If the item is
misstated, it is also counted as 10 misstatements. Larger population items may
be eliminated from the sampled population by auditing them 100 percent and
evaluating them separately, if the auditor so desires.
3. MUS is easy to apply. Monetary unit samples can be evaluated by the application
of simple tables. It is easy to teach and to supervise the use of MUS techniques.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 577
Firms that utilize MUS extensively use audit software or other computer
programs that streamline sample size determination and evaluation even
further than shown in this chapter.
4. MUS provides a statistical conclusion rather than a nonstatistical one. Many
auditors believe that statistical sampling aids them in making better and more
defensible conclusions.
There are two main disadvantages of MUS.
1. The total misstatement bounds resulting when misstatements are found may
be too high to be useful to the auditor. This is because these evaluation
methods are inherently conservative when misstatements are found and often
produce bounds far in excess of materiality. To overcome this problem, large
samples may be required.
2. It may be cumbersome to select PPS samples from large populations without
computer assistance.
For all these reasons, auditors commonly use MUS when zero or few misstate -
ments are expected, a dollar result is desired, and the population data are maintained
on computer files.
VARIABLES SAMPLING
OBJECTIVE 17-4 Variables sampling, like MUS, is a statistical method that auditors use. Variables
sampling and nonstatistical sampling for tests of details of balances have the same
Describe variables sampling.
objective—to measure the misstatement in an account balance. As with nonstatistical
sampling, when auditors determine that the misstatement amount exceeds the tolerable
amount, they reject the population and take additional actions.
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Several sampling techniques make up the general class of methods called variables
sampling: difference estimation, ratio estimation, and mean-per-unit estimation. These
are discussed later.
Differences Between The use of variables methods shares many similarities with nonstatistical sampling. All
Variables and 14 steps we discussed for nonstatistical sampling must be performed for variables
Nonstatistical Sampling methods, and most are identical. Some of the differences between variables and non-
statistical sampling are examined after we discuss sampling distributions.
Sampling Distributions To understand why and how auditors use variables sampling methods in auditing, it is |
useful to understand sampling distributions and how they affect auditors’ statistical
conclusions. The auditor does not know the mean value (average) of misstatements in
the population, the distribution of the misstatement amounts, or the audited values.
These population characteristics must be estimatedfrom samples, which, of course, is
the purpose of the audit test.
Assume that an auditor, as an experiment, took thousands of repeated samples of
(cid:2)
equal size from a population of accounting data having a mean value of X. For each
sample, the auditor calculates the mean value of the items in the sample as follows:
Σx
x = j
n
where:
x = mean value of the sample items
x = value of each individual sample item
j
n = sample size
578 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
After calculating ( x(cid:2)) for each sample, the auditor plots them into a frequency
distribution. As long as the sample size is sufficient, the frequency distribution of the
sample means will appear much like that shown in Figure 17-4.
A distribution of the sample means such as this is normal and has all the charac-
teristics of the normal curve: (1) the curve is symmetrical, and (2) the sample means
fall within known portions of the sampling distribution around the average or mean of
those means, measured by the distance along the horizontal axis in terms of standard
deviations.
Furthermore, the mean of the sample means (the midpoint of the sampling dis-
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tribution) is equal to the population mean, and the standard deviation of the sampling
distribution is equal to SD/(cid:3)(cid:2)n, where SD is the population standard deviation and nis
the sample size.
To illustrate, assume a population with a mean of $40 and a standard deviation
(cid:2)
of $15 (X= $40 and SD = $15), from which we elected to take many random samples
of 100 items each. The standard deviation of our sampling distribution is $1.50
(SD/(cid:3)(cid:2)n= 15/(cid:3)(cid:2) 100 = 1.50). The reference to “standard deviation” of the population and
to “standard deviation” of the sampling distribution is often confusing. To avoid
confusion, remember that the standard deviation of the distribution of the sample
means is often called the standard error of the mean (SE). With this information,
auditors can make the tabulation of the sampling distribution, as shown in Table 17-10
below.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 579
tnecrep
ni
seulav
fo
ycneuqerF
FIGURE 17-4 Frequency Distribution of Sample Means
–
Value ofx in dollars
TABLE 17-10 Calculated Sampling Distribution from a Population with a
Known Mean and Standard Deviation
(1) (4)
Number of Standard (2) (3) Percent of Sample
Errors of the Mean Value –Range Around Means Included
(Confidence Coefficient) [(1)x$1.50] X[$40 +/–(2)] in Range
1 $1.50 $38.50 − $41.50 68.2
2 $3.00 $37.00 − $43.00 95.4
3 $4.50 $35.50 − $44.50 99.7
(taken from table for normal curve)
To summarize, three things shape the results of the experiment of taking a large
number of samples from a known population:
(cid:2)
1. The mean value of all the sample means is equal to the population mean ( X).
A corollary is that the sample mean value ( x(cid:2)) with the highest frequency of
occurrence is also equal to the population mean.
2. The shape of the frequency distribution of the sample means is that of a
normal distribution (curve), as long as the sample size is sufficiently large,
regardless of the distribution of the population, as illustrated in Figure 17-5.
3. The percentage of sample means between any two values of the sampling
distribution is measurable. The percentage can be calculated by determining
the number of standard errors between any two values and determining the
percentage of sample means represented from a table for normal curves.
Statistical Inference Naturally, when samples are taken from a population in an actual audit situation, the
auditor does not know the population’s characteristics and, ordinarily, only one sample
is taken from the population. But the knowledge of sampling distributions enables |
auditors to draw statistical conclusions, or statistical inferences, about the population.
For example, assume that the auditor takes a sample from a population and calculates
(x(cid:2)) as $46 and SE at $9. (We’ll explain how SE is calculated later.) We can now calculate
a confidence interval of the population mean using the logic gained from the study of
sampling distributions. It is as follows:
ˆ
CI = X ± Z⋅SE
x
where: CI = confidence interval for the population mean
x
ˆ
X = point estimate of the population mean
⎪⎧1 = 68.2% confidence level
Apago ZP=DcFon fidEennceh coaefnficcienetr⎨ 2 = 95.4% confidence level
⎩⎪
3 = 99.7% confidence level
SE = standard error of the mean
⋅
Z SE = precision interval
For the example:
CI = $46 ± 1($9) = $46 ± $9 at a 68.2% confidence level
x
CI = $46 ± 2($9) = $46 ± $18 at a 95.4% confidence level
x
CI = $46 ± 3($9) = $46 ± $27 at a 99.7% confidence level
x
580 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
tnecrep
ni
seulav
ycneuqerF
FIGURE 17-5 Sampling Distribution for a Population Distribution
Mean
Sampling distribution—Normal
Population distribution—
Skewed
–
Value ofx in dollars
The results can also be stated in terms of confidence limits (CI(cid:2)x). The upper
confidence limit (UCL(cid:2)x) is X
(cid:2)ˆ +Z.
SE ($46 + $18 = $64 at a 95 percent confidence level)
and a lower confidence limit (LCL(cid:2)x) is
X(cid:2)ˆ –Z.
SE ($46 –$18 = $28 at a 95 percent con -
fidence level). Graphically, the results are as follows:
Lower Upper
confidence confidence
^
limit X limit
$28 $46 $64
Auditors can state the conclusions drawn from a confidence interval using
statistical inference in different ways. However, they must take care to avoid incorrect
conclusions, remembering that the true population value is always unknown. There is
always a possibility that the sample is not sufficiently representative of the population
to provide a sample mean and/or standard deviation reasonably close to those of the
population. The auditor can say, however, that the procedure used to obtain the sample
and compute the confidence interval will provide an interval that will contain the true
population mean value a given percent of the time. In short, the auditor knows the
reliability of the statistical inference process that is used to draw conclusions.
Auditors use the preceding statistical inference process for all the variables sampling Variables Methods
methods. Each method is distinguished by what is being measured. Let’s examine the
three variables methods individually.
Difference EstimationAuditors use difference estimationto measure the estimated
total misstatement amount in a population when both a recorded value and an
audited value exist for each item in the sample, which is almost always the case in
audits. For example, an auditor might confirm a sample of accounts receivable and
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determine the difference (misstatement) between the client’s recorded amount and the
amount the auditor considers correct for each selected account. The auditor makes an
estimate of the population misstatement based on the number of misstatements in the
sample, average misstatement size, individual misstatements in the sample, and
sample size. The result is stated as a point estimate of the population misstatement
plus or minus a computed precision interval at a stated confidence level. Referring
back to the discussion of sampling distributions, assume the auditor confirmed a
random sample of 100 from a population of 1,000 accounts receivable and concluded
that the confidence limits of the mean of the misstatement for accounts receivable
were between $28 and $64 at a 95 percent confidence level. The estimate of the total
population misstatement can also be easily calculated as being between $28,000 and
$64,000 at a 95 percent confidence level (1,000 x$28 and 1,000 x$64). If the auditor’s
tolerable misstatement is $100,000, the population is clearly acceptable. If tolerable
misstatement is $40,000, the population is not acceptable. An extended illustration
using difference estimation is shown on pages 583–589. |
Difference estimation frequently results in smaller sample sizes than any other
method, and it is relatively easy to use. For that reason, difference estimation is often
the preferred variables method.
Ratio Estimation Ratio estimation is similar to difference estimation except the
auditor calculates the ratio between the misstatements and their recorded value and
projects this to the population to estimate the total population misstatement. For
example, assume that an auditor finds misstatements totaling $12,000 in a sample with
a recorded value of $208,000. The misstatement ratio is .06 ($12,000/$208,000). If the
total recorded value of the population is $1,040,000 the projected misstatement in the
population is $62,400 ($1,040,000 x .06). The auditor can then calculate confidence
limits of the total misstatement for ratio estimation with a calculation similar to the one
shown for difference estimation. Ratio estimation can result in sample sizes even
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 581
smaller than difference estimation if the size of the misstatements in the population is
proportionate to the recorded value of the population items. If the size of the individual
misstatements is independent of the recorded value, difference estimation results in
smaller sample sizes. Most auditors prefer difference estimation because it is somewhat
simpler to calculate confidence intervals.
Mean-per-Unit Estimation In mean-per-unit estimation, the auditor focuses on
the audited value rather than the misstatement amount of each item in the sample.
Except for the definition of what is being measured, the mean-per-unit estimate is
calculated in exactly the same manner as the difference estimate. The point estimate of
the audited value equals the average audited value of items in the sample times the
population size. The computed precision interval is calculated on the basis of the
audited value of the sample items rather than the misstatements. When auditors have
computed the upper and lower confidence limits, they decide the acceptability of the
population by comparing these amounts with the recorded book value. For example,
assume the auditor takes a sample of 100 items from an inventory listing containing
3000 items and a recorded value $265,000. If the mean value of the items sampled is
$85, the estimated value of the inventory is $255,000 ($85 x 3000). If the recorded
value of $265,000 is within the upper confidence limit, the auditor would accept the
population balance. Mean-per-unit-estimation is rarely used in practice because
sample sizes are typically much larger than for the two previous methods.
Stratified As we discussed earlier in this chapter, stratified sampling is a method of sampling in
Statistical Methods which all the elements in the total population are divided into two or more sub-
populations. Each subpopulation is then independently tested. The calculations are
made for each stratum and then combined into one overall population estimate for a
confidence interval of the entire population. The results are measured statistically.
Stratification is applicable to difference, ratio, and mean-per-unit estimation, but is
most cAompmaonglyo u sedP wDithF m eaEn-npehr-uannit ecsteimration.
Stratifying a population is not unique to statistical sampling, of course. Auditors
have traditionally emphasized certain types of items when they are testing a population
using nonstatistical sampling. For example, in confirming accounts receivable, auditors
customarily place more emphasis on large accounts than on small ones. In statistical
stratified sampling, however, the approach is more objective and better defined than
for nonstatistical stratification methods.
Sampling Risks We have discussed acceptable risk of incorrect acceptance (ARIA) for nonstatistical
sampling. For variables sampling, auditors use ARIA as well as acceptable risk of
TABLE 17-11 Confidence Coefficient for Confidence Levels, ARIAs, and ARIRs
Confidence Level (%) ARIA (%) ARIR (%) Confidence Coefficient |
99 .5 1 2.58
95 2.5 5 1.96
90 5 10 1.64
80 10 20 1.28
75 12.5 25 1.15
70 15 30 1.04
60 20 40 .84
50 25 50 .67
40 30 60 .52
30 35 70 .39
20 40 80 .25
10 45 90 .13
0 50 100 .0
582 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
TABLE 17-12 ARIA and ARIR
Actual State of the Population
Actual Audit Decision Materially Misstated Not Materially Misstated
Conclude that the population is Correct conclusion— Incorrect conclusion—
materially misstated no risk risk is ARIR
Conclude that the population is Incorrect conclusion— Correct conclusion—
not materially misstated risk is ARIA no risk
incorrect rejection (ARIR). It is important to understand the distinctions between and
uses of the two risks.
ARIA After auditors perform an audit test and calculate statistical results, they must
conclude either that the population is or is not materially misstated. ARIA is the statis-
tical risk that the auditor has accepted a population that is, in fact, materially misstated.
ARIA is a serious concern to auditors because of the potential legal implications of con -
cluding that an account balance is fairly stated when it is misstated by a material amount.
An account balance can be either overstated or understated, but not both;
therefore, ARIA is a one-tailed statistical test. The confidence coefficients for ARIA are
therefore different from the confidence level. (Confidence level = 1 – 2 xARIA. So, if
ARIA equals 10 percent, the confidence level is 80 percent.) The confidence coefficients
for various ARIAs are shown in Table 17-11 together with confidence coefficients for
the confidence level and ARIR.
ARIR Acceptable risk of incorrect rejection (ARIR) is the statistical risk that the
auditor has concluded that a populAatipona isg moat eriPallDy mFis stEatend hwhaenn itc ise nort. ARIR
affects auditors’ actions only when they conclude that a population is not fairly stated.
When auditors find a balance not fairly stated, they typically increase the sample size
or perform other tests. An increased sample size will usually lead the auditor to con -
clude that the balance is fairly stated if the account is, in fact, not materially misstated.
While ARIA is always important, ARIR is important only when there is a high cost to
increasing the sample size or performing other tests. Confidence coefficients for ARIR
are also shown in Table 17-11.
As you examine the summary of ARIA and ARIR in Table 17-12 above, you might
conclude that auditors should attempt to minimize ARIA and ARIR. To accomplish
that, auditors have to increase the sample size, thus minimizing the risks. However, the
cost of that approach makes having reasonable ARIA and ARIR a more desirable goal.
ILLUSTRATION USING DIFFERENCE ESTIMATION
As we’ve discussed, several types of variables sampling techniques may be applicable to OBJECTIVE 17-5
auditing in different circumstances. To illustrate the concepts and methodology of
Use difference estimation in
variables sampling, we have selected difference estimation using hypothesis testing
tests of details of balances.
because of its relative simplicity. When this method is considered reliable in a given set
of circumstances, most auditors prefer it to other variables sampling methods.
For difference estimation, the same 14 steps as nonstatistical sampling are used in
determining whether the account balance in the audit of accounts receivable is
correctly stated. The following example is based on the use of positive confirmations in
the audit of Hart Lumber Company. Accounts receivable consists of 4,000 accounts
listed on the aged trial balance with a recorded value of $600,000. Internal controls are
considered somewhat ineffective, and a large number of small misstatements in
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 583
recorded amounts are expected in the audit. Total assets are $2,500,000, and net
earnings before taxes are $400,000. Acceptable audit risk is reasonably high because of
the limited users of the statements and the good financial health of Hart Lumber. |
Analytical procedures results indicated no significant problems. Assume that all
confirmations were returned or that effective alternative procedures were carried out.
Hence, the sample size is the number of positive confirmations sent.
Plan the Sample State the Objectives of the Audit Test The objective of the audit test is to determine
and Calculate the whether accounts receivable before consideration of the allowance for uncollectible
Sample Size Using accounts is materially misstated.
Difference Estimation
Decide Whether Audit Sampling Applies Audit sampling applies in the confirma -
tion of the accounts receivable because of the large number of accounts receivable.
Define Misstatement Conditions The misstatement condition is a client misstate -
ment determined by the confirmation of each account or alternative procedure.
Define the Population The population size is determined by count, as it was for
attributes sampling. An accurate count is much more important in variables sampling
becausepopulation size directly affects sample size and the computed precision limits.
The population size for Hart Lumber’s accounts receivable is 4,000.
Define the Sampling Unit The sampling unit is an account on the list of accounts
receivable.
Specify Tolerable Misstatement The amount of misstatement the auditor is willing
to accept is a materiality question. The auditor decides to accept a tolerable misstate-
ment of $21,000 in the audit of Hart Lumber’s accounts receivable.
Specify Acceptable Risk The auditor specifies two risks:
1. Acceptable risk of incorrect acceptance (ARIA).It is the risk of accepting accounts
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receivable as correct if it is actually misstated by more than $21,000. ARIA is
affected by acceptable audit risk, results of tests of controls and substantive tests
of transactions, analytical procedures, and the relative significance of accounts
receivable in the financial statements. For the Hart Lumber audit, assume an
ARIA of 10 percent.
2. Acceptable risk of incorrect rejection (ARIR).It is the risk of rejecting accounts
receivable as incorrect if it is not actually misstated by a material amount.
ARIR is affected by the additional cost of resampling. Because it is fairly costly
to confirm receivables a second time, assume an ARIR of 25 percent. (For audit
tests for which it is not costly to increase the sample size, a much higher ARIR
is common.)
After auditors specify the tolerable misstatement and ARIA, they can state a hypothe -
sis. The auditor’s hypothesis for the audit of accounts receivable for Hart Lumber is:
Accounts receivable is not misstated by more than $21,000 at an ARIA of 10 percent.
Estimate Misstatements in the Population This estimate has two parts:
1. Estimate an expected point estimate.Auditors need an advance estimate of the
population point estimate for difference estimation, much as they need an
estimated population exception rate for attributes sampling. The advance
estimate is $1,500 (overstatement) for Hart Lumber, based on the previous year’s
audit tests.
2. Make an advance population standard deviation estimate—variability of the
population. To determine the initial sample size, auditors need an advance
estimate of the variation in the misstatements in the population as measured
by the population standard deviation. (The calculation of the standard
deviation is explained later, when audit results are evaluated.) For Hart
Lumber, it is estimated to be $20 based on the previous year’s audit tests.
584 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Calculate the Initial Sample Size The initial sample size for Hart Lumber can be
now calculated using the following formula:
⎡ ⎤2
SD*(Z + Z )N
n =⎢ A R ⎥
⎣⎢ TM – E* ⎦⎥
where: n = initial sample size
SD* = advance estimate of the standard deviation
Z = confidence coefficient for ARIA (see Table 17-11)
A
Z = confidence coefficient for ARIR (see Table 17-11)
R
N = population size
TM = tolerable misstatement for the population (materiality)
E* = estimated point estimate of the population misstatement |
Applied to Hart Lumber, this equation yields:
2
⎡ ⎤
20(1.28 + 1.15)4,000
n = ⎢ ⎥ = (9.97)2 = 100
⎣ 21,000 – 1,500 ⎦
Select the Sample Because a random sample (other than PPS) is required, the Select the Sample
auditor must use one of the probabilistic sample selection methods discussed in and Perform
Chapter 15 to select the 100 sample items for confirmation. In this case the auditor the Procedures
used a computer generated random sample.
Perform the Audit Procedures The auditor must use care in confirming the accounts
receivable and performing alternaAtivpe parogceodu rePs uDsiFng thEe nmhethaonds cdiescurssed in
Chapter 16. For confirmations, a misstatement is the differencebetween the confirmation
response and the client’s balance after the reconciliation of all timing differences and
customer errors. For example, if a customer returns a confirmation and states the correct
balance is $887.12, and the balance in the client’s records is $997.12, the difference of
$110 is an overstatement amount if the auditor concludes that the client’s records are
incorrect. For nonresponses, the misstatements discovered by alternative procedures are
treated identically to those discovered through confirmation. At the end of this step, the
auditor determines a misstatement value for each item in the sample, many of which
are likely to be zero. The misstatements for Hart Lumber are shown in Table 17-13
(pp.586–587).
Generalize from the Sample to the Population In concept, nonstatistical sampling Evaluate the Results
and difference estimation accomplish the same thing—generalizing from the sample to
the population. While both methods measure the likely population misstatement based
on the results of the sample, difference estimation uses statistical measurement to
compute confidence limits. The following four steps describe the calculation of the
confidence limits for Hart Lumber Company. (The calculations are illustrated in Table
17-13, Steps 3 through 6.)
1. Compute the point estimate of the total misstatement. The point estimate is a
direct extrapolation from the misstatements in the sample to the misstatements
in the population. The calculation of the point estimate for Hart Lumber is
shown in Table 17-13, step 3.
It is unlikely that the actual, but unknown, misstatement is exactly the
same as the point estimate. Instead, it is more realistic to estimate the misstate -
ment in terms of a confidence interval determined by the point estimate plus
and minus a computed precision interval. The calculation of the confidence
interval is an essential part of difference estimation.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 585
TABLE 17-13 Calculation of Confidence Limits
Step Statistical Formula Illustration for Hart Lumber
1. Take a random sample n= sample size 100 accounts receivable are selected
of size n. randomly from the aged trial balance
containing 4,000 accounts.
2. Determine the value of each 75 accounts are confirmed by customers,
misstatement in the sample. and 25 accounts are verified by alternative
procedures. After reconciling timing differ-
ences and customer errors, the following
12 items were determined to be client
errors (understatements) stated in dollars:
1. $12.75 7. (.87)
2. (69.46) 8. 24.32
3. 85.28 9. 36.59
4.100.00 10. (102.16)
5. (27.30) 11. 54.71
6. 41.06 12. 71.56
Sum=$226.48
3. Compute the point estimate ∑e $226.48
e= j e = =$2.26
of the total misstatement.
n 100
∑e Eˆ= 4,000($2.26) =$9,040
Eˆ=Ne
or N
j
n
or
where A: pago PDF Enhancer Eˆ= 4,000 ⎛ ⎜$226.48⎞ ⎟ = $9,040
e =average misstatement in the sample ⎝ 100 ⎠
∑=summation
e =an individual misstatement in the sample
j
n=sample size
Eˆ=point
estimate of the total misstatement
N=population size
(rounded to nearest dollar)
4. Compute the population e (e )2
j j
standard deviation of the 1. $ 13 $ 169
∑(e )2 − n(e)2
misstatements from the SD = j 2. (69) 4,761
sample. n −1 3. 85 7,225
4. 100 10,000
5. (27) 729
where: 6. 41 1,681
7. (1) 1
SD=standard deviation
8. 24 576
e =an individual misstatement in the sample
j 9. 37 1,369
n=sample size 10. (102) 10,404 |
e=average misstatement in sample 11. 55 3,025
12. 72 5,184
$228 $45,124
$45,124−100($2.26)2
SD=
99
SD=$21.2
(Table 17-13 continued on next page)
586 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
TABLE 17-13 Calculation of Confidence Limits (Cont.)
Step Statistical Formula Illustration for Hart Lumber
5. Compute the precision
SD N−n $21.2 4,000−100
interval for the estimate CPI=NZ CPI= 4,000⋅1.28⋅
of the total population A n N 100 4,000
misstatement at the $21.2
desired confidence level.
= 4,000⋅1.28⋅ ⋅.99
10
where: = 4,000⋅1.28⋅$2.12⋅.99
CPI=computed precision interval =$10,800(rounded)
N =population size
Z =confidence coefficient for ARIA
A ( )
see Table 17-11
SD=population standard deviation
n=sample size
N−n
=finite correction factor
N
6. Compute the confidence UCL = Eˆ + CPI UCL =$9,040 +$10,800 =$19,840
limits at the CL desired. LCL = Eˆ− CPI LCL =$9,040 −$10,800 =$(1,760)
where:
UCL=computed upper confidence limit
LCL=computed lower confidence limit
Eˆ=point
estimate of the total misstatement
CPI=computed precision interval at desired CL
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2. Compute an estimate of the population standard deviation. The population
standard deviation is a statistical measure of the variability in the values of the
individual items in the population. If there is a large amount of variation in the
values of population items, the standard deviation will be larger than when the
variation is small. For example, in the confirmation of accounts receivable,
misstatements of $2, $275, and $812 have far more variation than the set $4,
$14, and $26. Obviously, the standard deviation is smaller in the second set.
