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limited to collection problems. The Star Mfg. matter was closed in October 2011, and he has not been involved in any other matters related to
the company since that time.
Examined statement and vouchers F Footed G/L Agreed to general ledger
In auditing the allocation of expenditures such as prepaid insurance and manufac-
turing overhead, the two most important considerations are adherence to accounting
standards and consistency with the preceding period. The two most important audit
procedures for auditing allocations are tests for overall reasonableness using analytical
procedures and recalculation of the client’s results.
Auditors commonly perform these tests as part of the audit of the related asset or
liability accounts. This may include verifying depreciation expense as part of the audit
of property, plant, and equipment, testing amortization of patents as part of verifying
new patents or the disposal of existing ones and verifying allocations between
inventory and cost of goods sold as part of the audit of inventory.
SUMMARY
This chapter concludes our discussion of accounts and transactions in the acquisition and
payment cycle. To adequately audit the numerous accounts associated with this cycle,
auditors need an understanding of key accounts, classes of transactions, business functions,
documents, and records related to acquisition and payment cycle trans actions. Many of
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 649
these accounts, such as accounts payable, property, plant, and equipment, depreciation
expense, and prepaid expenses, have unique characteristics that affect how the auditor
gathers sufficient appropriate evidence about related account balances. And, finally,
interrelationships between different audit tests in the acquisition and payment cycle can
provide a basis for the auditor’s verification of many financial statement accounts.
ESSENTIAL TERMS
Accrued liabilities—estimated unpaid individual transactions and amounts
obli gations for services or benefits that making up the total of an expense account
have been received prior to the balance
Fixed asset master file—a computer file
sheet date; common accrued liabilities
containing records for each piece of
include accrued commissions, accrued
equipment and other types of property
income taxes, accrued payroll, and accrued
owned; the primary accounting record
rent
for manufacturing equipment and other
Allocation—the division of certain
property, plant, and equipment accounts
expenses,such as depreciation and manu -
facturing overhead, among several expense Insurance register—a record of insurance
accounts policies in force, the expiration date of
Expense account analysis—the exami - each policy, premium amount and terms,
nation of underlying documentation of and other policy specifics
REVIEW QUESTIONS
19-1 (Objective 19-2)Explain the relationship between substantive tests of transactions for
the acquisition and payment cycle and tests of details of balances for the verification of
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property, plant, and equipment. Which aspects of property, plant, and equipment are directly
affected by the tests of controls and substantive tests of transactions and which are not?
19-2 (Objective 19-2) Explain why the emphasis in auditing property, plant, and equip -
ment is on the current period acquisitions and disposals rather than on the balances in the
account carried forward from the preceding year. Under what circumstances will the
emphasis be on the balances carried forward?
19-3 (Objective 19-2)What is the relationship between the audit of property, plant, and
equipment accounts and the audit of repair and maintenance accounts? Explain how the
auditor organizes the audit to take this relationship into consideration.
19-4 (Objective 19-2) List and briefly state the purpose of all audit procedures that might
reasonably be applied by an auditor to determine that all property, plant, and equipment
retirements have been recorded in the accounting system.
19-5 (Objective 19-2) In auditing depreciation expense, what major considerations should |
the auditor keep in mind? Explain how each can be verified.
19-6 (Objective 19-3) Explain the relationship between substantive tests of transactions
for the acquisition and payment cycle and tests of details of balances for the verification of
prepaid insurance.
19-7 (Objective 19-3)Explain why the audit of prepaid insurance should ordinarily take a
relatively small amount of audit time if the client’s assessed control risk for acquisitions is
low.
19-8 (Objective 19-3) Distinguish between the evaluation of the adequacy of insurance
coverage and the verification of prepaid insurance. Explain which is more important in a
typical audit.
19-9 (Objective 19-3)What are the major differences between the audit of prepaid expenses
and other asset accounts such as accounts receivable or property, plant, and equipment?
650 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
19-10 (Objective 19-4) Explain the relationship between accrued rent and substantive tests
of transactions for the acquisition and payment cycle. Which aspects of accrued rent are
not verified as part of the substantive tests of transactions?
19-11 (Objective 19-4) In verifying accounts payable, it is common to restrict the audit
sample to a small portion of the population items, whereas in auditing accrued property taxes,
it is common to verify all transactions for the year. Explain the reason for the difference.
19-12 (Objective 19-4) Which documents will be used to verify accrued property taxes and
the related expense accounts?
19-13 (Objective 19-5) List three expense accounts that are tested as part of the acquisition
and payment cycle or the payroll and personnel cycle. List three expense accounts that are
not directly verified as part of the cycle.
19-14 (Objective 19-5)What is meant by the analysis of expense accounts? Explain how
expense account analysis relates to the tests of controls and substantive tests of transactions
that the auditor has already completed for the acquisition and payment cycle.
19-15 (Objectives 19-2, 19-5) How will the approach for verifying repair expense differ
from that used to audit depreciation expense? Why will the approach be different?
19-16 (Objective 19-5)List the factors that should affect the auditor’s decision whether to
analyze an account balance. Considering these factors, list four expense accounts that are
commonly analyzed in audits.
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
19-17 (Objective 19-2) The following questions concern internal controls in the acquisi -
tion and payment cycle. Choose the best response.
a. Which of the following controls will most likely justify a reduced assessed level of
control risk for the existence asseArtipona fogr eoqu ipmPeDntF? Enhancer
(1) Internal auditors periodically select equipment items in the fixed assets master file
and locate the related equipment on company premises.
(2) Department heads are asked to provide information to the accounting depart-
ment each quarter about any equipment no longer in use or somewhat damaged.
(3) All contracts of equipment purchases are reviewed by both the controller and
attorney to verify that legal title transfers to the client and that none represent
operating leases.
(4) As part of quarterly and annual inventory physical counts, factory equipment is
listed and subsequently reconciled to the fixed asset master file.
b. Which of the following is not an internal control deficiency related to factory equip ment?
(1) Checks issued in payment of acquisitions of equipment are not signed by the
controller.
(2) All acquisitions of factory equipment are required to be made by the department
in need of the equipment.
(3) Factory equipment replacements are generally made when estimated useful lives,
as indicated in depreciation schedules, have expired.
(4) Proceeds from sales of fully depreciated equipment are credited to other income.
c. Which of the following controls will most likely justify a reduced assessed level of
control risk for the existence assertion related to the equipment account? |
(1) As purchases of equipment are recorded in the purchases journal, the system
automatically posts the item to the equipment master file.
(2) Internal auditors physically examines equipment on a periodic basis and verify
that the equipment is included in the equipment master file.
(3) All additions to the equipment account must be supported by a valid receiving
report.
(4) Assignment of general ledger account coding is reviewed by the accounts payable
supervisor as purchases are recorded in the purchases journal.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 651
19-18 (Objectives 19-2, 19-5) The following questions concern analytical procedures in
the acquisition and payment cycle. Choose the best response.
a. Which of the following comparisons will be most useful to an auditor in auditing an
entity’s income and expense accounts?
(1) Prior year accounts payable to current year accounts payable.
(2) Prior year payroll expense to budgeted current year payroll expense.
(3) Current year revenue to budgeted current year revenue.
(4) Current year warranty expense to current year contingent liabilities.
b. The controller of Excello Manufacturing, Inc., wants to use analytical procedures to
identify the possible existence of idle equipment or the possibility that equipment has
been disposed of without having been written off. Which of the following ratios will
best accomplish this objective?
(1) Depreciation expense/book value of manufacturing equipment.
(2) Accumulated depreciation/book value of manufacturing equipment.
(3) Repairs and maintenance cost/direct labor costs.
(4) Gross manufacturing equipment cost/units produced.
c. Which of the following analytical procedures might suggest that certain repairs and
maintenance expenses have been inappropriately capitalized?
(1) The ratio of additions to equipment divided by the beginning balance in the equip-
ment account is significantly lower than the same ratio from the prior three years.
(2) The balance in the repairs and maintenance expense account is noticeably lower
than amounts recorded in the past several years.
(3) The balance in the gross equipment account has decreased this year compared to
the prior year.
(4) The ratio of depreciation expense divided by gross equipment is higher in the
current year compared to prior years.
19-19 (Objective 19-2)The following questions concern the audit of asset accounts in the
acquisAitiopn aangd poay mePntD cyFcle . CEhonoshe tahen becst eresrponse.
a. In testing for unrecorded disposals of equipment, an auditor most likely will
(1) select items of equipment from the accounting records and then locate them
during the plant tour.
(2) compare depreciation journal entries with similar prior-year entries in search of
fully depreciated equipment.
(3) inspect items of equipment observed during the plant tour and then trace them to
the equipment master file.
(4) scan the general journal for unusual equipment additions and excessive debits to
repairs and maintenance expense.
b. Analysis of which account is least likely to reveal evidence related to unrecorded
retirement of equipment?
(1) Accumulated depreciation. (3) Property, plant, and equipment.
(2) Insurance expense. (4) Purchase returns and allowances.
c. In connection with the audit of the prepaid insurance account, which of the following
procedures is usually not performed by the auditor?
(1) Recompute the portion of the premium that expired during the year.
(2) Prepare excerpts of the insurance policies for audit documentation.
(3) Confirm premium rates with an independent insurance broker.
(4) Examine support for premium payments.
19-20 (Objectives 19-2, 19-4, 19-5)The following questions concern the audit of liabilities
or income and expense accounts. Choose the best response.
a. The auditor may note that annual depreciation expense is too low for a class of assets
by noting
(1) insured values greatly in excess of carrying amounts.
(2) large numbers of fully depreciated assets are still in use.
(3) continuous trade-ins of relatively new assets. |
(4) excessive recurring losses on assets retired.
652 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
b. Which of the following bestdescribes the independent auditor’s approach to obtain -
ing satisfaction concerning depreciation expense in the income statement?
(1) Verify the mathematical accuracy of the amounts charged to income as a result of
depreciation expense.
(2) Determine the method for computing depreciation expense and ascertain that it
is in accordance with accounting standards.
(3) Reconcile the amount of depreciation expense to those amounts credited to
accumulated depreciation accounts.
(4) Establish the basis for depreciable assets and verify the depreciation expense.
c. Before expressing an opinion concerning the audit of income and expenses, the auditor
will bestproceed with the audit of the income statement by
(1) applying a rigid measurement standard designed to test for understatement of net
income.
(2) analyzing the beginning and ending balance sheet inventory amounts.
(3) making net income comparisons to published industry trends and ratios.
(4) auditing income statement accounts concurrently with the related balance sheet
accounts.
DISCUSSION QUESTIONS AND PROBLEMS
19-21 (Objective 19-2) For each of the following misstatements in property, plant, and
equipment accounts, state an internal control that the client can implement to prevent the
misstatement from occurring and a substantive audit procedure that the auditor can use to
discover the misstatement:
1. The asset lives used to depreciate equipment are less than reasonable, expected useful
lives.
2. Capitalizable assets are routinely expensed as repairs and maintenance, perishable
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tools, or supplies expense.
3. Acquisitions of property are recorded at incorrect amounts.
4. A loan against existing equipment is not recorded in the accounting records. The
cash receipts from the loan never reached the company because they were used for
the down payment on a piece of equipment now being used as an operating asset. The
equipment is also not recorded in the records.
5. Computer equipment that is abandoned or traded for replacement equipment is not
removed from the accounting records.
6. Depreciation expense for manufacturing operations is charged to administrative
expenses.
7. Tools necessary for the maintenance of equipment are stolen by company employees
for their personal use.
19-22 (Objective 19-2) The following types of internal controls are commonly used by
organizations for property, plant, and equipment:
1. A fixed asset master file is maintained with a separate record for each fixed asset.
2. Written policies exist and are known by accounting personnel to differentiate between
capitalizable additions, freight, installation costs, replacements, and main tenance
expenditures.
3. Depreciation charges for individual assets are calculated for each asset; recorded in a
fixed asset master file that includes cost, depreciation, and accumulated depreciation
for each asset; and verified periodically by an independent clerk.
4. Acquisitions of fixed assets in excess of $20,000 are approved by the board of directors.
5. When practical, equipment is labeled with metal tags and is inventoried on a syste -
matic basis.
a. State the purpose of each of the internal controls just listed. Your answer should be in Required
the form of the type of misstatement that is likely to be reduced because of the control.
b. For each internal control, list one test of control the auditor can use to test for its existence.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 653
c. List one substantive procedure for testing whether the control is actually preventing
misstatements in property, plant, and equipment.
19-23 (Objectives 19-1, 19-2, 19-3, 19-5) The following audit procedures were planned by
Linda King, CPA, in the audit of the acquisition and payment cycle for Cooley Products, Inc.:
1. Review the acquisitions journal for large and unusual transactions.
2. Send letters to several vendors, including a few for which the recorded accounts |
payable balance is zero, requesting them to inform us of their balance due from
Cooley. Ask the controller to sign the letter.
3. Examine a sample of receiving report numbers and determine whether each one has
an initial indicating that it was recorded as an account payable.
4. Select a sample of equipment listed on fixed asset master files and inspect the asset to
determine that it exists and to determine its condition.
5. Refoot the acquisitions journal for 1 month and trace all totals to the general ledger.
6. Calculate the ratio of equipment repairs and maintenance to total equipment and
compare with previous years.
7. Obtain from the client a written statement that all mortgages payable have been
included in the current period financial statements and have been accurately recorded
and that the collateral for each is included in the footnotes.
8. Select a sample of cancelled checks and trace each one to the cash disbursements
journal, comparing the name, date, and amount.
9. For 20 nontangible acquisitions, select a sample of line items from the acquisitions
journal and trace each to related vendors’ invoices. Examine whether each transa ction
appears to be a legitimate expenditure for the client and that each was approvedand
recorded at the correct amount and date in the journal and charged to the correct
account per the chart of accounts.
10. Examine invoices and related shipping documents included in the client’s unpaid
invoice file at the audit report date to determine whether they were recorded in the
Aappproaprgiatoe a ccPouDntiFng peEriond hanad ant tchee corrrect amounts.
11. Recalculate the portion of insurance premiums on the client’s prepaid insurance
schedule that is applicable to future periods.
12. When the check signer’s assistant writes “paid” on supporting documents, watch
whether she does it after the documents are reviewed and the checks are signed.
Required a. For each procedure, identify the type of evidence being used.
b. For each procedure, identify whether it is an analytical procedure, a test of control, a
substantive test of transactions, or a test of details of balances.
c. For each test of control or substantive test of transactions, identify the transaction-
related audit objective(s) being met.
d. For each test of details of balances, identify the balance-related audit objective(s)
being met.
19-24 (Objective 19-2) Your client, Edgartown Corporation, prepared the following
schedule of land, buildings and equipment for the audit of financial statements for the year
ended December 31, 2011:
Account 1/1/11 12/31/11
Description Beginning Balance Additions Disposals Ending Balance
Land $ 7,500,000 — — $ 7,500,000
Building–Office 27,000,000 $250,000 — 27,250,000
Production Equipment 2,345,000 178,223 $ 34,779 2,488,444
Office Equipment 1,765,881 72,517 55,339 1,783,059
IT Hardware _____2_1_6__,5_4_2_ ________—_ ___1_9__,0_9_8_ _____1__9_7_,4_4_4_
Total $38,827,423 $500,740 $109,216 $39,218,947
Required a. What type of evidence would you examine to support the beginning balances in the
accounts?
654 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
b. What types of evidence would you use to support the additions to each account? How
might the sources of evidence differ for additions to the building account and the
equipment accounts?
c. What types of evidence would you examine to support equipment disposals?
d. What procedures would you perform related to the ending balances in the accounts?
e. In the audit of property, plant, and equipment accounts, auditors should consider
whether there are any implications to other accounts in the audit.
(1) What other accounts might be impacted by the additions of buildings and equip -
ment?
(2) What other accounts might be impacted by disposals of equipment?
19-25 (Objective 19-4)The following program has been prepared for the audit of accrued
real estate taxes of a client that pays taxes on 25 different pieces of property, some of which
have been acquired in the current year:
1. Obtain a schedule of accrued taxes from the client and tie the total to the general
ledger. |
2. Compare the charges for annual tax payments with property tax assessment bills.
3. Recompute accrued/prepaid amounts for all bills on the basis of the portion of the
year expired.
a. State the purpose of each procedure. Required
b. Evaluate the adequacy of the audit program.
19-26 (Objective 19-4) As part of the audit of different audit areas, auditors should be alert
for the possibility of unrecorded liabilities. For each of the following audit areas or accounts,
describe a liability that can be uncovered and the audit procedures that can uncover it:
a. Minutes of the board of directors meetings
b. Land and buildings
c. Rent expense Apago PDF Enhancer
d. Interest expense
e. Cash surrender value of life insurance
f. Cash in the bank
g. Officers’ travel and entertainment expenses
19-27 (Objective 19-5) While you are having lunch with a banker friend, you become
involved in explaining to him how your firm conducts a typical audit. Much to your
surprise, your friend is interested and is able to converse intelligently in discussing your
philosophy of emphasizing the importance of internal control, analytical procedures, tests
of controls, substantive tests of transactions, and tests of details of balance sheet accounts.
At the completion of your discussion, he says, “That all sounds great except for a couple of
things. The point of view we take these days at our bank is the importance of a continuous
earnings stream. You seem to be emphasizing fraud detection and a fairly stated balance
sheet. We would rather see you put more emphasis than you apparently do on the income
statement.”
How would you respond to your friend’s comments?
CASES
Ward Publishing Company — Part III (See Case 18-32 for Parts I and II)
19-28 (Objectives 19-1, 19-2, 19-5) Examine the tests of controls and substantive tests of
transactions results, including the sampling application in Case 18-32 (pp. 630–632), for
Ward Publishing Company. Assume that you have already reached several conclusions.
1. Your tests of details of balances for accounts payable are completed, and you found
no exceptions.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 655
2. Acceptable audit risk for property, plant, and equipment and all expenses is high.
3. Inherent risk for property, plant, and equipment is high because in the current year, the
client has acquired a material amount of new and used printing equipment and has
traded in older equipment. Some of the new equipment was ineffective and returned;
an allowance was received on others. Inherent risk for expense accounts is low.
4. New computer equipment and some printing equipment are being leased. The client
has never leased equipment before.
5. Analytical procedures for property, plant, and equipment are inconclusive because of
the large increases in acquisition and disposal activity.
6. Analytical procedures show that repairs, maintenance, and small tools expenses have
increased materially, both in absolute terms and as a percentage of sales. Two other
expenses have also materially increased, and one has materially decreased.
7. In examining the sample for tests of controls and substantive tests of transactions,
you observe that no sample items included any property, plant, and equipment or
lease transactions.
Required a. Explain the relationship between the tests of controls and substantive tests of trans -
actions results in Case 18-32 and the audit of property, plant, and equipment and leases.
b. How will the tests of controls and substantive tests of transactions results and your
conclusions (1 through 7) affect your planned tests of details for property, plant, and
equipment and leases? State your conclusions for each balance-related audit objective.
Do not write an audit program.
c. Explain the relationship between the tests of controls and substantive tests of trans-
actions results in Case 18-32 and the audit of expenses.
d. How will the tests of controls and substantive tests of transactions results and your
conclusions (1 through 7) affect your planned tests of details of balances for expenses? |
Do not write an audit program.
19-29 (Objective 19-2) You are doing the audit of the UTE Corporation, for the year ended
DecemAbepr 3a1,g 20o11 . TPheD foFllo wEingn schheadunle cfoer trhe property, plant, and equipment and
related allowance for depreciation accounts has been prepared by the client. You have
compared the opening balances with your prior year’s audit documentation.
UTE Corporation Analysis of Property, Plant, and Equipment
and Related Allowance for Depreciation Accounts
Year Ended December 31, 2011
Final Per Books
Description 12/31/10 Additions Retirements 12/31/11
Assets
Land $ 225,000 $ 50,000 $ 275,000
Buildings 1,200,000 175,000 1,375,000
Machinery and equipment 3__,8_5_0__,0_0_0_ _4_0_4__,0_0_0_ _2_6_0__,0_0_0_ 3__,9_9_4__,0_0_0_
$5,275,000 $629,000 $260,000 $5,644,000
Allowance for Depreciation
Building $ 600,000 $ 51,500 $ 651,500
Machinery and equipment _1_,7_3_2__,5_0_0_ _3_9_2__,2_0_0_ _2_,1_2__4_,7_0_0_
$2,332,500 $443,700 $2,776,200
The following information is found during your audit:
1. All equipment is depreciated on the straight-line basis (no salvage value taken into
consideration) based on the following estimated lives: buildings, 25 years; all other
items, 10 years. The corporation’s policy is to take one-half year’s depreciation on all
asset acquisitions and disposals during the year.
2. On April 1, the corporation entered into a 10-year lease contract for a die-casting
machine with annual rentals of $50,000, payable in advance every April 1. The lease
is cancelable by either party (60 days’ written notice is required), and there is no
option to renew the lease or buy the equipment at the end of the lease. The estimated
useful life of the machine is 10 years with no salvage value. The corporation recorded
656 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
the die-casting machine in the machinery and equipment account at $404,000, the
present value at the date of the lease, and $20,200, applicable to the machine, has
been included in depreciation expense for the year.
3. The corporation completed the construction of a wing on the plant building on June
30. The useful life of the building was not extended by this addition. The lowest
construction bid received was $175,000, the amount recorded in the buildings
account. Company personnel were used to construct the addition at a cost of
$160,000 (materials, $75,000; labor, $55,000; and overhead, $30,000).
4. On August 18, $50,000 was paid for paving and fencing a portion of land owned by
the corporation and used as a parking lot for employees. The expenditure was
charged to the land account.
5. The amount shown in the machinery and equipment asset retirement column
represents cash received on September 5, upon disposal of a machine acquired in
July 2007 for $480,000. The bookkeeper recorded depreciation expense of $35,000
on this machine in 2011.
6. Crux City donated land and building appraised at $100,000 and $400,000,
respectively, to the UTE Corporation for a plant. On September 1, the corporation
began operating the plant. Because no costs were involved, the bookkeeper made no
entry for the foregoing transaction.
a. In addition to inquiry of the client, explain how you would have found each of these Required
six items during the audit.
b. Prepare the adjusting journal entries with supporting computations that you would
suggest at December 31, 2011, to adjust the accounts for the preceding transactions.
Disregard income tax implications.*
19-30 (Objective 19-5)You are the manager in the audit of Vernal Manufacturing Company
and are turning your attention to the income statement accounts. The in-charge auditor
assessed control risk for all cycles as low, supported by tests of controls. There are no major
inherent risks affecting income and expense accounts. Accordingly, you decide that the
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major emphasis in auditing the income statement accounts will be to use analytical pro -
cedures. The client prepared a schedule of the key income statement accounts that compares
the prior-year totals with the current year totals. The in-charge auditor completed the last |
column of the audit schedule, which includes explanations of variances obtained from
discussions with client personnel. The audit schedule is included on page 658.
a. Examine the schedule prepared by the client and your staff and write a memorandum Required
to the in-charge that includes criticisms and concerns about the audit procedures
performed and questions for the in-charge auditor to resolve.
b. Evaluate the explanations for variances provided by client personnel. List any
alternative explanation to those given.
c. Indicate which variances are of special significance to the audit and how you believe
they should be responded to in terms of additional audit procedures.