The standard deviation has a significant effect on the computed precision
interval. As one might expect, the auditor’s ability to predict total misstatements
is better when there is a small amount of variation in the individual sample items.
The auditor can compute a reasonable estimate of the value of the popula -
tion standard deviation by using the standard statistical formula shown in
Table 17-13, step 4. The standard deviation estimate is determined from the
auditor’s sample results and is not affected by professional judgment.
3. Compute the precision interval. The precision interval is calculated by a
statistical formula. The results are a dollar measure of the inability to predict
the true population misstatement because the test is based on a sample rather
than on the entire population. For the computed precision interval to have any
meaning, it must be associated with ARIA. The formula to calculate the
precision interval is shown in Table 17-13, step 5.
An examination of the formula in step 5 of Table 17-13 indicates that the
effect of changing each factor while the other factors remain constant is as
follows:
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 587
Type Effect on the Computed
of Change Precision Interval
Increase ARIA Decrease
Increase the point estimate of Increase
the misstatements
Increase the standard deviation Increase
Increase the sample size Decrease
4. Compute the confidence limits.Auditors calculate the confidence limits, which
define the confidence interval, by combining the point estimate of the total
misstatements and the computed precision interval at the desired confidence
level (point estimate ± computed precision interval). The formula to calculate
the confidence limits is shown in Table 17-13, step 6.
The lower and upper confidence limits for Hart Lumber are ($1,760) and
$19,840, respectively. There is a 10 percent statistical risk that the population is
understated by more than $1,760, and the same risk that it is overstated by
more than $19,840. (Remember, an ARIA of 10 percent is equivalent to a
confidence level of 80 percent.)
Analyze the Misstatements There are no differences in analyzing misstatements for
nonstatistical and statistical methods. The auditor must evaluate misstatements to
determine the cause of each misstatement and decide whether modification of the
audit risk model is needed.
Decide the Acceptability of the Population To decide whether a population is |
acceptable, when auditors use a statistical method, they rely on a decision rule, as
follows: If the two-sided confidence interval for the misstatements is completely within
the plus and minus tolerable misstatements, accept the hypothesis that the book value
is not misstated by a material amount. Otherwise, accept the hypothesis that the book
value iAs mpisastagteod b y Pa mDaFter ialE amnohunat.ncer
This decision rule is illustrated in Figure 17-6. The auditor should conclude that
both the LCL and UCL for situations 1 and 2 fall completely within both the under-
statement and overstatement tolerable misstatement limits. Therefore, auditors can
accept the conclusion that the population is not misstated by a material amount. For
situations 3, 4, and 5, either LCL or UCL, or both, are outside tolerable misstatements.
Therefore, the population book value will be rejected for these situations.
Application of the decision rule to Hart Lumber leads the auditor to the conclusion
that the population should be accepted, because both confidence limits are within the
tolerable misstatement range.
Tolerable misstatement range
($21,000) 0 $21,000
LCL $9,040 UCL
Confidence interval
($1,760) $19,840
Action When a In accepting the population in this way, the auditor is taking a 10 percent chance
Hypothesis Is Rejected of being wrong—that is, that the population is, in fact, misstated by a material amount.
However, based on the auditor’s planning judgments, this level of risk is appropriate.
Analysis Given that the actual standard deviation (21.2) was larger than the advanced
estimate (20), and the actual point estimate ($9,040) was larger than the advanced
estimate ($1,500), it may seem surprising that the population was accepted. However,
588 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
FIGURE 17-6 Illustration of the Auditor’s Decision Rule for Difference
Estimation
(cid:4)Tolerable misstatement $0 Misstatements (cid:5)Tolerable misstatement
LCL UCL
#1
LCL UCL
#2
LCL UCL
#3
LCL UCL
#4
LCL UCL
#5
the use of a reasonably small ARIR caused the sample size to be larger than if ARIR had
been 100 percent. If ARIR had been 100 percent, which is common when the additional
audit cost to increase the sample size is small, the required sample size would have been
only 28:
2
⎡ ⎤
20(1.28 + 0) 4,000
⎢ ⎥ = 28
⎣ 21,000 – 1,500 ⎦
Assuming a sample size of 28 and the same actual point estimate and standard
deviation, the upper confidence limAipt waougldo h avPe bDeeFn $2E9,5n59h, aandn tcheerefrore, the
population book value would have been rejected. Auditors can use ARIR to reduce the
likelihood of needing to increase the sample size if the standard deviation or point
estimate is larger than was expected.
When one or both of the confidence limits lie outside the tolerable misstatement range,
the population is not considered acceptable. The courses of action for the auditor are
the same as those we discussed for nonstatistical sampling, except that a better estimate
of the population misstatement has been made.
For example, in the Hart Lumber case, if the confidence level had been $9,040 ±
$15,800 and the client had been willing to reduce the book value by $9,040, the results
would be 0 ± $15,800. The new computed lower confidence limit would be an under -
statement of $15,800, and the upper confidence limit a $15,800 overstatement, which are
both acceptable given the tolerable misstatement of $21,000. The minimum adjustment
that the auditor could make and still have the population acceptable is $3,840 [($9,040 +
$15,800) –$21,000].
However, the client may be unwilling to adjust the balance on the basis of a sample.
Furthermore, if the computed precision interval exceeds tolerable misstatement, no
adjustment to the books will satisfy the auditor. This would have been the case in the
previous example if tolerable misstatement had been only $15,000.
SUMMARY
This chapter discussed nonstatistical and statistical audit sampling methods for tests of
details of balances. In sampling for tests of balances, the auditor determines whether the |
dollar amount of an account balance is materially misstated. We then discussed the 14 steps
in nonstatistical sampling for tests of balances. When performing nons tatistical audit
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 589
sampling, the auditor uses judgment in generalizing from the sample to the population to
determine whether it is acceptable. Monetary unit sampling is the most common statistical
method for tests of balances. This method defines the sampling unit as individual dollars in
the recorded account balance, and as a result, larger accounts are more likely to be included
in the sample. Variables statistical sampling methods include difference estimation, ratio
estimation, and mean-per-unit estimation. These methods compare audited sample values
to recorded values to develop an estimate of the misstatement in the account value. Use of
variables sampling was illustrated using difference estimation.
ESSENTIAL TERMS
Acceptable risk of incorrect acceptance sampling with probability proportional
(ARIA)—the risk that the auditor is to size
willing to take of accepting a balance as Point estimate—a method of projecting
correct when the true misstatement in the from the sample to the population to
balance exceeds toler able misstatement estimate the population misstatement,
Acceptable risk of incorrect rejection commonly by assuming that misstate -
(ARIR)—the risk that the auditor is willing ments in the unaudited population are
to take of rejecting a balance as incorrect proportional to the misstatements found
when it is not misstated by a material in the sample
amount Probability proportional to size sample
Difference estimation—a method of selection (PPS)—sample selection of
variables sampling in which the auditor individual dollars in a population by the
estimates the population misstatement use of random or systematic sample
by multiplying the average misstatement selection
in the sample by the total number of Ratio estimation—a method of variables
population items and also calculates sampling in which the auditor estimates
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sampling risk the population misstatement by multi-
Mean-per-unit estimation—a method of plying the portion of sample dollars
variables sampling in which the auditor misstated by the total recorded popu-
estimates the audited value of a popu- lation book value and also calculates
lation by multiplying the average audited sampling risk
value of the sample by the population size Statistical inferences—statistical conclu -
and also calculates sampling risk sions that the auditor draws from sample
Misstatement bounds—an estimate of results based on knowledge of sampling
the largest likely overstatements and distributions
understatements in a population at a given Stratified sampling—a method of
ARIA, using monetary unit sampling sampling in which all the elements in the
Monetary unit sampling (MUS)—a total population are divided into two or
statis tical sampling method that provides more subpopulations that are indepen-
upper and lower misstatement bounds dently tested and statistically measured
expressed in monetary amounts; also Variables sampling—sampling techniques
referred to as dollar unit sampling, cumu- for tests of details of balances that use the
lative monetary amount sampling, and statistical inference process
REVIEW QUESTIONS
17-1(Objective 17-1)What major difference between (a) tests of controls and substantive
tests of transactions and (b) tests of details of balances makes attributes sampling inappro-
priate for tests of details of balances?
17-2 (Objective 17-2) Define stratified sampling and explain its importance in auditing.
How can an auditor obtain a stratified sample of 30 items from each of three strata in the
confirmation of accounts receivable?
590 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
17-3 (Objective 17-2) Distinguish between the point estimate of the total misstatements
and the true value of the misstatements in the population. How can each be determined? |
17-4 (Objective 17-2) Evaluate the following statement made by an auditor: “On every
aspect of the audit where it is possible, I calculate the point estimate of the misstatements
and evaluate whether the amount is material. If it is, I investigate the cause and continue to
test the population until I determine whether there is a serious problem. The use of
statistical sampling in this manner is a valuable audit tool.”
17-5 (Objective 17-3) Define monetary unit sampling and explain its importance in
auditing. How does it combine the features of attributes and variables sampling?
17-6 (Objectives 17-1, 17-2, 17-3, 17-4) Define what is meant by sampling risk. Does
sampling risk apply to nonstatistical sampling, MUS, attributes sampling, and variables
sampling? Explain.
17-7 (Objectives 17-1, 17-2) What are the major differences in the 14 steps used in
nonstatistical sampling for tests of details of balances versus for tests of controls and sub -
stantive tests of transactions?
17-8(Objective 17-3)The 2,620 inventory items described in Question 17-14 are listed on
44 inventory pages with 60 lines per page. There is a total for each page. The client’s data are
not in machine-readable form. Describe how a monetary unit sample can be selected in
this situation.
17-9(Objective 17-3)Explain how the auditor determines tolerable misstatement for MUS.
17-10 (Objective 17-2) Explain what is meant by acceptable risk of incorrect acceptance.
What are the major audit factors affecting ARIA?
17-11 (Objective 17-4) Evaluate the following statement made by an auditor: “I took a
random sample and derived a 90 percent confidence interval of $800,000 to $900,000. That
means that the true population value will be between $800,000 and $900,000, 90 percent of
the time.”
17-12(Objective 17-2)What is the reAlatpionashgip obe twPeenD AFRI A aEndn AhRAaCnR?cer
17-13 (Objective 17-3)What is meant by the “percent of misstatement assumption” for
MUS in those population items that are misstated? Why is it common to use a 100%
misstatement assumption when it is almost certain to be highly conservative?
17-14 (Objective 17-3)An auditor is determining the appropriate sample size for testing
inventory valuation using MUS. The population has 2,620 inventory items valued at
$12,625,000. The tolerable misstatement for both understatements and overstatements is
$500,000 at a 10% ARIA. No misstatements are expected in the population. Calculate the
preliminary sample size using a 100% average misstatement assumption.
17-15 (Objective 17-5)Assume that a sample of 100 units was obtained in sampling the
inventory in Question 17-14. Assume further that the following three misstatements were
found:
Misstatement Recorded Value Audited Value
1 $ 897.16 $ 609.16
2 47.02 0
3 1,621.68 1,522.68
Calculate adjusted misstatement bounds for the population. Draw audit conclusions based
on the results.
17-16 (Objective 17-3) Why is it difficult to determine the appropriate sample size for
MUS? How should the auditor determine the proper sample size?
17-17(Objective 17-5)What is meant by a decision rule using difference estimation? State
the decision rule.
17-18 (Objective 17-2)What alternative courses of action are appropriate when a popu -
lation is rejected using nonstatistical sampling for tests of details of balances? When should
each option be followed?
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 591
17-19 (Objective 17-4) Define what is meant by the population standard deviation and
explain its importance in variables sampling. What is the relationship between the
population standard deviation and the required sample size?
17-20(Objective 17-5) In using difference estimation, an auditor took a random sample of
100 inventory items from a large population to test for proper pricing. Several of the inven-
tory items were misstated, but the combined net amount of the sample misstatement was
not material. In addition, a review of the individual misstatements indicated that no
misstatement was by itself material. As a result, the auditor did not investigate the |
misstatements or make a statistical evaluation. Explain why this practice is improper.
17-21 (Objectives 17-3, 17-4) Distinguish among difference estimation, ratio estimation,
mean-per-unit estimation, and stratified mean-per-unit estimation. Give one example in
which each can be used. When is MUS preferable to any of these?
17-22(Objective 17-4)An essential step in difference estimation is the comparison of each
computed confidence limit with tolerable misstatement. Why is this step so important, and
what should the auditor do if one of the confidence limits is larger than the tolerable
misstatement?
17-23(Objective 17-4)Explain why difference estimation is commonly used by auditors.
17-24 (Objectives 17-3, 17-4)Give an example of the use of attributes sampling, MUS, and
variables sampling in the form of an audit conclusion.
MULTIPLE CHOICE QUESTIONS FROM CPA AND CIA EXAMINATIONS
17-25 (Objective 17-2)The following questions relate to determining sample size in tests of
details of balances. For each one, select the best response.
a. Mr. Murray decides to use stratified sampling. The reason for using stratified sampling
raAthper athagn oun resPtriDcteFd ranEdonmh saampnlincg eis rto
(1) reduce as much as possible the degree of variability in the overall population.
(2) give every element in the population an equal chance of being included in the
sample.
(3) allow the person selecting the sample to use personal judgment in deciding which
elements should be included in the sample.
(4) allow the auditor to emphasize larger items from the population.
b. Which of the following sample planning factors will influence the sample size for a
test of details of balances for a specific account?
Expected Amount Measure of
of Misstatements Tolerable Misstatement
(1) No No
(2) Yes Yes
(3) No Yes
(4) Yes No
c. How would increases in tolerable misstatement and assessed level of control risk affect
the sample size in substantive tests of details?
Increase in Increase in
Tolerable Misstatement Assessed Level of Control Risk
(1) Increase sample size Increase sample size
(2) Increase sample size Decrease sample size
(3) Decrease sample size Increase sample size
(4) Decrease sample size Decrease sample size
17-26(Objective 17-2)The following apply to evaluating results of audit sampling for tests
of details of balances. For each one, select the best response.
592 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
a. While performing a substantive test of details during an audit, the auditor determined
that the sample results supported the conclusion that the recorded account balance
was materially misstated. It was, in fact, not materially misstated. This situation
illustrates the risk of
(1) assessing control risk too high. (3) incorrect rejection.
(2) assessing control risk too low. (4) incorrect acceptance.
b. Which of the following is true regarding two random samples drawn in the same way
from the same population, one of size 30 and the other of size 300?
(1) The two samples would have the same expected value.
(2) The larger sample is more likely to produce a larger sample mean.
(3) The smaller sample will have a 95% confidence interval for the mean.
(4) The smaller sample will, on average, produce a lower estimate of the variance of
the population.
c. The accounting department reports the accounts receivable balance as $175,000. You
are willing to accept that balance if it is within $15,000 of the actual balance. Using a
variables sampling plan, you compute a 95% confidence interval of $173,000 to
$187,000. You would therefore
(1) find it impossible to determine the acceptability of the balance.
(2) accept the balance but with a lower level of confidence.
(3) take a larger sample before rejecting the sample and requiring adjustments.
(4) accept the $175,000 balance because the confidence interval is within the materiality
limits.
17-27 (Objectives17-3, 17-4, 17-5) The following relate to the use of statistical sampling
for tests of details of balances. For each one, select the best response. |
a. When the auditor uses monetary unit statistical sampling to examine the total dollar
value of invoices, each invoice
(1) has an equal probability of being selected.
(2) can be represented by no moArep thaang onoe m oPneDtarFy u niEt.nhancer
(3) has an unknown probability of being selected.
(4) has a probability proportional to its dollar value of being selected.
b. Which of the following would be an advantage of using variables sampling rather than
probability-proportional-to-size (PPS) sampling?
(1) An estimate of the standard deviation of the population’s recorded amount is not
required.
(2) The auditor rarely needs the assistance of a computer program to design an
efficient sample.
(3) The inclusion of zero and negative balances usually does not require special design
considerations.
(4) Any amount that is individually significant is automatically identified and selected.
c. In applying variables sampling, an auditor attempts to
(1) estimate a qualitative characteristic of interest.
(2) determine various rates of occurrence for specified attributes.
(3) discover at least one instance of a critical deviation.
(4) predict a monetary population value within a range of precision.
DISCUSSION QUESTIONS AND PROBLEMS
17-28 (Objective 17-2)You are planning to use nonstatistical sampling to evaluate the
results of accounts receivable confirmation for the Meridian Company. You have already
performed tests of controls for sales, sales returns and allowances, and cash receipts, and
they are considered excellent. Because of the quality of the controls, you decide to use an
acceptable risk of incorrect acceptance of 10%. There are 3,000 accounts receivable with a
gross value of $6,900,000. The accounts are similar in size and will be treated as a single
stratum. An overstatement or understatement of more than $150,000 is considered material.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 593
Required a. Calculate the required sample size. Assume your firm uses the following nonstatistical
formula to determine sample size:
Sample size = (Book value of population / Tolerable misstatement) xAssurance factor
An assurance factor of 2 is used for a 10% ARIA.
b. Assume that instead of good results, poor results were obtained for tests of controls
and substantive tests of transactions for sales, sales returns and allowances, and cash
receipts. How will this affect your required sample size? How will you use this
information in your sample size determination?
c. Regardless of your answer to part a, assume you decide to select a sample of 100
accounts for testing. Indicate how you will select the accounts for testing using
systematic selection.
d. Assume a total book value of $230,000 for the 100 accounts selected for testing. You
uncover three overstatements totaling $1,500 in the sample. Evaluate whether the
population is fairly stated.
17-29 (Objective 17-2) You are evaluating the results of a nonstatistical sample of 85
accounts receivable confirmations for the Bohrer Company. Information on the sample
and population are included below. An overstatement or understatement of more than
$100,000 is considered material.
Sample Population
_______________________ _______________________
# of Recorded # of Recorded
Stratum Accounts Value Accounts Value
1 > $75,000 8 $1,287,643 8 $1,287,643
2 $10,000 – $74,999 40 1,349,678 257 4,348,268
3 < $10,000 _2_5_ ____9_4_,_6_3_7_ 7__1_2_ ___9_4_7_,_6_8_2_
73 $2,731,958 977 $6,583,593
TheA copnfairmgaotio n rPespDoFnse s wEerne rhecaeivnedc weithrout exception, other than the following
items:
Acct. Recorded Confirmation
No. Value Response Auditor Follow-up
147 $ 24,692 $ 23,597 Customer was charged the wrong price.
228 183,219 157,216 $26,003 shipment recorded on December 30th;
goods were not shipped until January 3rd.
278 7,546 5,546 Customer sent $2,000 payment on December 29th;
received on January 2nd.
497 15,319 0 $17,443 shipment recorded on December 30th;
goods were not shipped until January 2nd.
564 8,397 7,858 Customer received less than the full quantity ordered. |
653 32,687 19,328 $13,359 shipment recorded on December 30th;
goods were not shipped until January 2nd.
830 5,286 0 $5,286 shipment made December 30th;
goods were received by the customer on
January 4th.
Required a. Evaluate each of the confirmation exceptions to determine whether they represent
misstatements.
b. Estimate the total amount of misstatement in the accounts receivable population.
Ignore sampling risk in the calculation.
c. Is the population acceptable? If not, indicate what follow-up action(s) you consider
appropriate in the circumstances.
17-30(Objective 17-3)The accounts receivable population for Jake’s Bookbinding Company
follows. This table is the same as Table 17-1 on page 560, except that cumulative amounts
are included to assist you in completing the problem. The population is smaller than is
ordinarily the case for statistical sampling, but an entire population is useful to show how
to select PPS samples.
594 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
a. Select a random PPS sample of 10 items, using computer software. Required
b. Select a sample of 10 items using systematic PPS sampling using the same concepts dis -
cussed in Chapter 15 for systematic sampling. Use a starting point of 1857. Identify the
physical units associated with the sample dollars. (Hint:The interval is 207,295 ÷ 10.)
c. Which sample items will always be included in the systematic PPS sample regardless of
the starting point? Will that also be true of random PPS sampling?
d. Which method is preferable in terms of ease of selection in this case?
e. Why will an auditor use MUS?
Population Recorded Cumulative Population Recorded Cumulative
Item Amount Amount Item (cont.) Amount (cont.) Amount (cont.)
1 $ 1,410 $ 1,410 21 $ 4,865 $117,385
2 9,130 10,540 22 770 118,155
3 660 11,200 23 2,305 120,460
4 3,355 14,555 24 2,665 123,125
5 5,725 20,280 25 1,000 124,125
6 8,210 28,490 26 6,225 130,350
7 580 29,070 27 3,675 134,025
8 44,110 73,180 28 6,250 140,275
9 825 74,005 29 1,890 142,165
10 1,155 75,160 30 27,705 169,870
11 2,270 77,430 31 935 170,805
12 50 77,480 32 5,595 176,400
13 5,785 83,265 33 930 177,330
14 940 84,205 34 4,045 181,375
15 1,820 86,025 35 9,480 190,855
16 3,380 89,405 36 360 191,215
17 530 89,935 37 1,145 192,360
18 955 90,890 38 6,400 198,760
19 4,490 95,380 39 100 198,860
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20 17,140 112,520 40 8,435 207,295
17-31(Objective 17-3)In the audit of Price Seed Company for the year ended September 30,
the auditor set a tolerable misstatement of $50,000 at an ARIA of 10%. A PPS sample of 100
was selected from an accounts receivable population that had a recorded balance of
$1,975,000. The following table shows the differences uncovered in the confirmation process:
Accounts Accounts
Receivable Receivable per
per Records Confirmation Follow-up Comments by Auditor
1. $2,728.00 $2,498.00 Pricing error on two invoices.
2. $5,125.00 -0- Customer mailed check 9/26; company received check 10/3.
3. $3,890.00 $1,190.00 Merchandise returned 9/30 and counted in inventory; credit
was issued 10/6.
4. $ 791.00 $ 815.00 Footing error on an invoice.
5. $ 548.00 $1,037.00 Goods were shipped 9/28; sale was recorded on 10/6.
6. $3,115.00 $3,190.00 Pricing error on a credit memorandum.
7. $1,540.00 -0- Goods were shipped on 9/29; customer received goods 10/3;
sale was recorded on 9/30.
a. Calculate the upper and lower misstatement bounds on the basis of the client mis- Required
statements in the sample.
b. Is the population acceptable as stated? If not, what options are available to the auditor
at this point? Which option should the auditor select? Explain.
17-32(Objective 17-3) You intend to use MUS as a part of the audit of several accounts for
Roynpower Manufacturing Company. You have done the audit for the past several years,
and there has rarely been an adjusting entry of any kind. Your audit tests of all tests of
controls and substantive tests of transactions cycles were completed at an interim date, and
control risk has been assessed as low. You therefore decide to use an ARIA of 10% and an |
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 595
EPER of 0% for all tests of details of balances. You also decide to use a 100% misstatement
assumption for both overstatements and understatements.
You intend to use MUS in the audit of the three most material asset balance sheet
account balances: accounts receivable, inventory, and marketable securities. You feel justi -
fied in using the same ARIA for each audit area because of the low assessed control risk.
The recorded balances and related information for the three accounts are as follows:
Recorded Value
Accounts receivable $ 3,600,000
Inventory 4,800,000
Marketable securities ____1_,6_0__0_,0_0__0_
$10,000,000
Net earnings before taxes for Roynpower are $2,000,000. You decide that a combined
misstatement of $100,000 is allowable for the client.
The audit approach to be followed will be to determine the total sample size needed for all
three accounts. A sample will be selected from all $10 million, and the appropriate testing for
a sample item will depend on whether the item is a receivable, inventory, or marketable security.
The audit conclusions will pertain to the entire $10 million, and no conclusion will be made
about the three individual accounts unless significant misstatements are found in the sample.
Required a. Evaluate the audit approach of testing all three account balances in one sample.
b. Calculate the required sample size for all three accounts.
c. Calculate the required sample size for each of the three accounts, assuming you decide
that the tolerable misstatement in each account is $100,000. (Recall that tolerable
misstatement equals preliminary judgment about materiality for MUS.)
d. Assume that you select the random sample using computer software. How will you
identify which sample item in the population to audit for the number 4,627,871?
What audit procedures will be performed?
e. AAssupmae tghato yo u PselDectF a samEpnle hof a200n scamepler items for testing and you find one mis -
statement in inventory. The recorded value is $987.12 and the audit value is $887.12.
Calculate the misstatement bounds for the three combined accounts and reach
appropriate audit conclusions.
17-33(Objectives 17-2, 17-3, 17-4, 17-5) An audit partner is developing an office training
program to familiarize her professional staff with audit sampling decision models applicable
to the audit of dollar-value balances. She wishes to demonstrate the relationship of sample
sizes to population size and estimated population exception rate and the auditor’s specifica-
tions as to tolerable misstatement and ARIA. The partner prepared the following table to
show comparative population characteristics and audit specifications of the two populations:
Audit Specifications as to a
Characteristics of Population 1 Sample from Population 1
Relative to Population 2 Relative to a Sample from Population 2
Estimated Population Tolerable
Size Exception Rate Misstatement ARIA
Case 1 Equal Equal Equal Lower
Case 2 Smaller Smaller Equal Higher
Case 3 Larger Equal Equal Lower
Case 4 Equal Larger Larger Equal
Case 5 Larger Equal Smaller Higher
Required In items (1) through (5) you are to indicate for the specific case from the table the required
sample size to be selected from population 1 relative to the sample from population 2.
(1) In case 1, the required sample size from population 1 is _____.
(2) In case 2, the required sample size from population 1 is _____.
(3) In case 3, the required sample size from population 1 is _____.
(4) In case 4, the required sample size from population 1 is _____.
(5) In case 5, the required sample size from population 1 is _____.
596 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Your answer choice should be selected from the following responses:
a. Larger than the required sample size from population 2.
b. Equal to the required sample size from population 2.
c. Smaller than the required sample size from population 2.
d. Indeterminate relative to the required sample size from population 2.* |
17-34 (Objective 17-5) In auditing the valuation of inventory, the auditor, Claire Butler,
decided to use difference estimation. She decided to select an unrestricted random sample
of 80 inventory items from a population of 1,840 that had a book value of $175,820. Butler
decided in advance that she was willing to accept a maximum misstatement in the popu-
lation of $6,000 at an ARIA of 5 percent. There were eight misstatements in the sample,
which were as follows:
Audit Value Book Value Sample Misstatements
$ 812.50 $ 740.50 $(72.00)
12.50 78.20 65.70
10.00 51.10 41.10
25.40 61.50 36.10
600.10 651.90 51.80
.12 0 (.12)
51.06 81.06 30.00
___8__3_.1_1_ __1_0__4_.2_2_ __2__1_.1_1_
Total $1,594.79 $1,768.48 $173.69
a. Calculate the point estimate, the computed precision interval, the confidence interval, Required
and the confidence limits for the population. Label each calculation. Use a computer
for this purpose (instructor’s option).
b. Should Butler accept the book value of the population? Explain.
c. What options are available to her at this point?
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17-35(Objective 17-5)Marjorie Jorgenson, CPA, is verifying the accuracy of outstanding
accounts payable for Marygold Hardware, a large, single-location retail hardware store.
There are 650 vendors listed on the outstanding accounts payable list. She has eliminated
from the population 40 vendors that have large ending balances and will audit them
separately. There are now 610 vendors.
She plans to do one of three tests for each item in the sample: examine a vendor’s state -
ment in the client’s hands, obtain a confirmation when no statement is on hand, or exten -
sively search for invoices when neither of the first two is obtained. There is no accounts
payable master file available, and a large number of misstatements are expected. Marjorie
has obtained facts or made audit judgments as follows:
ARIR 20% ARIA 10%
Tolerable misstatement $ 45,000 Expected misstatement $ 20,000
Recorded book value $ 600,000 Estimated standard deviation $ 280
a. Under what circumstances is it desirable to use difference estimation in the situation Required
described? Under what circumstances is it undesirable?
b. Calculate the required sample size for the audit tests of accounts payable using
difference estimation, assuming that ARIR is ignored.
c. Assume that the auditor selects exactly the sample size calculated in part b. The point
estimate calculated from the sample results is $21,000 and the estimated population
standard deviation is 267. Is the population fairly stated as defined by the decision
rule? Explain what causes the result to be acceptable or unacceptable.
d. Calculate the required sample size for the audit tests of accounts payable, assuming
that the ARIR is considered.
e. Explain the reason for the large increase of the sample size resulting from including
ARIR in determining sample size.
*AICPA adapted.
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 597
CASES
17-36 (Objective 17-3)You are doing the audit of Peckinpah Tire and Parts, a wholesale
auto parts company. You have decided to use monetary unit sampling (MUS) for the audit
of accounts receivable and inventory. The following are the recorded balances:
Accounts receivable $12,000,000
Inventory $23,000,000
You have already made the following judgments:
Materiality for planning purposes $800,000
Acceptable audit risk 5%
Inherent risk:
Accounts receivable 80%
Inventory 100%
Assessed control risk:
Accounts receivable 50%
Inventory 80%
Analytical procedures have been planned for inventory, but not for accounts receivable.
The analytical procedures for inventory are expected to have a 60% chance of detecting a
material misstatement should one exist.
You have concluded that it will be difficult to alter sample size for accounts receivable
confirmation once confirmations are sent and replies are received. However, inventory tests
can be reopened without great difficulty.
After discussions with the client, you believe that the accounts are in about the same
condition this year as they were last year. Last year no misstatements were found in the confir- |
mation of accounts receivable. Inventory tests revealed an overstatement amount of about 1%.
FoAr rpequairgemoen ts Pa–cD, mFa ke Eanny ahssuamnpticones nrecessary in deciding the factors affecting
sample size. If no table is available for the ARIA chosen, estimate sample size judgmentally.
Required a. Plan the sample size for the confirmation of accounts receivable using MUS.
b. Plan the sample size for the test of pricing of inventories using MUS.
c. Plan the combined sample size for both the confirmation of accounts receivable and
the price tests of inventory using MUS.
d. (Instructor’s option) Using an electronic spreadsheet, generate a list of random dollars
in generation order and in ascending order for the sample of accounts receivable items
determined in part a.
17-37 (Objectives 17-2, 17-3)You have just completed the accounts receivable confir -
mation process in the audit of Danforth Paper Company, a paper supplier to retail shops
and commercial users. Following are the data related to this process:
Accounts receivable recorded balance $ 2,760,000
Number of accounts 7,320
A nonstatistical sample was taken as follows:
All accounts over $10,000 (23 accounts) $ 465,000
77 accounts under $10,000 $ 81,500
Tolerable misstatement for the confirmation test $ 100,000
Inherent and control risk are both high
No relevant analytical procedures were performed
The following are the results of the confirmation procedures:
Recorded Value Audited Value
Items over $10,000 $ 465,000 $ 432,000
Items under $10,000 81,500 77,150
(continued on following page)
598 Part 3 / APPLICATION OF THE AUDIT PROCESS TO THE SALES AND COLLECTION CYCLE
Recorded Value Audited Value
Individual misstatements for items under $10,000:
Item 12 5,120 4,820
Item 19 485 385
Item 33 1,250 250
Item 35 3,975 3,875
Item 51 1,850 1,825
Item 59 4,200 3,780
Item 74 2,405 0
a. Evaluate the results of the nonstatistical sample. Consider both the direct implications Required
of the misstatements found and the effect of using a sample.
b. Assume that the sample was a PPS sample. Evaluate the results using monetary unit
sampling.
c. (Instructor’s option) Do the preceding analyses using an electronic spreadsheet.
ACL PROBLEM
17-38(Objective 17-3)This problem requires the use of ACL software, which is included in
the CD attached to the text. Information about installing and using ACL and solving this
problem can be found in Appendix, pages 838–842. You should read all of the reference
material, especially the material on sampling, to answer questions a–e. For this problem use
the “Inventory” file in the “Inventory_Review” subfolder under tables in Sample_Project.
Suggested commands, where applicable, are indicate at the end of the problem requirements.
a. Calculate the sample size and sampling interval for an MUS sample based on inven - Required
tory value at cost (Value). Use a confidence level of 90%, materiality of $40,000, and
expected errors of $2,500. (Sampling/Calculate Sample Size; select “monetary” radio
button) Apago PDF Enhancer
b. What is the sampling size and sampling interval if you increase materiality to $50,000
and decrease expected errors to $1,000?
c. Select the sample based on the sampling interval determined in part a. (Sampling
/Sample Records; select “Sample type” as MUS. For “Sample Parameters” select fixed
interval and enter the interval from part a.; use a random start of 3179.)
d. How many items were selected for testing? Why is this number less than the sample
size determined in part a?
e. What is the largest item selected for testing? How many sample items are larger than the
sampling interval? How many items are larger than the sampling interval in the population?
INTERNET PROBLEM 17-1:
MONETARY UNIT SAMPLING CONSIDERATIONS
Monetary unit sampling (MUS) is the most commonly used statistical method of sampling
for tests of details because of its simplicity and its ability to provide statistical results in
dollars. Read an article titled “Monetary-Unit Sampling Using Microsoft Excel” that
appeared in the May 2005 issue of The CPA Journal (www.nysscpa.org/cpajournal/2005/ |
505/essentials/p36.htm) to answer the following questions.
a. The authors suggest that there are three critical steps in applying MUS. What are these Required
steps?
b. How do the authors indicate that an MUS sample size is determined?
c. What two factors must be considered when evaluating the results of the sample?
Chapter 17 / AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES 599
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T
R
A
P
C H A P T E R S
18 – 2 3
4
APPLICATION OF THE AUDIT
PROCESS TO OTHER CYCLES
Each chapter in Part 4demonstrates the relationship of internal controls,
substantive tests of transactions, and analytical procedures to the related balance
sheet and income statement accounts in the cycle and to test of details of balances.
•
Chapters 18 and 19address the audit of the acquisition and payment
cycle, including the audit of accounts payable and other liability accounts.
•
Chapter 20covers the audit of the payroll and personnel cycle.
•
Chapter 21addresses the audit of the inventory and warehousing cycle,
including physical observation tests and the relationship of the inventory
and warehousing cycle to other cycles.
•
Chapter 22includes the audit of the capital acquisition and repayment cycle.
•
Chapter 23is the audit of cash balances, which is covered last because
cash is affected by the transactions in other cycles.
18
C H A P T E R
AUDIT OF THE ACQUISITION
AND PAYMENT CYCLE:
LEARNING OBJECTIVES
TESTS OF CONTROLS,
After studying this chapter,
you should be able to
SUBSTANTIVE TESTS
18-1 Identify the accounts and the
classes of transactions in the
acquisition and payment cycle.
OF TRANSACTIONS,
18-2 Describe the business functions
and the related documents and
records in the acquisition and
AND ACCOUNTS PAYABLE
payment cycle.
18-3 Understand internal control,
and design and perform tests of
controls and substantive tests of
False Purchases Camouflage Overstated Profits transactions for the acquisition
and payment cycle.
Comptronix Corporation announced that senior members of its manage-
18-4 Describe the methodology for
ment team overstated profits, and there would be material adjustments to
designing tests of details of
the prior years’ audited financial statem ents. Central to the fraud was the balances for accounts payable
use of fictitious purchases of large equipment items to overstate fixed using the audit risk model.
assets and hide fictitious sales. Apago PDF Enhancer 18-5 Design and perform analytical
procedures for accounts payable.
The senior executives circumvented Comptronix’s existing internal controls
18-6 Design and perform tests of
by bypassing the purchasing and receiving departments so that no one at
details of balances for accounts
Comptronix could discover the scheme. Comptronix employees usually payable, including out-of-period
created a fairly extensive paper trail for equipment purchases. Company liability tests.
internal controls over acquisition and cash disbursement transactions 18-7 Distinguish the reliability of
typically required a purchase order, receiving report, and vendor invoice vendors’ invoices, vendors’
before payment could be authorized by the Chief Operating Officer or the statements, and confirmations
of accounts payable as audit
controller/treasurer, who were both participants in the fraud. As a result,
evidence.
the executives were able to bypass controls over cash disbursements and
authorize payment for nonexistent purchases without creating any docu -
ments for the fictitious transactions.
The company also created fictitious sales and related receivables. The company issued checks to pay for the false
purchase transactions. The checks were then redeposited into the company’s bank account and recorded as
collections on the fictitious receivables. As a result, it appeared that the fictitious sales were collected, and that
payments were made to support the false fixed asset purchases.
The fraud scheme grossly exaggerated the company’s performance by reporting profits when the company was
actually incurring losses. On the day that the public announcement of the fraud was made, Comptronix’s common |
stock price declined abruptly by 72 percent! The SEC ultimately charged the executives with violating the antifraud
provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC permanently barred the
executives from serving as officers or directors of any public company, ordered them to repay bonuses and trading
losses avoided, and imposed civil monetary penalties against them.
Source: Accounting and Auditing Enforcement Release No. 543, Commerce Clearing House, Inc., Chicago.
We’ll now discuss the acquisition and payment cycle. The acquisition of goods and services includes the
acquisition of such things as raw materials, equipment, supplies, utilities, repairs and maintenance, and
research and development. In the first part of the chapter, we’ll examine assessing control risk and designing tests of
controls and substantive tests of transactions for the classes of transactions in the acquisition and payment cycle.
Then, we’ll cover performing tests of details of balances for accounts payable.
As with the sales and collection cycle, auditors need to understand the business functions and documents and
records in a company before they can assess control risk and design tests of controls and substantive tests of
transactions. We first examine two related topics:
1. The acquisition and payment cycle classes of transactions and account balances in a typical company
2. Typical documents and records used in the acquisition and payment cycle
ACCOUNTS AND CLASSES OF TRANSACTIONS IN
THE ACQUISITION AND PAYMENT CYCLE
OBJECTIVE 18-1 The objective in the audit of the acquisition and payment cycle is to evaluate whether
the accounts affected by the acquisitions of goods and services and the cash disburse -
Identify the accounts and
ments for those acquisitions are fairly presented in accordance with accounting
the classes of transactions in
standards. Figure 18-1 shows the way accounting information flows through the various
the acquisition and payment
cycle. accounts in the acquisition and payment cycle.
There are three classes of transactions included in the cycle:
1. Acquisitions of goods and services
2. Cash disbursements
3. Purchase returns and allowances and purchase discounts
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FIGURE 18-1 Accounts in the Acquisition and Payment Cycle
Cash in bank Rawmaterialpurchases
Accountspayable
Acquisitions
Cash of goods
disbursements and
Purchase returns services Property,plant,
and allowances Purchase and equipment
returns and
allowances
Purchase
discounts
Purchasediscounts Prepaid expenses
Manufacturing expense Selling expense Administrative expense
control account control account control account
Subsidiary Subsidiary
accounts accounts
Subsidiary Commissions Supplies
accounts Travel expense Officers travel
Repair andmaintenance Delivery expense Legalfees
Taxes Repairs Auditingfees
Supplies Advertising Taxes
Freight in
Utilities
602 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Ten typical accounts involved in the acquisition and payment cycle are shown by T
accounts in Figure 18-1. For simplicity, we show only the control accounts for the three
major categories of expenses used by most companies. For each control account,
examples of the subsidiary expense accounts are also given. Note the large number of
accounts affected by this cycle. It is therefore not surprising that auditing the acquisition
and payment cycle often takes more time than any other cycle.
Figure 18-1 shows that every transaction is either debited or credited to accounts
payable. Because many companies make acquisitions directly by check or through
petty cash, the figure is an oversimplification. We assume that acquisitions made for
cash are processed in the same manner as those made by accounts payable.
BUSINESS FUNCTIONS IN THE CYCLE AND
RELATED DOCUMENTS AND RECORDS
The acquisition and payment cycle involves the decisions and processes necessary for OBJECTIVE 18-2
obtaining the goods and services for operating a business. The cycle typically begins
Describe the business
with the initiation of a purchase requisition by an authorized employee who needs the |
functions and the related
goods or services, and it ends with payment on accounts payable. In the following documents and records in
discussion, the example of a small manufacturing company that makes tangible the acquisition and payment
products for sale to third parties is used, but the principles covered here also apply to cycle.
service companies, government entities, and other types of organizations.
The third column of Table 18-1 (p. 604) lists four business functions that occur in
every business in recording the three classes of transactions in the acquisition and
payment cycle. The first three functions are for recording the acquisition of goods and
services on account, and the fourth function is for recording cash disbursements for
payments to vendors. For simplicity, our illustration does not show processing
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purchase returns and allowances and purchase discounts. Although purchase returns
and allowances and purchase discounts business functions also occur in this cycle, we
omit them here because the amounts are not significant for most companies.
Next, we examine in more detail each of the four business functions, paying
particular attention to the typical documents and records used. These are listed in the
fourth column of Table 18-1.
The request for goods or services by the client’s personnel is the starting point for the Processing
cycle. The exact form of the request and the required approval depend on the nature of Purchase Orders
the goods and services and company policy. Common documents include:
Purchase Requisition Apurchase requisitionis used to request goods and services
by an authorized employee. This may take the form of a request for such acquisitions as
materials by production staff or the storeroom supervisor, outside repairs by office or
plant personnel, or insurance by the vice president in charge of property and equip -
ment. Companies often rely on pre-specified reorder points used by the computer to
initiate inventory purchase requisitions automatically.
Purchase Order A purchase order is a document used to order goods and services
from vendors. It includes the description, quantity, and related information for goods
and services the company intends to purchase and is often used to indicate authorization
of the acquisition. Companies often submit purchase orders electronically to vendors
who have made arrangements for electronic data interchange (EDI).
The receipt by the company of goods or services from the vendor is a critical point in Receiving
the cycle because it is when most companies first recognize the acquisition and related Goods and Services
liability on their records. When goods are received, adequate control requires
examination for description, quantity, timely arrival, and condition. A receiving
report is a paper or electronic document prepared at the time goods are received. It
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 603
TABLE 18-1 Classes of Transactions, Accounts, Business Functions, and Related Documents and Records
for the Acquisition and Payment Cycle
Classes of
Transactions Accounts Business Functions Documents and Records
Acquisitions Inventory Processing purchase orders Purchase requisition
Property, plant, and equipment Purchase order
Prepaid expenses
Leasehold improvements Receiving goods and services Receiving report
Accounts payable
Manufacturing expenses Recognizing the liability Vendor’s invoice
Selling expenses Debit memo
Administrative expenses Voucher
Acquisitions transaction file
Acquisitions journal or listing
Accounts payable master file
Accounts payable trial balance
Vendor’s statement
Cash disbursements Cash in bank (from cash Processing and recording cash Check or electronic payment
disbursements) disbursements Cash disbursements transaction file
Accounts payable Cash disbursements journal or listing
Purchase discounts
includes a description of the goods, the quantity received, the date received, and other
relevant data.
Recognizing The proper recognition of the liability for the receipt of goods and services requires |
the Liability prompAt apnda agccuora tePreDcoFrdi ngE. Tnheh inaitnialc reecorrding affects the financial statements
and the actual cash disbursement; therefore, companies must take care to include all
acquisition transactions, only acquisitions that occurred, and at the correct amounts.
Common documents and records include:
Vendor’s Invoice Avendor’s invoiceis a document received from the vendor and shows
the amount owed for an acquisition. It indicates the description and quantity of goods
and services received, price (including freight), cash discount terms, date of the billing
and total amount. The vendor’s invoice is important because it indicates the amount
recorded in the acquisition transaction file. For companies using EDI, the vendor’s
invoice is transmitted electronically, which affects how the auditor evaluates evidence.
Debit Memo A debit memo is also a document received from the vendor and
indicates a reduction in the amount owed to a vendor because of returned goods or an
allowance granted. It often takes the same form as a vendor’s invoice, but it supports
reductions in accounts payable rather than increases.
Voucher A voucheris commonly used by organizations to establish a formal means
of recording and controlling acquisitions, primarily by enabling each acquisition
transaction to be sequentially numbered. Vouchers include a cover sheet or folder for
containing documents and a package of relevant documents such as the purchase
order, copy of the packing slip, receiving report, and vendor’s invoice. After payment, a
copy of the check is added to the voucher package.
Acquisitions Transaction File This is a computer-generated file that includes all
acquisition transactions processed by the accounting system for a period, such as a day,
week, or month. It contains all information entered into the system and includes
information for each transaction, such as vendor name, date, amount, account classifi-
cation or classifications, and description and quantity of goods and services purchased.
The file can also include purchase returns and allowances or there can be a separate file
604 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
for those transactions. Depending on the company’s needs, the information in the
acquisitions transaction file is used for a variety of records, listings, or reports, such as
an acquisitions journal, accounts payable master file, and trans actions for a certain
account balance or division.
Acquisitions Journal or Listing Theacquisitions journalor listing, often referred
to as the purchases journal, is generated from the acquisitions transaction file and
typically includes the vendor name, date, amount, and account classification or classi-
fications for each transaction, such as repair and main tenance, inventory, or utilities. It
also identifies whether the acquisition was for cash or accounts payable. The journal or
listing can cover any time period, typically a month. The journal or listing includes
totals of every account number included for the time period. The same transactions
included in the journal or listing are also posted simultaneously to the general ledger
and, if they are on account, to the accounts payable master file.
Accounts Payable Master File An accounts payable master filerecords acquisi tions,
cash disbursements, and acquisition returns and allowances transactions for each
vendor. The master file is updated from the acquisition, returns and allowances, and cash
disbursement computer transaction files. The total of the individual account balances in
the master file equals the total balance of accounts payable in the general ledger. A
printout of the accounts payable master file shows, by vendor, the beginning balance in
accounts payable, each acquisition, acquisition return and allowance, cash disbursement,
and the ending balance. Many companies do not maintain an accounts payable master
file by vendor. These companies pay on the basis of individual vendor’s invoices. There -
fore, the total of unpaid vendors’ invoices in the master file equals total accounts payable. |
Accounts Payable Trial Balance An accounts payable trial balancelisting includes
the amount owed to each vendor or for each invoice or voucher at a point in time. It is
prepared directly from the accounts payable master file.
Vendor’s Statement A vendor’s sAtatpemaengtois a dPocDumFe nt Eprnepharead nmconethlry by the
vendor and indicates the beginning balance, acquisitions, returns and allowances,
payments to the vendor, and ending balance. These balances and activities are the
vendor’s representations of the transactions for the period, not the client’s. Except for
disputed amounts and timing differences, the client’s accounts payable master file
should be the same as the vendor’s statement.
The payment for goods and services represents a significant activity for all entities. This Processing
activity directly reduces balances in liability accounts, particularly accounts payable. and Recording
Documents associated with the disbursement process that auditors examine include: Cash Disbursements
Check This document is commonly used to pay for the acquisition when payment is
due. Most companies use computer-prepared checks based on information included in
the acquisition transactions file at the time goods and services are received. Checks are
typically prepared in a multi-copy format, with the original going to the payee, one
copy filed with the vendor’s invoice and other supporting documents, and another filed
numerically. In most cases, individual checks are recorded in a cash disbursements
transaction file.
After a check is signed by an authorized person, it is an asset. Therefore, signed
checks should be mailed by the signer or a person under the signer’s control. When
cashed by the vendor and cleared by the client’s bank, it is called a cancelled check. At
that point it is no longer an asset, but now is a document. In many EDI arrangements,
the company submits payments to the vendor electronically through an electronic
funds transfer (EFT) between the company’s bank and the vendor’s bank.
Cash Disbursements Transaction File This is a computer-generated file that
includes all cash disbursements transactions processed by the accounting system for a
period, such as a day, week, or month. It includes the same type of information
discussed for the acquisitions transaction file.
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 605
Cash Disbursements Journal or Listing This is a listing or report generated from
the cash disbursements transaction file that includes all transactions for any time
period. The same transactions, including all relevant information, are included in the
accounts payable master file and general ledger.
METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS
OBJECTIVE 18-3 In a typical audit, the most time-consuming accounts to verify by substantive tests of
details of balances are accounts receivable, inventory, fixed assets, accounts payable,
Understand internal control,
and expense accounts. Notice that four of these five are directly related to the acquisi-
and design and perform tests
tion and payment cycle. If the auditor can reduce tests of details of the account
of controls and substantive
tests of transactions for the balances by using tests of controls and substantive tests of transactions to verify the
acquisition and payment effectiveness of internal controls for acquisitions and cash disbursements, the net time
cycle. saved can be dramatic. Tests of controls and substantive tests of transactions for the
acquisition and payment cycle receive a considerable amount of attention, especially
when the client has effective internal controls.