INTERNET PROBLEM 19-1: CENTERPULSE LTD. FRAUD
The Securities and Exchange Commission (SEC) found that Centerpulse Ltd., a publicly-
traded company based in Switzerland, fraudulently misstated its 2002 third and fourth
quarter financial statements filed with the SEC. Visit the SEC’s website (www.sec.gov) and
search the link to “Litigation Releases” to locate Litigation Release 20336 issued on October
17, 2007 against selected members of the Centerpulse management team. View the SEC
Complaint in this matter to learn more about this fraud.
a. What members of management were allegedly involved in the accounting fraud? Required
b. What were the primary incentives that allegedly pressured management to engage in
the fraud?
*AICPA adapted.
Chapter 19 / COMPLETING THE TESTS IN THE ACQUISITION AND PAYMENT CYCLE 657
Vernal Manufacturing Co.
Income Statement Accounts
12/31/11
PerG/L PerG/L Change
Account 12/31/10 12/31/11 Amount Percent Explanationsby Client
Sales $8,467,312 $9,845,231 $1,377,919 16.3 Sales increase due to two new customers who
Sales returns and allowances (64,895) (243,561) (178,666) 275.3 accountfor 20% of volume. Larger returns due
Gain on sale of assets 43,222 (143,200) (186,422) –431.3 to need to cement relations with these
Interest income 243 223 (20) –8.2 customers.
Miscellaneous income 6,365 25,478 19,113 300.3 Trade-in of several sales cars that needed
8,452,247 9,484,171 1,031,924 12.2 replacement.
Cost of goods sold:
Beginning inventory 1,487,666 1,389,034 (98,632) –6.6
Purchases 2,564,451 3,430,865 866,414 33.8 Increase in these accounts due to increased
Freight in 45,332 65,782 20,450 45.1 volume with new customers as indicated above.
Purchase returns (76,310) (57,643) 18,667 –24.5
Factory wages 986,755 1,145,467 158,712 16.1
Factory benefits 197,652 201,343 3,691 1.9
Factory overhead 478,659 490,765 12,106 2.5
Factorydepreciation 344,112 314,553 (29,559) –8.6
Ending inventory (1,389,034) (2,156,003) (766,969) 55.2 Inventory being heldfor new customers.
4,639,283 4,824,163 184,880 4.0
Selling, general and administrative:
Executive salaries 167,459 174,562 7,103 4.2 Normal salary increases.
Executive benefits 32,A321pago34 ,48P8 DF 2E,16n7 ha6n.7 cer
Office salaries 95,675 98,540 2,865 3.0
Office benefits 19,888 21,778 1,890 9.5
Travel and entertainment 56,845 75,583 18,738 33.0 Sales andpromotional expenses increased in an
Advertising 130,878 156,680 25,802 19.7 attempt to obtain new major customers. Two
Other sales expense 34,880 42,334 7,454 21.4 obtained andprogram will continue.
Stationery and supplies 38,221 21,554 (16,667) –43.6 Probably a misclassification; will investigate.
Postage 14,657 18,756 4,099 28.0 Normal increase.
Telephone 36,551 67,822 31,271 85.6 Normal increase.
Dues andmemberships 3,644 4,522 878 24.1 Normal increase.
Rent 15,607 15,607 0 0.0
Legal fees 14,154 35,460 21,306 150.5 Timing of billing forfees.
Accounting fees 16,700 18,650 1,950 11.7 Normal increase.
Depreciation, SG&A 73,450 69,500 (3,950) –5.4 Normal change.
Baddebt expense 166,454 143,871 (22,583) –13.6 Haven’t reviewedyetfor the current year.
Insurance 44,321 45,702 1,381 3.1 Normal change.
Interest expense 120,432 137,922 17,490 14.5 Normal change.
Other expense 5,455 28,762 23,307 427.3 Amount not material.
1,087,592 1,212,093 124,501 11.4
5,726,875 6,036,256 309,381 5.4
Income before taxes 2,725,372 3,447,915 722,543 26.5 |
Income taxes 926,626 1,020,600 93,974 10.1 Increasedue to increased income before tax.
Net income $1,798,746 $2,427,315 $ 628,569 34.9
c. What was the nature of the expense that management inappropriately delayed?
d. The complaint also notes that management failed to write-off an impaired asset. What
were the circumstances resulting in the impairment?
e. By what percentage amount did these actions overstate Centerpulse’s 2002 pretax
income?
658 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
20
C H A P T E R
AUDIT OF THE PAYROLL
AND PERSONNEL CYCLE
LEARNING OBJECTIVES
After studying this chapter,
The Staff Auditor Must Never “Simply Follow Orders”
you should be able to
Leslie Scott graduated with a Masters of Accounting degree from a major
20-1 Identify the accounts and
university before joining the audit staff of a CPA firm. During her first “busy transactions in the payroll and
season,” she worked on the audit of Sysco, Inc., a software development personnel cycle.
company. Her immediate supervisor on the Sysco audit was Bob Stith. Bob 20-2 Describe the business functions
had been with the firm 3 years longer than Leslie and worked on the Sysco and the related documents and
audit the previous year. He supervised Leslie’s work on capitalized software records in the payroll and
personnel cycle.
development costs.
20-3 Understand internalcontrol and
To prepare, Leslie read applicable accounting standards and had a good design and perform tests of
understanding of the accounting rules for the capitalization of such costs. controls and substantive tests of
transactions for the payroll and
She understood, for example, that costs can not be capitalized until tech-
personnel cycle.
nological feasibility has been established, either through detail program
20-4 Design and perform a nalytical
design or product design and the completion of a working model, con-
procedures for the payroll and
firmed by testing.
personnel cycle.
20-5 Design and perform tests of
Bob drafted an audit program for capitalized software development costs.
He told Leslie to verify the payroll coAstps tahagt woer e Pa sDignFifi caEnt npahrt aof nthecer details of balances for accounts in
the payroll and personnel cycle.
development cost and to talk to Jack Smart, Sysco’s controller, about
whether the projects with capitalized costs had reached the technol ogical
feasibility stage. Leslie tested the payroll costs and found no misstate-
ments. She also made inquiries of Smart and was told that the appropriate stage was reached. Leslie docu mented
Smart’s representation in the audit files and went on to the next area assigned to her.
Later, Leslie began to have second thoughts. Because management’s representations are a weak form of audit evi-
dence, she doubted whether Jack Smart was the most knowledgeable person about the technical status of software
projects. To resolve her concerns and to verify Smart’s representations, she decided to talk to the responsible software
engineers about one of the projects. She intended to clear this with Bob, but he was at another client’s office that
morning, so she proceeded on her own initiative. The engineer she talked to on the first project told her that he was
almost finished with a working model but had not tested it yet. She decided to inquire about another project and dis-
covered the same thing. Leslie documented these findings on an audit schedule and planned to discuss the situation
with Stith as soon as he returned to the job. When Leslie told Bob of her findings and showed him the schedule, he
told her the following:
“Listen, Leslie, I told you to just talk to Jack. You shouldn’t do procedures that you’re not instructed to do. I want
you to destroy this schedule and don’t record the wasted time. We’re under a lot of time pressure and we can’t
bill Sysco for procedures that aren’t necessary. There’s nothing wrong with the capitalized software development
costs. The fact that they have working products that they’re selling indicates technological feasibility was reached.” |
Leslie was extremely distressed with this reaction from Bob but followed his instructions. The following fall, the SEC
conducted an investigation of Sysco and found, among other things, that they had overstated capitalized software
development costs. The SEC brought an action against both the management of Sysco and its auditors.
Thepayroll and personnel cycleinvolves the employment and payment of all employees. Labor is an important
consideration in the valuation of inventory in manufacturing, construction, and other industries. As the story
involving Leslie Scott and the audit of Sysco, Inc. demonstrates, improper valuation and allocation of labor can result
in a material misstatement of net income. Payroll is also an area in which company resources can be wasted because
of inefficiency or stolen through fraud.
As with the sales and collection and acquisition and payment cycles, the audit of the payroll and personnel
cycle includes obtaining an understanding of internal control, assessing control risk, tests of controls and
substantive tests of transactions, analytical procedures, and tests of details of balances. In a typical audit, the main
differences between the payroll and personnel cycle and other cycles include:
• There is only one class of transactions for payroll. Most cycles include at least two classes of transactions. For
example, the sales and collection cycle includes both sales and cash receipts transactions, and often includes sales
returns and charge-off of uncollectible accounts. Payroll has only one class because the receipt of services from
employees and the payment for those services through payroll usually occur within a short time period.
• Transactions are generally far more significant than related balance sheet accounts. Payroll-related accounts such as
accrued payroll and withheld taxes are usually small compared to the total amount of transactions for the year.
• Internal controls over payroll are effective for almost all companies, even small ones. Strict federal and state
regulations encourage effective controls for withholding and paying payroll taxes. Also, employee morale
problems can occur if employees are not paid or are underpaid.
Because of these three characteristics, auditors typically emphasize tests of controls, substantive tests of
transactions, and analytical procedures in the audit of payroll. Tests of details of balances take only a few minutes
for most payroll-related accounts. Before we discuss the tests in the cycle, let’s review the transactions and account
balances, as well as the documents and records used in the payroll and personnel cycle for a typical company.
ACCOUNTS AND TRANSACTIONS
IN THE PAYROLL AND PERSONNEL CYCLE
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OBJECTIVE 20-1 The overall objective in the audit of the payroll and personnel cycle is, of course, to
evaluate whether the account balances affected by the cycle are fairly stated in accor -
Identify the accounts and
dance with applicable accounting standards.
transactions in the payroll
Typical accounts in the payroll and personnel cycle are shown in Figure 20-1.
and personnel cycle.
T accounts are used to illustrate the way in which accounting information flows
through the various accounts in the payroll and personnel cycle. In most systems, the
accrued wages and salaries account is used only at the end of an accounting period.
Throughout the period, expenses are charged when the employees are actually paid
rather than when the labor costs are incurred. Accruals for labor are recorded by
adjusting entries at the end of the period for any earned but unpaid labor costs.
BUSINESS FUNCTIONS IN THE CYCLE
AND RELATED DOCUMENTS AND RECORDS
OBJECTIVE 20-2 The payroll and personnel cycle begins with hiring employees and ends with paying
them for the services they performed and the government and other institutions for
Describe the business
withheld and accrued payroll taxes and benefits. In between, the cycle involves
functions and the related
obtaining services from employees consistent with company objectives, and properly |
documents and records in
the payroll and personnel accounting for the services.
cycle. Turn to Table 20-1 on page 662. The third column identifies the four business
functions in a typical payroll and personnel cycle and illustrates the relationships
among the business functions, classes of transactions, accounts, and documents and
records. Auditors must understand the business functions and documents and records
before they can assess control risk and design tests of controls and substantive tests of
transactions.
660 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 20-1 Accounts in the Payroll and Personnel Cycle
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The human resources department provides an independent source for interviewing Human Resources
and hiring qualified personnel. The department is also an independent source of
records for the internal verification of wage information, including additions and
deletions from the payroll and changes in wages and deductions.
Human Resource Records Human resource recordsinclude such data as the date of
employment, personnel investigations, rates of pay, authorized deductions, perfor -
mance evaluations, and termination of employment.
Deduction Authorization Form This form is used to authorize payroll deductions,
including the number of exemptions for withholding income taxes, 401(K) and other
retirement savings plans, health insurance, and union dues.
Rate Authorization Form This form is used to authorize the rate of pay. The source
of the information is a labor contract, authorization by management, or in the case of
officers, authorization from the board of directors.
Timekeeping and payroll preparation are important in the audit of payroll because Timekeeping and
they directly affect payroll expense for each period. Adequate controls are necessary to Payroll Preparation
prevent misstatements in the following four activities:
• Prepare time records by employees
• Summarize and calculate gross pay, deductions, and net pay
• Payment of payroll
• Prepare payroll records
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 661
TABLE 20-1 Classes of Transactions, Accounts, Business Functions, and Related
Documents and Records forthePayroll and Personnel Cycle
Class of Business Documents
Transactions Accounts Functions and Records
Payroll Payroll cash Human resources and Human resource records
All payroll expense accounts employment Deduction authorization
All payroll withholding accounts form
All payroll accrual accounts Rate authorization form
Timekeeping and payroll Time record
preparation Job time ticket
Payroll transaction file
Payroll journal or listing
Payroll master file
Payment of payroll Payroll direct deposit
or check
Payroll bank account
reconciliation
Preparation of payroll tax W-2 form
returns and payment Payroll tax returns
of taxes
Time Record Thetime recordis a document indicating the time the hourly employee
started and stopped working each day and the number of hours the employee worked.
Time records may be in paper or electronic form, and they may be prepared automati -
cally by time clocks or identification card readers. Time records are usually submitted
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Salaried or exempt employees usually do not complete time records. They may be
required to complete time reports to be compensated for overtime, vacation, or sick days.
Job Time Ticket The job time ticket is a form indicating which jobs an employee
worked on during a given time period. This form is used only when an employee works
on different jobs or in different departments. Job time tickets are often done electroni -
cally by a time and expense reporting system.
Payroll Transaction File This computer-generated file includes all payroll trans -
actions processed by the accounting system for a period, such as a day, week, or month.
The file contains all information entered into the system and information for each
transaction, such as employee name and identification number, date, gross and net pay,
various withholding amounts, and account classification or classifications. Depending |
on the company’s needs, the information on the payroll transaction file is used for a
variety of records, listings, and reports, such as the payroll journal, payroll master file,
and payroll bank reconciliation.
Payroll Journal or Listing This report is generated from the payroll transaction file
and typically includes the employee name, date, gross and net payroll amounts,
withholding amounts, and account classification or classifications for each transaction.
The same transactions included in the journal or listing are also posted simultaneously
to the general ledger and to the payroll master file.
Payroll Master File The payroll master file is a computer file used for recording
payroll transactions for each employee and maintaining total employee wages paid for
the year to date. The record for each employee includes gross pay for each payroll
period, deductions from gross pay, net pay, check number, and date. This master file is
updated from payroll transaction files. The total of the individual employee earnings in
the master file equals the total balance of gross payroll in various general ledger accounts.
662 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
GHOSTS ON Melvin Turner was extremely ill and needed the fictitious checks were white, but the file
expensive medicines to treat his condition. He copies of legitimate checks were green. Several
THE PAYROLL
was responsible for recording payroll hours and additional clues indicated the presence of the
preparing payroll records at the not-for-profit fraud:
organization where he was employed. A separate ◆ Multiple direct deposits were made to the
employee was responsible for adding and deleting same bank account but under different
employees to the payrollsystem. However,Turner
employees’ names.
circumvented this control by looking over her ◆ None of the fake employees had a personnel
shoulder to steal her user ID and password, allow- file or amounts withheld.
ing him to add fictitious employees to the payroll. ◆ Employee numbers for the ghost employees
After adding the “ghost” employees to the were higher than those of other employees.
payroll, Turner entered wage and other relevant
Confronted with the evidence, Turner pleaded
information and arranged for direct deposit of the
guilty to the charges. Under a plea bargain agree -
fictitious employees’ pay to his own bank account.
ment, he was ordered to make restitution and
He alsocreated fictitious documentation for the
was sentenced to 15 years of probation.
ghost employees’ work, as well as file copies of
thepaychecks. Source: Joseph T. Wells, “Keep Ghosts Off the
The fraud was detected by the organization’s Payroll,” Journal of Accountancy(December 2002),
external auditor who noted that the file copies of pp. 77–82.
The approval and distribution of payroll must be carefully controlled to prevent theft. Payment of Payroll
To increase control, payroll disbursements are generally processed separately from
other disburse ments.
Payment of Payroll Payments are issued to employees in exchange for services
performed. Payments may be made by check, but are usually deposited directly into
employees’ individual bank accounts. The amount paid is the gross pay less taxes and
other deductions withheld.
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Payroll Bank Account Reconciliation An independent bank reconciliation is
impor tant for all cash accounts, including payroll, for finding errors and fraud. An
imprest payroll accountis a separate payroll account in which a small balance is main -
tained. The exact amount of each net payroll is transferred by check or electronic funds
transfer from the general account to the imprest account immediately before
distribution of the payroll. The imprest account limits the client’s exposure to payroll
fraud and separates routine payroll expenditures from other expenditures. It also
simplifies reconciliation of the payroll bank account.
Federal and state payroll laws require the timely preparation and submission of payroll Preparation of
tax returns. Most computerized payroll systems prepare payroll tax returns using Payroll Tax Returns |
informa tion on the payroll transaction and master files. To prevent misstatements and and Payment of Taxes
potential liability for taxes and penalties, a competent individual must independently
verify the output.
W-2 Form This is a form sent to each employee that summarizes the employee’s
earning for the calendar year, including gross pay, income taxes withheld, and FICA
(Social Security) withheld. The same information is also submitted to the Internal
Revenue Service and state and local tax commissions when applicable. This information
is prepared from the payroll master file and is normally computer generated.
Payroll Tax Returns These are forms submitted to local, state, and federal units of
government to show payment of withheld taxes and the employer’s tax. The nature
and due dates of the forms vary depending on the type of taxes. These forms are
prepared from information on the payroll master file and are usually computer
generated. Federal withholding and Social Security payments are due semiweekly or
monthly, depending on the amount of withholding. Most state unemployment taxes
are due quarterly.
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 663
METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS
OBJECTIVE 20-3 Now that you are familiar with the business functions and related documents and records
in the payroll and personnel cycle, we will discuss assessing control risk and the design of
Understand internalcontrol
tests of controls and substantive tests of transactions for the cycle. The methodology for
and design and perform tests
designing tests of controls and substantive tests of transactions for the payroll and
of controls and substantive
tests of transactions for the personnel cycle is the same as that used in Chapter 14 for the sales and collection cycle and
payroll and personnel cycle. in Chapter 18 for the acquisition and payment cycle: understand internal control, assess
planned control risk, determine the extent of testing of controls, and design tests of
controls and substantive tests of transactions to meet transaction-related audit objectives.
Internal control for payroll is normally highly structured and well controlled to
manage cash disbursed, to minimize employee complaints and dissatisfaction and to
minimize payroll fraud. Because of relatively common payroll concerns from company
to company, high-quality computerized payroll accounting programs are available.
Because processing payroll is similar for most organizations, and programs need to
be modified annually for changes in withholding schedules, companies commonly
use an outside payroll service for processing payroll. The auditor can often rely on
the internal con trols of the service organization if the service organiza tion’s auditor
issues a report on the service organization’s internal control, discussed in Chapter 12
(pp. 389–390).
It is usually not difficult for companies to establish good control in the payroll and
personnel cycle. For factory and office employees, there are usually a large number of
relatively homogeneous, small-amount transactions. For executives, there are usually
fewer payroll transactions, but they are ordinarily consistent in timing and amount.
Consequently, auditors seldom expect to find exceptions in testing payroll transactions.
OccasAionpalaly,g coon troPl tDesFt d evEiatniohnsa ocncucr, eburt most monetary misstatements are
corrected by internal verification controls or in response to employee complaints. Even
when there are misstatements, they are rarely material.
Tests of controls and substantive tests of transactions procedures are the most
important means of verifying account balances in the payroll and personnel cycle.
These tests are emphasized because of the lack of independent third-party evidence,
such as confirmation, for verifying accrued wages, withheld income taxes, accrued
payroll taxes, and other balance sheet accounts. Furthermore, in most audits, the
amounts in the balance sheet accounts are small and can be verified with relative ease if |
the auditor is confident that payroll transactions are correctly entered into the
computer and payroll tax returns are correctly prepared.
Even though tests of controls and substantive tests of transactions are the most
important parts of testing payroll, tests in this area are usually not extensive. Many
audits have a minimal risk of material misstatements, even though payroll is often a
significant part of total expenses. There are three reasons for this:
1. Employees are likely to complain to management if they are underpaid.
2. All payroll transactions are typically uniform and uncomplicated.
3. Payroll transactions are subject to audit by federal and state governments for
income tax withholding, Social Security, and unemployment taxes.
Understand Internal Following the same approach used in Chapter 14 for tests of sales and cash receipts
Control — Payroll and transactions, the internal controls, tests of controls, and substantive tests of trans -
Personnel Cycle actions for each transaction-related audit objective are summarized in Table 20-2
(p. 666). Again, you should recognize the following:
• Internal controls vary from company to company; therefore, the auditor must
identify the controls, significant deficiencies, and material weaknesses for each
organization.
664 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
• Controls the auditor intends to rely on to reduce assessed control risk must be
tested with tests of controls.
• If the auditor is reporting on the effectiveness of internal control over financial
reporting, the level of understanding controls and extent of tests of controls
must be sufficient to issue an opinion on the effectiveness of internal control
over financial reporting.
• Substantive tests of transactions vary depending on the assessed control risk and
the other considerations of the audit, such as the effect of payroll on inventory.
• Tests are not actually performed in the order given in Table 20-2. The tests of
controls and substantive tests of transactions are combined when appropriate
and are performed in as convenient a manner as possible, using a performance
format audit program.
The purposes of many internal controls and the nature of the tests of controls and
substantive tests of transactions are apparent for most tests from their descriptions in
Table 20-2. Next, the key controls for the payroll and personnel cycle for assessing
control risk are discussed.
Adequate Separation of Duties Separation of duties is important in the payroll and
personnel cycle, especially to prevent overpayments and payments to nonexistent
employees. The payroll function should be kept independent of the human resources
department, which controls key payroll activities, such as adding and deleting employees.
Payroll processing should also be separate from the issuance of payroll disbursements.
Proper Authorization As already noted, only the human resources department
should be authorized to add and delete employees from the payroll or change pay rates
and deductions. The number of hours worked by each employee, especially overtime,
should be authorized by the employee’s supervisor. Approval may be noted on all time
records or done on an exception basis only for overtime hours.
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Adequate Documents and Records The appropriate documents and records
depend on the nature of the payroll system. Time records are necessary for hourly
employees but not for salaried employees. For employees compensated based on piece
rate or other incentive systems, different records are required. For many companies,
time records must be adequate to accumulate payroll costs by job or assignment.
Prenumbered documents for recording time are less of a concern for payroll because
the completeness objective is normally not a concern.