Tests of controls and substantive tests of transactions for the acquisition and
payment cycle are divided into two broad areas:
1. Tests of acquisitions, which concern three of the four business functions
discussed earlier in this chapter: processing purchase orders, receiving goods
and services, and recognizing the liability
2. Tests of payments, which concern the fourth function, processing and |
recording cash disbursements
Figure 18-2 illustrates the methodology for designing tests of controls and sub -
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stantive tests of transactions for the acquisition and payment cycle. It is the same
methodology used in earlier chapters. Next, let’s examine each part of Figure 18-2,
starting with understanding internal control.
Understand The auditor gains an understanding of internal control for the acquisition and payment
Internal Control cycle as part of performing risk assessment procedures by studying the client’s flow -
charts, reviewing internal control questionnaires, and performing walkthrough tests for
acquisition and cash disbursement transactions. The procedures for understanding
internal control in the acquisition and payment cycle are similar to the procedures
performed in other transaction cycles, as discussed in earlier chapters.
Assess Planned Next, the key internal controls for each of the business functions described earlier in
Control Risk this chapter are examined. These are authorization of purchases, separation of the
custody of the received goods from other functions, timely recording and independent
review of transactions, and authorization of payments to vendors.
Authorization of Purchases Proper authorization for acquisitions ensures that the
goods and services acquired are for authorized company purposes, and it avoids the
acquisition of excessive or unnecessary items. Most companies require different levels of
authorization for different types of acquisitions or dollar amounts. For example, acqui -
sitions of fixed assets in excess of a specified dollar limit require approval by the board of
directors; items acquired relatively infrequently, such as insurance policies and long-term
service contracts, are approved by certain officers; supplies and services costing less than
a designated amount are approved by supervisors and department heads; and some types
of raw materials and supplies are reordered automatically when they fall below a predeter -
minedlevel, often by direct communication with vendors’ computers.
After the purchase requisition for an acquisition has been approved, a purchase
order to acquire the goods or services must be initiated. A purchase order is issued to a
606 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 18-2 Methodology for Designing Tests of Controls and Substantive
Tests of Transactions for the Acquisition and Payment Cycle
Understand internal
control—
acquisitions and
cashdisbursements
Assessplanned
control risk—
acquisitions and
cashdisbursements
Determine extent
of testing controls*
Design tests of controls Auditprocedures
and substantive tests
of transactions for Sample size
acquisitions and cash
disbursements to meet Items to select
transaction-related
Timing
audit objectives
* Extent of testing of controls is determined byplanned reliance on controls. For acceleratedfiler
public companies, testing must be sufficient to issue an opinion on internal control over
financial reporting.
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vendor for a specified item at a certain price to be delivered at or by a designated time.
The purchase order, issued either in written or electronic form, is generally viewed as a
legal document, and represents an offer to buy the goods or services.
Companies commonly establish purchasing departments to ensure an adequate
quality of goods and services at a minimum price. For effective internal control, the
purchas ing department should be separate from those who authorize the acquisition or
receive the goods. All purchase orders should be prenumbered to permit easier accounting
for all outstanding purchases orders and should be designed to minimize the likelihood of
unintentional omissions on the form when goods are ordered.
Separation of Asset Custody from Other Functions Most companies have the
receiving department initiate a receiving report as evidence of the receipt and
examination of goods. One copy is normally sent to the raw materials storeroom and
another to the accounts payable department for their information needs. To prevent |
theft and misuse, the goods should be physically controlled from the time of their
receipt until their use or disposal. The personnel in the receiving department should be
independent of the storeroom personnel and the accounting department. Finally, the
accounting records should transfer responsibility for the goods each time they are
moved, from receiving to storage, from storage to manufacturing, etc.
Timely Recording and Independent Review of Transactions In some companies,
the recording of the liability for acquisitions is made on the basis of the receipt of
goods and services. In others, recording is deferred until the vendor’s invoice is
received. In either case, the accounts payable department typically has responsibility
for verifying the appropriateness of acquisitions. This is done by comparing the details
on the purchase order, the receiving report, and the vendor’s invoice to determine that
the descriptions, prices, quantities, terms, and freight on the vendor’s invoice are
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 607
correct. Typically, the accounts payable department also verifies extensions, footings,
and account distributions. In some cases, computer software matches documents and
verifies invoice accuracy automatically. The accounts payable department should also
account for all receiving reports to assure that the completeness objective is satisfied.
An important control in the accounts payable and information technology
departments is the requirement that personnel who record acquisitions do not have
access to cash, marketable securities, and other assets. Adequate documents and records,
proper procedures for record keeping, and independent checks on performance are also
necessary controls in the accounts payable function.
Authorization of Payments The most important controls over cash disbursements
include:
• The signing of checks by an individual with proper authority
• Separation of responsibilities for signing checks and performing the accounts
payable function
• Careful examination of supporting documents by the check signer at the time
the check is signed
The checks should be prenumbered to make it easier to account for all checks and
printed on special paper that makes it difficult to alter the payee or amount. Companies
should take care to provide physical control over blank, voided, and signed checks.
They should also have a method of canceling supporting documents to prevent their
reuse as support for another check at a later time. A common method is to document
the check number on the supporting documents.
Determine Extent of After auditors identify key internal controls and deficiencies, they assess control risk.
Testing of Controls When auditors intend to rely on controls to support a preliminary control risk assessment
below maximum, the auditor performs tests of controls to obtain evidence that controls are
operating effectively. As the operating effectiveness of controls improves and is supported
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by additional tests of controls, the auditor is able to reduce substantive testing. Of course,
if the client is an accelerated filer public company, the auditor must document and test
controls sufficiently to issue an opinion on internal control over financial reporting.
Design Tests Table 18-2 summarizes key internal controls, common tests of controls, and common sub -
of Controls and stantive tests of transactions for each transaction-related audit objective. We assume the
Substantive Tests existence of a separate acquisitions journal or listing for recording all acquisitions.
of Transactions As you examine Table 18-2, you should:
for Acquisitions • Relate each of the internal controls to transaction-related audit objectives
• Relate tests of controls to internal controls
• Relate substantive tests of transactions to transaction-related audit objectives
after considering controls and deficiencies in the system
The audit evidence for an audit engagement will vary with the internal controls
and other circumstances. Significant audit efficiencies can be achieved on many audits |
when controls are operating effectively.
APPLE MANAGER An Apple Computer manager was accused of countries in Asia to receive the kickbacks, and
receiving over $1 million in kickbacks from Asian also received payments directly when traveling
ACCUSED OF
suppliers of iPhone and iPod accessories. The to Asia. The payments were referred to by code
RECEIVING manager transmitted confidential information to words such as “sample” to avoid detection by
KICKBACKS the suppliers, which allowed them to negotiate co-workers.
favorable contracts with Apple.
RELATED
The alleged scheme involved a chain of U.S.
Source: Adapted from Pete Carey, “Apple
TO iPHONE and foreign bank accounts, as well as a front Manager Indicted in Kickback Scheme,”
company to receive payments. The manager San Jose Mercury News, August 13, 2010
AND iPOD
reportedly opened bank accounts in several (www.mercurynews.com).
608 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 18-2 Summary of Transaction-Related Audit Objectives, Key Controls, Tests of Controls, and
Substantive Tests of Transactions for Acquisitions
Transaction-Related Common Substantive Tests
Audit Objectives Key Internal Controls Common Tests of Controls of Transactions
Recorded acquisitions are Purchase requisition, purchase Examine documents in Review the acquisitions journal,
for goods and services order, receiving report, voucher package for general ledger, and accounts
received, consistent with and vendor’s invoice are existence. payable master file for large
the best interests of the attached to the voucher.* or unusual amounts.†
client (occurrence). Acquisitions are approved at Examine indication of Examine underlying documents
the proper level. approval. for reasonableness
Computer accepts entry of Attempt to input transactions and authenticity (vendors’
purchases only from with valid and invalid invoices, receiving reports,
authorized vendors in the vendors. purchase orders, and
vendor master file. purchase requisitions).*
Documents are cancelled to Examine indication of Examine vendor master file
prevent their reuse. cancellation. for unusual vendors.
Vendors’ invoices, receiving Examine indication of internal Trace inventory acquisitions
reports, purchase orders, verification. to inventory master file.
and purchase requisitions Examine fixed assets acquired.
are internally verified.*
Existing acquisition Purchase orders are pre- Account for a sequence of Trace from a file of receiving
transactions are recorded numbered and accounted for. purchase orders. reports to the acquisitions
(completeness). Receiving reports are pre- Account for a sequence of journal.*
numbered and accounted for.* receiving reports. Trace from a file of vendors’
Vouchers are prenumbered and Account for a sequence of invoices to the acquisitions
accounted for. vouchers. journal.
Recorded acquisition Calculations and amounts are Examine indication of internal Compare recorded transactions
transactions are accurate internally verified. verification. in the acquisitions journal
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(accuracy). Batch totals are compared with Examine file of batch totals with the vendor’s invoice,
computer summary reports. for initials of data control receiving report, and other
clerk; compare totals to supporting documentation.*
summary reports. Recompute the clerical
Acquisitions are approved for Examine indication of approval. accuracy on the vendor’s
prices and discounts. invoice, including discounts
and freight.
Acquisition transactions are Accounts payable master file Examine indication of internal Test clerical accuracy by footing
correctly included in contents are internally verification. the journals and tracing
the accounts payable verified. postings to general ledger
and inventory master Accounts payable master file Examine initials on general and accounts payable and
files and are correctly or trial balance totals are ledger accounts indicating inventory master files.
summarized (posting compared with general comparison.
and summarization). ledger balances.
Acquisition transactions are An adequate chart of accounts Examine procedures manual Compare classification with |
correctly classified is used. and chart of accounts. chart of accounts by referring
(classification). Account classifications are Examine indication of internal to vendors’ invoices.
internally verified. verification.
Acquisition transactions are Procedures require recording Examine procedures manual Compare dates of receiving
recorded on the correct transactions as soon as and observe whether reports and vendors’ invoices
dates (timing). possible after the goods unrecorded vendors’ with dates in the acquisitions
and services have been invoices exist. journal.*
received.
Dates are internally verified. Examine indication of internal
verification.
*Receiving reports are used only for tangible goods and are therefore not used for services, such as utilities and repairs and maintenance. Often, vendors’ invoices
are the only documentation available.
†This analytical procedure can also apply to other objectives, including completeness, accuracy, and timing.
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 609
Four of the six transaction-related audit objectives for acquisitions deserve special
attention and are therefore examined more closely. The correctness of many asset,
liability, and expense accounts depends on the correct recording of transactions in the
acquisitions journal, especially related to these four objectives.
1.Recorded Acquisitions Are for Goods and Services Received, Consistent
with the Best Interests of the Client (Occurrence) If the auditor is satisfied that
the controls are adequate for this objective, tests for improper transactions and recorded
transactions that did not occur can be greatly reduced. Adequate controls prevent the
unintentional recording of acquisitions that did not occur, especially recording dupli-
cate acquisitions. Adequate controls are also likely to prevent the client from including
as a business expense or asset fraudulent transactions or those that primarily benefit
manage ment or other employees rather than the entity being audited. In some
instances, improper transactions are obvious, such as the acquisition of unauthorized
personal items by employees. In other instances, the appropriateness of a transaction is
more difficult to evaluate, such as the payment of officers’ memberships to country
clubs or expense-paid vacations to foreign countries for management and their families.
If the controls over improper transactions or transactions that did not occur are
inadequate, more extensive examination of supporting documentation is necessary.
2. Existing Acquisitions Are Recorded (Completeness) Failure to record the
acquisition of goods and services received understates accounts payable and may result
in an overstatement of net income and owners’ equity. Therefore, auditors consider
this an essential objective for acquisitions. It may be difficult in some audits to perform
tests of details of balances to determine whether unrecorded transactions exist, so the
auditor must rely on controls and substantive tests of transactions for this purpose. In
addition, because the audit of accounts payable usually takes considerable time,
effective internal controls, properly tested, can significantly reduce audit costs.
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3.Acquisitions Are Accurately Recorded (Accuracy) The extent of tests of details
of many balance sheet and expense accounts depends on the auditor’s evaluation of the
effectiveness of the internal controls over the accuracy of recorded acquisition trans-
actions. For example, if the auditor believes that the fixed asset transactions are correctly
recorded in the acquisitions journal, it is acceptable to vouch fewer current period
acquisitions during tests of details of balances than if the controls are inadequate.
When a client uses perpetual inventory records, tests of details of inventory can
also be significantly reduced if the auditor believes the perpetual records are accurate.
The controls over acquisitions included in the perpetual records are normally tested as
a part of the tests of controls and substantive tests of transactions for acquisitions. |
4. Acquisitions Are Correctly Classified (Classification) Tests of details of certain
individual accounts can be reduced if the auditor believes that internal controls are
adequate to provide reasonable assurance of correct classification in the acquisitions
journal. Although all accounts are affected to some degree by effective controls over
classification, the two areas most affected are current period acquisitions of fixed assets,
and all expense accounts, such as repairs and maintenance, utilities, and advertising.
It is relatively time-consuming for auditors to perform documentation tests
of current period fixed asset acquisitions and expense accounts for accuracy and
classification. Therefore, time-savings can be significant when controls are effective.
Design Tests Table 18-3 for cash disbursements uses the same format as Table 18-2 (p. 609) for acqui -
of Controls and sitions. We assume for these controls and audit procedures that separate cash disburse -
Substantive Tests ments and acquisitions journals exist. Our comments about the methodology and process
of Transactions for for developing audit procedures for acquisitions apply equally to cash disbursements.
Cash Disbursements Auditors typically perform the acquisitions and cash disbursements tests at the
same time. For a transaction selected for examination from the acquisitions journal,
the vendor’s invoice, receiving report and other acquisition documentation are
610 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 18-3 Summary of Transaction-Related Audit Objectives, Key Controls, Tests of Controls, and
Substantive Tests of Transactions for Cash Disbursements
Transaction-Related Common Substantive Tests
Audit Objectives Key Internal Controls Common Tests of Controls of Transactions
Recorded cash disbursements There is adequate segregation Discuss with personnel and Review the cash disbursements
are for goods and services of duties between accounts observe activities. journal, general ledger, and
actually received payable and custody of accounts payable master file
(occurrence). signed checks or authority to for large or unusual amounts.*
disburse funds electronically. Trace the cancelled check or
Supporting documentation Discuss with personnel and electronic bank records of
is examined before signing observe activities. disbursements to the related
of checks or electronic acquisitions journal entry and
disbursement of funds by examine for payee name and
an authorized person. amount.
Approval of payment on Examine indication of Examine cancelled check for
supporting documents is approval. authorized signature, proper
given at the time checks endorsement, and cancellation
are signed. by the bank or use bank records
to verify payee for electronic
payments.
Examine supporting documents as
part of the tests of acquisitions.
Existing cash disbursement Checks are prenumbered Account for a sequence of Reconcile recorded cash
transactions are recorded and accounted for. checks. disbursements with the
(completeness). The bank reconciliation is Examine bank reconciliations cash disbursements on the
prepared monthly by an and observe their bank statement (proof of
employee independent preparation. cash disbursements).
of recording cash
disbursements or custody
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Recorded cash disbursement Calculations and amounts Examine indication of internal Compare cancelled checks and
transactions are accurate are internally verified. verification. electronic bank records of
(accuracy). The bank reconciliation is Examine bank reconciliations disbursements with the related
prepared monthly by an and observe their acquisitions journal and cash
independent person. preparation. disbursements journal entries.
Recompute cash discounts.
Prepare a proof of cash
disbursements.
Cash disbursement transactions Accounts payable master file Examine indication of internal Test clerical accuracy by footing
are correctly included in the contents are internally verification. journals and tracing postings
accounts payable master file verified. Examine initials on general to general ledger and accounts |
and are correctly summarized Accounts payable master file ledger accounts indicating payable master file.
(posting and summarization). or trial balance totals are comparison.
compared with general
ledger balances.
Cash disbursement An adequate chart of Examine procedures manual Compare classification with
transactions are correctly accounts is used. and chart of accounts. chart of accounts by referring
classified (classification). Account classifications are Examine indication of internal to vendors’ invoices and
internally verified. verification. acquisitions journal.
Cash disbursement Procedures require recording Examine procedures manual Compare dates on cancelled
transactions are recorded of transactions as soon as and observe whether checks or electronic bank
on the correct dates possible after the check has unrecorded checks exist. records with the cash
(timing). been signed or electronically disbursements journal.
submitted for bank processing. Compare dates on cancelled
Dates are internally verified. Examine indication of internal checks or electronic bank
verification. records with the bank
cancellation date.
*This analytical procedure can also apply to other objectives, including completeness, accuracy, and timing.
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 611
examined at the same time as the related cancelled check. Thus, the verification is done
efficiently without reducing the effectiveness of the tests.
Attributes Sampling Because of the importance of tests of controls and substantive tests of transactions for
for Tests of Controls acquisitions and cash disbursements, the use of attributes sampling is common. The
and Substantive approach is similar to that used for the tests of controls and substantive tests of trans-
Tests of Transactions actions for sales discussed in the “Statistical Audit Sampling” section on page 501 of
Chapter 15.
There are three important differences in acquisitions and payments compared to
other cycles.
1. As discussed in the beginning of the chapter, there are a larger number of accounts
involved in this cycle, including both income statement and balance sheet accounts.
The effect is an increased potential for classification misstate ments, some of
which are likely to affect income. An example is a misclassification between repair
and maintenance expenses and fixed assets. As a result, auditors often reduce
the tolerable exception rate, especially for the classification attribute.
2. It is more common in this cycle for transactions to require significant judgment,
such as for leases and construction costs. These judgment requirements result in
an increased likelihood of misstatements. As a result, auditors often reduce the
tolerable exception rate for the accuracy attribute.
3. The dollar amounts of individual transactions in the cycle cover a wide range.
As a result, auditors commonly segregate large and unusual items and test
them on a 100 percent basis.
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES FOR ACCOUNTS PAYABLE
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OBJECTIVE 18-4 Because all acquisition and payment cycle transactions typically flow through accounts
payable, this account is critical to any audit of the acquisition and payment cycle.
Describe the methodology
Accounts payable are unpaid obligationsfor goods and services received in the ordinary
for designing tests of details
course of business. Accounts payable includes obligations for the acquisition of raw
of balances for accounts
payable using the audit risk materials, equipment, utilities, repairs, and many other types of goods and services that
model. were received before the end of the year. Most accounts payable can also be identified
by the existence of vendors’ invoices for the obligation.
Accounts payable should be distinguished from accrued liabilities and interest-
bearing obligations. A liability is an account payable only if the total amount of the
obligation is known and owed at the balance sheet date. If the obligation includes the
payment of interest, it should be recorded as a note payable, contract payable, |
mortgage payable, or bond payable.
Figure 18-3 summarizes the methodology for designing tests of details for accounts
payable. This methodology is the same as that used for accounts receivable in Chapter
16 (see Figure 16-1 on page 520).
If tests of controls and related substantive tests of transactions show that controls
are operating effectively, and if analytical procedures results are satisfactory, the auditor
is likely to reduce tests of details of balances for accounts payable. However, because
accounts payable tend to be material for most companies, auditors almost always
perform some tests of details of balances.
Identify Client The recent focus by many companies on improving their supply-chain management
Business Risks activities has led to numerous changes in the design of systems used to initiate and
Affecting Accounts record acquisition and payment activities. Efforts to streamline the purchasing of goods
Payable (Phase I) and services, including greater emphasis on just-in-time inventory purchasing, increased
sharing of information with suppliers, and the use of technology and e-commerce to
612 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 18-3 Methodology for Designing Tests of Details of Balances for
AccountsPayable
Identify client
business risks
Phase I
affecting accounts
payable
Set tolerable misstatement
and assess
Phase I
inherent risk
for accounts payable
Assess control risk
for the acquisition Phase I
andpayment cycle
Design andperform tests of
controls and substantive
tests of transactions for Phase II
the acquisition and
andpayment cycle
Design and
perform analytical
Phase III
proceduresfor
accountspayable
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Design tests of Auditprocedures
details of accounts Sample size
payable to satisfy Phase III
balance-related Items to select
audit objectives
Timing
transact business, are changing all aspects of the acquisition and payment cycle for
many companies. These arrangements and systems can be complex.
Significant client business risks may arise from these changes. For example, suppliers
may have greater access to accounts payable records, allowing them to continually
monitor the status of payable balances and to perform detailed reconcili ations of
transactions. Access by external parties, such as suppliers, to accounting records threatens
the likelihood of misstatement if that access is not properly controlled. Also, increased
focus on improving the logistics of physically moving inventory throughout a company’s
distribution chain may increase the difficulty of establishing effective cutoff of accounts
payable balances at year-end. The auditor needs to understand the nature of changes to
these systems to identify whether client business risks and related management controls
affect the likelihood of material misstatements in accounts payable.
Like accounts receivable, a large number of transactions can affect accounts pay - Set Tolerable
able. The balance is often large and made up of a large number of vendor balances Misstatement and
and it is relatively expensive to audit the account. For these reasons, auditors Assess Inherent Risk
typically set tolerable misstatement for accounts payable relatively high. For the same (Phase I)
reasons, auditors often assess inherent risk as medium or high. They are especially
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 613
concerned about the completeness and cutoff balance-related audit objectives because
of the potential for understatements in the account balance.
Assess Control Risk As shown in Figure 18-3 (p. 613), after auditors set tolerable misstatement and inherent
and Design risk for accounts payable, they assess control risk based on an understanding of
and Perform Tests internal control. The auditor’s ultimate substantive tests depend on the relative effec -
of Controls tiveness of internal controls related to accounts payable. Therefore, auditors must have
and Substantive a thorough understanding of how these controls relate to accounts payable.
Tests of Transactions The effects of the client’s internal controls on accounts payable tests can be |
illustrated by two examples:
(Phases I and II)
1. Assume that the client has highly effective internal controls over recording
and paying for acquisitions. The receipt of goods is promptly documented by
prenumbered receiving reports; prenumbered vouchers are promptly and
efficiently prepared and recorded in the acquisition transactions file and the
accounts payable master file. Cash disbursements are made promptly when
due and immediately recorded in the cash disbursements transactions file
and the accounts payable master file. Individual accounts payable balances in
the master file are reconciled monthly with vendors’ statements, and the
computer automatically reconciles the master file total to the general ledger.
Under these circumstances, the verification of accounts payable should
require little audit effort once the auditor concludes that internal controls are
operating effectively.
2. Assume that receiving reports are not used, the client defers recording acquisi -
tions until cash disbursements are made, and because of cash shortages, bills
are often paid several months after their due date. When an auditor faces such
a situation, there is a high likelihood of an understatement of accounts
payable; therefore, extensive tests of details of accounts payable are necessary
Atpo daetgero mi neP wDheFthe r aEccnouhntas pnaycabele ris correctly stated on the balance sheet
date.
We discussed the most important controls over accounts payable and the related
tests of controls and substantive tests of transactions earlier in this chapter. In addition
to those controls, each month an independent person or computer program should
reconcile vendors’ statements with recorded liabilities and the accounts payable master
file with the general ledger. After assessing control risk, the auditor designs and
performs tests of controls and substantive tests of transactions for acquisitions and
cash disbursements.
Design and Perform The use of analytical procedures is as important in the acquisition and payment cycle
Analytical Procedures as it is in every other cycle, especially for uncovering misstatements in accounts
(Phase III) payable. Table 18-4 illustrates analytical procedures for the balance sheet and income
statement accounts in the acquisition and payment cycle that are useful for un -
OBJECTIVE 18-5 covering areas in which additional investigation is desirable.
Auditors should compare current year expense totals with prior years to uncover
Design and perform
misstatements of accounts payable as well as in the expense accounts. Because of
analytical procedures for
accounts payable. double-entry accounting, a misstatement of an expense account usually also results
in an equal mis statement of accounts payable. Therefore, comparing current
expenses such as rent, utilities, and other regularly scheduled bills with prior years is
an effective procedure for analyzing accounts payable when expenses from year to
year are expected to be relatively stable.