Physical Control Over Assets and Records Access to unsigned payroll checks
should be restricted. Checks should be signed by a responsible employee, and payroll
should be distributed by someone independent of the payroll and timekeeping
functions. Any unclaimed checks should be returned for redeposit. If checks are signed |
by a signature machine, access to the machine should be restricted. Similarly, when pay -
ment occurs through direct deposit, access to systems used to authorize payments
should be restricted.
Independent Checks on Performance Payroll computations should be indepen -
dently verified, including comparison of batch totals to summary reports. A member of
management or other responsible employee should review the payroll output for any
obvious misstatements or unusual amounts. When manufacturing labor affects inven -
tory valuation or when it is necessary to accumulate costs by job, adequate controls are
necessary to verify the proper assignment of costs.
Payroll taxes and other withholdings are important in many companies, both because Payroll Tax Forms
the amounts are often material and because the potential liability for failure to timely and Payments
file tax forms can be severe.
Preparation of Payroll Tax Forms As a part of understanding internal control, the
auditor should review the preparation of at least one of each type of payroll tax form
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 665
TABLE 20-2 Summary of Transaction-Related Audit Objectives, Key Controls, Tests of Controls, and
Substantive Tests of Transactions for Payroll
Transaction-Related Key Internal Common Test Common Substantive
Audit Objectives Controls of Controls Tests of Transactions
Recorded payroll Time records are approved by Examine time records for Review the payroll journal,
payments are for work supervisor. indication of approvals. general ledger, and payroll
actually performed Time clock is used to record time. Examine time records. earnings records for large or
by existing employees Adequate human resource files Review human resource unusual amounts.*
(occurrence). are maintained. policies. Compare cancelled check or
Employment is authorized. Examine human resource files. direct deposit information
There is separation of duties Review organization chart, with human resource records.
among human resources, discuss with employees, Compare cancelled checks with
timekeeping, and payroll and observe duties being payroll journal for name,
disbursements. performed. amount, and date.
Only employees existing in the Examine printouts of Examine cancelled checks for
computer data files are transactions rejected by the proper endorsement.
accepted when they are computer as having non-
entered. existent employee numbers.
Disbursements are authorized Examine payroll records for
before issuance. indication of approval.
Existing payroll Payroll checks are prenumbered Account for a sequence of Reconcile the disbursements in
transactions and accounted for. payroll checks. the payroll journal with the
are recorded Bank accounts are independently Discuss with employees and disbursements on the payroll
(completeness). reconciled. observe reconciliation. bank statement.
Prove the bank reconciliation.
Recorded payroll Calculations and amounts are Examine indication of internal Recompute hours worked from
transactions are for internally verified. verification. time records.
the amount of time Batch totals are compared with Examine file of batch totals for Compare pay rates with union
actually worked and computer summary reports. initials of data control clerk; contract, approval by board of
are at the proper pay Apago PDF comEpnareh totaals nto csumemrary reports. directors, or other source.
rates; withholdings are Wage rate, salary, or commission Examine payroll records Recompute gross pay.
correctly calculated rate is properly authorized. for indication of authorization. Check withholdings by referring
(accuracy). Withholdings, including amounts Examine authorizations in to tax tables and authorization
for insurance and payroll human resource file. forms in human resource file.
savings, are properly Recompute net pay.
authorized. Compare cancelled check or
direct deposit with payroll
journal for amount.
Payroll transactions are Payroll master file contents are Examine indication of internal Test clerical accuracy by footing |
correctly included in internally verified. verification. the payroll journal and tracing
the payroll master file Payroll master file totals are Examine initialed summary postings to the general ledger
and are correctly compared with general ledger total reports indicating that and the payroll master file.
summarized (posting totals. comparisons have been made.
and summarization).
Payroll transactions are An adequate chart of accounts Review chart of accounts. Compare classification with chart
correctly classified is used. of accounts or procedures
(classification). Account classifications are Examine indication of internal manual.
internally verified. verification. Review time record for employee
department and job ticket for
job assignment and trace
through to labor distribution.
Payroll transactions are Procedures require recording Examine procedures manual and Compare date of recorded
recorded on the correct transactions as soon as observe when recording takes payment in the payroll journal
dates (timing). possible after the payroll place. with date on cancelled check
is paid. or direct deposit and time
Dates are internally verified. Examine indication of internal record.
verification. Compare date on check with date
the check cleared the bank.
*This analytical procedure can also apply to other objectives, including completeness, accuracy, and timing.
666 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
that the client is responsible for filing. The potential for liability for unpaid taxes,
penalty, and interest arises if the client fails to prepare the tax forms correctly. The
payroll tax forms are for such taxes as federal income and FICA withholding, state and
city income withholding, and federal and state unemployment.
A detailed reconciliation of the information on the tax forms and the payroll
records may be necessary when the auditor believes the tax returns may be incorrectly
prepared. Indications of potential misstatements in the returns include the payment of
penalties and interest in the past for improper payments, new personnel in the payroll
department who are responsible for the preparation of the returns, the lack of internal
verification of the information, and cash flow problems for the client.
Timely Payment of the Payroll Taxes Withheld and Other Withholdings It is
desirable to test whether the client has fulfilled its legal obligation in submitting
payments for all payroll withholdings as a part of the payroll tests even though the
payments are usually made from general cash disbursements. The withholdings of
concern in these tests include taxes, 401(K) and other retirement savings, union dues,
insurance, and payroll savings.
Auditors must first determine the client’s requirements for submitting the payments,
which can be determined by referencing such sources as tax laws, union contracts, and
agreements with employees. Once auditors know the requirements, they can easily deter -
mine whether the client has made timely payments at correct amounts by comparing the
subsequent cash disbursement with the payroll records.
Auditors often extend their payroll audit procedures if payroll significantly affects the Inventory and
valuation of inventory, or when the auditor is concerned about the possibility of Fraudulent Payroll
material fraudulent payroll transactions, such as nonexistent employees or fraudu- Considerations
lent hours.
Relationship Between Payroll aAndp Inavgenoto ryP VDaluFat ioEnnWhhean npacyreollr is a sig -
nificant portion of inventory, which is common for manufacturing and construction
companies, the improper account classification of payroll can materially affect asset
valuation for accounts such as work in process, finished goods, or construction in
process. For example, the overhead charged to inventory at the balance sheet date can
be overstated if the salaries of administrative personnel are inadvertently or inten -
tionally charged to indirect manufacturing overhead. Similarly, the valuation of
inventory is affected if the direct labor cost of individual employees is incorrectly |
charged to the wrong job or process. When jobs are billed on a cost-plus basis, revenue
and the valuation of inventory are both affected by charging labor to incorrect jobs.
When labor is a material part of inventory valuation, auditors should emphasize
testing internal controls over proper classification of payroll transactions. Con sistency
from period to period is essential for classification and can be tested by tracing job tickets
or other evidence of an employee having worked on a job or process to the account ing
records that affect inventory valuation. For example, if employees must account for all
of their time each week by assigning it to individual jobs, a useful test is to trace the
recorded hours of several employees to the related job-cost records to make sure each
has been correctly recorded. It may also be desirable to trace from the job-cost records to
time cards as a test for nonexistent payroll charges being included in inventory.
Tests for Nonexistent Employees Issuing payroll disbursements to individuals who
do not work for the company (nonexistent employees) often results from the con -
tinuance of an employee on payroll after employment was terminated. Usually, the
person committing this type of embezzlement is a payroll clerk, foreman, fellow
employee, or perhaps the former employee. Under some systems, a foreman can clock
in daily for an employee and approve the time card at the end of the time period. If the
foreman also distributes paychecks or if payroll is deposited directly into employees’
accounts, considerable opportunity exists for embezzlement.
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 667
To detect embezzlement, auditors may compare the names on cancelled checks or
the account into which payroll has been deposited with time cards and other records
for authorized signatures and reasonableness of the endorsements. It is also common to
scan endorsements on cancelled checks for unusualor recurring second endorsements
as an indication of a possible fraudulent check. Examining checks that are recorded as
voided is also desirable to make sure that they have not been fraudulently used.
To test for nonexistent employees, auditors can trace selected transactions recorded
in the payroll journal to the human resources department to determine whether the
employees were actually employed during the payroll period. If paid by check, the
endorsement on the cancelled check written out to an employee can be compared with
the authorized signature on the employee’s withholding authorization forms.
A procedure that tests for proper handling of terminated employees is to select
several files from the human resource records for employees who were terminated in
the current year to determine whether each received termination pay consistent with
company policy. Continuing payments to terminated employees can be tested by
examining payroll records in the subsequent period to verify that the employee is no
longer being paid. Naturally, this procedure is not effective if the human resources
department is not informed of terminations.
In some cases, the auditor may request a surprise payroll payoff. This is a pro -
cedure in which all employees must pick up and sign their check or direct deposit
payroll record in the presence of a supervisor and the auditor. Any checks that have not
been claimed must be subject to an extensive investigation to determine whether an
unclaimed check is fraudulent. Surprise payoff is often expensive but it may be the only
likely means of detecting an embezzlement.
Tests for Fraudulent Hours Fraudulent hours occur when an employee reports
more time than was actually worked. Because of the lack of available evidence, it
is usually difficult for an auditor to discover fraudulent hours. One procedure is to
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reconcile the total hours paid according to the payroll records with an inde pendent
record of the hours worked, such as those often maintained by production control.
Similarly, it may be possible to observe an employee clocking in more than one time |
card under a buddy approach. However, it is ordinarily easier for the client to prevent
this type of embezzlement by adequate controls than for the auditor to detect it.
METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES
During the first two phases of the audit, auditors assess control risk and perform tests of
controls and substantive tests of transactions. After completing these tests and assessing
the likelihood of misstatement in financial statement accounts in the payroll and per -
sonnel cycle, the auditor follows the methodology for designing tests of details of balances.
The methodology for deciding the appropriate tests of details of balances for
payroll liability accounts is the same as that followed in Chapter 16 for accounts
receivable and Chapters 18 and 19 for acquisition and payment balance sheet accounts.
See Figure 16-1 on page 520 for the accounts receivable methodology.)
Identify Client Significant client business risks affecting payroll are unlikely for most companies.
Business Risks However, client business risk may exist for complex compensation arrangements,
Affecting Payroll including bonus and stock option plans and other deferred compensation arrange -
(Phase I) ments. For example, many technology and other companies provide extensive stock
options as part of their compensation packages for key employees that signifi cantly
impact compensation expense and shareholders’ equity. Examples of other risks
include events such as renegotiation of union contracts and dis crimination claims. The
auditor should understand the likelihood of these events and determine their potential
effects on the financial statements, including footnote disclosures.
668 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
ONE IN Option backdating is the issuance of a stock option other companies demonstratedsimilar favorable
at a date later than the date indicated in the patterns in the timing of stock option grants.
300 BILLION
option contract. Many companies, including such Not surprisingly, option backdating led to the
well-respected companies as Microsoft and Apple question, “Where were the auditors?” However,
Computer, issued options that were back dated, others wonder whether auditors should have been
allowing executives to profit by retroactively locking questioning legal documents showing the grant
in low stock prices that preceded a run-up in the date of an option. “I don’t blame the auditors for
company’s stock. this,” said Nell Minow, editor for The Corporate
If options are granted on random dates, there Library, a g overnance research company. “My
should be no discernible pattern in the company’s question is, ‘Where were the compensation
stock price performance following an option grant. committees?’”
A pattern of stock price increases following stock
Sources: Adapted from 1. Charles Forelle, “How the
option grants suggests backdating. Based on the
Journal Analyzed Stock-Option Grants,” The Wall
stock price performance of Affiliated Computer
Street Journal(March 18, 2006) p. A5; 2. David
Services,The Wall Street Journalcalculated the Reilly, “Backdating Woes Beg the Question Of
odds of the favorable timing of then-president Auditors’ Role,” The Wall Street Journal(June 23,
Jeffrey Rich’s options at one in 300 billion. Several 2006) p. C1.
Most companies have a large number of transactions involving payroll, often with large Set Tolerable
total amounts. However, balance sheet accounts are normally insignificant, except for Misstatement and
labor charged to inventory. Assess Inherent Risk
Aside from the potential for fraud, inherent risk is typically low for all balance-related (Phase I)
audit objectives. There is inherent risk of payroll fraud because most trans actions involve
cash. Therefore, auditors often consider the occurrence transaction-related objective
important. Also, for manufacturing companies with significant labor charged to inventory,
the potential exists for misclassification between payroll expense and inventory or among
categories of inventory. As a part of gaining an understanding of the client, the auditor may |
identify complex payroll-related issueAs, spucah ags soto ck-PbaDseFd c omEpnenshataionn pclanes, rthat may
increase inherent risks related to the accounting and disclosure of those arrangements.
Earlier in this chapter, we discussed assessing control risk and the related tests of Assess Control Risk
controls and substantive tests of transactions. Refer to Table 20-2 (p. 666) for a review and Perform Related
of these topics. Tests (Phases I and II)
The use of analytical procedures is as important in the payroll and personnel cycle as it Perform Analytical
is in every other cycle. Table 20-3 illustrates analytical procedures for the balance sheet Procedures (Phase III)
and income statement accounts in the payroll and personnel cycle. Most of the
relationships in the first column are predictable and are therefore useful for identifying OBJECTIVE 20-4
areas in which additional investigation is desirable.
Design and perform
analytical procedures for the
payroll and personnel cycle.
TABLE 20-3 Analytical Procedures for the Payroll and Personnel Cycle
Analytical Procedure Possible Misstatement
Compare payroll expense account balance with Misstatement of payroll expense accounts
previous years (adjusted for pay rate increases
and increases in volume).
Compare direct labor as a percentage of sales with Misstatement of direct labor and inventory
previous years.
Compare commission expense as a percentage of Misstatement of commission expense and
sales with previous years. commission liability
(continued on following page)
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 669
TABLE 20-3 Analytical Procedures for the Payroll and Personnel Cycle(Cont.)
Analytical Procedure Possible Misstatement
Compare payroll tax expense as a percentage of Misstatement of payroll tax expense and
salaries and wages with previous years payroll tax liability
(adjusted for changes in the tax rates).
Compare accrued payroll tax accounts with Misstatement of accrued payroll taxes and
previous years. payroll tax expense
Design and Perform The verification of the liability accounts associated with payroll, often termed accrued
Tests of Details of payroll expenses, is ordinarily straightforward if internal controls are operating effec -
Balances for Liability tively. When the auditor is satisfied that payroll transactions are being correctly
and Expense Accounts recorded in the payroll journal and the related payroll tax forms are being accurately
(Phase III) prepared and taxes promptly paid, the tests of details of balances should not be time
consuming.
OBJECTIVE 20-5 The two major balance-related audit objectives in testing payroll liabilities are:
1. Accruals in the trial balance are stated at the correct amounts (accuracy).
Design and perform tests
2. Transactions in the payroll and personnel cycle are recorded in the proper
of details of balances for
accounts in the payroll and period (cutoff).
personnel cycle.
The primary concern in both objectives is to make sure that there are no under -
stated or omitted accruals. Next, we examine the major liability accounts in the payroll
and personnel cycle.
Amounts Withheld from Employees’ Pay Payroll taxes withheld but not yet paid to
the goAveprnmaegnto ca n PbeD teFste d Eby ncohmapanrincg teher balance with the payroll journal, the
payroll tax form prepared in the subsequent period, and the subsequent period cash dis -
bursements. Other withheld items such as retirement savings, union dues, savings bonds,
and insurance can be verified in the same manner. If internal controls are operating
effectively, cutoff and accuracy can easily be tested at the same time by these procedures.
Accrued Salaries and Wages The accrual for salaries and wages arises whenever
employees are not paid for the last few days or hours of earned wages until the subse -
quent period. Salaried personnel usually receive all of their pay except overtime on the
last day of the month, but often, several days of wages for hourly employees are unpaid
at the end of the year.
The correct cutoff and accuracy of accrued salaries and wages depend on company |
policy, which should be followed consistently from year to year. Some companies
calculate the exact hours of pay that were earned in the current period and paid in the
subsequent period, whereas others compute an approximate proportion. For example,
if the subsequent payroll results from 3 days of employment during the current year
and 2 days of employment during the subsequent year, the use of 60 percent of the
subsequent period’s gross pay as the accrual is an example of an approximation.
After the auditor has determined the company’s policy for accruing wages and
knows that it is consistent with that of previous years, the appropriate audit procedure
to test for cutoff and accuracy is to recalculate the client’s accrual. The most likely
misstatement of any significance in the balance is the failure to include the proper
number of days of earned but unpaid wages.
Accrued Commissions The same concepts used in verifying accrued salaries and
wages are applicable to accrued commissions, but the accrual is often more difficult to
verify because companies often have several different types of agreements with sales -
people and other commission employees. For example, some salespeople might be paid
a commission every month and earn no salary, whereas others will get a monthly salary
670 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
plus a commission paid quarterly. In verifying accrued commissions, it is necessary
first to determine the nature of the commission agreement and then test the calcula -
tions based on the agreement. The auditor should compare the method of accruing
commissions with that of previous years for purposes of consistency.
Accrued Bonuses In many companies, the year-end unpaid bonuses to officers
and employees are such a major item that the failure to record them will result in
a material misstatement. The verification of the recorded accrual can usually be
accomplished by comparing it with the amount authorized in the board minutes.
Accrued Vacation Pay, Sick Pay, or Other Benefits The consistent accrual of these
liabilities relative to those of the preceding year is the most important consideration in
evaluating the fairness of the amounts. The company policy for recording the liability
must first be determined, and then the recorded amounts must be recalculated. The
company policy should be in accordance with accounting standards for compensated
absences.
Accrued Payroll Taxes Payroll taxes, such as FICA and state and federal unem -
ployment taxes, can be verified by examining tax forms prepared in the subsequent
period to determine the amount that should have been recorded as a liability at the
balance sheet date.
Tests of Details of Balances for Expense Accounts Several accounts on the
income statement are affected by payroll transactions. The most important are officers’
salaries and bonuses, office salaries, sales salaries and commissions, and direct manu-
facturing labor. Often, costs may be broken down further by division, product, or
branch. Fringe benefits such as medical insurance may also be included in the expenses.
Auditors should need to do relatively little additional testing of the income
statement accounts in most audits beyond analytical procedures, tests of controls,
substantive tests of transactions, andA replataedg teosts ofP liaDbiFlity aEcconunhtsa alnreacdye driscussed.
Extensive additional testing should be necessary only when auditors uncover signi -
ficant deficiencies or material weaknesses in internal control, significant misstatements
in the liability tests, or major unexplained variances in the analytical procedures.
Nevertheless, some income statement accounts are often tested in the payroll and
personnel cycle. These include officers’ compensation, commissions, payroll tax expense,
total payroll, and contract labor.
Officers’ Compensation It is common to verify whether the total compensation of
officers is the amount authorized by the board of directors, because their salaries and
bonuses must be included in the company’s Form 10-K filed with the SEC and federal |
income tax return. Verification of officers’ compensation is also warranted because some
individuals may be in a position to pay themselves more than the authorized amount.
The usual audit test is to obtain the authorized salary of each officer from the minutes
of the board of directors meetings and compare it with the related earnings record.
Commissions Auditors can verify commission expense with relative ease if the
commission rate is the same for each type of sale and the necessary sales information
is available in the accounting records. The total commission expense can be verified by
multiplying the commission rate for each type of sale by the amount of sales in that
category. If the desired information is not available, it may be necessary to test the
annual or monthly commission payments for selected salespeople and trace those to
the total commission payments.
Payroll Tax Expense Payroll tax expense for the year can be tested by first reconciling
the total payroll on each payroll tax form with the total payroll for the entire year. Total
payroll taxes can then be recomputed by multiplying the appropriate rate by the taxable
payroll. The calculation is often time-consuming because the tax is usually applicable
on only a portion of the payroll and the rate may change partway through the year if
the taxpayer’s financial statements are not on a calendar-year basis. On most audits, the
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 671
calculation is costly and is not necessary unless analytical procedures indicate a problem
that cannot be resolved through other procedures. When necessary, the test is ordi -
narily done in conjunction with tests of payroll tax accruals.
Total Payroll A closely related test to the one for payroll taxes is the reconciliation of
total payroll expense in the general ledger with the payroll tax returns and the W-2
forms. The objectives of the test are to determine whether payroll transactions were
charged to a non-payroll account or not recorded in the payroll journal at all. Because
the payroll tax records and the payroll are both usually prepared directly from the
payroll master file, the misstatements, if any, are likely to be in both records. Tests of
controls and substantive tests of transactions are a better means of uncovering these
two types of misstatements in most audits.
Contract Labor To reduce payroll costs, many organizations contract with outside
organizations to provide staffing. The individuals providing the services are employed by
the outside organization. For example, companies frequently contract with information
technology services firms to handle the company’s IT management and staffing func -
tions.The fees paid to the outside organization are tested by comparing the amounts with
the signed contract arrangement between the company and the outside services firm.
Presentation and Disclosure Objectives Required disclosures for payroll and
personnel cycle transactions and balances are not extensive. However, some complex
transactions, such as stock options and other executive officer compensation plans
may require footnote disclosure. Auditors may combine audit procedures related to
the four presentation and disclosure objectives with tests of details of balances for
liability and expense accounts. Other procedures related to presentation and disclosure
objectives are further discussed in Chapter 24.
SUMMARY
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This chapter described the audit of the payroll and personnel cycle. Figure 20-2 illustrates
the major accounts in the payroll and personnel cycle and the types of audit tests used to
audit these accounts. Tests of controls and substantive tests of transactions are emphasized
because of the significance of transactions and the high quality of internal controls in most
companies. Tests of details of balances are normally limited to analytical procedures and
verification of accrued liabilities related to payroll.
FIGURE 20-2 Types of Audit Tests for the Payroll and Personnel Cycle
(seeFigure20-1 on p. 661 for accounts) |
Direct Labor and
Cash in Bank Payroll Liabilities Payroll Expenses
Payments Expenses
Audited by Audited by
TOC, STOT, TOC, STOT,
and AP and AP
Ending balance Ending balance
Audited by Audited by
AP and TDB AP and TDB
Tests of controls Substantive Tests of
Analytical Sufficient
(including procedures (cid:3) tests of (cid:3) (cid:3) details of (cid:2)
procedures appropriate
to obtain an understanding transactions balances
(AP) evidence
of internal control) (TOC) (STOT) (TDB)
672 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
ESSENTIAL TERMS
Accrued payroll expenses—the liability Payroll and personnel cycle—the trans -
accounts associated with payroll; these action cycle that begins with the hiring
include accounts for accrued salaries and of personnel, includes obtaining and
wages, accrued commissions, accrued accounting for services from the emp loyees,
bonuses, accrued benefits, and accrued and ends with payment to the employees for
payroll taxes the services performed and to the govern-
ment and other institutions for withheld
Human resource records—records that
and accrued payroll taxes and benefits
in clude such data as the date of employ -
ment, per sonnel investigations, rates of Payroll master file—a computer file for
pay, authori zed deductions, performance recording each payroll transaction for
evaluations, and termination of employ - each employee and maintaining total
ment employee wages paid and related data for
the year to date
Imprest payroll account—a bank account
to which the exact amount of payroll for Time record—a document indicating the
the pay period is transferred by check or time that the employee started and stopped
wire transfer from the employer’s general working each day and the number of hours
cash account worked
REVIEW QUESTIONS
20-1 (Objective 20-1)Identify five general ledger accounts that are likely to be affected by
the payroll and personnel cycle in most audits.