Design and Perform The overall objective in the audit of accounts payable is to determine whether the
Tests of Details of accounts payable balance is fairly stated and properly disclosed. Seven of the eight
Accounts Payable balance-related audit objectives discussed in Chapter 6 (pp. 158–160) are applicable
Balance (Phase III) to accounts payable: existence, completeness, accuracy, classification, cutoff, detail
tie-in, and rights and obligations. Realizable value is not applicable to liabilities.
614 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 18-4 Analytical Procedures for the Acquisition and Payment Cycle
Analytical Procedure Possible Misstatement
Compare acquisition-related expense account Misstatement of accounts payable
balances with prior years. and expenses.
Review list of accounts payable for unusual, Classification misstatement for nontrade
nonvendor, and interest-bearing payables. liabilities.
Compare individual accounts payable with Unrecorded or nonexistent accounts,
previous years. or misstatements.
Calculate ratios, such as purchases divided Unrecorded or nonexistent accounts, |
by accounts payable, and accounts payable or misstatements.
divided by current liabilities.
There is an important difference in emphasis in the audit of liabilities and assets.
OBJECTIVE 18-6
When auditors verify assets, they emphasize overstatements through verifi cation by
confirmation, physical examination, and examination of supporting docu ments. The Design and perform tests
of details of balances for
opposite approach is taken in verifying liability balances; that is, the main focus is on
accounts payable, including
understated or omitted liabilities.
out-of-period liability tests.
The difference in emphasis in auditing assets and liabilities results directly from the
legal liability of CPAs. If equity investors, creditors, and other users determine subse -
quent to the issuance of the audited financial statements that earnings and owners’
equity were materially overstated, a lawsuit against the CPA firm is fairly likely. Because
an overstatement of owners’ equity can arise either from an overstatement of assets or
an understatement of liabilities, it isA naptuaragl foor CPPAsD toF em pEhansizhe athonsec tweor types of
misstatements. Auditors should not ignore the possibility that assets are understated or
liabilities are overstated, and should design tests to detect material understatements of
earnings and owners’ equity, including those arising from material overstatements of
accounts payable.
We will use the same balance-related audit objectives from Chapter 16 that we
applied to verifying accounts receivable, as they also apply to liabilities, with three
minor modifications:
1. The realizable value objective is not applicable to liabilities. Realizable value
applies only to assets.
2. The rights aspect of the rights and obligations objective is not applicable to
liabilities. For assets, the auditor is concerned with the client’s rights to the
use and disposal of the assets. For liabilities, the auditor is concerned with the
client’s obligations for the payment of the liability. If the client has no obliga -
tion to pay a liability, it should not be included as a liability.
3. For liabilities, there is emphasis on the search for understatements rather than
for overstatements, as we just discussed.
Table 18-5 (p. 616) includes the balance-related audit objectives and common tests
of details of balances procedures for accounts payable. The auditor’s actual audit
procedures vary considerably depending on the nature of the entity, the materiality of
accounts payable, the nature and effectiveness of internal controls, and inherent risk.
As auditors perform test of details of balances for accounts payable and other liability
accounts they may also gather evidence about the four presentation and disclosure
objectives, especially when performing completeness objective tests. Other procedures
related to presentation and disclosure objectives are done as part of procedures to
complete the audit, which we will discuss in Chapter 24.
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 615
Out-of-Period Liability Tests Because of the emphasis on understatements in
liability accounts, out-of-period liability tests are important for accounts payable. The
extent of tests to uncover unrecorded accounts payable, often called the search for
unrecorded accounts payable, depends heavily on assessed control risk and the
materiality of the potential balance in the account. The same audit procedures used to
uncover unrecorded payables are applicable to the accuracy objective. The following
are typical audit procedures:
Examine Underlying Documentation for Subsequent Cash Disbursements Auditors
examine supporting documentation for cash disbursements subsequent to the balance
sheet date to determine whether a cash disbursement was for a current period liability. If
it is a current period liability, the auditor should trace it to the accounts payable trial
balance to make sure it is included. The receiving report indicates the date inventory was
received and is therefore an especially useful document. Similarly, the vendor’s invoice |
usually indicates the date services were provided. Auditors often examine documentation
for cash disbursements made in the subsequent period for several weeks after the balance
sheet date, especially when the client does not pay bills on a timely basis.
Examine Underlying Documentation for Bills Not Paid Several Weeks After the Year-
End Auditors carry out this procedure in the same manner as the preceding one and for
the same purpose. This procedure differs in that it is done for unpaid obligations near
the end of the audit rather than for obligations that have already been paid.
TABLE 18-5 Balance-Related Audit Objectives and Tests of Details of Balances for Accounts Payable
Common Tests of Details
Balance-Related Audit Objective of Balances Procedures Comments
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Accounts payable in the accounts Re-add or use the computer to total the All pages need not ordinarily be
payable list agree with related accounts payable list. footed if footing manually.
master file, and the total is Trace the total to the general ledger.
correctly added and agrees with Trace individual vendors’ invoices to master Unless controls are deficient, tracing
the general ledger (detail tie-in). file for names and amounts. to master file should be limited.
Accounts payable in the accounts Trace from accounts payable list to vendors’ Ordinarily receives little attention
payable list exist (existence). invoices and statements. because the primary concern is
Confirm accounts payable, emphasizing with understatements.
large and unusual amounts.
Existing accounts payable are included Perform out-of-period liability tests These are essential audit tests for
in the accounts payable list (see discussion). accounts payable.
(completeness).
Accounts payable in the accounts payable Perform same procedures as those used Ordinarily, the emphasis in these
list are accurate (accuracy). for existence objective and out-of-period procedures for accuracy is
liability tests. understatement rather than
omission.
Accounts payable in the accounts payable Review the list and master file for related Knowledge of the client’s business
list are correctly classified (classification). parties, notes or other interest-bearing is essential for these tests.
liabilities, long-term payables, and debit
balances.
Transactions in the acquisition and payment Perform out-of-period liability tests These are essential audit tests for
cycle are recorded in the proper period (see discussion). accounts payable. These are
(cutoff). Perform detailed tests as part of physical called cutoff tests.
observation of inventory (see discussion).
Test for inventory in transit (see discussion).
The company has an obligation to pay the Examine vendors’ statements and confirm Normally not a concern in the audit
liabilities included in accounts payable accounts payable. of accounts payable because all
(obligations). accounts payable are obligations.
616 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
For example, in an audit with a March 31 year-end, assume the auditor examines
the supporting documentation for checks paid through June 28. Bills that are still
unpaid on June 28 should be examined to determine whether they are obligations at
March 31.
Trace Receiving Reports Issued Before Year-End to Related Vendors’ Invoices All
merchandise received before the year-end of the accounting period should be included
as accounts payable. By tracing receiving reports issued up to year-end to vendors’
invoices and making sure that they are included in accounts payable, the auditor is
testing for unrecorded obligations.
Trace Vendors’ Statements That Show a Balance Due to the Accounts Payable Trial
Balance If the client maintains a file of vendors’ statements, auditors can trace any
statement that has a balance due at the balance sheet date to the listing to make sure it
is included as an account payable.
Send Confirmations to Vendors with Which the Client Does Business Although the
use of confirmations for accounts payable is less common than for accounts receivable, |
auditors use them occasionally to test for vendors omitted from the accounts payable
list, omitted transactions, and misstated account balances. Sending confirmations to
active vendors for which a balance has not been included in the accounts payable list is
a useful means of searching for omitted amounts. This type of confirmation is
commonly called a zero balance confirmation. Additional discussion of confirmation
of accounts payable is deferred until the end of this chapter.
Cutoff Tests Accounts payable cutoff testsare done to determine whether transactions
recorded a few days before and after the balance sheet date are included in the correct
period. The five out-of-period liability audit tests we just discussed are all cutoff tests for
acquisitions, but they emphasize understatements. For the first three procedures, it is also
appropriate to examine supporting documentation as a test of overstatement of accounts
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payable. For example, the third procedure tests for understatements (unrecorded
accounts payable) by tracing receiving reports issued before year-end to related vendors’
invoices. To test for overstatement cutoff amounts, the auditor should trace receiving
reports issued afteryear-end to related invoices to make sure that they are not recorded as
accounts payable (unless they are inventory in transit, which is discussed shortly).
We’ve already discussed most cutoff tests in the preceding section, but we will focus
on two aspects here: the relationship of cutoff to physical observation of inventory and
the determination of the amount of inventory in transit.
Relationship of Cutoff to Physical Observation of Inventory In determining that the
accounts payable cutoff is correct, it is essential that the cutoff tests be coordinated with
the physical observation of inventory. For example, assume that an inventory acquisition
for $400,000 is received late in the afternoon of December 31, after the physical
inventory is completed. If the acquisition is included in accounts payable and
purchases but excluded from ending inventory, the result is an understatement of net
earnings of $400,000. Conversely, if the acquisition is excluded from both inventory and
accounts payable, there is a misstatement in the balance sheet, but the income statement
is correct. The only way the auditor will know which type of misstatement has occurred
is to coordinate cutoff tests with the observation of inventory.
The cutoff information for acquisitions should be obtained during the physical
obser vationof inventory. At that time, the auditor should review the procedures in the
receiving department to determine that all inventory received was counted, and the
auditor should record in the audit documentation the last receiving report number of
inventory included in the physical count. Subsequent to the physical count date, the
auditor should then test the accounting records for cutoff. The auditor should trace the
previously documented receiving report numbers to the accounts payable records to
verify that they are correctly included or excluded. For example, assume that the last
receiving report number representing inventory included in the physical count was
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 617
3167. The auditor should record this docu ment number and subsequently trace it and
several preceding numbers to their related vendors’ invoices and to the accounts
payable list or the accounts payable master file to determine that they are all included.
Similarly, accounts payable for acquisitions recorded on receiving reports with
numbers larger than 3167 should be excluded from accounts payable.
When the client’s physical inventory takes place before the last day of the year, the
auditor must still perform an accounts payable cutoff at the time of the physical count
in the manner described in the preceding paragraph. In addition, the auditor must
verify whether all acquisitions that took place between the physical count and the end of
the year were added to the physical inventory and accounts payable. For example, if the |
client takes the physical count on December 27 for a December 31 year-end, the cutoff
information is taken as of December 27. After the physical count date, the auditor must
first test to determine whether the cutoff was accurate as of December 27. After deter -
mining that the December 27 cutoff is accurate, the auditor must test whether all
inventory received subsequent to the physical count, but on or before the balance sheet
date, was added to inventory and accounts payable by the client.
Inventory in Transit In accounts payable, auditors must distinguish between acquisi -
tions of inventory that are on an FOB destinationbasis and those that are made FOB
origin. For FOB destination, title passes to the buyer when the inventory is received, so
only inventory received on or before the balance sheet date should be included in
inventory and accounts payable at year-end. When an acquisition is FOB origin, the
company must record the inventory and related accounts payable in the current period
if shipment occurred on or before the balance sheet date.
Auditors can determine whether inventory has been acquired FOB destination or
origin by examining vendors’ invoices. Auditors should examine invoices for merchandise
received shortly after year-end to determine whether they were on an FOB origin basis.
For those that were, and when the shipment dates were on or before the balance sheet
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date, the inventory and related accounts payable must be recorded in the current
period if the amounts are material.
Reliability of Evidence Auditors need to understand the relative reliability of the three primary types of
evidence ordinarily used for verifying accounts payable: vendors’ invoices, vendors’
OBJECTIVE 18-7 statements, and confirmations.
Distinguish the reliability Distinction Between Vendors’ Invoices and Vendors’ Statements Auditors should
of vendors’ invoices, distinguish between vendors’ invoices and vendors’ statements in verifying the amount
vendors’ statements, and due to a vendor. Auditors get highly reliable evidence about individual transactionswhen
confirmations of accounts
they examine vendors’ invoices and related supporting documents, such as receiving
payable as audit evidence.
reports and purchase orders. A vendor’s statement is not as desirable as invoices for
verifying individual transactions because a statement includes only the total amount of
the transaction. The units acquired, price, freight, and other data are not included.
Which of these two documents is better for verifying the correct balance in accounts
payable? The vendor’s statement is superior for verifying accounts payable because it includes
the ending balance. The auditor can compare existing vendors’ invoices with the client’s
list and still not uncover missing ones, which is the primary concern in accounts payable.
Which of these two documents is better for testing acquisitions in tests of controls
and substantive tests of transactions? The vendor’s invoice is superior for verifying
transactions because the auditor is verifying individual transactions and the invoice
shows the details of the acquisitions.
Difference Between Vendors’ Statements and Confirmations The most impor -
tant distinction between a vendor’s statement and a confirmation of accounts payable
is the source of the information. A vendor’s statement has been prepared by the vendor
(an independent third party) but is in the hands of the client at the time the auditor
examines it. This provides the client with an opportunity to alter a vendor’s statement
or to withhold certain statements from the auditor.
618 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
A response to a confirmation request for accounts payable is normally an itemized
statement sent directly to the CPA’s office by the vendor. It provides the same informa -
tion as a vendor’s statement but is more reliable. In addition, confirmations of accounts
payable often include a request for information about notes and acceptances payable as
well as consigned inventory owned by the vendor but stored on the client’s premises. An |
illustration of a typical accounts payable confirmation request is given in Figure 18-4.
Due to the availability of vendors’ statements and vendors’ invoices, which are both
relatively reliable evidence because they originate from a third party, confirmation of
accounts payable is less common than confirmation of accounts receivable. If the client
has adequate internal controls and vendors’ statements are available for examination,
confirmations are normally not sent. However, when the client’s internal controls are
deficient, when statements are not available, or when the auditor questions the client’s
integrity, it is desirable to send confirmation requests to vendors. Because of the emphasis
on understatements of liability accounts, the accounts confirmed should include large,
active, zero balance accounts and a representative sample of all others.
In most instances when auditors confirm accounts payable, they do it shortly after
the balance sheet date. However, if assessed control risk is low, it may be possible to
confirm accounts payable at an interim date as a test of the effectiveness of internal
controls. Then, if the confirmations indicate that the internal controls are ineffective, it
is possible to design other audit procedures to test accounts payable at year-end.
When auditors examine vendors’ statements or receive confirmations, there must
be a reconciliation of the statement or confirmation with the accounts payable list.
Differences are often caused by inventory in transit, checks mailed by the client but not
received by the vendor at the statement date, and delays in processing accounting
records. The reconciliation is of the same general nature as that discussed in Chapter 16
for accounts receivable. The documents typically used to reconcile the balances on the
accounts payable list with the confirmations or vendors’ statements include receiving
reports, vendors’ invoices, and canceAllepd cahegckos. PDF Enhancer
FIGURE 18-4 Accounts Payable Confirmation Request
January 15, 2012
ROGER MEAD, INC.
Jones Sales, Inc.
2116 Stewart Street
Wayneville, Kentucky 36021
To Whom It May Concern:
Our auditors, Murray and Rogers, CPAs, are conducting an audit of our financial statements.
For this purpose, please furnish them with the following information as of December 31,
2011.
(1) Itemized statements of our accounts payable to you showing all unpaid items;
(2) A complete list of any notes and acceptances payable to you (including any which
have been discounted) showing the original date, dates due, original amount, unpaid
balance, collateral, and endorsers; and
(3) An itemized list ofyour merchandise consigned to us.
Your prompt attention to this request will be appreciated. An envelope is enclosedfor
your reply.
Yours truly,
Phil Geriovini, President
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 619
Sample Size Our discussion of tests of details of the accounts payable balance has focused heavily
on the typical audit procedures performed, the documents and records examined, and
the timing of the tests. The auditor must also consider sample sizes in the audit of
accounts payable.
Sample sizes for accounts payable tests vary considerably, depending on such
factors as the materiality of accounts payable, the number of accounts outstanding,
assessed control risk, and the results of the prior year. When a client’s internal controls
are deficient, which is not uncommon for accounts payable, almost all population
items must be verified. In other situations, minimal testing may suffice.
Statistical sampling is less commonly used for the audit of accounts payable than
for accounts receivable. Defining the population and determining the population size
is more difficult for accounts payable. Because the emphasis is on omitted accounts
payable, auditors must try to ensure that the population includes all potential payables.
SUMMARY
Figure 18-5 summarizes how the four types of audit procedures are used to obtain audit
assurance for transactions and accounts in the acquisition and pay ment cycle. After using |
procedures to obtain an understanding of internal control and tests of controls, auditors
can evaluate whether controls over transactions in the cycle are operating effectively. When
control risk is assessed as low the auditor can reduce substantive testing of ending balances
in the related accounts. On the other hand, a higher assessed control risk results in the need
for more substantive testing in related accounts. In this chapter, the ending balance we
focused on was accounts payable.
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FIGURE 18-5 Types of Audit Tests for the Acquisition and Payment Cycle
(seeFigure18-1 on page 602 for accounts)
Cash in Bank Accounts Payable Acquisition Expenses
Payments Expenses
Audited by Audited by
TOC, STOT, and AP TOC, STOT, and AP
Ending balance
Audited by
AP and TDB
Acquisition Assets
Acquisition of
Assets
Audited by
TOC, STOT, and AP
Ending balance
Ending balance
Audited by
Audited by AP and
AP and TDB
TDB
Tests of controls Substantive Tests of
Analytical Sufficient
(including procedures to (cid:3) tests of (cid:3) (cid:3) details of (cid:2)
procedures appropriate
obtain an understanding transactions balances
(AP) evidence
of internal control) (TOC) (STOT) (TDB)
620 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
By combining all types of audit tests shown in Figure 18-5, the auditor can obtain a
higher overall assurance for transactions and accounts in the acquisition and payment cycle
than the assurance obtained from any one test. The auditor can increase the assurance
obtained from any one of the tests, and thereby increase the overall assurance for the cycle.
ESSENTIAL TERMS
Accounts payable master file—a com - Purchase order—a document prepared
puter file for maintaining a record for or electronically issued by the purchasing
each vendor of individual acquisitions, department indicating the description,
cash disbursements, acquisition returns quantity, and related information for
and allowances, and vendor balances goods and services that the company
Accounts payable trial balance—a listing intends to purchase
of the amount owed to each vendor at a
Purchase requisition—request by an
point in time; prepared directly from the
authorized employee to the purchasing
accounts payable master file
department to place an order for inven -
Acquisition and payment cycle—the tory and other items used by an entity
transaction cycle that includes the acquisi -
Receiving report—a document prepared
tionof and payment for goods and services
by the receiving department at the time
from suppliers outside the organization
tangible goods are received, indicating the
Acquisitions journal—a journal or listing
description of the goods, the quantity
generated from the acquisitions transaction
received, the date received, and other rele -
file and typically includes information
vant data; it is part of the documentation
such as vendor name, date, amount, and
necessary for payment to be made
account classification for each transaction
Vendor’s invoice—a document or record
Cutoff tests—tests to determine whether
that specif ies the details of an acquisition
transactions recorded a few days beAforpe ago PDF Enhancer
trans action and amount of money owed
and after the balance sheet date are in -
to the vendor for an acquisition
cluded in the correct period
Debit memo—a document indicating a Vendor’s statement—a statement pre -
reduction in the amount owed to a vendor pared monthly by the vendor, which
because of returned goods or an allow- indicates the customer’s beginning bal -
ance granted ance, acquisitions, payments, and ending
balance
FOB destination—shipping contract in
which title to the goods passes to the buyer Voucher—a document used to establish a
when the goods are received formal means of recording and con trol -
FOB origin—shipping contract in which ling acquisitions, primarily by enabling
title to the goods passes to the buyer at the each acquisition transaction to be sequen -
time that the goods are shipped tially numbered
REVIEW QUESTIONS
18-1 (Objective 18-1) List five asset accounts, three liability accounts, and five expense |
accounts included in the acquisition and payment cycle for a typical manufac turing company.
18-2 (Objective 18-3) List one possible internal control for each of the six transaction-
related audit objectives for cash disbursements. For each control, list a test of control to test
its effectiveness.
18-3 (Objective 18-3) List one possible control for each of the six transaction-related audit
objectives for acquisitions. For each control, list a test of control to test its effectiveness.
18-4 (Objective 18-3) Evaluate the following statement by an auditor conc erning tests of
acquisitions and cash disbursements: “In selecting the acquisi tions and cash disbursements
sample for testing, the best approach is to select a random month and test every transaction
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 621
for the period. Using this approach enables me to thoroughly understand internal control
because I have examined everything that happened during the period. As a part of the
monthly test, I also test the beginning and ending bank reconciliations and prepare a proof
of cash for the month. At the completion of these tests I feel I can evaluate the effectiveness
of internal control.”
18-5 (Objective 18-3)What is the importance of cash discounts to the client and how can
the auditor verify whether they are being taken in accordance with company policy?
18-6 (Objective 18-3) What are the similarities and differences in the objectives of the
following two procedures? (1) Select a random sample of receiving reports and trace them
to related vendors’ invoices and acquisitions journal entries, comparing the vendor’s name,
type of material and quantity acquired, and total amount of the acquisition. (2) Select a
random sample of acquisitions journal entries and trace them to related vendors’ invoices
and receiving reports, comparing the vendor’s name, type of material and quantity
acquired, and total amount of the acquisition.
18-7 (Objectives 18-2, 18-3) If an audit client does not have prenumbered checks, what
type of misstatement has a greater chance of occurring? Under the circumstances, what
audit procedure can the auditor use to compensate for the deficiency?
18-8 (Objective 18-2) What is meant by a voucher? Explain how its use can improve an
organization’s internal controls.
18-9 (Objective 18-2) Explain why most auditors consider the receipt of goods and
services the most important point in the acquisition and payment cycle.
18-10 (Objectives 18-3, 18-6) Explain the relationship between tests of the acquisition and
payment cycle and tests of inventory. Give specific examples of how these two types of tests
affect each other.
18-11 (Objectives 18-3, 18-4) Explain the relationship between tests of the acquisition and
payment cycle and tests of accounts payable. Give specific examples of how these two types
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of tests affect each other.
18-12 (Objective 18-6)The CPA examines all unrecorded invoices on hand as of February
28, 2012, the last day of the audit. Which of the following misstatements is most likely to be
uncovered by this procedure? Explain.
a. Accounts payable are overstated at December 31, 2011.
b. Accounts payable are understated at December 31, 2011.
c. Operating expenses are overstated for the 12 months ended December 31, 2011.
d. Operating expenses are overstated for the two months ended February 28, 2012.*
18-13 (Objective 18-7) Explain why it is common for auditors to send confirmation
requests to vendors with “zero balances” on the client’s accounts payable listing but
uncommon to follow the same approach in verifying accounts receivable.
18-14 (Objectives 18-2, 18-7)Distinguish between a vendor’s invoice and a vendor’s state -
ment. Which document should ideally be used as evidence in auditing acquisition
transactions and which for verifying accounts payable balances? Why?
18-15 (Objective 18-7) It is less common to confirm accounts payable at an interim date
than accounts receivable. Explain why.
18-16 (Objective 18-6)In testing the cutoff of accounts payable at the balance sheet date, |
explain why it is important that auditors coordinate their tests with the physical obser -
vation of inventory. What can the auditor do during the physical inventory to enhance the
likelihood of an accurate cutoff?
18-17 (Objective 18-6) Distinguish between FOB destination and FOB origin. What
procedures should the auditor follow concerning acquisitions of inventory on an FOB
origin basis near year-end?
*AICPA adapted.
622 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
18-18 (Objective 18-3) The following questions concern internal controls in the acquisi -
tion and payment cycle. Choose the best response.
a. A client erroneously recorded a large purchase twice. Which of the following internal
controls would be most likely to detect this error in a timely and efficient manner?
(1) Footing the purchases journal.
(2) Reconciling vendors’ monthly statements with subsidiary payable ledger accounts.
(3) Tracing totals from the purchases journal to the ledger accounts.
(4) Sending written quarterly confirmations to all vendors.
b. Budd, the purchasing agent of Lake Hardware Wholesalers, has a relative who owns a
retail hardware store. Budd arranged for hardware to be delivered by manufacturers to
the relative’s retail store on a COD basis, thereby enabling his relative to buy at Lake’s
wholesale prices. Budd was probably able to accomplish this because of Lake’s poor
internal control over
(1) purchase requisitions. (3) cash receipts.
(2) purchase orders. (4) perpetual inventory records.
c. Which of the following is an internal control that will prevent paid cash disbursement
documents from being presented for payment a second time?