20-2 (Objectives 20-1, 20-3) ExplainA thpe raelagtioons hiPp bDetFwe enE thne phayaronll acnde prersonnel
cycle and inventory valuation.
20-3 (Objective 20-3)List five tests of controls that can be performed for the payroll and
personnel cycle and state the purpose of each control tested.
20-4 (Objective 20-3) Explain why the percentage of total audit time in the cycle devoted
to performing tests of controls and substantive tests of transactions is usually far greater for
the payroll and personnel cycle than for the sales and collection cycle.
20-5 (Objectives 20-2, 20-3)Evaluate the following comment by an auditor: “My job is to
determine whether the payroll records are fairly stated in accordance with accounting
standards, not to find out whether they are following proper hiring and termination
procedures. When I conduct an audit of payroll, I keep out of the human resources
department and stick to the time cards, journals, and payroll checks. I don’t care whom
they hire and whom they fire, as long as they properly pay the ones they have.”
20-6 (Objective 20-3) Distinguish between the following payroll audit procedures and
state the purpose of each: (1) trace a random sample of prenumbered time cards to the
related payments in the payroll register and compare the hours worked with the hours
paid, and (2) trace a random sample of payments from the payroll register to the related
time cards and compare the hours worked with the hours paid. Which of these two
procedures is typically more important in the audit of payroll? Why?
20-7 (Objective 20-5) In auditing payroll withholding and payroll tax expense, explain
why emphasis should normally be on evaluating the adequacy of the payroll tax return
preparation procedures rather than the payroll tax liability. If the preparation procedures
are inadequate, explain the effect this will have on the remainder of the audit.
20-8 (Objective 20-4) List several analytical procedures for the payroll and personnel cycle
and explain the type of misstatement that might be indicated when there is a significant dif-
ference in the comparison of the current year with previous years’ results for each of the tests. |
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 673
20-9 (Objective 20-3)Explain the circumstances under which an auditor should perform
audit tests primarily designed to uncover fraud in the payroll and personnel cycle. List
three audit procedures that are primarily for the detection of fraud and state the type of
fraud the procedure is meant to uncover.
20-10 (Objective 20-2)Distinguish among a payroll master file, a W-2 form, and a payroll
tax return. Explain the purpose of each.
20-11 (Objectives 20-2, 20-3)List the supporting documents and records the auditor will
examine in a typical payroll audit in which the primary objective is to detect fraud.
20-12 (Objective 20-3) List five types of authorizations in the payroll and personnel cycle
and state the type of misstatement that is likely to occur when each authorization is lacking.
20-13 (Objective 20-5) Explain why it is common to verify total officers’ compensation
even when the tests of controls and substantive tests of transactions results in payroll are
excellent. What audit procedures can be used to verify officers’ compensation?
20-14 (Objective 20-2) Explain what is meant by an imprest payroll account. What is its
purpose as a control over payroll?
20-15 (Objective 20-3)List several audit procedures that the auditor can use to determine
whether payroll transactions are recorded at the proper amounts.
20-16 (Objective 20-3) Explain how audit sampling can be used to test the payroll and
personnel cycle.
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
20-17 (Objective 20-3) The following questions concern internal controls in the payroll
and personnel cycle. Choose the best response.
a. A factory foreman at Steblecki Corporation discharged an hourly worker but did not
notify the human resources department. The foreman then forged the worker’s
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signature on time cards and work tickets and, when giving out the checks, diverted the
payroll checks drawn from the discharged worker to his own use. The most effective
procedurefor preventing this activity is to
(1) require written authorization for all employees added to or removed from the
payroll.
(2) have a paymaster who has no other payroll responsibility distribute the payroll checks.
(3) have someone other than persons who prepare or distribute the payroll obtain
custody of unclaimed payroll checks.
(4) from time to time, rotate persons distributing the payroll.
b. An auditor found that employee time records in one department are not properly
approved by the supervisor. Which of the following could result?
(1) Duplicate paychecks might be issued.
(2) The wrong hourly rate could be used to calculate gross pay.
(3) Employees might be paid for hours they did not work.
(4) Payroll checks might not be distributed to the appropriate employees.
c. The purpose of segregating the duties of hiring personnel and distributing payroll
checks is to separate the
(1) human resource function from the controllership function.
(2) administrative controls from the internal accounting controls.
(3) authorization of transactions from the custody of related assets.
(4) operational responsibility from the record-keeping responsibility.
20-18 (Objective 20-3) The following questions concern audit testing of the payroll and
personnel cycle. Choose the best response.
a. When control risk is assessed as low for assertions related to payroll, substantive tests
of payroll balances most likely would be limited to applying analytical procedures and
(1) observing the distribution of payroll checks.
(2) footing and crossfooting the payroll register.
674 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
(3) inspecting payroll tax returns.
(4) recalculating payroll accruals.
b. A common audit procedure in the audit of payroll transactions involves tracing
selected items from the payroll journal to employee time cards that have been
approved by supervisory personnel. This procedure is designed to provide evidence in
support of the audit proposition that
(1) only proper employees worked and their pay was correctly computed. |
(2) jobs on which employees worked were charged with the appropriate labor cost.
(3) internal controls over payroll disbursements are operating effectively.
(4) all employees worked the number of hours for which their pay was computed.
c. In performing tests concerning the granting of stock options, an auditor should
(1) confirm the transaction with the Secretary of State in the state of incorporation.
(2) verify the existence of option holders in the entity’s payroll records or stock ledgers.
(3) determine that sufficient treasury stock is available to cover any new stock issued.
(4) trace the authorization for the transaction to a vote of the board of directors.
DISCUSSION QUESTIONS AND PROBLEMS
20-19 (Objectives 20-2, 20-3) Items 1 through 8 are selected questions typically found in
internal control questionnaires used by auditors to obtain an understanding of internal control
in the payroll and personnel 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. Does an appropriate official authorize initial rates of pay and any subsequent changes
in rates?
2. Are formal records such as time cards used for keeping time?
3. Is approval by a department head or foreman required for all time cards before they
are submitted for payment?
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4. Does anyone verify pay rates, overtime hours, and computations of gross payroll
before payroll checks are prepared?
5. Does an adequate means exist for identifying jobs or products, such as work orders,
job numbers, or some similar identification provided to employees to ensure proper
coding of time records?
6. Is the issuance of payments to employees independent of timekeeping?
7. Are employees required to show identification to receive paychecks?
8. Are written notices required documenting reasons for termination?
a. For each of the questions, state the transaction-related audit objective(s) being ful - Required
filled if the control is in effect.
b. For each control, list a test of control to test its effectiveness.
c. For each of the questions, identify the nature of the potential financial misstate -
ment(s) if the control is not in effect.
d. For each of the potential misstatements in part c, list a substantive audit procedure for
determining whether a material misstatement exists.
20-20 (Objectives 20-2, 20-3)Following are some of the tests of controls and substantive
tests of transactions procedures often performed in the payroll and personnel cycle. (Each
procedure is to be done on a sample basis.)
1. Reconcile the monthly payroll total for direct manufacturing labor with the labor
cost distribution.
2. Examine the time card for the approval of a foreman.
3. Recompute hours on the time card and compare the total with the total hours for
which the employee has been paid.
4. Compare the employee name, date, check number, and amounts on cancelled checks
with the payroll journal.
5. Trace the hours from the employee time cards to job tickets to make sure that the
total reconciles and trace each job ticket to the job-cost record.
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 675
6. Account for a sequence of payroll checks in the payroll journal.
7. Select employees from the personnel file who have been terminated, and determine
whether their termination pay was in accordance with the union contract. As part of
this procedure, examine two subsequent periods to determine whether the termi-
nated employee is still being paid.
Required a. Identify whether each of the procedures is primarily a test of control or a substantive
test of transactions.
b. Identify the transaction-related audit objective(s) of each of the procedures.
20-21 (Objectives 20-2, 20-3)The following misstatements are included in the accounting
records of Lathen Manufacturing Company:
1. Joe Block and Frank Demery take turns “punching in” for each other every few days.
The absent employee comes in at noon and tells his foreman that he had car trouble |
or some other problem. The foreman does not know that the employee is getting
paid for the time.
2. The foreman submits a fraudulent time card for a former employee each week and
delivers the related payroll check to the employee’s house on the way home from
work. They split the amount of the paycheck.
3. Employees often overlook recording their hours worked on job-cost tickets as
required by the system. Many of the client’s contracts are on a cost-plus basis.
4. Direct labor was unintentionally charged to job 620 instead of job 602 by the payroll
clerk when he key-entered the labor distribution sheets. Job 602 was completed and
the costs were expensed in the current year, whereas job 620 was included in work-
in-process.
5. The payroll clerk prepares a check to the same nonexistent person every week when
he enters payroll transactions in the computer system, which also records the
amount in the payroll journal. He submits it along with all other payroll checks for
signature. When the checks are returned to him for distribution, he takes the check
Aanpd daepgosoits it iPn aD spFec ialE bannkh aacconunct beearring that person’s name.
6. In withholding payroll taxes from employees, the computer operator deducts $.50
extra federal income taxes from several employees each week and credits the amount
to his own employee earnings record.
7. The payroll clerk manually prepares payroll checks but often forgets to record one or
two checks in the computer-prepared payroll journal.
Required a. For each misstatement, state a control that should have prevented it from occurring
on a continuing basis.
b. For each misstatement, state a substantive audit procedure that could uncover it.
20-22 (Objectives 20-3, 20-4, 20-5) The following audit procedures are typical of those
found in auditing the payroll and personnel cycle:
1. Scan journals for all periods for unusual transactions to determine whether they are
recorded correctly.
2. Select a sample of 40 entries in the payroll journal and trace each to an approved
time card.
3. Discuss with management any payroll liabilities recorded in the prior year that are
not provided for in the current period.
4. Examine evidence that payroll hours and wage rates are verified by an independent
person.
5. Obtain a schedule of all payroll liabilities and trace to the general ledger.
6. Select a sample of 20 cancelled payroll checks and account for the numerical sequence.
7. Foot and cross-foot the payroll journal for two periods and trace totals to the general
ledger.
8. Compute payroll tax expense as a percentage of total wages, salaries, and commissions.
9. Select a sample of 20 payroll payments and trace to payroll journal entries for name,
date, and amounts.
10. Compute direct labor, indirect labor, and commissions as a percentage of net sales
and compare with prior years.
676 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
11. Examine owner approval of rates of pay and withholdings.
12. For payroll liabilities, examine subsequent cash disbursements and supporting
documents such as payroll tax returns, depository receipts, and tax receipts.
a. Select the type of test for each audit procedure from the following: Required
(1) Test of control (3) Analytical procedure
(2) Substantive test of transactions (4) Test of details of balances
b. For each test of control or substantive test of transactions, identify the applicable
transaction-related audit objective(s).
c. For each test of details of balances, identify the applicable balance-related audit
objective(s).
20-23 (Objectives 20-3, 20-5) The following are steps in the methodology for designing
tests of controls, substantive tests of transactions, and tests of details of balances for the
payroll and personnel cycle:
1. Design tests of details of balances for the payroll and personnel cycle.
2. Evaluate risk and materiality for payroll expense and liability accounts.
3. Evaluate whether control risk can be assessed as low for payroll.
4. Design and perform payroll- and personnel-related analytical procedures. |
5. Identify controls and deficiencies in internal control for the payroll and personnel
cycle.
6. Obtain an understanding of the payroll and personnel cycle internal controls.
7. Evaluate tests of controls and substantive tests of transactions results.
8. Design payroll and personnel cycle tests of controls and substantive tests of trans actions.
9. Assess inherent risk for payroll-related accounts.
a. Identify (1) those steps that are tests of controls or substantive tests of transactions Required
and (2) those that are tests of details of balances.
b. Put steps that are tests of controls and substantive tests of transactions in the order of
their performance in most auditsA. pago PDF Enhancer
c. Put the tests of details of balances in their proper order.
20-24 (Objective 20-4) In comparing total payroll tax expense with that of the preceding
year, Merlin Brendin, CPA, observed a significant increase, even though the total number of
employees increased only from 175 to 185. To investigate the difference, he selected a large
sample of payroll disbursement transactions and carefully tested the withholdings for each
employee in the sample by referring to federal and state tax withholding schedules. In his
test, he found no exceptions; therefore, he concluded that payroll tax expense was fairly
stated.
a. Evaluate Brendin’s approach to testing payroll tax expense. Required
b. Discuss a more suitable approach for determining whether payroll tax expense is
correctly stated for the year.
20-25 (Objective 20-3)You are assessing internal control in the audit of the payroll and
personnel cycle for Rogers Products Company, a manufacturing company specializing in
assembling computer parts. Rogers employs approximately two hundred hourly and thirty
salaried employees in three locations. Each location has one foreman who is responsible for
overseeing operations. The owner of the company lives in Naples, Florida and is not actively
involved in the business. The two key executives are the vice president of sales and con-
troller, and both have been employed by the company for more than fifteen years.
New hourly employees are hired by the foremen at each location on an as needed basis.
Each foreman recommends the wage rate for each new employee as well as wage rate increases.
The effectiveness of employees varies considerably and their wages are adjusted accord -
ingly. All wage rates are approved by the controller.
Since each hourly employee works independently, Rogers has a highly flexible work
schedule policy, as long as they start after 7:00 a.m. and are finished by 6:00 p.m. Each
foreman has a supply of prenumbered time cards that they distribute to employees on
Monday morning. Because some employees do not start until later in the day several time
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 677
cards are kept in a box by the time clock for their use. Hourly employees use time clocks to
record when they start and stop working. Each Friday, after the employees complete their
work for the week, the foremen account for the time cards they distributed, approve them,
and send them by an overnight courier to the main office in Cincinnati.
The payroll clerk receives the time cards on Saturday and enters the information using
payroll software that prepares the checks or direct deposit authorizations and the related
payroll records. The checks are ready for the controller to sign Monday morning. She
compares each check to the payroll transactions list sent by the payroll department and
returns the checks using the same courier to each location. The foremen pick up the checks
and distribute each check to the appropriate employee. If an employee is not present at the
end of the day the foreman mails it to the employee’s address.
Except for the foremen, all salaried employees work in the Cincinnati office. The vice
president of sales or controller hires all salaried employees, depending on their responsi -
bilities, and determines their salaries and salary adjustments. The owner determines the |
salary of the vice president of sales and controller. The payroll clerk also processes the
payroll transactions for salaried employees using the same payroll software that is used for
hourly employees, but all salaried employees use direct deposit so no check is prepared.
The payroll software has access controls that are set by the controller. She is the only
person who has access to the salary and wage rate module of the software. She updates the
software for new wage rates and salaries and changes of existing ones. The accounting clerk
has access to all other payroll modules. The controller’s assistant has been taught to
reconcile bank accounts and does the reconciliation monthly.
Required a. Identify the internal control deficiencies in the Rogers Products Company’s payroll system.
b. For each deficiency, state the type of misstatement that is likely to result. Be as specific
as possible in describing the nature of the misstatement. If the potential misstatement
involves fraud, identify who is most likely to perpetuate the fraud.
20-26 (Objective 20-3) The following are various asset misappropriations involving the
payroll and personnel cycle.
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1. The payroll clerk submitted payroll information for a fictitious employee and had
the funds directly deposited to a bank account that he controlled.
2. An employee adds 10 overtime hours that she did not work to her time record each
pay period.
3. Two factory employees have an arrangement that one of them will take each Friday
off, and the other employee will record their time worked so that the absent employee
will be paid.
4. A supervisor does not notify human resources that an hourly employee has left the
company. He continues to submit time records for the employee. The money is
directly deposited in the former employee’s bank account, and he splits the amount
paid with the supervisor.
5. The payroll clerk increased his salary by $100 each pay period. After a few weeks, he
also increased the hourly rate for his friend who works in the shipping department.
Required a. For each misappropriation, indicate the transaction-related audit objective that was
not met.
b. Indicate one or more controls that would be most effective in preventing or detecting
the misappropriation.
c. Because the controller is concerned about fictitious employees, she has recommended
a surprise payroll payoff. Which misappropriations would be detected by the surprise
payroll payoff? How is the payoff done if employees do not receive payroll checks
because payment is directly deposited into their bank accounts?
20-27 (Objective 20-4) Archer Uniforms, Inc., is a distributor of professional uniforms to retail
stores that sell work clothing to professionals, such as doctors, nurses, security guards, etc.
Traditionally, most of the sales are to retail stores throughout the United States and Canada.
Most shipments are processed in bulk for delivery directly to retail stores or to the corporate
office warehouse distribution facilities for retail store chains. In early 2011, Archer Uniforms
began offering the sale of uniforms directly to professionals through its company Web site.
678 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Professionals can access online information about uniform styles, sizes, and prices. Purchases
are applied to the customer’s personal credit card, and the credit card agencies wire funds to
Archer’s bank account periodically throughout the month. Management made this decision
based on its conclusion that the online sales would tap a new market of professionals who do
not have easy access to retail stores. Thus, the volume of shipments to retail stores is expected
to remain consistent.
Because Archer’s IT staff lacked the necessary experience to create and support the online
sales system, management engaged an information technology consulting firm to design and
maintain the online sales system.
Before performing analytical procedures related to the payroll and personnel cycle accounts, Required
develop expectations of how these recent events at Archer Uniforms, Inc., will affect payroll |
expense for the following departments during 2011 compared to prior years. Indicate the
degree(extensive, moderate, little) to which you expect the payroll expense account balance
to increase or decrease during 2011.
1. Warehouse and Shipping Department 5. Receiving Department
2. IT Department 6. Executive Management
3. Accounts Receivable Department 7. Marketing
4. Accounts Payable Department
20-28 (Objectives 20-4, 20-5)During the first-year audit of Jones Wholesale Stationery, you
observe that commissions amount to almost 25 percent of total sales, which is somewhat
higher than in previous years. Further investigation reveals that the industry typically has
larger sales commissions than Jones and that there is significant variation in rates depending
on the product sold.
At the time a sale is made, the salesperson records the commission rate and the total amount
of the commissions on the office copy of the sales invoice. When sales are entered into the
computer system for the recording of sales, the debit to sales commission expense and credit to
accrued sales commission are also recorded. As part of recording the sales and sales commission
expense, the accounts receivable clerk vAerpifieas tghe opri cePs, qDuaFnt itieEs, cnomhm aissniocn reaters, and all
calculations on the sales invoices. Both the accounts receivable and the salesperson’s master files
are updated when the sale and sales commission are recorded. On the fifteenth day after the
end of the month, the salesperson is paid for the preceding month’s sales commissions.
a. Develop an audit program to verify sales commission expense, assuming that no audit Required
tests have been conducted in any audit area to this point.
b. Develop an audit program to verify accrued sales commissions at the end of the year,
assuming that the tests you designed in part a resulted in no significant misstatements.
CASE
20-29 (Objective 20-3)Roost and Briley, CPAs, are doing the audit of Leggert Lumber Co.,
an international wholesale lumber broker. Because of the nature of their business, payroll
and telephone expense are the two largest expenses.
You are the in-charge auditor on the engagement responsible for writing the audit
program for the payroll and personnel cycle. Leggert Lumber uses a computer service
company to prepare weekly payroll checks, update earnings records, and prepare the weekly
payroll journal for its 30 employees. The president maintains all human resource files,
knows every employee extremely well, and is a full-time participant in the business.
All employees, except the president, check into the company building daily using a
time clock. The president’s secretary, Mary Clark, hands out the time cards daily, observes
employees clocking in, collects the cards, and immediately returns them to the file. She goes
through the same process when employees clock out on their way home.
At the end of each week, employees calculate their own hours. Clark rechecks those
hours, and the president approves all time cards. Each Tuesday, Clark submits payroll input
to the computer service center. She files a copy of the input data, which includes the
following information for each employee:
Chapter 20 / AUDIT OF THE PAYROLL AND PERSONNEL CYCLE 679
Information Source
Employee name Time card
Social Security number Employee list
Hourly labor rate* Wage rate list (approved by president)
Regular hours Time card
Overtime hours Time card
Special deductions* Special form (prepared by employee)
W-4 information* W-4 form
Termination of employment* President
*Included on input form only for new employees, terminations, and changes.
The service center uses the payroll data to update master files, and print out payroll
checks and a payroll register. The payroll register has the following headings:
Employee name Overtime payroll dollars State taxes withheld
Social Security number Gross payroll Other deductions
Regular hours FICA taxes withheld Net pay
Overtime hours Medicare withheld Check number
Regular payroll dollars Federal taxes withheld
A line is prepared for each employee and the journal is totaled. |
Payroll checks and the journal are delivered to Clark, who compares the information
on the journal with her payroll input and initials the journal. She gives the checks to the
president, who signs them and personally delivers them to employees.
Clark re-adds the journal and posts the totals to the ledger. Bank statements with copies of
cancelled checks are mailed to the president, and he prepares a monthly bank reconciliation.
Required a. Is there any loss of documentation because of the computer service center? Explain.
b. For each transaction-related audit objective for the payroll and personnel cycle, write
appropriate tests of controls and substantive tests of transactions audit procedures.
Consider both controls and deficiencies in writing your program. Label each procedure
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as either a test of control or a substantive test of transactions.
c. Rearrange your design format audit program in requirement b into a performance
format audit program.
d. Prepare a sampling data sheet using either nonstatistical or attributes sampling, such
as the ones shown in Chapter 15, for the audit program in part b. Set ARACR and
other factors required for sampling as you consider appropriate. Do not assume that
you actually performed any tests.
INTERNET PROBLEM 20-1:
RISKS OF OUTSOURCING THE PAYROLL FUNCTION
Outsourcing the payroll function can provide many benefits, but there are also risks
associated with outsourcing. The IRS (www.irs.gov) provides information on outsourcing
payroll duties for employers who outsource the payroll function (search for “payroll
outsourcing”). The IRS also provides information on employment tax fraud investigations
(search for “employment tax fraud”).
Required a. If the third party makes the payroll tax payments, are they responsible for any defi -
ciencies or failure to make payments?
b. What should be the employer address used for correspondence with the IRS? Why do
you think this provision exists?
c. Read the fiscal year 2009 investigation entitled “Former Owner of Payroll Company
Sentenced to 10 Years in Prison.” What was the number of clients and the amount of
payroll taxes that this payroll operator was charged with failing to remit.
d. Review other investigations in 2010 and 2009. Are there other cases of fraud involving
payroll service providers?
680 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
21
C H A P T E R
AUDIT OF THE INVENTORY
AND WAREHOUSING CYCLE
LEARNING OBJECTIVES
After studying this chapter,
Phantom Inventory
you should be able to
Mickey Monus was the local hero in Youngstown, Ohio. He acquired a local
21-1 Describe the business functions
drugstore, and within 10 years, added 299 more stores to form the national and the related documents and
deep-discount retail chain, Phar-Mor, Inc. The company was viewed as the records in the inventory and
rising star by some retail experts and was considered to be the next Wal- warehousing cycle.
Mart. Even Sam Walton announced that the only company he feared in the 21-2 Explain the five parts of the audit
expansion of Wal-Mart was Phar-Mor. of the inventory and warehousing
cycle.
Phar-Mor sold a variety of household products and prescription drugs at 21-3 Design and perform audit tests
substantially lower prices than other discount stores. Monus described the of cost accounting.
company’s strategy as “power buying,” whereby Phar-Mor loaded up on 21-4 Apply analytical procedures to
products when suppliers were selling at rock-bottom prices and passed the accounts in the inventory and
those savings to cost-conscious customers through deeply discounted warehousing cycle.
prices. 21-5 Design and perform physical
observation audit tests for
Actually, Phar-Mor’s prices were so low that the company was selling goods inventory.
for less than their cost, causing the company to lose money. However, 21-6 Design and perform audit tests
Monus continued to argue internally Athapt tahrgouogh PhParD-MFor’ s pEownehr bauyningc, er of pricing andcompilation for
inventory.
it would get so large that it could sell its way out of trouble. Unwilling to |
allow these shortfalls to damage Phar-Mor’s appearance of success, Monus 21-7 Integrate the various parts of the
audit of theinventory and
and his team began to engage in creative accounting so that Phar-Mor
warehousing cycle.
never reported these losses in its financial statements.
Management dumped the losses into “bucket accounts,” only to reallocate
those amounts to the company’s hundreds of stores in the form of phantom increases in inventory costs. Monus’
team issued fake invoices for merchandise purchases, made fraudulent journal entries to increase invent ory and
decrease cost of goods sold, and overcounted and double-counted inventory items.
Unfortunately, the auditors never uncovered the fraud. They allegedly observed inventory in only four stores out of
300, and they informed Phar-Mor management months in advance about the stores they would visit. Phar-Mor
executives fully stocked the four selected stores but allocated the false inventory increases to the other 296 stores.
The fraud was ultimately uncovered when a travel agent received a Phar-Mor check signed by Monus paying for
expenses that were unrelated to Phar-Mor. The agent showed the check to her landlord, who happened to be a Phar-
Mor investor, and he contacted David Shapiro, Phar-Mor’s CEO. Subsequent investigation of the invalid expenditure
eventually led to the discovery of the inventory fraud.
Monus was eventually convicted and went to jail for 5 years. The CFO, who did not profit personally, was sentenced
to 33 months in prison. The audit failure cost the audit firm over $300 million in civil judgments.
Sources: Adapted from Beasley, Buckless, Glover, and Prawitt, Auditing Cases: An Interactive Learning Approach, 4th edition, Prentice-
Hall, 2009, pp. 119–131 and Joseph T. Wells, “Ghost Goods: How to Spot Phantom Inventory,” Journal of Accountancy (June 2001),
pp. 33–36.
Theinventory and warehousing cycleis unique because of its close relationships to other transaction cycles. For
a manufacturing company, raw material enters the inventory and warehousing cycle from the acquisition and
payment cycle, while direct labor enters it from the payroll and personnel cycle. The inventory and warehousing cycle
ends with the sale of goods in the sales and collection cycle.
The audit of inventory, especially tests of the year-end inventory balance, is often the most complex and time-
consuming part of the audit. As the audit of Phar-Mor demonstrates, finding misstatements in inventory accounts
can be challenging. Factors affecting the complexity of the audit of inventory include:
• Inventory is often the largest account on the balance sheet.
• Inventory is often in different locations, making physical control and counting difficult.
• Diverse inventory items such as jewels, chemicals, and electronic parts are often difficult for auditors to observe
and value.
• Inventory valuation is also difficult when estimation of inventory obsolescence is necessary and when manu-
facturing costs must be allocated to inventory.
• There are several acceptable inventory valuation methods and some organizations may prefer to use different
valuation methods for different parts of the inventory, which is acceptable under accounting standards.
BUSINESS FUNCTIONS IN THE CYCLE AND
RELATED DOCUMENTS AND RECORDS
OBJECTIVE 21-1 Inventory takes many different forms, depending on the nature of the business. For
retail or wholesale businesses, the largest account in the financial statements is often
Describe the business
merchandise inventory available for sale. To study the inventory and warehousing
functions and the related
cycle, we will use an example of a manufacturing company, whose inventory may
documents and records in the
inventory and warehousing include raw materials, purchased parts and supplies for use in production, goods in the
cycle. process of being manufactured, and finished goods available for sale. Still, most of the
principles discussed apply to other types of businesses as well.
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Figure 21-1 shows the physical flow of goods and the flow of costs in the inventory |
and warehousing cycle for a manufacturing company. Examine the debits to the raw
materials, direct labor, and manufacturing overhead T accounts to see how the inventory
and warehousingcycle ties in to the acquisition and payment cycle and the payroll and
personnel cycle. The direct tie-in to the sales and collection cycle occurs at the point
where finished goods are relieved (credited) and a charge is made to cost of goods sold.
The inventory and warehousing cycle can be thought of as comprising two
separate but closely related systems, one involving the physical flow of goods and the
FIGURE 21-1 Flow of Inventory and Costs
Raw Materials
Beginning
inventory Raw materials
used
Purchases
Ending
inventory
Direct labor
Work-in- Finished Cost of
Actual Applied
process goods goods sold
manufacturing manufacturing
direct labor direct labor Beginning Beginning
Manufacturing inventory Cost of inventory
overhead goods Cost of
manufactured goods sold
Actual Applied Ending Ending
overhead overhead inventory inventory
682 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
other the related costs. Six functions make up the inventory and warehousing cycle.
Each of these is discussed next.
The inventory and warehousing cycle begins with the acquisition of raw materials for Process
production. Adequate controls over purchasing must be maintained whether inventory Purchase Orders
purchases are for raw materials for a manufacturer or finished goods for a retailer.
Purchase requisitions are forms used to request the purchasing department to order
inventory. These requisitions may be initiated by stockroom personnel as raw materials
are needed, by automated computer software when raw materials reach a predeter -
mined level, by orders placed for the materials required to produce a customer order, or
by orders initiated on the basis of a periodic raw materials count.
Receipt of the ordered materials, which is also part of the acquisition and payment cycle, Receive Raw Materials
involves the inspection of material received for quantity and quality. The receiving
department prepares a receiving report that becomes a part of the documentation
before payment is made. After inspection, the material is sent to the storeroom and
copies of the receiving documents, or electronic notifications of the receipt of goods,
are typically sent to purchasing, the storeroom, and accounts payable. Control and
accountability are necessary for all transfers.
Once received, materials are normally stored in a stockroom. When another depart - Store Raw Materials
ment needs materials for production, personnel submit a properly approved materials
requisition, work order, or similar document or electronic notice that indicates the
type and quantity of materials needed. This requisition document is used to update the
perpetual inventory master files and record transfers from raw materials to work-in-
process accounts. These updates occur automatically in organizations with integrated
inventory management and accounting software systems.
Processing inventory varies greatly fAropm acogmpoan y PtoD coFm paEny.n Chomapannicese dertermine Process the Goods
the finished goods items and quantities they will produce based on specific orders from
customers, sales forecasts, predetermined finished goods inventory levels, and
economical production runs. A separate production control department is often
responsible for determining the type and quantities to produce.
An adequate cost accounting system is an important part of the processing of goods
function for all manufacturing companies. The system shows the relative profitability
of the products for management planning and control and values inventories for pre -
paring financial statements. Two primary types of cost systems exist: job cost systems
and process cost systems, but there are many variations and combinations of these
systems. In a job cost system, costs are accumulated by individual jobs when material
is issued and labor costs incurred. In a process cost system, they are accumulated by |
processes, with unit costs for each process assigned to the products passing through
the process.
Cost accounting records consist of master files, spreadsheets, and reports that
accumulate material, labor, and overhead costs by job or process as those costs are
incurred. When jobs or products are completed, the related costs are transferred from
work-in-process to finished goods based on production department reports.
When finished goods are completed, they are placed in the stockroom to await ship - Store Finished Goods
ment. In companies with good internal controls, finished goods are kept under physical
control in a separate, limited-access area. The control of finished goods is often
considered part of the sales and collection cycle.
Shipping completed goods is part of the sales and collection cycle. The actual ship ment Ship Finished Goods
of goods to customers in exchange for cash or other assets, such as accounts receivable,
creates the exchange of assets necessary for meeting revenue recognition criteria. For
most sales transactions, the actual shipment becomes the trigger for recognizing the
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 683
related accounts receivable and sales in the accounting system. Thus, shipments of
finished goods must be authorized by a properly approved shipping document.
Perpetual Inventory We have not yet discussed one type of record used for inventory: a perpetual inventory
Master Files master file. Separate perpetual records are normally kept for raw materials and finished
goods. Most companies do not use perpetuals for work-in-process.
Perpetual inventory master files typically include information about the units of
inventory acquired, sold, and on hand. In well-designed computerized systems, they
also include information about unit costs.
For acquisitions of raw materials, the perpetual inventory master file is updated
automatically when acquisitions of inventory are processed as part of recording acqui-
si tions. For example, when the number of units and unit cost for each raw material
acquisition are entered in the computer system, this information is used to update
perpetual inventory master files along with the acquisitions journal and accounts
payable master file.
Transfers of raw material from the storeroom must be separately entered into the
computer to update the perpetual records. Typically, only the units transferred need to
be entered because the computer determines the unit costs from the master file.
Finished goods perpetual inventory master files include the same type of informa -
tion as raw materials perpetuals but are considerably more complex if costs are included
along with units. Finished goods costs include raw materials, direct labor, and
manufacturing overhead, which often requires allocations and detailed record keeping.
When finished goods perpetuals include unit costs, the cost accounting records must
be integrated into the computer system.
Figure 21-2 summarizes the business functions and the physical flow of inventory
from the purchase of raw materials to the shipment of finished goods. It also includes
the most common documents and records used to support the functions and physical
flows.Apago PDF Enhancer
PARTS OF THE AUDIT OF INVENTORY
OBJECTIVE 21-2 Now that you are familiar with the business functions and the related documents and
records in the inventory and warehousing cycle, we turn our attention to the audit of
Explain the five parts of the
the cycle. The overall objective in the audit of the inventory and warehousing cycle is to
audit of the inventory and
provide assurance that the financial statements fairly account for raw materials, work-
warehousing cycle.
in-process, finished goods inventory, and cost of goods sold.
The audit of the inventory and warehousing cycle can be divided into five activities
within the cycle:
1. Acquire and record raw materials, labor, and overhead
2. Internally transfer assets and costs
3. Ship goods and record revenue and costs
4. Physically observe inventory
5. Price and compile inventory |
Acquire and This part of the audit includes the first three functions in Figure 21-2. These include
Record Raw Materials, processing purchase orders, receiving raw materials, and storing raw materials.
Labor, and Overhead The auditor obtains an understanding of internal controls over these three func-
tions and then performs tests of controls and substantive tests of transactions in both the
acquisition and payment cycle and the payroll and personnel cycle. These tests should
satisfy auditors that controls affecting the acquisitions of raw materials and manufac -
turing costs are operating effectively and that acquisition transactions are correctly
stated. When direct labor is a significant part of manufactured inventory, auditors
should verify the proper accounting for these costs in the payroll and person nel cycle.
684 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 21-2 Functions in the Inventory and Warehousing Cycle
FUNCTIONS
Process Receive Store Process Store Ship
purchase orders raw materials raw materials* the goods finished goods* finished goods
Put Put
Receive Put Ship
FLOW OF materials completed
raw materials finished
INVENTORY in goods in
materials in storage goods
production storage
RELATED Purchase Receiving Raw Raw Finished Shipping
DOCUMENTATION requisition report materials materials goods document
perpetual requisition perpetual
Purchase Vendor’s inventory inventory Finished
order invoice master Cost master file goods
file accounting perpetual
records† Cost inventory
accounting master file
records†
Cost
accounting
records†
*Inventory counts are taken and compared with perpetual and book amounts at any stage of the cycle. The auditor must determine that cutoff for recording
documents corresponds to the physical location of the items. A count must ordinarily be taken once a year. If the perpetual inventory system is operating well,
this can be done on a cycle basis throughout the year.
†Includes cost information for materials, direct labor, and overhead.
Internal transfers of inventory incluAdep taheg foour th PanDd Ffift h Efunnchtioansn inc Feigurre 21-2: Transfer
process the goods and store finished goods. Clients account for these activities in the Assets and Costs
cost accounting records, which are independent of other cycles and are tested as part of
the audit of the inventory and warehousing cycle.
Recording shipments and related costs is the last function shown in Figure 21-2. Ship Goods and
Because it is part of the sales and collection cycle, auditors obtain an understanding and Record Revenue
test internal controls over recording shipments as a part of auditing that cycle, including and Costs
procedures to verify the accuracy of the credits to inventory recorded in perpetual
inventory master files.
Auditors must observe the client taking a physical inventory count to determine whether Physically
recorded inventory actually exists at the balance sheet date and is correctly counted by Observe Inventory
the client. Physical examination is an essential type of evidence used to verify the exis -
tence and count of inventory. The story at the beginning of this chapter, when auditors
failed to uncover Phar-Mor’s fraud, demonstrates the importance of physically observing
inventories, especially when those inventories are material to the financial statements.
Costs used to value inventory must be tested to determine whether the client has Price and
correctly followed an inventory method that is both in accordance with accounting Compile Inventory
standards and consistent with previous years. Audit procedures used to verify these
costs are called price tests. In addition, the auditor must perform inventory
compilation tests, which are tests to verify whether the physical counts were correctly
summarized, the inventory quantities and prices were correctly extended, and the
extended inventory correctly footed to equal the general ledger inventory balance.
Figure 21-3 (p. 686) summarizes the five parts of the audit of the inventory and
ware housing cycle. Because of the interrelationships of the inventory and ware housing |
cycle with other cycles, some parts of the audit of inventory are most efficiently tested
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 685
FIGURE 21-3 Audit of Inventory
Part of audit Cycle in which tested
Acquire and record Acquisition and
raw materials, payment and
labor, and overhead payroll andpersonnel
Internally transfer Inventory and
assets and costs warehousing
Ship goods and
Sales and
record revenue
collection
and costs
Physically observe Inventory and
inventory warehousing
Price and compile Inventory and
inventory warehousing
with the audit tests of other cycles. As noted in Figure 21-3, auditors test the acquisi -
tion and recording of raw materials, labor, and overhead as part of the audit of the
acquisition and payment and payroll and personnel cycles. Also, they test shipment of
goods and recording of revenue and related costs in the audit of the sales and collection
cycle. Because we have already discussed obtaining an understanding of internal
controAls panad tgestos o f cPonDtrFols anEd nsuhbstaanntivce teesrts of transactions for these other cycles
in earlier chapters, they are not repeated here (the first and third box in Figure 21-3).
The physical observation of inventory and the pricing and compilation of the
inventory are audited using analytical procedures and tests of details of balances (the
last two boxes in Figure 21-3). For tests of details of balances the auditor must consider
business and inherent risks, set tolerable misstatement for inventory, and evaluate the
results of the tests of controls and substantive tests of transactions for the transactions
and activities in the first three boxes in Figure 21-3. This is the same methodology that
we discussed in chapters 14-20 for other cycles. The remainder of the chapter deals
with the parts of the audit of inventory in Figure 21-3 that are tested as part of the
inventory and warehousing cycle, including the use of analytical procedures for tests of
the physical inventory observation and inventory pricing and compilation.
AUDIT OF COST ACCOUNTING
OBJECTIVE 21-3 Our discussion of the audit of cost accounting begins with the internal transfer of
assets from raw materials to work-in-process to finished goods inventory. We also focus
Design and perform audit
on systems and controls related to the transfer of inventory costs, which are accounted
tests of cost accounting.
for in the cost accounting records.
Cost accounting systems and controls of different companies vary more than most
other audit areas because of the wide variety of items of inventory and the level of
sophistication desired by management. For example, a company that manufactures
farm machines may have completely different cost records and internal controls than a
steel fabricating shop that makes and installs custom-made metal cabinets. Of course,
small companies with owners actively involved in the manufacturing process need less
sophisticated records than large, multiproduct companies.
686 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Cost accounting controls are those related to processes affecting physical inventory Cost Accounting
and the tracking of related costs from the time raw materials are requisitioned to the Controls
completion of the manufactured product and its transfer to storage. It is convenient to
divide these controls into two broad categories:
1. Physical controls over raw materials, work-in-process, and finished goods
inventory
2. Controls over the related costs
Almost all companies need physical controls over their assets to prevent loss from
misuse and theft. To protect assets, most companies physically segregate and restrict
Acquire and record
access to storage areas for raw material, work-in-process, and finished goods to control raw materials,
the movement of inventory. In some instances, managers assign custody of inven tory labor, and overhead
to specific individuals who are responsible for protecting the inventory. Clients may
Internally transfer
use approved prenumbered documents for authorizing movement of inventory to assets and costs |
protect the assets from improper use. Electronic or paper copies of these documents
should be sent directly to accounting by the persons issuing them, by passing people Ship goods and
record revenue
with custodial responsibilities. An example of an effective document of this type is an
and costs
approved materials requisition for obtaining raw materials from the storeroom.
Perpetual inventory master files maintained by persons who do not have cus tody of Physically observe
inventory
or access to assets are another useful cost accounting control for a number of reasons:
• They provide a record of inventory on hand, which is used to initiate production Price and compile
or acquisition of additional materials or goods. inventory
• They provide a record of the use of raw materials and the sale of finished goods,
which can be reviewed for obsolete or slow-moving items.
• They provide a record to pinpoint responsibility when there are differences
between physical counts and the amounts shown on the perpetual listings.
Also, adequate internal controls that integrate production and accounting records
to provide accurate costs for all prodAupctsa arge iomp oPrtaDntF to aiEd mnahnaagenmecnte inr pricing
finished goods, controlling costs, and costing inventory.
The concepts in auditing inventory cost accounting are no different from those dis - Tests of
cussed for other transaction cycles: understand internal controls in the cost accounting Cost Accounting
system, assess planned control risk, determine extent of testing controls, and design
tests of controls and substantive tests of transactions to meet transaction-related audit
objectives. The auditor is concerned with four aspects of cost accounting:
1. Physical controls over inventory
2. Documents and records for transferring inventory
3. Perpetual inventory master files
4. Unit cost records
Physical Controls Auditor tests of physical controls over raw materials, work-in-
process, and finished goods are limited to observation and inquiry. Auditors can
examine the raw materials storage area to determine whether the inventory is protected
from theft and misuse by locks or other security measures, including an inventory
custodian. They can ask inventory custodians to explain their duties related to their
oversight of inventory monitored by them. If auditors conclude that the physical
controls are so inadequate that inventory will be difficult to accurately count, they should
expand observation of physical inventory tests to make sure that an adequate count is
carried out.
Documents and Records for Transferring Inventory The auditor’s primary
concerns in verifying the transfer of inventory from one location to another are that
recorded transfers exist, all actual transfers are recorded, and the quantity, description,
and date of all recorded transfers are accurate. Products labeled with standardized bar
codes that can be scanned by laser bar-code readers and other technologies make it
easier for clients to track the movement of goods through production.
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 687
When auditing inventory transfers, auditors first need to understand the client’s
internal controls for recording transfers before they can perform relevant tests. After
they under stand the internal controls, they can easily perform tests of controls or
substantive tests of transactions by examining documents and records to test the
occurrence and accuracy objectives for the transfer of goods from the raw material
storeroom to manufacturing. For example, auditors may account for a sequence of
raw material requisitions, examine the requisitions for proper approval, and compare
the quantity, description, and date with the information recorded in the raw material
perpetual inventory master files to verify that related controls operated effectively
and that amounts are correctly recorded. Similarly, the auditor may compare
completed production records with perpetual inventory master files to be sure that
all manufactured goods were physically delivered to the finished goods storeroom. |
Perpetual Inventory Master Files The reliability of perpetual inventory master
files affects the timing and extent of the auditor’s physical examination of inventory.
When perpetual inventory master files are accurate, auditors can test the physical
inventory before the balance sheet date. An interim physical inventory or use of cycle
counts throughout the year can result in significant cost savings for both the client and
the auditor, and it enables the audit to be completed earlier. The auditor may also
reduce tests of physical inventory counts when the client has reliable perpetual
inventory records and assessed control risk related to physical observation of inventory
is low.
Auditors test perpetual inventory master files by examining documentation that
supports additions and reductions of inventory amounts in the master files. For
example, as part of the tests of the perpetual records, auditors may examine documents
supporting inventory activities including the addition of acquired raw material
inventory, the reduction of raw material inventory for use in production, the increase
in finished goods inventory when goods have been manufactured and the decrease
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when finished goods are sold. Usually, it is relatively easy to test the accuracy of the
perpetual inventory master files after the auditor determines the adequacy of the
design and implementation of inventory internal controls and the related level of
assessed control risk. Auditors test the perpetual records for acquisitions of raw
materials in the acquisition and payment cycle, while reductions in finished goods for
sale are tested in the sales and collection cycle.
For many companies, traditional documents exist only in electronic form and the
perpetual inventory system is integrated with other accounting cycles. As a result, the
auditor can test computer controls to support a reduction in control risk, which
reduces substantive testing and can result in audit efficiencies.
Unit Cost Records Accurate cost data for raw materials, direct labor, and manufac -
turing overhead is essential for fairly stated raw materials, work in progress and
finished goods inventories. To maintain accurate cost data, clients must integrate their
cost accounting records with production and other accounting records.
When testing inventory cost records, the auditor must first obtain an under -
standing of internal control in the cost accounting system. This understanding can be
time-consuming because the flow of costs is integrated with accounting records in
three other cycles: acquisition and payment, payroll and personnel, and sales and
collection.
After auditors understand internal controls affecting cost accounting records, the
approach to internal verification of cost accounting records involves the same concepts
that were discussed in the verification of acquisition, payroll and sales transactions.
Auditors usually test cost accounting records as a part of the acquisition, payroll, and
sales tests to avoid testing the records more than once and to increase audit efficiency.
When testing acquisition transactions, auditors should trace the units and unit costs of
raw materials to additions recorded in the perpetual inventory master files and the total
688 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
cost to cost accounting records. Similarly, when clients maintain payroll cost data for
different jobs, auditors should trace from the payroll summary directly to job cost
records when they audit payroll.