(1) The date on cash disbursement documents must be within a few days of the date
that the document is presented for payment.
(2) The official signing the check compares the check with the documents and should
deface the documents.
(3) Unsigned checks are prepared by individuals who are responsible for signing checks.
(4) Cash disbursement documents are approved by at least two responsible manage -
ment officials.
d. Which of the following questioAnsp waougld obe bePstD toF in cluEdne inh aan nintcerenarl control
questionnaire concerning the completeness assertion for purchases?
(1) Is an authorized purchase order required before the receiving department can
accept a shipment or the vouchers payable department can record a voucher?
(2) Are purchase requisitions prenumbered and independently matched with vendor
invoices?
(3) Is the unpaid voucher file periodically reconciled with inventory records by an
employee who does not have access to purchase requisitions?
(4) Are purchase orders, receiving reports, and vouchers prenumbered and periodi -
cally accounted for?
18-19 (Objectives 18-6, 18-7) The following questions concern accumulating evidence in
the acquisition and payment cycle. Choose the best response.
a. In auditing accounts payable, an auditor’s procedures most likely will focus primarily
on management’s assertion of
(1) existence. (3) completeness.
(2) realizable value. (4) valuation and allocation.
b. Which of the following audit procedures is best for identifying unrecorded trade
accounts payable?
(1) Examining unusual relationships between monthly accounts payable balances
and recorded cash payments.
(2) Reconciling vendors’ statements to the file of receiving reports to identify items
received just prior to the balance sheet date.
(3) Reviewing cash disbursements recorded subsequent to the balance sheet date to
deter mine whether the related payables apply to the prior period.
(4) Investigating payables recorded just prior to and just subsequent to the balance
sheet date to determine whether they are supported by receiving reports.
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 623
c. An auditor traced a sample of purchase orders and the related receiving reports to the
acquisitions journal and cash disbursements journal. The purpose of this substantive
test of transactions most likely was to |
(1) identify unusually large purchases that should be investigated further.
(2) verify that cash disbursements were for goods actually received.
(3) determine that purchases were properly recorded.
(4) test whether payments were for goods actually ordered.
18-20 (Objective 18-3, 18-6) The following questions concern the audit of accounts
payable.
a. For effective internal control, the accounts payable department generally should
(1) stamp, perforate, or otherwise cancel supporting documentation after payment is
mailed.
(2) ascertain that each requisition is approved as to price, quantity, and quality by an
authorized employee.
(3) omit information about the quantity ordered on the copy of the purchase order
forwarded to the receiving department prior to receipt of goods.
(4) establish the agreement of the vendor’s invoice with the receiving report and
purchase order.
b. When using confirmations to provide evidence about the completeness assertion for
accounts payable, the appropriate population most likely is
(1) vendors with whom the entity has previously done business.
(2) amounts recorded in the accounts payable subsidiary ledger.
(3) payees of checks drawn in the month after year-end.
(4) invoices filed in the entity’s open invoice file.
DISCUSSION QUESTIONS AND PROBLEMS
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18-21 (Objective 18-3) Questions 1 through 8 are typically found in questionnaires used
by auditors to obtain an understanding of internal control in the acquisition and payment
cycle. In using the questionnaire for a client, a “yes” response to a question indicates a possible
internal control, whereas a “no” indicates a potential deficiency.
1. Is the purchasing function performed by personnel who are independent of the
receiving and shipping functions and the payables and disbursing functions?
2. Are all vendors’ invoices routed directly to accounting from the mailroom?
3. Are all receiving reports prenumbered and the numerical sequence checked by a
person independent of check preparation?
4. Are all extensions, footings, discounts, and freight terms on vendors’ invoices checked
for accuracy?
5. Does a responsible employee review and approve the invoice account distribution
before the transaction is entered in the computer?
6. Are checks automatically posted in the cash disbursements journal as they are prep ared?
7. Are all supporting documents properly cancelled at the time the checks are signed?
8. Is the custody of checks after signature and before mailing handled by an employee
independent of all payable, disbursing, cash, and general ledger functions?
Required a. For each of the preceding questions, state the transaction-related audit objective(s)
being fulfilled if the control is in effect.
b. For each internal control, list a test of control to test its effectiveness.
c. For each of the preceding questions, identify the nature of the potential financial
misstatement(s) if the control is not in effect.
d. For each of the potential misstatements in part c, list a substantive audit procedure
that can be used to determine whether a material misstatement exists.
624 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
18-22 (Objective 18-3) Following are some of the tests of controls and substantive tests of
transactions procedures commonly performed in the acquisition and payment cycle. Each
is to be done on a sample basis.
1. Trace transactions recorded in the acquisitions journal to supporting documenta-
tion, comparing the vendor’s name, total dollar amounts, and authorization for
acquisition.
2. Account for a sequence of receiving reports and trace selected ones to related vendors’
invoices and acquisitions journal entries.
3. Review supporting documents for clerical accuracy, correctness of account distri bution,
and reasonableness of expenditure in relation to the nature of the client’s operations.
4. Examine documents in support of acquisition transactions to make sure that each
transaction has an approved vendor’s invoice, receiving report, and purchase order
included.
5. Foot the cash disbursements journal, trace postings of the total to the general ledger, |
and trace postings of individual cash disbursements to the accounts payable master
file.
6. Account for a numerical sequence of checks in the cash disbursements journal and
examine all voided or spoiled checks for proper cancellation.
7. Prepare a proof of cash disbursements for an interim month.
8. Compare dates on cancelled checks with dates on the cash disbursements journal
and the bank cancellation date.
a. State whether each procedure above is primarily a test of control or substantive test of Required
transactions.
b. State the purpose(s) of each procedure.
18-23 (Objective 18-3) Donnen Designs, Inc. is a small manufacturer of women’s casual-
wear jewelry, including bracelets, necklaces, earrings, and other moderately priced accessory
items. Most of their products are made from silver, various low-cost stones, beads, and other
decorative jewelry pieces. Donnen DesAignps ias ngot oinv olPvedD inF th e Emannuhfacatunrincg oef hrigh-end
jewelry items, such as those made of gold and semiprecious or precious stones.
Personnel responsible for purchasing raw material jewelry items for Donnen Designs
would like to place orders directly with suppliers who offer their products for sale through
Internet Web sites. Most suppliers provide pictures of all jewelry components on their Web
sites, along with pricing and other sales-term information. Customers who have valid
business licenses are able to purchase the products at wholesale, rather than retail prices.
Customers can place orders online and pay for those goods immediately by using a valid
credit card. Purchases made by credit card are shipped by the suppliers after the credit
approval is received from the credit card agency, which usually occurs the same day.
Customers can also place orders online with payment being later made by check. However,
in that event, purchases are not shipped until the check is received and cashed by the
supplier. Some of the suppliers allow a 30-day full-payment refund policy, whereas other
suppliers accept returns but only grant credit toward future purchases from that supplier.
a. Identify advantages for Donnen Designs if management allows purchasing personnel Required
to order goods online through supplier Web sites.
b. Identify potential risks associated with Donnen Designs’ purchase of jewelry pieces
through supplier Internet Web sites.
c. Describe advantages of allowing purchasing agents to purchase products online using
a Donnen Designs credit card.
d. Describe advantages of allowing purchasing agents to purchase products online with
payment made only by check.
e. What internal controls can be implemented to ensure that
(1) purchasing agents do not use Donnen credit cards to purchase nonjewelry items
for their own purposes, if Donnen allows purchasing agents to purchase jewelry
using Donnen credit cards?
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 625
(2) purchasing agents do not order jewelry items from the suppliers and ship those
items to addresses other than Donnen addresses?
(3) Donnen does not end up with unused credits with jewelry suppliers as a result of
returning unacceptable jewelry items to suppliers who only grant credit toward
future purchases?
18-24 (Objectives 18-3, 18-6) The following misstatements are included in the accounting
records of Westgate Manufacturing Company.
1. The accounts payable clerk prepares a monthly check to Story Supply Company for
the amount of an invoice owed and submits the unsigned check to the treasurer for
payment along with related supporting documents that have already been approved.
When she receives the signed check from the treasurer, she records it as a debit to
accounts payable and deposits the check in a personal bank account for a company
named Story Company. A few days later, she records the invoice in the acquisitions
journal again, resubmits the documents and a new check to the treasurer, and sends
the check to the vendor after it has been signed.
2. The amount of a check in the cash disbursements journal is recorded as $4,612.87
instead of $6,412.87. |
3. The accounts payable clerk intentionally excluded from the cash disbursements
journal seven large checks written and mailed on December 26 to prevent cash in the
bank from having a negative balance on the general ledger. They were recorded on
January 2 of the subsequent year.
4. Each month, a fraudulent receiving report is submitted to accounting by an
employee in the receiving department. A few days later, he sends Westgate an invoice
for the quantity of goods ordered from a small company he owns and operates in the
evening. A check is prepared, and the amount is paid when the receiving report and
the vendor’s invoice are matched by the accounts payable clerk.
5. Telephone expense (account 2112) was unintentionally charged to repairs and
Amapinatenganoce (aPccoDunFt 2 12E1)n. hancer
6. Acquisitions of raw materials are often not recorded until several weeks after the
goods are received because receiving personnel fail to forward receiving reports to
accounting. When pressure from a vendor’s credit department is put on Westgate’s
accounting department, it searches for the receiving report, records the transactions
in the acquisitions journal, and pays the bill.
Required a. For each misstatement, identify the transaction-related audit objective that was not met.
b. For each misstatement, state a control that should have prevented it from occurring
on a continuing basis.
c. For each misstatement, state a substantive audit procedure that could uncover it.
18-25 (Objectives 18-5, 18-6, 18-7)The following auditing procedures were performed in
the audit of accounts payable:
1. Obtain a list of accounts payable. Re-add and compare with the general ledger.
2. Trace from the general ledger trial balance and supporting documentation to deter -
mine whether accounts payable, related parties, and other related assets and
liabilities are properly included on the financial statements.
3. For liabilities that are payable in a foreign currency, determine the exchange rate and
check calculations.
4. Discuss with the bookkeeper whether any amounts included on the accounts
payable list are due to related parties, debit balances, or notes payable.
5. Obtain vendors’ statements from the controller and reconcile them to the listing of
accounts payable.
6. Obtain vendors’ statements directly from vendors and reconcile them to the listing
of accounts payable.
7. Examine supporting documents for cash disbursements several days before and after
year-end.
626 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
8. Examine the acquisitions and cash disbursements journals for the last few days of the
current period and first few days of the succeeding period, looking for large or
unusual transactions.
a. For each procedure, identify the type of audit evidence used. Required
b. For each procedure, identify which balance-related audit objective(s) were satisfied.
c. Evaluate the need to have certain objectives satisfied by more than one audit pro cedure.
18-26 (Objectives 18-3, 18-4) In testing cash disbursements for the Jay Klein Company,
you obtained an understanding of internal control. The controls are reasonably good, and
no unusual audit problems arose in previous years.
Although there are not many individuals in the accounting department, there is a
reasonable separation of duties in the organization. There is a separate purchasing agent
who is responsible for ordering goods and a separate receiving department that counts the
goods when they are received and prepares receiving reports. There is a separation of duties
between recording acquisitions and cash disbursements, and all information is recorded in
the two journals independently. The controller reviews all supporting documents before
signing the checks, and he immediately mails the checks to the vendors. Check copies are
used for subsequent recording.
All aspects of internal control seem satisfactory to you, and you perform minimum tests
of 25 transactions as a means of assessing control risk. In your tests, you discover the
following exceptions: |
1. Two items in the acquisitions journal were misclassified.
2. Three invoices were not initialed by the controller, but there were no dollar misstate -
ments evident in the transactions.
3. Five receiving reports were recorded in the acquisitions journal at least 2 weeks later
than their date on the receiving report.
4. One invoice was paid twice. The second payment was supported by a duplicate copy
of the invoice. Both copies of thAe ipnvaoicge woer e mPaDrkeFd “paEidn.” hancer
5. One check amount in the cash disbursements journal was for $100 less than the
amount stated on the vendor’s invoice.
6. One voided check was missing.
7. Two receiving reports for vendors’ invoices were missing from the transaction
packets. One vendor’s invoice had an extension error, and the invoice was initialed
that the amount had been checked.
a. Identify whether each of 1 through 7 is a control test deviation, a monetary mis - Required
statement, or both.
b. For each exception, identify which transaction-related audit objective was not met.
c. What is the audit importance of each of these exceptions?
d. What follow-up procedures would you use to determine more about the nature of
each exception?
e. How would each of these exceptions affect the rest of your audit? Be specific.
f. Identify internal controls that should have prevented each misstatement.
18-27 (Objective 18-3, 18-6) The Broughton Cap Company requires that prenumbered
receiving reports be completed when purchased inventory items arrive in the receiving
department.At the time of receipt,the receiving clerk writes the date of receipt on the
receivingdocument.ThelastreceiptinthefiscalyearendedJune30,2011wasrecordedon
receiving report 7279.The accounts payable department prepares prenumbered voucher
packages as receiving reports are received from the receiving department.Entries in the
acquisitionsjournalarepreparedusinginformationcontainedinthevoucherpackage.
ForlateJune2011andearlyJuly2011,receiptsof goodsareincludedinvoucherpackages
asfollows:
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 627
ReceivingReportNo. VoucherNo.
7276 2532
7277 2526
7278 2527
7279 2530
7280 2531
7281 2528
7282 2529
TheJune2011andJuly2011acquisitionsjournalsincludedthefollowinginformation:
ACQUISITIONSJOURNAL – JUNE2011
DayofMonth VoucherNo. AmountofPurchase
29 2526 $7,256.22
29 2528 $3,466.10
30 2531 $8,221.89
30 2532 $1,980.44
ACQUISITIONSJOURNAL – JULY2011
DayofMonth VoucherNo. AmountofPurchase
1 2527 $5,001.99
1 2529 $4,888.33
2 2530 $1,933.74
Required a. Whichvoucherpackages,ifany,arerecordedinthewrongaccountingperiod?Preparean
adjustingentrytocorrectthefinancialstatementsfortheyearendedJune30,2011.Assume
Broughtonusesaperpetualinventorysystemandallpurchasesareinventoryitems.
b. Assume the receiving clerk accidentally wrote June 30 on receiving reports 7280
through7282.Explainhowthatwillaffectthecorrectnessofthefinancialstatements.
Howwillyou,asanauditor,discoverthaterror?
c. DAescpriabe,ginoge nePralDteFrm s,tEhenauhdiatpnroccedeurresyouwouldfollowinmakingsurethat
cutoffforpurchasesisaccurateatthebalancesheetdate.
d. Identify internal controls that will reduce the likelihood of cutoff misstatements
relatedtopurchases.
18-28 (Objective 18-6) You were in the final stages of your audit of the financial statem ents
of Ozine Corporation for the year ended December 31, 2011, when you were consulted by
the corporation’s president, who believes there is no point to your examining the year 2012
acquisitions journal and testing data in support of year 2012 entries. He stated that (a) bills
pertaining to 2011 that were received too late to be included in the December acquisitions
journal were recorded as of the year-end by the corporation by journal entry, (b) the
internal auditor made tests after the year-end, and (c) he will furnish you with a letter
certifying that there were no unrecorded liabilities.
Required a. Should a CPA’s test for unrecorded liabilities be affected by the fact that the client
made a journal entry to record 2011 bills that were received late? Explain. |
b. Should a CPA’s test for unrecorded liabilities be affected by the fact that a letter is
obtained in which a responsible management official certifies that to the best of his or
her knowledge all liabilities have been recorded? Explain.
c. Should a CPA’s test for unrecorded liabilities be eliminated or reduced because of the
internal audit tests? Explain.
d. Assume that the corporation, which handled some government contracts, had no
internal auditor but that an auditor for a federal agency spent 3 weeks auditing the
records and was just completing his work at this time. How will the CPA’s unrecorded
liability test be affected by the work of the auditor for a federal agency?
e. What sources in addition to the year 2012 acquisitions journal should the CPA con -
sider to locate possible unrecorded liabilities?*
*AICPA adapted.
628 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
18-29 (Objective 18-3) Even though Bergeron Wholesale Company is privately held,
management has decided that it is worthwhile to have effective internal controls to the extent it is
practical in a small company, as a way to reduce the likelihood of error and fraud. Theyhave
implementedthefollowingsystemforacquisitionsandpayments.
Prenumberedpurchaseordersare approvedandinitialedbythevicepresidentoffinance
forallpurchases,includingbothtangibleandserviceacquisitions.Whengoodarereceivedthe
goods are counted and a prenumbered receiving report is prepared with a copy sent to
accounting.Thegoodsarestoredinthewarehouseunderthecontroloftheshippingmanager.
Thereceivingreportisusedtoupdatetheperpetualrecords,whichincludeonlyquantities
and are used to determine the need to reorder goods and for control over the physical
quantitiesofinventory.Whenavendor’sinvoiceisreceived,thechiefaccountantcomparesit
to the purchase order,and for tangible goods the receiving report,for both accuracy and
appropriatenessof theexpenditure,thenstaplesthedocumentsandinitialseachvendor’s
invoice.Shethenrecordsthetransactioninthepurchasesjournalandrelatedrecordsusing
small business accountingsoftware.Passwordprotectionisusedforallrecordstoprevent
unauthorizedaccess.Thechiefaccountantpreparesthechecksandupdatesthecashdisburse-
ments journal using the same accounting software and submits the checks to Bergeron’s
presidentforsignaturealongwithallsupportingdocumentation.Thepresident reviewsand
initialsallsupportbeforesigningchecksandmailsthemtovendorsonhiswayhomefrom
work.Thecontrollerreceivesthemonthlybankreconciliationdirectlyfromthebankanddoes
adetailedreconciliation,includingexaminingcancelledchecksandsupportingdocumentation
forlargerandunusualamounts.Thecontroller alsoreceivesthemonthlyaccountspayable
listingfromthechiefaccountant,comparesthetotaltothegeneralledger,initialsthelisting
and files it.Once each quarter the inventory is counted and compared to the perpetual
records,bothasacheckonrecordkeepingandtodetermineif thereareinventorylosses.
Differencesarelisted,usedfordiscussionwiththecontrollerandshippingmanager,andfiled.
a. List at least ten internal controls in the Bergeron acquisition and payment cycle. Be as Required
specific as possible.
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b. For each control, identify the transaction-related audit objective(s) to which the
control relates.
c. For each control, list one test of control that is useful to test the effectiveness of the
control. Be as specific as possible.
18-30 (Objective 18-7) As part of the June 30, 2011, audit of accounts payable of Milner
Products Company, the auditor sent 22 confirmations of accounts payable to vendors in the
form of requests for statements. Four of the statements were not returned by the vendors, and
five vendors reported balances different from the amounts recorded in Milner’s accounts
payable master file. The auditor made duplicate copies of the five vendors’ statements to
maintain control of the independent information and turned the originals over to the client’s
accounts payable clerk to reconcile the differences. Two days later, the clerk returned the five
statements to the auditor with the information on the audit schedule following part c. |
a. Evaluate the acceptability of having the client perform the reconciliations, assuming Required
that the auditor intends to perform adequate additional tests.
b. Describe the additional tests that should be performed for each of the five statements
that included differences.
c. What audit procedures should be performed for the nonresponses to the confirma -
tion requests?
Statement 1 Balance per vendor’s statement $ 6,618.01
Payment by Milner on June 30, 2011 (4,601.01)
_________
Balance per master file $ 2,017.00
Statement 2 Balance per vendor’s statement $ 9,618.93
Invoices not received by Milner (2,733.18)
Payment by Milner on June 15, 2011 (1,000.00)
_________
Balance per master file $ 5,885.75
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 629
Statement 3 Balance per vendor’s statement $26,251.80
Balance per master file (20,516.11)
_________
Difference cannot be located because the vendor
failed to provide details of its account balance $ 5,735.69
Statement 4 Balance per vendor’s statement $ 6,170.15
Credit memo issued by vendor on July 15, 2011 (2,360.15)
_________
Balance per master file $ 3,810.00
Statement 5 Balance per vendor’s statement $ 8,619.21
Payment by Milner on July 3, 2011 (3,000.00)
Unlocated difference not followed up
because of minor amount 215.06
_________
Balance per master file $ 5,834.27
18-31 (Objective 18-6) The physical inventory for Ajak Manufacturing was taken on
December 30, 2011, rather than December 31, because the client had to operate the plant
for a special order the last day of the year. At the time of the client’s physical count, you
observed that acquisitions represented by receiving report number 2631 and all preceding
ones were included in the physical count, whereas inventory represented by succeeding
numbers was excluded. On the evening of December 31, you stopped by the plant and
noted that inventory represented by receiving report numbers 2632 through 2634 was
received subsequent to the physical count but before the end of the year. You later noted
that the final inventory on the financial statements contained only those items included in
the physical count. In testing accounts payable at December 31, 2011, you obtain a
schedule from the client to aid you in testing the adequacy of the cutoff. The following
schedule includes the information that you have not yet resolved:
INFORMATION ON THE VENDOR’S INVOICE
Amount Presently
Receiving Amount of Included in or FOB Origin
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Report Vendor’s Excluded from or
Number Invoice Accounts Payable* Invoice Date Shipping Date Destination
2631 $4,256.40 Included 12-30-11 12-30-11 Origin
2632 6,320.54 Excluded 12-26-11 12-15-11 Destination
2633 3,761.22 Included 12-31-11 12-26-11 Origin
2634 7,832.18 Excluded 12-16-11 12-27-11 Destination
2635 6,847.77 Included 12-28-11 12-31-11 Origin
2636 6,373.58 Excluded 01-03-12 12-31-11 Destination
2637 5,878.36 Excluded 01-05-12 12-26-11 Origin
2638 3,355.05 Excluded 12-31-11 01-03-12 Origin
*All entries to record inventory acquisitions are recorded by the client as a debit to purchases and a credit to
accounts payable.
Required a. Explain the relationship between inventory and accounts payable cutoff.
b. For each of the receiving reports, state the misstatement in inventory or accounts
payable, if any exists, and prepare an adjusting entry to correct the financial state -
ments, if a misstatement exists.
c. Which of the misstatements in part b are most important? Explain.
CASE
18-32 (Objectives 18-2, 18-3, 18-4, 18-6) The following tests of controls and substantive
tests of transactions audit procedures for acquisitions and cash disbursements are to be
used in the audit of Ward Publishing Company. You concluded that internal control
appears effective and a reduced assessed control risk is likely to be cost beneficial. Ward’s
active involvement in the business, good separation of duties, and a competent controller
and other employees are factors affecting your opinion.
630 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Ward Publishing Company — Part I |
(See page 632 for Part II, and Case 19-28 on pages 655–656 for Part III)
Tests of Controls and Substantive Tests of Transactions Audit Procedures
for Acquisitions and Cash Disbursements
1. Foot and cross-foot the acquisitions and cash disbursements journals for 2 months
and trace totals to postings in the general ledger.
2. Scan the acquisitions and cash disbursements journals for all months and investigate
any unusual entries.
3. Reconcile cash disbursements per books to cash disbursements per bank statement
for 1 month.
4. Examine evidence that the bank reconciliation is prepared by the controller.
5. Inquire and observe whether the accounts payable master file balances are peri-
odically reconciled to vendors’ statements by the controller.
6. Examine the log book as evidence that the numerical sequence of checks is accounted
for by someone independent of the preparation function.
7. Inquire and observe that checks are mailed by D. Ward or someone under his
supervision after he signs checks.
8. Examine initials indicating that the controller balances the accounts payable master
file to the general ledger monthly.
9. Select a sample of entries in the cash disbursements journal, and
a. obtain related cancelled checks and compare with entry for payee, date, and
amount and examine signature endorsement.
b. obtain vendors’ invoices, receiving reports, and purchase orders, and
(1) determine that supporting documents are attached to vendors’ invoices.
(2) determine that documents agree with the cash disbursements journal.
(3) compare vendors’ names, amounts, and dates with entries.
(4) determine whether a discount was taken when appropriate.
(5) examine vendors’ invoices for initials indicating an independent review of
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chart of account codings.
(6) examine reasonableness of cash disbursements and account codings.
(7) review invoices for approval of acquisitions by Ward.
(8) review purchase orders and/or purchase requisitions for proper approval.
(9) verify prices and recalculate footings and extensions on invoices.