Determining the reasonableness of manufacturing overhead costs assigned to
work-in-process is challenging for auditors because management must make assump-
tions that affect overhead allocations that can significantly affect the unit costs of
inventory and therefore the fairness of inventory valuation. In evaluating these overhead
cost allocations, the auditor must consider the reasonableness of the alloca tion method,
assuming the method complies with accounting standards, and whether it is con -
sistently applied. |
Management typically allocates overhead using total direct labor dollars as the
basis for allocation. In this case, the overhead rate should approximate total actual
manufacturing overhead divided by total actual direct labor dollars. Because auditors
test total manufacturing overhead as part of the tests of the acquisition and payment
cycle and test direct labor as part of the payroll and personnel cycle, determining
the reasonableness of the rate is not difficult. However, if for example, manufac -
turing overhead is applied on the basis of machine hours, the auditor must verify
the reasonableness of the machine hours by separate tests of the client’s machine records.
Because internal controls over cost accounting records vary significantly among
companies, specific tests of controls are not discussed here. Auditors should design
appropriate tests based on their understanding of the cost accounting records and the
extent to which they will be relied on to reduce substantive tests.
ANALYTICAL PROCEDURES
Analytical procedures are importan At i pn a aud git oing i Pnv Dent For y a En nd w har aeh nou csi eng r, as they OBJECTIVE 21-4
are in all other cycles. Table 21-1 (p. 690) shows several common analytical procedures
Apply analytical procedures to
and possible misstatements that may be indicated when fluctuations occur. We’ve
the accounts in the inventory
discussed several of those analytical procedures, such as gross margin percentage, in
and warehousing cycle.
relation to other cycles.
In addition to performing analytical procedures that examine the relationship of
inventory account balances with other financial statement accounts (as shown in
Figure 21-1 on page 682), auditors often use nonfinancial information to assess the
reason ableness of inventory-related balances. For example, auditors may need knowl-
edge about the size and weight of inventory products, their methods of storage (stacks,
tanks, etc.), and the capacity of storage facilities (available square footage) to determine
whether recorded inventory is consistent with available inventory storage. After
performing the appropriate tests of the cost accounting records and analytical procedures,
auditors have a basis for designing and performing tests of details of the ending
inventory balance.
PHYSICAL OBSERVATION OF INVENTORY
Because inventory varies significantly for different companies, obtaining an under- OBJECTIVE 21-5
standing of the client’s industry and business is more important for both physical
Design and perform physical
inventory observation and inventory pricing and compilation than for most audit areas.
observation audit tests for
Examples of key considerations that auditors should consider include the inventory
inventory.
valuation method selected by management, the potential for inventory obsolescence,
and the risk that consignment inventory might be intermingled with owned inventory.
Auditors often first familiarize themselves with the client’s inventory by conduc -
ting a tour of the client’s inventory facilities, including receiving, storage, production,
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 689
TABLE 21-1 Analytical Procedures for the Inventory and Warehousing Cycle
Analytical Procedure Possible Misstatement
Compare gross margin percentage with that Overstatement or understatement of inventory and
of previous years. cost of goods sold.
Compare inventory turnover (cost of goods Obsolete inventory, which affects inventory and cost
sold divided by average inventory) with of goods sold.
that of previous years. Overstatement or understatement of inventory.
Compare unit costs of inventory with those Overstatement or understatement of unit costs,
of previous years. which affect inventory and cost of goods sold.
Compare extended inventory value with that Misstatements in compilation, unit costs, or
of previous years. extensions, which affect inventory and cost of
goods sold.
Compare current year manufacturing costs Misstatements of unit costs of inventory, especially
with those of previous years (variable direct labor and manufacturing overhead, which |
costs should be adjusted for changes in affect inventory and cost of goods sold.
volume).
plan ning, and record-keeping areas. The tour should be led by a supervisor who can
answer questions about production, especially about any changes in internal controls
and other processes since last year.
Acquire and record While gaining an understanding of the effect of the client’s business and industry
raw materials, on inventory, auditors assess client business risk to determine if those risks increase the
labor, and overhead
likelihood of material misstatements in inventory. Examples of common sources of
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business risk for inventory include short product cycles, potential obsolescence, use of
Internally transfer
assets and costs just-in-time inventory, reliance on a few key suppliers, and use of sophisticated inven-
tory management technology.
Ship goods and After assessing client business risk, the auditor decides tolerable misstatement and
record revenue
assesses inherent risk for inventory, which is typically highly material for manufac turing,
and costs
wholesale, and retail companies. Auditors often assess a high inherent risk for companies
Physically observe with significant inventory, depending on the circumstances. Auditors often have a
inventory greater concern for misstatements when inventory is stored in multiple locations, the
costing method is complex, and the potential for inventory obsolescence is great.
Price and compile
When assessing control risk, the auditor is primarily concerned with internal
inventory
controls over perpetual records, physical controls, inventory counts, and inventory
compilation and pricing. The nature and extent of these controls varies widely from
company to company.
Inventory Observation Auditors have been required to perform physical observation tests of inventory since a
Requirements major fraud involving the recording of nonexisting inventory was uncovered in 1938 at
the McKesson & Robbins Company. The fraud was not discovered because the auditors
did not physically observe the inventory, which at the time was not required.
Auditing standards requireauditors to satisfy themselves about the effectiveness of
the client’s methods of counting inventory and the reliance they can place on the
client’s representations about the quantities and physical condition of the inventories.
To meet the requirement, auditors must:
• Be present at the time the client counts their inventory for determining year-end
balances
• Observe the client’s counting procedures
• Make inquiries of client personnel about their counting procedures
• Make their own independent tests of the physical count
690 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
An essential point in the auditing standards is the distinction between who observes
the physical inventory count and who is responsible for taking the count. The client is
responsible for setting up the procedures for taking an accurate physical inventory and
actually making and recording the counts. The auditor is responsible for evaluating
and observing the client’s procedures, including doing test counts of the inventory and
drawing conclusions about the adequacy of the physical inventory.
An auditor’s physical examination of inventory is not required if inventory is
housed in a public warehouse or overseen by outside custodians. In those situations,
auditors verify inventory by confirmation with the custodian. However, if inventory
stored with outside custodians represents a significant portion of current assets or
total assets, the auditor should apply additional procedures, such as investigating the
custodian’s inventory procedures, obtaining an independent accountant’s report on
the custodian’s control procedures over the custody of goods, or observing the physical
count of the goods held by the custodian, if practical.
Regardless of the inventory record-keeping method, the client must make a periodic Controls
physical count of inventory, but not necessarily every year. The physical count may Over Physical Count |
be performed at or near the balance sheet date, at an interim date, or on a cycle basis
throughout the year. The latter two approaches are appropriate only if there are
adequate controls over the of the perpetual inventory master files.
Adequate controls over the client’s physical count of inventory include proper client
instructions for the physical count, supervision by responsible company personnel,
independent internal verification of the counts by other client personnel, independ ent
reconciliations of the physical counts with perpetual inventory master files, and
adequate client control over count sheets or tags used to record inventory counts.
Auditors need to understand the client’s physical inventory count controls before
the count of inventory begins. While this understanding is necessary to evaluate the
effectiveness of the client’s procedurAes,p it aalsgo oen ablPesD thFe a udEitonr hto amankec coenrstructive
suggestions beforehand. Obviously, if the client’s physical inventory count controls are
inadequate, the auditor must spend more time making sure that the physical count is
accurate.
The auditor’s decisions in the physical observation of inventory are similar to those made Audit Decisions
for other audit areas. They include selecting audit procedures, deciding the timing of the
procedures, determining sample size, and selecting items for testing. The last three decisions
are discussed next, followed by a discussion of the appropriate audit procedures.
Timing The auditor decides whether the physical count can be taken before year-end
primarily on the basis of the accuracy of the perpetual inventory master files. When a
client does an interim physical count, which the auditor will agree to only when
internal controls are effective, the auditor observes the inventory count at that time,
and also tests transactions recorded in the perpetual inventory records from the date of
the count to year-end. When the perpetual records are accurate and related controls
operate effectively, it may be unnecessary for the client to count all the inventory at
year-end. Instead, the auditor can compare the perpetuals with the actual inventory on
a sample basis at convenient times throughout the year, as long as controls over
additions and reductions to the perpetual records are tested and found to operate
effectively. When there are no perpetuals and the inventory is material, the client must
take a complete physical inventory near the end of the accounting period.
Sample Size The number of inventory items auditors should count is difficult to
specify because auditors concentrate on observing the client’s procedures rather than
on selecting items for testing. For convenience, sample size in physical observation may
be considered in terms of the total number of hours spent rather than the number of
inventory items counted. The key determinants of the amount of time needed to test
inventory are the adequacy of internal controls over the physical counts, accuracy of
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 691
the perpetual inventory master files, total dollar amount and type of inventory, number
of different significant inventory locations, nature and extent of misstate ments dis -
covered in previous years, and other inherent risks.
In some situations, inventory is so material that it requires dozens of auditors to
observe the physical count. In other situations, one auditor can complete the observation
in a short time. Audit planning for inventory count testing and coordination with client
personnel is critical. Poor planning may lead to audit difficulties. For example, it is
impossible to observe client personnel counting inventory after they have completed
their counts and it is difficult to expand sample sizes or reperform tests after the physical
inventory has been taken.
Selection of Items When auditors observe the client counting inventory, they should
be careful to:
• Observe the counting of the most significant items and a representative sample
of typical inventory items |
• Inquire about items that are likely to be obsolete or damaged
• Discuss with management the reasons for excluding any material items
Physical The same balance-related audit objectives discussed in previous sections for tests of
Observation Tests details of balances provide a frame of reference for discussing the physical observation
tests. However, before discussing those objectives, some overall comments about the
client’s inventory process are important to consider.
The most important part of the observation of inventory is determining whether
the physical count is being taken in accordance with the client’s instructions. To do this
effectively, it is essential that the auditor be present while the physical count is taking place.
When the client’s employees are not following the inventory instructions, the
auditor must either contact the supervisor to correct the problem or modify the physical
observation procedures. For example, if the procedures require one team to count the
inventAorpy aandg ao se coPndD tFeam Eto nrehcoaunnt ict aes ar test of accuracy, the auditor should
inform management if both teams are observed counting together.
OVERSTATEMENT In 2004, the Securities and Exchange Com mission The production credits were based on incon-
(SEC) charged Measurement Specialties, Inc. sistent methodologies across multiple company
OF INVENTORY
(MSI) and its chief financial officer, Kirk Dischino, locations and across different time periods.
DISTORTS with materially overstating its earnings by Additionally, the “actual costs” Dischino used to
capitalizing overhead expenses into inventory. The calculate the production credits were incorrect.
EARNINGS FOR
impact of the fraudulent manipulations of For example, he used estimated costs when actual
MEASUREMENT inventory resulted in a 435% overstatement of costs were available, included costs that were not
the company’s pre-tax income for the fiscal year properly allocable to inventory, and included costs
SPECIALISTS, INC.
ended March 31, 2001, and as the fraud continued, that could not be reconciled to the company’s
the company was able to avoid reporting a net loss accounting records. Finally, he failed to adjust
in the first quarter of the following year. During inventories to the lower of cost or market. As a
the time of the fraud, Dischino sold 40,000 result, inventory as stated on the March 31, 2001
shares of company stock. year-end balance sheet was valued materially
MSI, based in Fairfield, New Jersey, designed, above actual costs, and at times above its net
manufactured, and marketed a variety of sensors realizable value, resulting in an inventory overstate-
for electronic, automotive, military, and other mentof $7.5 million compared to pre-tax income
uses. Between June 30, 2000 and February 2002, of $2.4 million for the year ended March 31, 2001.
Dischino inflated the carrying value of MSI’s Mr. Dischino was required to pay a disgorge-
inventory by recording “production credits” that ment of profits from the stock sales of $215,734
he manually calculated to reflect variances plus a civil penalty of the same amount. He was
between standard costs and actual costs of the also suspended from serving as an accountant
inventory. These variances arise if a company uses before the SEC.
standard costs to value inventory. Accounting
standards require the company to determine Source: Securities and Exchange Commission,
whether any differences exist between standard Accounting and Auditing Enforcement Release No.
costs and actual costs at the end of each period. 2046, June 28, 2004 (www.sec.gov).
692 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Table 21-2 (p. 694) lists common tests of details of balances audit procedures for
physical inventory observation. Detail tie-in is the only balance-related audit objectives
not included. That balance-related objective is discussed under compilation of
inventory. In the discussion that follows, we assume that the client counts inventory
on the balance sheet date and records the inventory counts on prenumbered tags. |
When they record inventory counts in a different way, audit procedures will vary. In
addition to the detailed procedures in Table 21-2, the auditor should also inspect all
physical areas where inventory is warehoused to make sure that all inventory has
been counted and properly tagged. Boxes or other containers holding inventory
should also be opened during test counts to be certain inventory is physically present.
As part of their analytical procedures performed after the client has completed the
inventory counts, the auditor may compare high-dollar-value inventory to counts in
the previous year and inventory master files as a test of reasonableness.
AUDIT OF PRICING AND COMPILATION
Auditors must verify that the physical counts or perpetual record quantities are OBJECTIVE 21-6
correctly priced and compiled. Inventory price testsinclude all the tests of the client’s
Design and perform audit
unit prices to determine whether they are correct. Inventory compilation tests include
tests of pricing and
testing the client’s summarization of the inventory counts, recalculating price times
compilation for inventory.
quantity, footing the inventory summary, and tracing the totals to the general ledger.
Adequate internal controls surrounding the tracking of unit costs that are integrated Pricing and
with production and other accounting records provides assurance that clients use Compilation Controls
reasonable costs for valuing ending inventory. Standard cost records that indicate
variances in material, labor, and overhead costs are helpful to evaluate the reason -
ableness of production records if mAapnaagegmeont hPas DprFoc edEurnes hina plnacce teo kreep the
standards updated for changes in production processes and costs. Management should
also have someone independent of the department responsible for determining the
Acquire and record
costs review them for reasonableness.
raw materials,
To prevent including or overstating the value of obsolete inventory, clients should labor, and overhead
have a formal review and reporting of obsolete, slow-moving, damaged, and overstated
Internally transfer
inventory items. The review should be done by a knowledgeable employee who reviews
assets and costs
perpetual inventory master files for inventory turnover and holds discussions with
engineering or production personnel.
Ship goods and
Clients need inventory compilation internal controls to ensure that the physical record revenue
counts are correctly summarized, priced at the same amount as the unit records, and costs
correctly extended and totaled, and included in the perpetual inventory master file and
Physically observe
related general ledger inventory accounts at the proper amount. The most important inventory
internal control for accurate unit costs, extensions, and footings is internal verification
by a competent, independent person, who relies on adequate documents and records Price and compile
inventory
that were used for taking the physical count. If the physical inventory counts are
recorded by the client on prenumbered tags and carefully reviewed before the personnel
who counted the inventory are released from the physical examination of inventory,
there should be little risk of misstatement in summarizing inventory count tags.
Table 21-3 (p. 695) lists the audit objectives and related tests for inventory pricing and Pricing and
compila tion, except for the cutoff objective. As we’ve already discussed, physical Compilation
observation is a major source of cutoff information for sales and purchases. Tests of the Procedures
accounting records for cutoff are done as a part of sales (sales and collection cycle) and
acquis itions (acquisition and payment cycle).
Auditors can apply the objectives using information obtained from the client as a
frame of reference, including each inventory item’s description, quantity, unit price,
and extended value. We assume the information reflected in the inventory perpetual
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 693
TABLE 21-2 Balance-Related Audit Objectives and Tests of Details of Balances for Physical Inventory |
Observation
Balance-Related Audit Objective Common Inventory Observation Procedures Comments
Inventory as recorded on tags Select a random sample of tag numbers and The purpose is to uncover the inclusion
exists (existence). identify the tag with that number attached to of nonexistent items as inventory.
the actual inventory.
Observe whether movement of inventory takes
place during the count.
Existing inventory is counted Examine inventory to make sure it is tagged. Special concern should be directed to
and tagged, and tags are Observe whether movement of inventory takes omission of large sections of inventory.
accounted for to make place during the count.
sure none are missing Inquire as to inventory in other locations.
(completeness). Account for all used and unused tags to make This test should be done at the completion
sure none are lost or intentionally omitted. of the physical count.
Record the tag numbers for those used and This test should be done at the completion
unused for subsequent follow-up. of the physical count.
Inventory is counted accurately Recount client’s counts to make sure the Recording client counts in the audit files on
(accuracy). recorded counts are accurate on the tags inventory count sheets is done for two
(also check descriptions and unit of count, reasons: to obtain documentation that an
such as dozen or gross). adequate physical examination was made,
Compare physical counts with perpetual and to test for the possibility that the
inventory master file. client might change the recorded counts
Record client’s counts for subsequent testing. after the auditor leaves the premises.
Inventory is classified correctly Examine inventory descriptions on the tags and These tests will be done as a part of the
on the tags (classification). compare with the actual inventory for raw first procedure in the accuracy objective.
material, work-in-process, and finished goods.
Evaluate whether the percent of completion
recorded on the tags for work-in-process is
reasonable.
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Information is obtained to make Record in the audit files for subsequent follow-up the Obtaining proper cutoff information for
sure sales and inventory last shipping document number used at year-end. sales and acquisitions is an essential
purchases are recorded in Make sure the inventory for the above item was part of inventory observation. The
the proper period (cutoff). excluded from the physical count. appropriate tests were discussed for
Review shipping area for inventory set aside for sales in Chapter 16 and for acquisitions
shipment but not counted. in Chapter 18.
Record in the audit files for subsequent follow-up
the last receiving report number used at year-end.
Make sure the inventory for the above item was
included in the physical count.
Review receiving area for inventory that should be
included in the physical count.
Obsolete and unusable inventory Test for obsolete inventory by inquiry of factory
items are excluded or noted employees and management and alertness for
(realizable value). items that are damaged, rust- or dust-covered,
or located in inappropriate places.
The client has rights to inventory Inquire about consignment or customer inventory
recorded on tags (rights). included on client’s premises.
Be alert for inventory that is set aside or specially
marked as indications of nonownership.
listing is recorded in inventory item description order, with raw material, work-in-
process, and finished goods listed separately. The listing totals should equal the general
ledger balance.
Valuation of Inventory In performing inventory valuation tests (often called price tests), the auditor has three
concerns. First, the method must be in accordance with accounting standards. Second,
the application of the method must be consistent from year to year. Third, inventory
694 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 21-3 Balance-Related Audit Objectives and Tests of Details of Balances for Inventory Pricing
and Compilation
Balance-Related Common Inventory Pricing |
Audit Objective and Compilation Procedures Comments
Inventory in the inventory listing Perform compilation tests (see existence, completeness, Unless controls are deficient, extending
schedule agrees with the physical and accuracy objectives). and footing tests should be limited.
inventory counts, the extensions Foot the inventory listing schedules for raw materials,
are correct, and the total is work-in-process, and finished goods.
correctly added and agrees with Trace the totals to the general ledger.
the general ledger (detail tie-in). Extend the quantity times the price on selected items.
Inventory items in the inventory Trace inventory listed in the schedule to inventory The next five objectives are affected by
listing schedule exist (existence). tags and auditor’s recorded counts for existence the results of the physical inventory
and description. observation. The tag numbers and
Account for unused tag numbers shown in the counts verified as a part of physical
auditor’s documentation to make sure no tags have inventory observation are traced to
been added. the inventory listing schedule as a
part of these tests.
Existing inventory items are Trace from inventory tags to the inventory listing
included in the inventory listing schedules and make sure inventory on tags is included.
schedule (completeness). Account for tag numbers to make sure none have been
deleted.
Inventory items in the inventory Trace inventory listed in the schedule to inventory tags and
listing schedule are accurate auditor’s recorded counts for quantity and description.
(accuracy). Perform price tests of inventory. For a discussion of price
tests, see text material on pages 693–697.
Inventory items in the inventory Verify the classification into raw materials, work-in-process,
listing schedule are correctly and finished goods by comparing the descriptions on
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classified (classification). inventory tags and auditor’s recorded test counts with
the inventory listing schedule.
Inventory items in the inventory Perform tests of lower of cost or market, selling price,
listing are stated at realizable and obsolescence.
value (realizable value).
The client has rights to inventory Trace inventory tags identified as nonowned during the
items in the inventory listing physical observation to the inventory listing schedule
schedule (rights). to make sure these have not been included.
Review contracts with suppliers and customers and
inquire of management for the possibility of the
inclusion of consigned or other nonowned inventory,
or the exclusion of owned inventory.
cost versus market value (replacement cost or net realizable value) must be considered.
Because the method of verifying the pricing of inventory depends on whether
inventory items are acquired or manufactured, these two categories are discussed
separately.
Pricing Purchased Inventory The primary types of inventory included in this
category are raw materials, purchased parts, and supplies. As a first step in verifying the
valuation of purchased inventory, the auditor must determine whether the client uses
LIFO, FIFO, weighted average, or some other valuation method. Auditors must also
determine which costs should be included in the valuation of an item of inventory. For
example, the auditor must find out whether freight, storage, discounts, and other costs
are included and the auditor must compare the findings with the preceding year to
make sure that the costs are determined consistently.
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 695
SWITCH TO IFRS As the profession continues to explore the move Research performed by Georgia Tech’s
from U.S. GAAP to International Financial Financial Analysis Lab suggests that current
REQUIRES CHANGE
Reporting Standards (IFRS), one of the more LIFO users could be significantly affected by the
FROM LIFO notable issues is the accounting treatment for switch from LIFO. Examination of a sample 30
inventories. IFRS does not allow the use of the companies that use LIFO found that the
Last-In, First-Out (LIFO) inventory valuation companies’ pretax income would have been |
method, which is widely used among U.S. nearly 12 percent higher if they had followed
companies but scarcely used elsewhere. FIFO. One possible solution is that the U.S.
Companies using LIFO would have to switch Treasury Department might explore the
to FIFO or the average cost method. elimination of the current LIFO conformity rule.
Companies that use LIFO sometimes prefer Companies currently using LIFO are closely
it over other methods of inventory accounting monitoring the implications of the adoption of
because of favorable tax benefits. As U.S. IFRS and CPAs are being called upon to help
companies evaluate the impact of a potential shift manage the possible change in accounting
to IFRS, they are realizing potentially significant methods.
tax consequences from such a move. This is
largely due to the fact that the IRS requires
Sources: Adapted from: 1. Robert Bloom and
taxpayers who apply LIFO for tax purposes to also
William J. Cenker, “The Death of LIFO? Changing
apply it for income measurement in financial
Inventory Method Requires Managing Accounting
reporting. Because IFRS does not permit LIFO for Tax-Differences,” Journal of Accountancy, January
book accounting, U.S. companies will not be able 2009; 2. Sarah Johnson, “One Beneficiary of IFRS
to use it for tax purposes. Switch: The Taxman,” CFO.com, December 22, 2008.