(10) compare quantities and descriptions on purchase orders, receiving reports,
and vendors’ invoices to the extent applicable.
(11) examine vendors’ invoices and receiving reports to determine that the check
numbers are included and the documents are marked “paid” at the time of
check signing.
c. Trace postings to the accounts payable master file for name, amount, and date.
10. Select a sample of receiving reports issued during the year and trace to vendors’
invoice and entries in the acquisitions journal.
a. Compare type of merchandise, name of vendor, date received, quantities, and amounts.
b. If the transaction is indicated in the acquisitions journal as paid, trace the check
number to the entry in the cash disbursements journal. If unpaid, investigate reasons.
c. Trace transactions to accounts payable master file, comparing name, amount, and date.
Prepare all parts of a sampling data sheet (such as the one in Figure 15-2 on page 490) through Required
the planned sample size for the preceding audit program, assuming that a line item in the
cash disbursements journal is used for the sampling unit. Use either nonstatistical or
attributes sampling. For all procedures for which the line item in the cash disbursements
journal is not an appropriate sampling unit, assume that audit procedures were performed
on a nonsampling basis. For all tests of controls, use a tolerable exception rate of 5%, and
for all substantive tests of transactions, use a rate of 6%. Use an ARACR of 10%, which is
considered medium. Plan for an estimated population exception rate of 1% for tests of con-
trols and 0% for substantive tests of transactions.
Prepare the data sheet using the computer (instructor option—also applies to Part II).
Chapter 18 / AUDIT OF THE ACQUISITION AND PAYMENT CYCLE 631
Part II
Assume a sample size of 50 for all procedures, regardless of your answers in Part I. For
other procedures, assume that an adequate sample size for the circumstance was selected.
The only exceptions in your audit tests for all tests of controls and substantive tests of |
transactions audit procedures are as follows:
1. Procedure 2—Two large transactions were identified as being unusual. Investigation
determined that they were authorized acquisitions of fixed assets. They were both
correctly recorded.
2. Procedure 9b(1)—A purchase order was not attached to a vendor’s invoice. The pur -
chase order was found in a separate file and determined to be approved and appropriate.
3. Procedure 9b(5)—Six vendors’ invoices were not initialed as being internally
verified. Three actual misclassifications existed. The controller explained that he
often did not review codings because of the competence of the accounting clerk
doing the coding and was surprised at the mistakes.
Required a. Complete the sampling data sheet from Part I using either nonstatistical or attributes
sampling.
b. Explain the effect of the exceptions on tests of details of accounts payable. Which
balance-related audit objectives are affected, and how do those objectives, in turn,
affect the audit of accounts payable?
c. Given your tests of controls and substantive tests of transactions results, write an audit
program for tests of details of balances for accounts payable. Assume:
(1) The client provided a list of accounts payable, prepared from the master file.
(2) Acceptable audit risk for accounts payable is high.
(3) Inherent risk for accounts payable is low.
(4) Analytical procedure results were excellent.
INTERNET PROBLEM 18-1:
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IDENTIFYING ACCOUNTS PAYABLE FRAUD
The embezzlement of funds from organizations is often orches trated through fictitious
accounts payable and related cash disbursement transactions. The AuditNet online
resource center for auditors includes information about typical accounts payable fraud
techniques. Visit www.auditnet.org and select the link for “Virtual Library” to search for a
two-part series article “Ten Ways to Identify Accounts Payable Fraud.” Read both Part 1 and
Part 2 of this article to answer the following questions.
Required a. What contributes to the risk that entities fail to detect duplicate payments to vendors?
b. What techniques might help detect duplicate payments?
c. How can applying Benford’s law help detect fraudulent accounts payable transactions?
d. What techniques can be used to identify fraudulent transactions that are just below
amounts for required approvals?
e. What techniques might help detect fictitious vendors in the vendor master file that
might result in unauthorized payments being sent to employees?
632 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
19
C H A P T E R
COMPLETING THE TESTS
IN THE ACQUISITION
LEARNING OBJECTIVES
AND PAYMENT CYCLE:
After studying this chapter,
you should be able to
VERIFICATION OF
19-1 Recognize the many accounts
in the acquisition and payment
cycle.
SELECTED ACCOUNTS
19-2 Design and perform audit tests
of property, plant, and equipment
and related accounts.
19-3 Design and perform audit tests
Incorrect Classifications Hide A Greater Net Loss
of prepaid expenses.
TV Communications Network (TVCN), a Denver-based wireless cable 19-4 Design and perform audit tests
of accrued liabilities.
television company, materially understated losses in its financial statements
by improperly recording $2.5 million of expenses as a direct decrease in 19-5 Design and perform audit tests of
income and expense accounts.
stockholders’ equity. The misstatement took the company from an actual
net loss of $4.7 million to a reported loss of only $2.2 million.
According to the investigation by the SEC, the expenses charged to equity were from dis bursements for the
development and distribution of brochures promoting the company’s business prospects. The payments should have
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been expensed and reflected in the income state ment as advertising expenses.
The internal controls associated with the advertising expenses were clearly inadequate. TVCN typically did not have
invoices or other documentation available when payments were made by the company’s president, who controlled
the bank account. Because of the lack of adequate documentation, when the financial statements were prepared, |
TVCN employees responsible for recording the expenses did not have sufficient information to properly classify the
disbursements. The SEC found that even when documentation was available, the accounts where the transactions
were recorded conflicted with the supporting documentation.
Unfortunately, TVCN’s auditor relied on inquiry of the company president as the primary evidence about the nature of
the advertising payments. In his substantive testing of transa ctions exceeding $10,000, the auditor relied on the
company controller to identify all transactions meeting the criteria for review. Needless to say, the controller did not
present all transactions meeting the $10,000 scope. As you might expect, the SEC brought charges against the auditor
for failing to comply with auditing standards.
Source:Accounting and Auditing Enforcement Release No. 534, Commerce Clearing House, Inc., Chicago.
In Chapter 18, we noted that transactions in the acquisition and payment cycle affect several asset accounts:
supplies, property, plant and equipment, and prepaid expenses accounts, to name a few. Payments made for
services also affect many expense accounts. To continue our discussion of the acquisition and payment cycle, this
chapter examines audit issues related to other accounts commonly found in the acquisition and payment cycles of
most businesses.
The story about TVCN highlights the importance of understanding the nature of acquisition and payment cycle
transactions. Because transactions in this cycle affect numerous accounts in both the balance sheet and the income
statement, incorrectly classified transactions may significantly affect reported results, as they did for TVCN. Auditors
need to understand the nature of transactions flowing through the acquisition and payment cycle so that they can
effectively assess the risk of material misstatement and perform further audit procedures to evaluate accounts in the
cycle.
TYPES OF OTHER ACCOUNTS IN
THE ACQUISITION AND PAYMENT CYCLE
OBJECTIVE 19-1 Table 19-1 highlights many of the typical accounts associated with transactions in the
acquisition and payment cycle. The types of assets, expenses, and liabilities will differ for
Recognize the many
many companies, especially those in industries other than retail, wholesale and manu-
accounts in the acquisition
facturing.
and payment cycle.
The methodology associated with auditing these accounts is similar to the audits of
other accounts discussed in earlier chapters. The methodology is the same as Figure
18-3 on page 613 for accounts payable, except for the name of the account being audited.
The last chapter presented an overview of typical tests of controls and substantive
tests of transactions for acquisition and payment cycle transactions, as well as
commonly used analytical procedures and tests of details of balances for accounts
payablAe. pIna thgis och aptPerD, thFe issEuens fohr asonmec oef trhe other key accounts in this cycle are
examined, namely the audit of:
• Property, plant, and equipment • Other liabilities
• Prepaid expenses • Income and expense accounts
AUDIT OF PROPERTY, PLANT, AND EQUIPMENT
OBJECTIVE 19-2 Property, plant, and equipment are assets that have expected lives of more than one
year, are used in the business, and are not acquired for resale. The intent to use the assets
Design and perform audit
as part of the operation of the client’s business and their expected lives of more than
tests of property, plant, and
one year are the significant characteristics that distinguish these assets from inventory,
equipment and related
accounts. prepaid expenses, and investments. Table 19-2 shows examples of some of the typical
TABLE 19-1 Accounts Typically Associated with Acquisition and Payment
CycleTransactions
Assets Expenses Liabilities
Cash Cost of goods sold Accounts payable
Inventory Rent expense Rent payable
Supplies Property taxes Accrued professional fees
Property, plant, and equipment Income tax expense Accrued property taxes
Patents, trademarks, and copyrights Insurance expense Other accrued expenses |
Prepaid rent Professional fees Income taxes payable
Prepaid taxes Retirement benefits
Prepaid insurance Utilities
634 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 19-2 Classifications of Property, Plant, and Equipment Accounts
Land and land improvements
Buildings and building improvements
Equipment
Furniture and fixtures
Autos and trucks
Leasehold improvements
Construction-in-process for property, plant, and equipment
classifications of property, plant, and equipment accounts. The acquisition of property,
plant, and equipment occurs through the acquisition and payment cycle.
Because the audits of property, plant, and equipment accounts are similar, one
example (equipment) is used to illustrate an approach to auditing all three types of
accounts. Significant differences in the verification of other types of accounts are
discussed as they arise.
The accounts commonly used for equipment are illustrated in Figure 19-1. Notice that Overview of
the debits to equipment arise from the acquisi tion and payment cycle. Because the Equipment-Related
source of debits in the asset account is the acquisitions journal, the accounting system Accounts
has normally already been tested for recording current period additions to equipment
as part of the tests of the acquisition and payment cycle (which we studied in the last
chapter). However, because equipment additions are infrequent, often for large amounts,
and subject to special controls, such as board of directors’ approval, the auditor may
decide not to rely heavily on these tests as evidence supporting fixed asset additions.
The primary accounting record for equipment and other property, plant, and
equipment accounts is generally a fiAxpeda asgseot m aPsteDr fiFle . TEhen mhasatenr ficlee inrcludes a
detailed record for each piece of equipment and other types of property owned. Each
record in the file includes a description of the asset, date of acquisition, original cost,
current year depreciation, and accumulated depreciation for the property.
The totals for all records in the master file equal the general ledger balances for the
related accounts: equipment, depreciation expense, and accumulated depreciation. The
master file also contains information about property acquired and disposed of during
the year.
FIGURE 19-1 Equipment and Related Accounts
Accumulated
Equipment depreciation
Beginning Beginning
balance balance
(1) Acquisitions Disposals Disposals Current period
depreciation
Ending balance Ending balance
Gain or loss Depreciation
on disposals expense
(1) Acquisitions of equipment arise from the acquisition andpayment cycle.
See Figure 18-1 (p. 602).
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 635
Auditors verify equipment differently from current asset accounts for three reasons:
1. There are usually fewer current period acquisitions of equipment, especially
large equipment used in manufacturing.
2. The amount of any given acquisition is often material.
3. The equipment is likely to be kept and maintained in the accounting records
for several years.
Because of these differences, the auditing of equipment emphasizes the verification
of current period acquisitions rather than the balance in the account carried forward
from the preceding year. In addition, the expected life of assets over one year requires
depreciation expense and accumulated depreciation accounts, as shown in Figure 19-1
(p. 635), which are verified as part of the audit of the assets. Finally, equipment may be
sold or disposed of, triggering a gain or loss entry that the auditor may need to verify.
Although the approach to verifying equipment differs from that used for current
assets, several other asset accounts are verified in much the same manner. These include
patents, copyrights, catalog costs, and all property, plant, and equipment accounts.
In the audit of equipment and related accounts, it is helpful to separate the tests
into the following categories:
• Perform analytical procedures
• Verify current year acquisitions
• Verify current year disposals |
• Verify the ending balance in the asset account
• Verify depreciation expense
• Verify the ending balance in accumulated depreciation
Next, let’s examine the use of these categories of tests in the audit of equipment,
depreciation expense, accumulated depreciation, and gain or loss on disposal accounts.
Perform As in Aallp auadigt aore as,P thDe tFyp e Eof nanhalyatincalc perocredures depends on the nature of the
Analytical Procedures client’s operations. Table 19-3 illustrates analytical procedures often performed for
equipment.
As you can see, most of the typical analytical procedures assess the likelihood of
material misstatements in depreciation expense and accumulated depreciation. Later in
the chapter, the substantive tests auditors often focus on for these accounts are discussed.
Verify Current Year Companies must correctly record current year additions because the assets have long-
Acquisitions term effects on the financial statements. The failure to capitalize a fixed asset, or the
recording of an acquisition at the incorrect amount, affects the balance sheet until the
company disposes of the asset. The income statement is affected until the asset is fully
depreciated.
TABLE 19-3 Analytical Procedures for Equipment
Analytical Procedure Possible Misstatement
Compare depreciation expense divided by gross Misstatement in depreciation expense
equipment cost with previous years. and accumulated depreciation.
Compare accumulated depreciation divided by gross Misstatement in accumulated
equipment cost with previous years. depreciation.
Compare monthly or annual repairs and maintenance, Expensing amounts that should be
supplies expense, small tools expense, and similar capitalized.
accounts with previous years.
Compare gross manufacturing cost divided by some Idle equipment or equipment that was
measure of production with previous years. disposed of but not written off.
636 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Because of the importance of current period acquisitions in the audit of equipment,
auditors use seven of the eight balance-related audit objectives as a frame of reference
for tests of details of balances: existence, completeness, accuracy, classification, cutoff,
detail tie-in, and rights and obligations. (Realizable value is discussed in connection
with verifying ending balances.) The balance-related audit objectives and common
audit tests are shown in Table 19-4. Existence, com pleteness, accuracy, class ification,
and rights are usually the major objectives for this part of the audit.
As in all other audit areas, the actual audit tests and sample size depend heavily on
tolerable misstatement, inherent risk, and assessed control risk. Tolerable misstatement is
important for verifying current year additions because these transactions vary from
immaterial amounts in some years to a large number of significant acquisitions in others.
TABLE 19-4 Balance-Related Audit Objectives and Tests of Details of Balances for Equipment Additions
Balance-Related Common Tests of Details
Audit Objective of Balances Procedures Comments
Current year acquisitions in the Foot the acquisitions schedule. Footing the acquisitions schedule and
acquisitions schedule agree with Trace the individual acquisitions to tracing individual acquisitions should
related master file amounts, and the master file for amounts and be limited unless controls are deficient.
the total agrees with the general descriptions.
ledger (detail tie-in).
Trace the total to the general ledger. All increases in the general ledger
balance for the year should reconcile
to the schedule.
Current year acquisitions as listed Examine vendors’ invoices and receiving
exist (existence). reports.
ApPhyasicgallyo ex amPineD asFsets . Enhancer It is uncommon to physically examine
assets acquired unless controls are
deficient or amounts are material.
Existing acquisitions are recorded Examine vendors’ invoices of closely related This objective is one of the most
(completeness). accounts such as repairs and maintenance important for equipment. |
to uncover items that should be recorded
as equipment.
Review lease and rental agreements.
Current year acquisitions as listed are Examine vendors’ invoices. Extent depends on inherent risk and
accurate (accuracy). effectiveness of internal controls.
Current year acquisitions as listed are Examine vendors’ invoices in various The objective is closely related to
correctly classified (classification). equipment accounts to uncover items that tests for completeness. It is done
should be classified as manufacturing or in conjunction with that objective
office equipment, part of the buildings, and tests for accuracy.
or repairs.
Examine vendors’ invoices of closely related
accounts such as repairs to uncover items
that should be recorded as equipment.
Examine rent and lease expense for
capitalizable leases.
Current year acquisitions are recorded Review transactions near the balance sheet Usually done as part of accounts
in the correct period (cutoff). date for correct period. payable cutoff tests.
The client has rights to current year Examine vendors’ invoices. Ordinarily the main concern is
acquisitions (rights). whether equipment is owned or
leased. Purchase or lease contracts
are examined for equipment and
property deeds, abstracts, and tax
bills are frequently examined for
land or major buildings.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 637
The starting point for the verification of current year acquisitions is normally a
schedule obtained from the client of all acquisitions recorded in the general ledger
property, plant, and equipment accounts during the year. The client obtains this
informa tion from the property master file. A typical schedule lists each addition
separately and includes the date of the acquisition, vendor, description, notation of
whether it is new or used, life of the asset for depreciation purposes, depreciation
method, and cost.
As you study Table 19-4 (p. 637), notice that the most common audit test to verify
addi tions is to examine vendors’ invoices. Additional testing, beyond that which is
done as part of the tests of controls and substantive tests of transactions, is often
necessary because of the complexity of many equipment transactions and the materiality
of the amounts. It is normal for auditors to verify large and unusual transactions for
the entire year as well as a representative sample of typical additions. The extent of
testing depends on the auditor’s assessed control risk for acquisitions and the materiality
of the additions.
In testing acquisitions, the auditor must understand accounting standards to make
certain the client follows the related requirements. For example, the auditor needs to
be alert for the possibility of the client’s failure to include material transportation and
installation costs as part of the asset’s acquisition cost and the failure to properly
record the trade-in of existing equipment. The auditor also needs to know the client’s
capitalization policies to determine whether acquisitions are treated consistently with
those of the preceding year. For example, if the client’s policy is to automatically
expense acquisitions that are less than a certain amount, such as $1,000, the auditor
should verify that the policy is followed in the current year.
Auditors should also verify recorded transactions for correct classification among
various equipment accounts. In some cases, amounts recorded as manufacturing
equip ment should be classified as office equipment or as a part of the building. It is also
possibAle pthae cglieont haPs iDncFor recEtlyn chapaitanlizcede rerpairs, rents, or similar expenses. Poor
internal controls over document preparation, as illustrated by the chapter-opening story
about TVCN, can result in significant misclassifications of disbursement transactions.
Clients commonly include transactions that should be recorded as assets in repairs
and maintenance expense, lease expense, supplies, small tools, and similar accounts.
The misstatement may result from a lack of understanding accounting standards or |
from clients’ desires to avoid income taxes. If auditors conclude this type of material
misstate ment is likely, they may need to vouch larger amounts debited to the expense
accounts. It is a common practice to do so as part of the audit of the property, plant, and
equipment accounts.
Auditors also need to examine whether the client has a right to record equipment
as an asset. Some large manufacturing equipment and other types of machinery, such
as sophisticated medical equipment or computer data center equipment, may be under
an operating lease. Auditors frequently examine purchase or lease contracts to determine
whether capitalization of the equipment is appropriate.
Verify Current Transactions involving the disposal of equipment are often misstated when company
Year Disposals internal controls lack a formal method to inform management of the sale, trade-in,
abandonment, or theft of recorded machinery and equipment. If the client fails to
record disposals, the original cost of the equipment account will be overstated
indefinitely, and net book value will be overstated until the asset is fully depreciated.
Formal methods of tracking disposals and provisions for proper authorization of the
sale or other disposal of equipment help reduce the risk of misstatement. There should
also be adequate internal verification of recorded disposals to make sure that assets are
correctly removed from the accounting records.
The auditor’s main objectives in the verification of the sale, trade-in, or abandon -
ment of equipment are to gather sufficient appropriate evidence that all disposals are
recorded and at the correct amounts. The starting point for verifying disposals is the
638 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
client’s schedule of recorded disposals. The schedule typically includes the date when
the asset was disposed of, name of the person or firm acquiring the asset, selling price,
original cost, acquisition date, and accumulated depreciation.
Detail tie-in tests of the recorded disposals schedule are necessary, including
footing the schedule, tracing the totals on the schedule to the recorded disposals in the
general ledger, and tracing the cost and accumulated depreciation of the disposals to
the property master file.
Because the failure to record disposals of equipment no longer used in the business
can significantly affect the financial statements, the search for unrecorded disposals is
essential. The nature and adequacy of the controls over disposals affect the extent of the
search. The following procedures are often used for verifying disposals:
• Review whether newly acquired assets replace existing assets
• Analyze gains and losses on the disposal of assets and miscellaneous income for
receipts from the disposal of assets
• Review plant modifications and changes in product line, changes in major costly
computer-related equipment, property taxes, or insurance coverage for indica -
tions of deletions of equipment
• Make inquiries of management and production personnel about the possibility
of the disposal of assets
When an asset is sold or disposed of without having been traded in for a replace -
ment asset, the accuracy of the transaction can be verified by examining the related
sales invoice and property master file. The auditor should compare the cost and
accumulated depreciation in the master file with the recorded entry in the general
journal and recompute the gain or loss on the disposal of the asset for comparison with
the accounting records. When trade-in of an asset for a replacementoccurs, the auditor
should be sure that the new asset is capitalized and the replaced asset correctly elimi -
nated from the records, considering the book value of the asset traded in and the
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additional cost of the new asset.
Two of the auditor’s objectives when auditing the ending balance in the equipment Verify Ending Balance
accounts include determining that: of Asset Account
1. All recorded equipment physically exists on the balance sheet date (existence) |
2. All equipment owned is recorded (completeness)
When designing audit tests to meet these objectives, auditors first consider the
nature of internal controls over equipment. Ideally, auditors are able to conclude that
controls are sufficiently strong to allow them to rely on balances carried forward from
the prior year. Important controls include the use of a master file for individual fixed
assets, adequate physical controls over assets that are easily movable (such as
computers, tools, and vehicles), assignment of identification numbers to each plant
asset, and periodic physical count of fixed assets and their reconciliation by accounting
personnel. A formal method of informing the accounting department of all disposals
of fixed assets is also an important control over the balance of assets carried forward
into the current year.
Typically, the first audit step concerns the detail tie-in objective: Equipment, as
listed in the master file, agrees with the general ledger. Examining a printout of the
master file that totals to the general ledger balance is ordinarily sufficient. The auditor
may choose to use audit software to foot an electronic version of the master file or
manually test-foot a few pages.
After assessing control risk for the existence objective, the auditor decides whether
it is necessary to verify the existence of individual items of equipment included in the
master file. If there is a high likelihood of a material amount of missing fixed assets still
included in the master file, the auditor can select a sample from the master file and
examine the actual assets. Similarly, based on the auditor’s assessment of control risk
for the completeness objective, the auditor may physically examine a sample of major
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 639
equipment items and trace them to the master file. In rare cases, the auditor may decide
it is necessary for the client to take a complete physical inventory of fixed assets to make
sure they all exist, and the fixed asset records are complete. If a physical inventory is taken,
the auditor normally observes the count.
The auditor normally does not need to test the accuracy or classification of fixed
assets recorded in prior periods because, presumably, they were verified in previous
audits at the time they were acquired. But the auditor should be aware that companies
may occasionally have equipment on hand that is no longer used in operations. If the
amounts are material, the auditor should evaluate whether they should be written
down to net realizable value (realizable value objective) or at least classified separately
as “nonoperating equipment.”
In addition to performing procedures to obtain evidence related to balance-related
audit objectives for fixed assets, auditors also perform audit procedures related to the four
presen tation and disclosure objectives for fixed assets. A major consideration in verifying
disclosures related to fixed assets is the possibility of legal encumbrances. Auditors may
use several methods to determine whether equipment is encumbered, including:
• Read the terms of loan and credit agreements
• Mail loan confirmation requests to banks and other lending institutions
• Have discussions with the client or send letters to legal counsel
The proper presentation and disclosure of equipment in the finan cial statements
must be evaluated carefully to make sure that accounting standards are followed.
Equipment should include the gross cost and should ordinarily be separated from
other fixed assets. Leased property should also be disclosed separately, and all liens on
property must be included in the footnotes. Auditors must perform sufficient tests to
verify that all four presentation and disclosure objectives are met.
Verify Depreciation expense is one of the few expense accounts not verified as part of tests of
Depreciation Expense controAls panad gsubost anPtivDe tFest s oEf ntrahnsaacntiocnse. Trhe recorded amounts are determined
by internal allocationsrather than by exchange transactions with outside parties. When |
depreciation expense is material, more tests of details of depreciation expense are
required than for an account that has already been verified through tests of controls
and substantive tests of transactions.
The most important balance-related audit objective for depreciation expense is
accuracy. Auditors focus on determining whether the client followed a consistent
depreciation policyfrom period to period, and the client’s calculations are correct.