In selecting specific inventory items for pricing, auditors should focus on larger
dollar amounts and on products that are known to have wide fluctuations in price. They
should also test a representative sample of all types of inventory and depart ments.
Stratified variables or monetary unit sampling is commonly used for these tests.
The auditor should list the inventory items to be verified for pricing and request the
client Ato plocaatge tohe apPprDopFria teE venndhoras’ ninvcoiecesr. The auditor must examine sufficient
invoices to account for the entire quantity of inventory for the item being tested,
especially for the FIFO valuation method.Assume that the client values an inventory
item at $12.00 per unit for 1,000 units, using FIFO. When the auditor examines the
most recent invoices for acquisitions of that inventory item, she finds that the most
recent acquisition of the inventory item in the year being audited was for 700 units at
$12.00 per unit, and the immediately preceding acquisition was for 600 units at $11.30
per unit. Using correct FIFO valuation techniques, the inventory items should be
included at $11,790 (700 units at $12 and 300 at $11.30). The client’s calculations
overstates inventory by $210.00 ($12,000 – $11,790). Assuming the client makes this
same error on many inventory items, the misstatement amount can be material.
When the client has perpetual inventory master files that include unit costs of
acquisitions, it is usually much faster to test the pricing by tracing the unit costs to the
perpetuals rather than to vendors’ invoices. Naturally, when perpetual inventory
records are used to verify unit costs, auditors must test the unit costs recorded in the
perpetual records to vendors’ invoices as a part of the tests of the acquisition and
payment cycle transactions.
Pricing Manufactured Inventory In pricing work-in-process and finished goods,
the auditor must consider the cost of raw materials, direct labor, and manufacturing
overhead. The need to verify each of these makes the audit of work-in-process and
finished goods inventory more complex than the audit of purchased inventory.
Nevertheless, several considerations that apply to the audit of purchased inventory still
apply, such as selecting the items to be tested, testing for whether cost or market value
is lower, and evaluating the possibility of obsolescence.
In pricing raw materials in manufactured products, auditors must consider both
the unit cost of the raw materials and the number of units required to manufacture a
unit of output. The unit cost can be verified in the same manner as that used for other
696 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
purchased inventory, by examining vendors’ invoices or perpetual inventory master |
files. Auditors must examine engineering specifications, inspect the finished product,
or find a similar method to determine the number of units it takes to manufacture a
product.
Similarly, while testing direct labor, auditors must verify the hourly costs of direct
labor and the number of hours it takes to manufacture a unit of output. Hourly labor
costs can be verified by examining labor payroll or union contracts. Auditors can
determine the number of hours needed to manufacture the product from engineering
specifications or similar sources.
The proper manufacturing overhead in work-in-process and finished goods
depends on the approach the client uses to allocate manufacturing overhead. Auditors
must evaluate the method being used for consistency and reasonableness and recom-
pute the costs to determine whether the overhead is correct. For example, if the rate is
based on direct labor dollars, the auditor can divide the total manufacturing overhead
by the total direct labor dollars to determine the actual overhead rate. This rate can
then be compared with the overhead rate used by the client to determine unit costs.
Testing of pricing for work-in-process and finished goods is often done in conjunction
with tests of standard costs. When auditors have tested standard costs with satisfactory
results, they can limit testing of the unit costs of ending inventory to tracing the price
used to value ending inventory to the standard cost records.
When the client has standard costs records, an efficient and useful method of
determining valuation is to review and analyze variances. Small variances in material,
labor, and manufacturing overhead are evidence of reliable cost records.
Cost or Market In pricing inventory, auditors must consider whether replacement
cost or net realizable value is lower than historical cost. For purchased finished goods
and raw materials, auditors can test for replacement cost by examining vendor invoices
of the subsequent period or recent invoices if no purchases of an inventory item were
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made after year-end. All manufacturing costs must be considered in evaluating
realizable value for work-in-process and finished goods for manufactured inventory.
Auditors must consider the sales value of inventory items and the possible effect of
rapid fluctuation of prices to determine net realizable value.
INTEGRATION OF THE TESTS
Figure 21-4 (p. 698) and the discussions that follow summarize and illustrate the audit OBJECTIVE 21-7
of the inventory and warehousing cycle as a series of integrated tests.
Integrate the various parts
Tests of the Acquisition and Payment Cycle When auditors verify inventory of the audit of theinventory
acquisitions as part of the tests of the acquisition and payment cycle, they are also and warehousing cycle.
obtaining evidence about the accuracy of raw materials acquired and all manufacturing
overhead costs incurred except labor. These acquisition costs either flow directly into
cost of goods sold or become the largest part of the ending inventory of raw material,
work-in-process, and finished goods. In audits where clients have perpetual inventory
master files, auditors commonly test these as a part of tests of controls and substantive
tests of transactions procedures performed in the acquisition and payment cycle.
Similarly, if manufacturing costs are assigned to individual jobs or processes, they are
usually tested as a part of the same cycle.
Tests of the Payroll and Personnel Cycle When auditors verify labor costs, the
same conditions apply as for acquisitions. In most cases, the cost accounting records
for direct and indirect labor costs can be tested as part of the audit of the payroll and
personnel cycle.
Tests of the Sales and Collection Cycle The relationship between the sales and
collection cycle and the inventory and warehousing cycle is not as interwoven as the two
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 697
FIGURE 21-4 Interrelationship of Various Audit Tests
Tests of
acquisition and
payment cycle |
Raw materials
Beginning
inventory Work-in-
(cid:3)
process
Acquisitions
of Beginning
raw materials inventory
(cid:4) (cid:3)
Tests ofpayroll
Ending i (cid:2)nventory Direc (cid:3)t labor andpersonnel cycle
Raw material Raw material
used used
(cid:3)
Indirect labor
and other
manufacturing
overhead Finished
(cid:4)
goods
Ending
inventory
(cid:2) Beginning inventory
(cid:3)
Inventory tests Cost of goods
Cost of goods
•Tests of cost accounting records manufactured
manufactured
•Tests ofphysical inventory observation (cid:4)
•TA esp ts oa fpg ricio ng anP d cD omF pil atioE nnhancer Ending
inventory
(cid:2)
Cost of
goods sold
Tests of
sales and
collection cycle
cycles we just discussed. Nonetheless, most of the audit testing in the storage of finished
goods, as well as the shipment and recording of sales, takes place when the sales and
collection cycle is tested. When the client uses standard cost records, auditors may be able
to test the standard cost of goods sold at the same time that sales tests are performed.
Tests of Cost Accounting Tests of cost accounting records are meant to verify the
controls affecting inventory that auditors did not verify as part of testing in the
preceding three cycles. Auditors test the physical controls, transfers of raw material
costs to work-in-process, transfers of costs of completed goods to finished goods,
perpetual inventory master files, and unit cost records.
Physical Inventory, Pricing, and Compilation Physical inventory, pricing, and
compilation are each equally important in the audit of inventory because a mis statement
in any one activity results in misstated inventory and cost of goods sold. In most audits,
cost of goods sold is a residual of beginning inventory plus acquisitions of raw materials,
direct labor, and other manufacturing costs minus ending inventory. Because cost of
698 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
goods sold is a residual and often one of the largest accounts on the income statement,
the importance of auditing ending inventory becomes obvious.
In testing physical inventory, auditors may rely heavily on the perpetual inventory
master files if they have been tested as a part of one or more of the cycles we’ve dis -
cussed and are considered reliable. When that is the case, auditors can observe and test
the physical count at a time other than year-end and rely on the perpetuals to keep
adequate records of the quantities.
When testing the unit costs, auditors may also rely, to some degree, on the tests of
the cost records made during the substantive tests of transactions. Standard cost records
are also useful for comparison with the actual unit costs. When standard costs are used
to represent historical cost, they must be tested for reliability.
Finally, as auditors test controls and perform substantive tests related to inventory
transactions and balances, they also integrate tests related to balance-related audit
objectives with tests performed to satisfy the four presentation and disclosure objectives.
Accounting standards require disclosure of inventory valuation methods and other
relevant inventory information, such as LIFO reserve information, in the footnotes.
The auditor should obtain an understanding of client controls related to inventory dis-
closures and perform tests of those controls and other substantive tests to obtain
sufficient appropriate evidence for each of the four presentation and disclosure objectives.
SUMMARY
In this chapter, we discussed the audit of the inventory and warehousing cycle. Because of
the difficulties associated with establishing the existence and valuation of inven tories, the
cycle is often the most time-consuming and complex part of the audit. This cycle is also
unique because many of the tests of the inputs to the cycle are tested as part of the audit of
other cycles. Tests performed as part of the inventory and warehousing cycle focus on cost
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accounting records, physical observation, and tests of the pricing and compilation of the
ending inventory balance.
ESSENTIAL TERMS |
Cost accounting controls—controls over Inventory price tests—audit procedures
physical inventory and the related costs used to verify the costs used to value
from the point at which raw materials are physical inventory
requisitioned to the point at which the Job cost system—system of cost account -
manufactured product is completed and ing in which costs are accumulated by
transferred to storage individual jobs when material is used and
labor costs are incurred
Cost accounting records—the accounting
records concerned with the manufacture Perpetual inventory master file—a con -
and processing of the goods and storing tinuously updated computerized record
finished goods of inventory items purchased, used,
sold, and on hand for merchandise, raw
Inventory and warehousing cycle—the materials, and finished goods
transaction cycle that involves the physical
Process cost system—system of cost
flow of goods through the organization, as
accounti ng in which costs are accumu-
well as related costs
lated for a process, with unit costs for each
Inventory compilation tests—audit pro - process assigned to the products passing
cedures used to verify whether physical through the process
counts of inventory are correctly sum- Standard cost records—records that
marized, inventory quantities and prices indicate variances between projected
are correctly extended, and extended in - material, labor, and overhead costs and
ventory is correctly footed the actual costs
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 699
REVIEW QUESTIONS
21-1 (Objective 21-1)Give the reasons why inventory is often the most difficult and time-
consuming part of many audits.
21-2 (Objectives 21-1, 21-7)Explain the relationship between the acquisition and payment
cycle and the inventory and warehousing cycle in the audit of a manufacturing company.
List several audit procedures in the acquisition and payment cycle that support your
explanation.
21-3 (Objectives 21-1, 21-3) State what is meant by cost accounting records and explain
their importance in the conduct of an audit.
21-4 (Objectives 21-3) Many auditors assert that certain audit tests can be significantly
reduced for clients with adequate perpetual records that include both unit and cost data.
What are the most important tests of the perpetual records that the auditor must make
before reducing assessed control risk? Assuming the perpetuals are determined to be
accurate, which tests can be reduced?
21-5 (Objective 21-5) Before the physical examination, the auditor obtains a copy of the
client’s inventory instructions and reviews them with the controller. In obtaining an under -
standing of inventory procedures for a small manufacturing company, these deficiencies
are identified: Shipping operations will not be completely halted during the physical
examination, and there will be no independent verification of the original inventory count
by a second counting team. Evaluate the importance of each of these deficiencies and state
its effect on the auditor’s observation of inventory.
21-6 (Objective 21-5) At the completion of an inventory observation, the controller
requested the auditor to give him a copy of all recorded test counts to facilitate the correction
of all discrepancies between the client’s and the auditor’s counts. Should the auditor
comply with the request? Why?
21-7 (OAbpjecativge 2o1- 5)PWDhaFt m ajEorn auhdita pnroccedeurres are involved in testing for the owner -
ship of inventory during the observation of the physical counts and as a part of subsequent
valuation tests?
21-8 (Objectives 21-4, 21-5, 21-6) In the verification of the amount of the inventory, one
of the auditor’s concerns is that slow-moving and obsolete items be identified. List the
auditing procedures that can be used to determine whether slow-moving or obsolete items
have been included in inventory.
21-9 (Objective 21-5) During the taking of physical inventory, the controller intentiona lly
withheld several inventory tags from the employees responsible for the physical count.
After the auditor left the client’s premises at the completion of the inventory observation, |
the controller recorded nonexistent inventory on the tags and thereby significantly over-
stated earnings. How could the auditor have uncovered the misstatement, assuming that
there are no perpetual records?
21-10 (Objective 21-5) Explain why a proper cutoff of purchases and sales is heavily
dependent on the physical inventory observation. What information should be obtained
during the physical count to make sure that cutoff is accurate?
21-11 (Objective 21-6)Define what is meant by compilation tests. List several examples of
audit procedures to verify compilation.
21-12 (Objective 21-4)List the major analytical procedures for testing the overall reason-
ableness of inventory. For each test, explain the type of misstatement that could be identified.
21-13 (Objective 21-6) Included in the December 31, 2011, inventory of the Wholeridge
Supply Company are 2,600 deluxe ring binders in the amount of $5,902. An examination of
the most recent acquisitions of binders showed the following costs: January 26, 2012, 2,300
at $2.42 each; December 6, 2011, 1,900 at $2.28 each; November 26, 2011, 2,400 at $2.07
each. What is the misstatement in valuation of the December 31, 2011, inventory for deluxe
ring binders, assuming FIFO inventory valuation? What would your answer be if the
January 26, 2012, acquisition was for 2,300 binders at $2.12 each?
700 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
21-14 (Objectives 21-6, 21-7) The Ruswell Manufacturing Company applied manufac -
turing overhead to inventory at December 31, 2011, on the basis of $3.47 per direct labor
hour. Explain how you will evaluate the reasonableness of total direct labor hours and
manufacturing overhead in the ending inventory of finished goods.
21-15 (Objective 21-7)Each employee for the Gedding Manufacturing Co., a firm using a
job-cost inventory costing method, must reconcile his or her total hours worked with the
hours worked on individual jobs using a job time sheet at the time weekly payroll time
cards are prepared. The job time sheet is then stapled to the time card. Explain how you
could test the direct labor dollars included in inventory as a part of the payroll and
personnel tests.
21-16 (Objective 21-5) Assuming that the auditor properly documents receiving report
numbers as a part of the physical inventory observation procedures, explain how the
proper cutoff of purchases, including tests for the possibility of raw materials in transit,
should be verified later in the audit.
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
21-17 (Objective 21-1)The following questions concern internal controls in the inventory
and warehousing cycle. Choose the best response.
a. Which of the following controls will most likely justify a reduced assessed level of
control risk for the occurrence assertion for purchases of inventory?
(1) Receiving reports for inventory additions are accounted for and entry of received
goods into the purchases system is verified by accounting clerks.
(2) The purchases system automatically updates the perpetual inventory master file
when transactions are entered into the purchases journal.
(3) The perpetual inventory system will not allow an addition of inventory to be
posted without entry of a vaAlidp reaceigvinog repPorDt nFum bEer.nhancer
(4) At the close of each day, the system reconciles the perpetual inventory master file
to the inventory general ledger account and generates an exception report when
differences exist.
b. For control purposes, the quantities of materials ordered may be omitted from the
copy of the purchase order that is
(1) returned to the requisitioner.
(2) forwarded to the receiving department.
(3) forwarded to the accounting department.
(4) retained in the purchasing department’s files.
c. Which of the following procedures will best detect the theft of valuable items from an
inventory that consists of hundreds of different items selling for $1 to $10 and a few
items selling for hundreds of dollars?
(1) Maintain a perpetual inventory master file of only the more valuable items with |
fre quent periodic verification of the validity of the perpetuals.
(2) Have an independent CPA firm prepare an internal control report on the effec-
tiveness of the administrative and accounting controls over inventory.
(3) Have separate warehouse space for the more valuable items with sequentially
numbered tags.
(4) Require an authorized officer’s signature on all requisitions for the more valuable
items.
21-18 (Objectives 21-1, 21-3)The following questions concern testing the client’s internal
controls for inventory and warehousing. Choose the best response.
a. When an auditor tests a client’s cost accounting records, the auditor’s tests are pri -
marily designed to determine that
(1) costs have been correctly assigned to finished goods, work-in-process, and cost of
goods sold.
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 701
(2) quantities on hand have been computed based on acceptable cost accounting
techniques that reasonably approximate actual quantities on hand.
(3) physical inventories are in substantial agreement with book inventories.
(4) the internal controls are in accordance with accounting standards and are
functioning as planned.
b. The accuracy of perpetual inventory master files may be established, in part, by com -
paring perpetual inventory records with
(1) purchase requisitions. (3) purchase orders.
(2) receiving reports. (4) vendor payments.
c. Which of the following sets of duties related to inventory and warehousing causes the
greatest concern about inadequate segregation of duties?
(1) Individuals in charge of approving disbursements related to inventory purchases
have “read-only” ability to view the list of vendors in the pre-approved vendor
master file.
(2) Purchasing agents who arrange for shipment of raw materials from vendors are
responsible for verifying actual receipt of the inventory items at the receiving dock.
(3) The receiving department has access to copies of the purchase orders that exclude
information about quantities ordered.
(4) Accounts payable personnel have access to receiving reports and purchases orders
in addition to vendor invoices for inventory purchases.
21-19 (Objectives 21-1, 21-4, 21-5, 21-6)The following questions deal with tests of details
of balances and analytical procedures for inventory. Choose the best response.
a. Which of the following procedures is the auditor least likely to perform on the actual
date the physical inventory count is observed?
(1) Examine inventory to make sure that it is tagged by client count teams.
(2) Watch for inventory items that are rust- or dust-covered or otherwise damaged.
(3) Observe client count teams to determine if they are conducting the physical
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inventory count in accordance with client policies and procedures.
(4) Examine documentation supporting the acquisition of highly material inventory
items on hand at the count date.
b. An inventory turnover analysis is useful to the auditor because it may detect
(1) inadequacies in inventory pricing.
(2) methods of avoiding cyclical holding costs.
(3) the existence of obsolete merchandise.
(4) the optimum automatic reorder points.
c. A CPA auditing inventory may appropriately apply attributes sampling to estimate the
(1) average price of inventory items.
(2) percentage of slow-moving inventory items.
(3) dollar value of inventory.
(4) physical quantity of inventory items.
DISCUSSION QUESTIONS AND PROBLEMS
21-20 (Objectives 21-1, 21-3, 21-5, 21-6, 21-7) Items 1 through 8 are selected questions
typically found in questionnaires used by auditors to obtain an understanding of internal
control in the inventory and warehousing 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 a detailed perpetual inventory master file maintained for raw materials inventory?
2. Are physical inventory counts made by someone other than storekeepers and those
responsible for maintaining the perpetual inventory master file?
3. Is the clerical accuracy of the final inventory compilation checked by a person |
independent of those responsible for preparing it?
702 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
4. Does the receiving department prepare prenumbered receiving reports and account
for the numbers periodically for all inventory received, showing the description and
quantity of materials?
5. Is all inventory stored under the control of an inventory custodian in areas where
access is limited?
6. Are all shipments to customers authorized by prenumbered shipping documents?
7. Are standard cost records used for raw materials, direct labor, and manufacturing
overhead?
8. Is there a stated policy with specific criteria for writing off obsolete or slow-moving
goods?
a. For each of the preceding questions, state the purpose of the internal control. Required
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 to
determine whether a material misstatement exists.
21-21 (Objective 21-1, 21-3, 21-5, 21-6, 21-7) The Frist Corporation has the following
inter nal controls related to inventory:
1. The inventory purchasing system only allows purchases from pre-approved vendors.
2. The perpetual inventory system tracks the average number of days each inventory
product number has been in the warehouse.
3. Microchips are embedded in each product and when inventory items are removed
from the warehouse to shipping, radio-frequencies signal a deduction of inventory
to the perpetual inventory system.
4. Only authorized inventory warehousing personnel are allowed in inventory storage
areas.
5. All inventory products are stored in warehousing areas that are segregated from
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other storage areas used to house equipment and supplies.
6. On a weekly basis, inventory accounting personnel take samples of inventory
products selected from the perpetual inventory system and verify that the inventory
is on-hand in the warehouse and that the quantities in the listing are correct.
7. On a weekly basis, inventory accounting personnel select inventory items on hand in
the warehouse and verify that the item is included in the perpetual inventory listing
at the correct amount.
8. The perpetual inventory system subtotals the quantity of inventory in the system and
interfaces with the general ledger system on a daily basis to ensure quantities agree.
9. The perpetual inventory system will not accept inventory additions without the
recording on a valid receiving report.
10. All inventory held on consignment at Frist Corporation is stored in a separate area of
the warehouse.
For each of the internal controls: Required
a. Identify the related transaction-related audit objective(s) affected by the control.
b. Describe risks the control is designed to mitigate.
c. Design a test of control to determine if the control is operating effectively.
21-22 (Objective 21-3)The cost accounting records are often an essential area to audit in a
manufacturing or construction company.
a. Why should the auditor review the cost accounting records and test their accuracy? Required
b. For the audit of standard cost accounting records in which 35 parts are manufactured,
explain how you would determine whether each of the following were reasonable for
part no. 21:
(1) Standard direct labor hours (4) Standard units of raw materials
(2) Standard direct labor rate (5) Standard cost of a unit of raw materials
(3) Standard overhead rate (6) Total standard cost
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 703
21-23 (Objectives 21-1, 21-3, 21-5, 21-6) Following are audit procedures commonly
performed in the inventory and warehousing cycle for a manufacturing company:
1. Read the client’s physical inventory instructions and observe whether they are being
followed by those responsible for counting the inventory.
2. Account for a sequence of inventory tags and trace each tag to the physical inventory |
to make sure it actually exists.
3. Compare the client’s count of physical inventory at an interim date with the perpetual
inventory master file.
4. Trace the auditor’s test counts recorded in the audit files to the final inventory
compilation and compare the tag number, description, and quantity.
5. Compare the unit price on the final inventory summary with vendors’ invoices.
6. Account for a sequence of raw material requisitions and examine each requisition
for an authorized approval.
7. Trace the recorded additions on the finished goods perpetual inventory master file to
the records for completed production.
Required a. Identify whether each of the procedures is primarily a test of control or a substantive test.
b. State the purpose(s) of each of the procedures.
21-24 (Objectives 21-1, 21-5, 21-6) The following misstatements are included in the
inventory and related records of Westbox Manufacturing Company:
1. An inventory item was priced at $12 each instead of at the correct cost of $12 per
dozen.
2. In taking the physical inventory, the last shipments for the day were excluded from
inventory and were not included as a sale until the subsequent year.
3. The clerk in charge of the perpetual inventory master file altered the quantity on an
inventory tag to cover up the shortage of inventory caused by its theft during the year.
4. After the auditor left the premises, several inventory tags were lost and were not
included in the final inventory summary.
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5. When raw material acquisitions were recorded, the improper unit price was included
in the perpetual inventory master file. Therefore, the inventory valuation was mis -
stated because the physical inventory was priced by referring to the perpetual records.