In determining the former, auditors must weigh four considerations:
1. The useful life of current period acquisitions
2. The method of depreciation
3. The estimated salvage value
4. The policy of depreciating assets in the year of acquisition and disposition
The client’s policies can be determined by discussions with appropriate personnel
and comparing their responses with information in the auditor’s permanent files. In
deciding on the reasonableness of the useful lives assigned to newly acquired assets, the
auditor must consider the physical life of the asset, the expected life (taking into
account obsolescence or the company’s normal policy of upgrading equipment), and
established company policies on trading in equipment.
Occasionally, changing circumstances may necessitate a company to reevaluate the
useful life of an asset. When this occurs, the revaluation should involve a change in
accounting estimate rather than a change in accounting principle. The effect of this on
depreciation must be evaluated.
A useful method of auditing depreciation is an analytical procedures test of
reasonableness made by multiplying undepreciated fixed assets by the depreciation rate
for the year. In making these calculations, the auditor must make adjustments for
current year additions and disposals, assets with different lengths of life, and assets
640 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
with different methods of depreciation. Many CPA firms maintain an electronic
spreadsheet in their permanent file that includes a breakdown of the fixed assets by
method of depreciation and length of life. If the software calculations are reasonably
close to the client’s totals and if assessed con trol risk for depreciation expense is low,
tests of details for deprecia tion can be eliminated.
When an overall reasonableness test cannot be accomplished, more detailed tests
are usually needed. To do this, auditors recompute depreciation expense for selected
assets to determine whether the client is following a proper and consistent depreciation
policy. To be relevant, the detailed calculations should be tied in to the total depreciation
calculations by footing the depreciation expense on the property master file and recon-
ciling the total with the general ledger. Because accounting standards require footnote
disclosures related to fixed asset depreciation, including disclosure of depreciation
methods and related useful lives by asset class, auditors perform procedures to obtain
evidence that the four presentation and disclosure-related audit objectives for
depreciation are satisfied. For example, auditors compare information obtained through
audit tests of the depreciation expense accounts to information disclosed in footnotes
to ensure the information presented is consistent with the actual method and assump -
tions used to calculate and record depreciation.
The debits to accumulated depreciation are normally tested as a part of the audit of Verify Ending Balance
disposals of assets, while the credits are verified as a part of depreciation expense. If the in Accumulated
auditor traces selected transactions to the accumulated depreciation records in the Depreciation
property master file as a part of these tests, then little additional testing should be
required for the ending balance in accumulated depreciation.
Two objectives are usually emphasized in the audit of the ending balance in
accumulated depreciation:
1. Accumulated depreciation as stated in the property master file agrees with the
general ledger. This objectivAe cpana bge soat isfiPedD byF t estE-fonothinga tnhec acecurmulated |
depre ciation in the property master file and tracing the total to the general ledger.
2. Accumulated depreciation in the master file is accurate.
In some cases, the life of equipment may be significantly reduced because of
reductions in customer demands for products, unexpected physical deteri oration, a
modification in operations, or other changes. Because of these possibilities, auditors
must evaluate the adequacy of the allowances for accumulated depreciation each year
to make sure that the net book value does not exceed the realizable value of the assets.
AUDIT OF PREPAID EXPENSES
Prepaid expenses, deferred charges, and intangibles are assets that vary in life from OBJECTIVE 19-3
several months to several years. These include:
Design and perform audit
• Prepaid rent • Patents • Deferred charges tests of prepaid expenses.
• Organization costs • Prepaid insurance • Copyrights
• Prepaid taxes • Trademarks
In some cases, these accounts are highly material. However, in a typical audit, the
company does not have many of the accounts listed or they are immaterial.
Analytical procedures are often sufficient for prepaid expenses, deferred charges,
and intangibles. In certain audits, some of these assets can be significant. In this section,
we examine some of the typical internal controls and related audit tests commonly
associated with prepaid expenses. In the following discussion, an example of the audit of
prepaid insurance is used as an account representative of this group because:
1. Prepaid insurance is found in most audits—virtually every company has some
type of insurance.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 641
FIGURE 19-2 Prepaid Insurance and Related Accounts
Prepaid insurance Insurance expense
Beginning balance Current period
insurance expense
(1) Acquisitions
(insurance premiums)
Ending balance
(1) Acquisitions of insurance premiums arise from the acquisition andpayment cycle.
This can be observed by examining Figure 18-1 (p. 602).
2. Problems commonly encountered in the audit of prepaid insurance are typical
of this class of accounts.
3. The auditor’s responsibility for the review of insurance coverage is an addi -
tional consideration not found in the other accounts in this category.
Overview of Figure 19-2 illustrates the accounts typically used for prepaid insurance and the
Prepaid Insurance relationship between prepaid insurance and the acquisition and payment cycle through
the debits to the prepaid insurance account. Because the source of the debits in the
asset account is the acquisitions journal, the payments of insurance premiums have
already been partially tested by means of the tests of controls and substantive tests of
acquisition and cash disbursement transactions.
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Internal Controls Internal controls for prepaid insurance and insurance expense can be conveniently
divided into three categories: controls over the acquisition and recording of insurance,
controls over the insurance register, and controls over the charge-off of insurance
expense. Controls over the acquisition and recording of insurance are a part of the
acquisition and payment cycle. Consistent with the procedures discussed in that cycle,
proper authorization for new insurance policies and payment of insurance premiums
are important controls.
An insurance registeris a record of insurance policies in force and the expiration
date of each policy. Auditors use insurance registers to identify policies in force related
to prepaid insurance accounts. Payment terms and amounts for the policies in force are
contained in the register. Because the terms and amounts provide the basis for deter-
mining prepaid insurance amounts, the auditor independently verifies these terms and
amounts to the underlying insurance policies or contracts.
Companies often have a standard monthly journal entry to reclassify prepaid
insurance as insurance expense. If a significant entry is required to adjust the balance in
prepaid insurance at the end of the year, it indicates a potential misstatement in the |
recording of the acquisition of insurance throughout the year or in the calculation of
the year-end balance in prepaid insurance.
Audit Tests In the audit of prepaid insurance, the auditor obtains a schedule from the client that lists
for each policy in force:
• Policy information, including policy number, amount of coverage and annual
premium
• Beginning prepaid insurance balance
• Payment of policy premiums
• Amount charged to insurance expense
• Ending prepaid insurance balance
642 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Throughout the audit of prepaid insurance and insurance expense, the auditor
should keep in mind that the amount in insurance expense is a residual. The only tests
of the balance in the expense account that are ordinarily necessary include analytical
procedures and a test to be sure that all charges to insurance expense arose from credits
to prepaid insurance. Because the payments of premiums are tested as part of the tests
of controls and substantive tests of transactions and analytical procedures, the
emphasis in the tests of details of balances is on prepaid insurance.
The beginning and ending balances in prepaid insurance are frequently immaterial
and often there are few transactions debited and credited to the balance during the
year, most of which are small and simple to understand. Therefore, the auditor can
generally spend little time verifying the balance or the transactions. If the auditor
decides not to verify the balance in detail, analytical procedures become increasingly
important to identify potentially significant misstatements. Auditors commonly per -
form the following analytical procedures for prepaid insurance and insurance expense:
• Compare total prepaid insurance and insurance expense with previous years.
• Compute the ratio of prepaid insurance to insurance expense and compare it
with previous years.
• Compare the individual insurance policy coverage on the schedule of insurance
obtained from the client with the preceding year’s schedule as a test of the elimi -
nation of certain policies or a change in insurance coverage.
• Compare the computed prepaid insurance balance for the current year on a policy-
by-policy basis with that of the preceding year as a test of an error in calculation.
• Review the insurance coverage listed on the prepaid insurance schedule with an
appropriate client official or insurance broker for adequacy of coverage. The
auditor cannot be an expert on insurance matters, but the auditor’s understanding
of accounting and the valuation of assets is necessary to make sure that a
company is not underinsured.
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For many audits, no additional substantive procedures are needed unless assessed
control risk is high or the tests indicate a high likelihood of a significant misstatement.
The remaining audit procedures, which are examined next, should be performed only
when there is a special reason for doing so. Our discussion of these tests uses the
balance-related audit objectives for performing tests of details of asset balances.
(Realizable value is not applicable.)
Insurance Policies in the Prepaid Insurance Schedule Exist and Existing
Policies Are Listed (Existence and Completeness) Tests for existence and omis -
sions of insurance policies in force can be performed on the client’s prepaid insurance
schedule in one of two ways:
1. Examine a sample of insurance invoices and policies in force for comparison
to the schedule.
2. Obtain a confirmation of insurance information from the company’s insurance
agent. Auditors typically prefer to send a confirmation to the client’s insurance
agent, because this approach is usually less time-consuming than vouching
tests and it provides 100 percent verification.
The Client Has Rights to All Insurance Policies in the Prepaid Insurance
Schedule (Rights)The party who will receive the benefit if an insurance claim is filed
has the rights. Ordinarily, the recipient named in the policy is the client, but when there
are mortgages or other liens, the insurance claim may be payable to a creditor. The |
review of insurance policies for claimants other than the client is an excellent test of
unrecorded liabilities and pledged assets.
Prepaid Amounts on the Schedule Are Accurate and the Total Is Correctly
Added and Agrees with the General Ledger (Accuracy and Detail Tie-in) Audit
tests to verify the accuracy of prepaid insurance involve verifying the amount of the
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 643
insurance premium, the length of the policy period, and the allocation of the premium to
unexpired insurance. The amount of the premium for a given policy and its time period can
be verified at the same time by examining the premium invoice or the confirmation from
an insurance agent. After these two have been verified, the client’s calculations of unex -
pired insurance can be tested by recalculation. The schedule of prepaid insurance can
then be footed and the totals traced to the general ledger to complete the detail tie-in tests.
The Insurance Expense Related to Prepaid Insurance Is Correctly Classified
(Classifi cation) The correct classification of debits to different insurance expense
accounts should be reviewed as a test of the income statement. In some cases, the
appropriate expense account is obvious because of the type of insurance, such as a policy
insuring a piece of equipment. In other cases, allocations are necessary. For example,
fire insurance on a building may require allocation to several accounts, including
manufacturing overhead. Charging the correct accounts and consistency with previous
years are the major considerations in evaluating classification.
Insurance Transactions Are Recorded in the Correct Period (Cutoff) Cutoff
for acquisitions of insurance is normally not a significant problem because of the small
number of policies and the immateriality of the amount. If auditors check cutoff of
insurance acquisitions, they do so as part of accounts payable cutoff tests.
AUDIT OF ACCRUED LIABILITIES
OBJECTIVE 19-4 A third major category of accounts in the acquisition and payment cycle is accrued
liabilities, which are the estimated unpaid obligations for services or benefits that
Design and perform audit
have been received before the balance sheet date. Many accrued liabilities represent
tests of accrued liabilities.
future obligations for unpaid services resulting from the passage of time but are not
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payable at the balance sheet date. For example, the benefits of property rental accrue
throughout the year. Therefore, at the balance sheet date, a certain portion of the total
rent cost that has not been paid should be accrued. Other similar liabilities include:
• Accrued payroll • Accrued professional fees
• Accrued payroll taxes • Accrued rent
• Accrued officers’ bonuses • Accrued interest
• Accrued commissions
A second type of accrual involves estimates where the amount of the obligation due
is uncertain, such as the obligation for federal income taxes when there is a reasonable
likelihood that the amount reported on the tax return will be changed after the Internal
Revenue Service audits the return. Accrued warranty costs and accrued pension costs
are similar accruals.
The verification of accrued expenses varies depending on the nature of the accrual
and the circumstances of the client. For most audits, accruals take little audit time. In
other instances, certain accounts, such as accrued income taxes, warranty costs, and
pension costs, are often material and require considerable audit effort. The following
discussion of the audit of accrued property taxes is used as an example of the audit of
an accrued liability account.
Auditing Accrued Figure 19-3 illustrates the accounts typically used by companies for accrued property
Property Taxes taxes, showing the relationship between accrued property taxes and the acquisition and
payment cycle through the debits to the liability account. Because the source of the debits
is the cash disbursements journal, the payments of property taxes should have already
been partially tested by the tests of the acquisition and payment cycle transactions. |
As with insurance expense, the balance in property tax expense is a residual
amount that results from the beginning and ending balances in accrued property taxes
644 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 19-3 Accrued Property Taxes and Related Accounts
Accruedproperty taxes Property tax expense
Beginning balance
(1) Payments Current period
(property taxes) property tax
expense
Ending balance
(1) Payments ofproperty taxes arise from the acquisition andpayment cycle. This can be
observed by examining Figure 18-1 (p. 602).
and the payments of property taxes. Therefore, the emphasis in the tests should be on
the ending property tax liability and payments. When auditors verify accrued property
taxes, all eight balance-related audit objectives except realizable value are relevant. Two
are especially significant:
1. Existing properties for which accrual of taxes is appropriate are on the accrual
schedule. The failure to include properties for which taxes should be accrued
will understate the property tax liability (completeness). A material misstate -
ment can occur, for example, if taxes on property were not paid before the
balance sheet date and not included as accrued property taxes.
2. Accrued property taxes are accurately recorded. The auditor’s concern is the
consistent treatment of the accrual from year to year (accuracy).
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The auditor uses two primary tests for the inclusion of all accruals. Auditors verify
the accruals at the same time as the audit of current year property tax payments. In
most audits, there are few property tax payments, but each payment is often material,
and therefore it is common to verify each one. Auditors also compare the accruals with
those of previous years.
The auditor often begins by obtaining a schedule of property tax payments from
the client and comparing each payment with the preceding year’s schedule to deter -
mine whether all payments have been included in the client-prepared schedule. The
fixed asset audit schedules also must be examined for major additions and disposals of
assets that may affect the property taxes accrual. All property affected by local property
tax regulations should be included in the schedule, even if the first tax payment has not
yet been made.
After auditors are satisfied that all taxable property has been included in the client-
prepared schedule, they evaluate the reasonableness of property taxes on each
property used by the client to estimate the accrual. In some instances, the total has
already been set by the taxing authority and sent to the client so it is possible to verify
the amount by comparing the amount on the schedule with the tax bill. In other cases,
the preceding year’s total payments must be adjusted for the expected increase in
property tax rates.
The auditor can verify the accrued property tax by recalculating the portion of the
total tax applicable to the current year for each piece of property. The most important
consideration is to use the same portion of each tax payment for the accrual that was used
in the preceding year, unless there are justifiable conditions for a change. After the accrual
and property tax expense for each piece of property have been recalculated, the totals
should be added and compared with the general ledger. In many cases, property taxes are
charged to more than one expense account. In that case, the auditor should test for correct
classification by evaluating whether the correct amount was charged to each account.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 645
AUDIT OF INCOME AND EXPENSE ACCOUNTS
OBJECTIVE 19-5 To complete our discussion of key accounts in the acquisition and payment cycle, an
overview is provided of procedures auditors typically use to determine whether the
Design and perform audit
income and expense accounts in the financial statements are fairly presented in
tests of income and expense
accordance with accounting standards. The auditor must be satisfied that each of the
accounts.
income and expense totals included in the income statement, as well as net earnings, |
are not materially misstated.
The auditor needs to be aware that most users of financial statements rely more
heavily on the income statement than on the balance sheet for making decisions. Equity
investors, long-term creditors, union representatives, and even short-term creditors are
more interested in the ability of a firm to generate profit than in the historical cost or
book value of the individual assets.
The following two concepts in the audit of income and expense accounts are
essential when considering the purposes of the income statement:
1. The matching of periodic income and expense is necessary for a correct deter -
mination of operating results.
2. The consistent application of accounting principles for different periods is
necessary for comparability.
Both of these concepts must be applied to the recording of individual transactions
and to the combining of accounts in the general ledger for statement presentation.
Approach to The audit of income and expense accounts is directly related to the balance sheet and is not
Auditing Income and a separate part of the audit process. A misstatement of an income statement account
Expense Accounts almost always equally affects a balance sheet account, and vice versa. As we have discussed
in preceding chapters, the audit of income and expense accounts is intertwined with
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the other parts of the audit. We provide a brief description of these tests here as a
review of material covered in earlier chapters. This review shows the interrelated
nature of different parts of the audit with income and expense account testing. The
parts of the audit directly affecting these accounts are:
UNDERSTATEMENT Dollar General Corporation is a Tennessee-based 2000. In an attempt to hide a portion of the
retailer of general merchandise. In 2005, the fraudulently recorded amounts in fiscal 2000
OF EXPENSES AT
Securities and Exchange Commission (SEC) from their auditors, the controller directed a
DOLLAR GENERAL settled enforcement actions against the senior accounting manager to move $1.3 million
company’s former CEO, President, CFO, and of the $9.4 million to the miscellaneous accrued
STORES
Controller for engaging in accounting fraud. liabilities account widely known at the company
In December 1999, employees discovered that as the “Rainy Day Fund” and $2.7 million to
the company had not recorded $13.4 million corporate bank clearing accounts. The auditors
in expenses related to import freight costs were unaware of this fraud when they signed the
associated with transporting products from audit report on the 1999 financial statements in
foreign countries to Dollar General. April 2000.
Management, including the president, CFO, The president allegedly supported the
and controller discussed this finding on approach given the company had already
January27, 2000 and determined that the announced expected fiscal year 1999 earnings
expenses should have been recorded in 1999 per share and he did not want to revise the
and prior years. They ultimately decided that the previously announced figure. They also knew
company would charge approximately $4 million that recording the entire expense in 1999 would
of the freight expenses in 1999 and recognize the negatively impact year-end bonus payments to
remaining $9.4 million in fiscal 2000 by amortizing Dollar General employees.
the expenses on a monthly basis over that fiscal Source: Securities and Exchange Commission
year, despite the fact the expenses were incurred Accounting and Auditing Enforcement Release No.
in prior years and had no relation to fiscal year 2226, April 6, 2005 (www.sec.gov).
646 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
• Analytical procedures
• Tests of controls and substantive tests of transactions
• Tests of details of account balances
Our emphasis here is on income and expense accounts directly related to the
acquisition and payment cycle, but the same concepts apply to the income statement
accounts in all other cycles.
Chapter 8 addressed analytical procedures. Subsequent chapters refer back to those Analytical Procedures |
procedures as part of specific audit areas. Analytical procedures should be thought of
as part of the test of the fairness of the presentation of both balance sheet and income
statement accounts. Table 19-5 shows a few analytical procedures and the possible
misstatements they may uncover in the audit of income and expense accounts.
Both tests of controls and substantive tests of transactions have the effect of simulta- Tests of Controls
neously verifying balance sheet and income statement accounts. For example, assume an and Substantive Tests
auditor concludes that internal controls are adequate to provide reasonable assurance of Transactions
that transactions in the acquisitions journal occurred, are accurately recorded, correctly
classified, and recorded in a timely manner. By doing so, the auditor obtains evidence
about the correctness of individual balance sheet accounts, such as accounts payable
and fixed assets, and income statement accounts, such as advertising and repairs.
Conversely, inadequate controls and misstatements discovered through tests of
controls and substantive tests of transactions indicate the likelihood of misstatements
in both the income statement and the balance sheet.
The most important means of verifying many of the income statement accounts in
each transaction cycle are understanding internal control and the related tests of
controls and substantive tests of transactions. For example, if the auditor concludes after
adequate tests that control risk can be appropriately assessed as low for transactions in
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TABLE 19-5 Analytical Procedures for Income and Expense Accounts
Analytical Procedure Possible Misstatement
Compare individual expenses with previous Overstatement or understatement of a balance
years. in an expense account.
Compare individual asset and liability Overstatement or understatement of a balance
balances with previous years. sheet account that will also affect an
income statement account (for example,
a misstatement of inventory affects cost
of goods sold).
Compare individual expenses with budgets. Misstatement of expenses and related balance
sheet accounts.
Compare gross margin percentage with Misstatement of cost of goods sold and
previous years. inventory
Compare inventory turnover ratio with Misstatement of cost of goods sold and
previous years. inventory
Compare prepaid insurance expense with Misstatement of insurance expense and
previous years. prepaid insurance.
Compare commission expense divided by Misstatement of commission expense and
sales with previous years. accrued commissions.
Compare individual manufacturing expenses Misstatement of individual manufacturing
divided by total manufacturing expenses expenses and related balance sheet
with previous years. accounts.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 647
the acquisition and payment cycle, the only additional verification of related income
statement accounts, such as utilities, advertising, and purchases, will occur through the
performance of analytical procedures and cutoff tests. However, certain income and
expense accounts are not verified at all by tests of controls and substantive tests of
transactions, and others must be tested more extensively by other substantive testing.
These are discussed next.
Tests of Details of Auditors must analyze the amounts included in certain income statement accounts
Account Balances— even though the previously mentioned tests have been performed. Next, we examine
Expense Analysis the meaning and methodology of analysis of accounts before moving on to a discus -
sion of when expense account analysis is appropriate.
Expense account analysisinvolves auditor examination of underlying documenta -
tion of individual transactions and amounts making up the detail of the total of an
expense account. The documents are the same type as those used for examining
transactions as part of tests of acquisition transactions, including invoices, receiving
reports, purchase orders, and contracts. Figure 19-4 illustrates a typical audit schedule |
showing expense analysis for legal expenses.
Although the focus of expense account analysis is on transactions, these tests differ
from tests of controls and substantive tests of transactions. The tests of controls and
substantive tests of transactions are meant to assess control risk. As such, they are tests
of classes of transactions, such as acquisitions, and therefore include many different
accounts. In the analysis of expense and other income statement accounts, the auditor
verifies transactions in specific accounts to determine whether the transactions are
appropriate for the client, properly classified, and accurately recorded.
Assuming satisfactory results are found in tests of controls and substantive tests of
transactions, auditors normally restrict expense analysis to those accounts with a rela -
tively high likelihood of material misstatement. As examples, auditors often analyze:
• Repairs and maintenance expense accounts to determine whether they erro -
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neously include property, plant, and equipment transactions
• Rent and lease expenses to determine the need to capitalize leases
• Legal expense to determine whether there are potential contingent liabilities,
disputes, illegal acts, or other legal issues that may affect the financial statements
Utilities, travel expense, and advertising accounts are rarely analyzed unless
analytical procedures indicate high potential for material misstatement.
Auditors often analyze expense account transactions as part of the verification of a re -
lated asset. It is common, for example, for auditors to analyze repairs and mainte nance as
part of verifying fixed assets, and insurance expense as part of testing prepaid insurance.
Tests of Details of Several expense accounts result from the allocation of accounting data rather than
Account Balances— discrete transactions. Such expenses include depreciation, depletion, and the amorti -
Allocation zation of copyrights and catalog costs. The allocation of manufacturing overhead
between inventory and cost of goods sold is an example of a different type of allocation
that affects expenses.
Allocations are important because they determine whether an expenditure is an asset
or a current period expense. If the client fails to follow accounting standards or fails to
calculate the allocation correctly, the financial statements can be materially misstated.
The allocation of expenses such as depreciation of fixed assets and amortization of
copyrights is required because the life of the asset is greater than one year. The original
cost of the asset is verified at the time of acquisition, but the charge-off takes place over
several years.
Other types of allocations directly affecting the financial statements arise because
the life of a short-lived asset does not expire on the balance sheet date. These may
include prepaid rent and insurance. Finally, accounting standards require the alloca -
tion of costs between current period manufacturing expenses and inventory as a means
of reflecting all costs of making a product.
648 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 19-4 Expense Analysis for Legal Expense
Schedule V-10 Date
Gilman Company, Inc.
Prepared by Client/JL 1/21/12
Legal Expenses
12/31/11 Approved by SW 1/28/12
A/C 913—Legal Expense
Paid to For Date Amount
Alexander J. Schweppe Retainer—12 months @ $1,000 Monthly $12,000
ABC v.Carson—patent Apr. 14 9,800
infringement suit Aug.9 7,109
Smith, Tom Consultation re: inquiryfrom June 6 1,000
Consumer Protection Bureau, July 10 750
State Attorney Generals office
L. Marvin Hall Assistance in collecting overdue Nov. 10 505
receivable from Star Mfg.
$31,164G/L
F
Per minutes of meeting of Board of DirectAorsp 1/1a0/1g1. oSch wePppDe reFapp oinEtedn gehneraal cnouncsele wirth retainer.
Attorney’s letter requested. Received 1/23/12. All matters listed are covered therein. Letters filed in General Section of audit file.
Attorney’s letter not requested. Per phone conversation with Mr. Hall 1/21/12, he rarely represents the company, and his services have been |
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