6. During the physical count, several obsolete inventory items were included.
7. Because of a significant increase in volume during the current year and excellent
control over manufacturing overhead costs, the manufacturing overhead rate applied
to inventory was far greater than actual cost.
Required a. For each misstatement, state an internal control that should have prevented it from
occurring.
b. For each misstatement, state a substantive audit procedure that can be used to uncover it.
21-25 (Objective 21-3, 21-5)You are responsible for the audit of inventory for Honey Best
Grocery Wholesales, Inc., a closely held grocery wholesaler that sells to independent
grocery stores. Inventory is by far the largest account on their balance sheet. Honey Best
operates in ten southeastern states with a central distribution center in Atlanta and local
distribution centers in each of the ten states in which it operates. Management has
implemented a sophisticated perpetual inventory system that includes only quantities to
assist in managing quantity levels in Atlanta and the local distribution centers. All
accounting is maintained in Atlanta, including purchases which originate from the Atlanta
office using online inventory information available for all centers. All inventory deliveries
are made to the Atlanta center and then sent to local centers, again using the online
information. Product and quantity information for sales are prepared online by each
distribution center for updating the perpetual records, with a hard copy sent to Atlanta.
Each center takes a quarterly physical inventory for comparison to and adjustment of the
perpetual records. The counts are sent to Atlanta where all adjustments are made. Regional
centers’ access to the perpetual records are limited to online sales transaction entry. Internal
auditors test the perpetual records continuously, sample physical inventory counts and test
inventory adjustments. Their tests and results are filed in Atlanta.
704 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
a. List six or more internal controls and tests of controls that can be used to test the Required
effectiveness of internal controls over inventory.
b. Assuming you determine that internal controls are effective, state how you can reduce
or change physical observation tests of inventory. Be specific. |
21-26 (Objective 21-4)Your client, Ridgewood Heating and Cooling, specializes in resi -
dential air conditioning and heating installations. The company maintains an inventory of
air conditioning units, furnaces, and air handling ductwork. The client has provided the
following selected financial statement information for the year ending December 31, 2011:
12/31/2011 12/31/2010 12/31/2009
Total Sales $55,443,900 $52,700,440 $50,384,300
Cost of Goods Sold 47,771,880 46,810,900 44,670,400
Ending Inventory 9,582,960 8,100,220 7,730,660
Following is a breakdown of the ending inventory account as of December 31, 2011:
Inventory Description Quantity Ending Balance
AC Unit – Model 635 1,240 Units $ 806,000
AC Unit – Model 770 1,733 Units 1,940,960
Furnace – Model 223 1,992 Furnaces 2,589,600
Furnace – Model 225 2,008 Furnaces 2,761,000
Air Handling Ducts 11,883 Boxes _1__,4_8_5__,4_0_0_
Total $9,582,960
Ridgewood stores inventory in a 100,000 square foot warehouse facility at a location different
from its corporate office. A single AC unit is stored on a 4 foot by 4 foot pallet. Warehouse
storage shelves allow the company to store 1 pallet on the floor while 2 additional pallets
are placed on shelves above the first pallet. Furnaces are also stored on similar sized pallets.
Due to the height of the furnaces, only one unit can be stored on a shelf above another
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pallet that rests on the floor. Air handling ducts are stored in boxes that are 5 foot by 5 foot
at the base and 7 feet tall. Three boxes can be stacked on top of the box that sits on the floor.
a. Design analytical procedures to evaluate the reasonableness of the ending inventory Required
account.
b. What concerns, if any, do you have about the ending inventory at Ridgewood Heating
and Cooling?
21-27 (Objective 21-5) You encountered the following situations during the December 31,
2011, physical inventory of Latner Shoe Distributor Company:
a. Latner maintains a large portion of the shoe merchandise in 10 warehouses through- Required
out the eastern United States. This ensures swift delivery service for its chain of stores.
You are assigned alone to the Boston warehouse to observe the physical inventory
process. During the inventory count, several express trucks pulled in for loading.
Although infrequent, express shipments must be attended to immediately. As a result,
the employees who were counting the inventory stopped to assist in loading the
express trucks. What should you do?
b. (1) In one storeroom of 10,000 items, you have test-counted about 200 items of high
value and a few items of low value. You found no misstatements. You also note
that the employees are diligently following the inventory instructions. Do you
think you have tested enough items? Explain.
(2) What would you do if you test-counted 150 items and found a substantial number
of counting errors?
c. In observing an inventory of liquid shoe polish, you note that one lot is 5 years old.
From inspection of some bottles in an open box, you find that the liquid has solidified
in most of the bottles. What action should you take?
d. During your observation of the inventory count in the main warehouse, you found that
most of the prenumbered tags that had been incorrectly filled out are being destroyed
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 705
and thrown away. What is the significance of this procedure and what action should
you take?
21-28 (Objective 21-5) In connection with his audit of the financial statements of Knutson
Products Co., an assembler of home appliances, for the year ended May 31, 2011, Ray Abel,
CPA, is reviewing with Knutson’s controller the plans for a physical inventory at the
company warehouse on May 31, 2011.
Finished appliances, unassembled parts, and supplies are stored in the warehouse,
which is attached to Knutson’s assembly plant. The plant will operate during the count. On
May 30, the warehouse will deliver to the plant the estimated quantities of unassembled
parts and supplies required for May 31 production, but there may be emergency requi - |
sitions on May 31. During the count, the warehouse will continue to receive parts and
supplies and to ship finished appliances. However, appliances completed on May 31 will be
held in the plant until after the physical inventory.
Required What procedures should the company establish to ensure that the inventory count includes
all items that should be included and that nothing is counted twice?*
21-29 (Objective 21-4) The following are sales, cost of sales, and inventory data for
Aladdin Products Supply Company, a wholesale distributor of cleaning supplies. Dollar
amounts are in millions.
2011 2010 2009 2008
Sales $92.8 $86.8 $78.4 $69.6
Cost of sales 68.4 67.2 60.8 54.0
Beginning inventory 9.2 8.4 7.6 6.0
Ending inventory 11.6 9.2 8.4 7.6
Required a. Calculate the following ratios, using an electronic spreadsheet program (instructor’s
option):
(1) Gross margin as a percentage of sales (2) Inventory turnover
b. LAist psevaergal olog icaPl cDauFses ofE thne chhaangnes cine thre two ratios.
c. Assume that $2,000,000 is considered material for audit planning purposes for 2011.
Do any of the fluctuations in the computed ratios indicate a possible material
misstatem ent? Demonstrate this by using the spreadsheet program to perform a
sensitivity analysis.
d. What should the auditor do to determine the actual cause of the changes?
21-30 (Objective 21-5) In an annual audit at December 31, 2011, you find the following
transactions near the closing date:
1. Merchandise costing $1,822 was received on January 3, 2012, and the related
acquisition invoice recorded January 5. The invoice showed the shipment was made
on December 29, 2011, FOB destination.
2. Merchandise costing $625 was received on December 28, 2011, and the invoice was
not recorded. You located it in the hands of the purchasing agent; it was marked “on
consignment.”
3. A packing case containing products costing $816 was standing in the shipping room
when the physical inventory was taken. It was not included in the inventory because
it was marked “Hold for shipping instructions.” Your investigation revealed that the
customer’s order was dated December 18, 2011, but that the case was shipped and
the customer billed on January 10, 2012. The product was a stock item of your client.
4. Merchandise received on January 6, 2012, costing $720 was entered in the acquisitions
journal on January 7, 2012. The invoice showed shipment was made FOB supplier’s
warehouse on December 31, 2011. Because it was not on hand December31, it was
not included in inventory.
5. A special machine, fabricated to order for a customer, was finished and in the
shipping room on December 31, 2011. The customer was billed on that date and the
machine excluded from inventory, although it was shipped on January 4, 2012.
*AICPA adapted.
706 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Assume that each of the amounts is material.
a. State whether the merchandise should be included in the client’s inventory. Required
b. Give your reason for your decision on each item.*
21-31 (Objective 21-6)As a part of your clerical tests of inventory for Martin Manufac -
turing, you have tested about 20% of the dollar items and have found the following
exceptions:
1. Extension errors:
Description Quantity Price Extension as Recorded
Wood 920 board feet $ 0.12/board foot $ 11.04
Metal-cutting tools 49 units 30.00 each 1,740.00
Cutting fluid 26 barrels 40.00/barrel 240.00
Sandpaper 600 sheets 0.95/hundred 579.00
2. Differences located in comparing last year’s costs with the current year’s costs on the
client’s inventory lists:
Description Quantity This Year’s Cost Preceding Year’s Cost
TA-114 precision-cutting torches 12 units $800.00 each Unable to locate
Aluminum scrap 4,500 pounds 8.00/ton $95.00/ton
Lubricating oil 400 gallons 55.00/gallon 95.00/barrel
3. Test counts that you were unable to find when tracing from the test counts to the
final inventory compilation:
Tag No. Quantity Current Year Cost Description
2958 20 tons $75.00/ton Cold-rolled bars
0026 3,000 feet 2.25/foot 4-inch aluminum stripping |
4. Page total, footing errors:
Page No. Client Total Correct Total
14 $2,375A.36pago PDF $2,E375n.30hancer
82 6,721.18 6,421.18
a. State the amount of the actual misstatement in each of the four tests. For any item for Required
which the amount of the misstatement cannot be determined from the information
given, state the considerations that will affect your estimate of the misstatement.
b. As a result of your findings, what will you do about clerical accuracy tests of the
inventory in the current year?
c. What changes, if any, would you suggest in internal controls and procedures for
Martin Manufacturing during the compilation of next year’s inventory to prevent
each type of misstatement?
21-32 (Objective 21-5)You have been engaged for the audit of the Y Company for the year
ended December 31, 2011. The Y Company is in the wholesale chemical business and
makes all sales at 25% over cost.
Following are portions of the client’s sales and purchases accounts for the calendar year
2011.
SALES
Balance Forward
Date Reference Amount Date Reference Amount
12-31 Closing entry $699,860 $658,320
12-27 *SI#965 5,195
12-28 SI#966 19,270
12-28 SI#967 1,302
12-31 SI#969 5,841
12-31 SI#970 7,922
_________ 12-31 SI#971 _____2_,0_1_0_
$699,860 $699,860
*SI = Sales invoice.
*AICPA adapted.
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 707
PURCHASES
Balance Forward
Date Reference Amount Date Reference Amount
$360,300 12-31 Closing entry $385,346
12-28 †RR#1059 3,100
12-30 RR#1061 8,965
12-31 RR#1062 4,861
12-31 RR#1063 ____8__,1_2_0_ _________
$385,346 $385,346
†RR = Receiving report.
You observed the physical inventory of goods in the warehouse on December 31, 2011,
and were satisfied that it was properly taken.
When performing a sales and purchases cutoff test, you found that at December 31,
2011, the last receiving report that had been used was no. 1063 and that no shipments have
been made on any sales invoices with numbers larger than no. 968. You also obtained the
following additional information:
1. Included in the warehouse physical inventory at December 31, 2011 were chemicals
that had been acquired and received on receiving report no. 1060 but for which an
invoice was not received until the year 2012. Cost was $2,183.
2. In the warehouse at December 31, 2011 were goods that had been sold and paid for
by the customer but which were not shipped out until the year 2012. They were all
sold on sales invoice no. 965 and were not inventoried.
3. On the evening of December 31, 2011 there were two cars on the Y company siding:
(a) Car AR38162 was unloaded on January 2, 2012, and received on receiving report
no. 1063. The freight was paid by the vendor.
(b) Car BAE74123 was loaded and sealed on December 31, 2011, and was switched
Apoaff gtheo co mPpaDnyF’s s idiEngn onh Jaanunarcy 2e, 2r012. The sales price was $12,700 and the
freight was paid by the customer. This order was sold on sales invoice no. 968.
4. Temporarily stranded at December 31, 2011 on a railroad siding were two cars of
chemicals en route to the Z Pulp and Paper Co. They were sold on sales invoice no.
966, and the terms were FOB destination.
5. En route to the Y Company on December 31, 2011 was a truckload of material that
was received on receiving report no. 1064. The material was shipped FOB desti-
nation, and freight of $75 was paid by the Y Company. However, the freight was
deducted from the purchase price of $975.
6. Included in the physical inventory were chemicals exposed to rain during transit and
deemed unsalable. Their invoice cost was $1,250, and freight charges of $350 had
been paid on the chemicals.
Required a. Compute the adjustments that should be made to the client’s physical inventory at
December 31, 2011.
b. Prepare a worksheet of adjusting entries that are required as of December 31, 2011.*
CASE
21-33 (Objective 21-6) You are assigned to the December 31, 2011, audit of Sea Gull
Airframes, Inc. The company designs and manufactures aircraft superstructures and
airframe components. You observed the physical inventory at December 31 and are |
satisfied that it was properly taken. The inventory at December 31, 2011, has been priced,
extended, and totaled by the client and is made up of about 5,000 inventory items with a
total valuation of $8,275,000. In performing inventory price tests, you have decided to
*AICPA adapted.
708 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
stratify your tests and conclude that you should have two strata: items with a value over
$5,000 and those with a value of less than $5,000. The book values are as follows:
No. of Items Total Value
More than $5,000 500 $4,150,000
Less than $5,000 4__,5_0_0_ __4_,1_2_5__,0_0_0_
5,000 $8,275,000
In performing pricing and extension tests, you have decided to test about 50 inventory
items in detail. You selected 40 of the over $5,000 items and 10 of those under $5,000 at
random from the population. You find all items to be correct except for items A through G
below, which you believe may be misstated. You have tested the following items, to this
point, exclusive of A through G:
No. of Items Total Value
More than $5,000 36 $360,000
Less than $5,000 7 2,600
Sea Gull Airframes uses a periodic inventory system and values its inventory at the
lower of FIFO cost or market. You were able to locate all invoices needed for your
examination. The seven inventory items in the sample you believe may be misstated, along
with the relevant data for determining the proper valuation, are shown next.
INVENTORY ITEMS POSSIBLY MISSTATED
Description Quantity Price Total1
A. L37 spars 3,000 meters $ 8.00/meter $24,000
B. B68 metal formers 10,000 inches 1.20/foot 12,000
C. R01 metal ribs 1,500 yards 10.00/yard 15,000
D. St26 struts 1,000 feet 8.00/foot 8,000
E. Industrial hand drills 45 units 20.00 each 900
F. L803 steel leaf springs A40ppaairsgo P6D9.0F0 e achE spnrinhg ance27r6
G. V16 fasteners 5.50 dozen 10.00/dozen 55
1Amounts are as stated on client’s inventory.
INFORMATION FOR PRICING FROM INVOICES (SEA GULL AIRFRAMES)
Voucher Voucher Receiving
Number Date Date Paid Terms Report Date Invoice Description
7-68 8-01-06 8-21-06 Net FOB destination 8-01-06 77 V16 fasteners at $10 per dozen
11-81 10-16-11 11-15-11 Net FOB destination 10-18-11 1,100 yards R01 metal ribs at $9.50 per yard;
2,000 feet St26 struts at $8.20 per foot
12-06 12-08-11 12-30-11 2/10, n/30 FOB S.P. 12-10-11 180 L803 steel leaf springs at $69 each
12-09 12-10-11 12-18-11 Net FOB destination 12-11-11 45 industrial hand drills at $20 each;
guaranteed for 4 years
12-18 12-27-11 12-27-11 2/10, n/30 FOB S.P. 12-21-11 4,200 meters L37 spars at $8 per meter
12-23 12-24-11 1-03-12 2/10, n/30 FOB dest. 12-26-11 12,800 inches B68 metal formers at $1.20 per foot
12-61 12-29-11 1-08-12 Net FOB destination 12-29-11 1,000 yards R01 metal ribs at $10 per yard;
800 feet St26 struts at $8 per foot
12-81 12-31-11 1-20-12 Net FOB destination 1-06-12 2,000 meters L37 spars at $7.50 per meter;
2,000 yards R01 metal ribs at $10 per yard
In addition, you noted a freight bill for voucher 12-23 in the amount of $200. This bill was
entered in the freight-in account. Virtually all freight was for the metal formers.
This is the first time Sea Gull Airframes has been audited by your firm.
a. Review all information and determine the inventory misstatements of the seven items Required
in question. State any assumptions you consider necessary to determine the amount
of the misstatements.
Chapter 21 / AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE 709
b. Prepare an audit schedule to summarize your findings. Use the computer to prepare
the schedule (instructor’s option).
INTERNET PROBLEM 21-1:
USING INVENTORY COUNT SPECIALISTS
Since 1938, when auditors failed to uncover fictitious inventory recorded by the McKesson
& Robbins Company, auditors have been ordinarily required to physically observe the
counting of inventory. It is important to recognize that auditors are not required to actually
count the inventory for inclusion on the balance sheet, but they are required to observe the
inventory being counted. Occasionally, companies employ inventory specialists to perform |
their inventory counts. One very large inventory counting specialist is Retail Grocery
Inventory Service, now known as RGIS. Visit RGIS’s (www.rgisinv.com) Web site and
answer the following questions.
Required a. Under the link to “Case Studies,” read the case about Hines Horticulture. How did
RGIS assist Hines in its inventory management?
b. What created the need for Hines to use a service provider such as RGIS?
c. Does an auditor’s responsibility for observing the physical inventory differ if a
company hires an inventory specialist such as RGIS to perform counts as opposed to
having its own employees perform inventory counts?
d. Would your expectations of the results of the physical observation of a client’s
inventory change if a client hired a company such as RGIS?
e. What are the advantages and disadvantages of hiring an inventory specialist such as
RGIS?
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710 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
22
C H A P T E R
AUDIT OF THE
CAPITAL ACQUISITION
LEARNING OBJECTIVES
AND REPAYMENT CYCLE
After studying this chapter,
you should be able to
22-1 Identify the accounts and the
A Dishonest Client Will Get The Best Of unique characteristics of the
capital acquisition and
The Auditor Almost Every Time
repayment cycle.
Able Construction Company entered into long-term construction contracts, 22-2 Design and perform audit tests
recognizing income using the percentage of completion method of of notes payable and related
accounts and transactions.
accounting. To finance its operations, Able borrowed funds from the bank
and agreed to comply with restrictive loan covenants dependent on 22-3 Identify the primaryconcerns
in the audit of owners’ equity
reported income from the long-term contracts. The percentage of
transactions.
completion method of accounting requires, among other things, an
22-4 Design and perform tests of
agreement with well-defined, enforceable terms, a reliable method of
controls, substantive tests of
estimating costs to complete the contracts, and recognition of losses at the
transactions, and tests of details
time they become known. As part of the audit of Able, its auditors read the of balances for capital stock and
contracts for all projects in progress, tested costs incurred to date, and retained earnings.
assessed the ultimate profitability of the contracts, including discussing
them with management. A significant part of verifying income under
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percentage of completion is auditing costs incurred.
In the current year, management’s records and schedules of projects indicate that all projects will result in a profit. For
each project, there is a separate schedule showing estimated total revenue from the project, costs incurred in the
current period, costs incurred to date, estimated total costs, percentage of completion, and profit recognized in the
current period. The auditor discussed each project with management, performed audit tests to support the schedule,
and concluded that the revenue, expenses, and profit were reasonably stated. Reported income allowed Able to meet
several of the restrictive covenants in its loan agreement with the bank.
In fact, Able had incurred a significant loss on one of its major projects. Able engaged a subcontractor to do
reconstructive work not anticipated in the original contract bid. In awarding the subcontract, Able entered into an
agreement with the subcontractor that the work would not be paid for until after its audit was completed in an effort
to defer recording losses associated with the additional work. Management hid the subcontractor’s invoices from the
auditors as they were received. During the next year, management recognized this loss but doctored the invoices so
that it appeared the “unexpected” additional cost was incurred during that year, and that the previous year’s
statements were correct and that all loan covenants with the bank were satisfied.
The fraudulent misstatement was discovered several years later when Able went bankrupt and the CPA firm was sued
by the bank for performing inadequate audits. The firm was ultimately found not responsible, but only after spending |
extensive time and large amounts of money defending its audit.
The final transaction cycle we discuss is the capital acquisition and repayment cycle, which concerns the
acquisition of capital resources through interest-bearing debt and owners’ equity and the repayment of the
capital. This cycle also includes the payment of interest and dividends.
Four characteristics of the capital acquisition and repayment cycle influence the audit of these accounts:
1. Relatively few transactions affect the account balances, but each transaction is often highly material. For
example, bonds are infrequently issued by companies, but the amount of a bond issue is normally large. Their size
makes it common for auditors, as a part of verifying the balance sheet accounts, to verify each transaction taking
place in the cycle for the entire year. Audit schedules for most accounts in the cycle include the beginning balance
of every account, every transaction that occurred during the year and the ending balance.
2. The exclusion or misstatement of a single transaction can be material.As a result, the auditor’s primary emphasis
in auditing these accounts is often on the completeness and accuracy balance-related audit objectives.
3. A legal relationship exists between the client entity and the holder of the stock, bond, or similar ownership
document.As the chapter-opening case of Able Construction Company demonstrates, the auditor must deter -
mine whether the client has met the requirements of debt or equity agreements. In the audit of the transactions
and amounts in the cycle, the auditor must take great care to make sure the significant legal requirements affecting
the financial statements have been met and adequately presented and disclosed in the statements.
4. A direct relationship exists between the interest and dividends accounts and debt and equity. In the audit of
interest-bearing debt, auditors should simultaneously verify the related interest expense and interest payable. This
is also true for owners’ equity, dividends declared, and dividends payable.
Auditors often learn about capital acquisition transactions while gaining an understanding of the client’s
business and industry performed as part of the auditor’s risk assessment procedures. Also, when public companies
issue additional debt and equity securities during the year, SEC rules require auditor consideration of financial
information included in the client’s new securities offering prospectus. In doing so, auditors frequently identify
business risk issues for capital acquisition activities that should be considered in the design of audit procedures for
transactions, account balances, and disclosures in the capital acquisition and repayment cycle.
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ACCOUNTS IN THE CYCLE
OBJECTIVE 22-1 The accounts in a company’s capital acquisition and repayment cycle depend on the type
of business the company operates and how its operations are financed. All corporations
Identify the accounts and the
have capital stock and retained earnings, but some may also have preferred stock, addi -
unique characteristics of the
capital acquisition and tional paid-in capital, and treasury stock. As with other cycles, cash is an important
repayment cycle. accountin the cycle because both the acquisition and repayment of capital affect the cash
account. The unique characteristics of the capital acquisition and repayment cycle affect
how auditors verify the accounts in the cycle. This cycle often includes these accounts:
• Notes payable • Cash in the bank
• Contracts payable • Capital stock—common
• Mortgages payable • Capital stock—preferred
• Bonds payable • Paid-in capital in excess of par
• Interest expense • Donated capital
• Accrued interest • Retained earnings
• Appropriations of retained earnings • Dividends payable
• Treasury stock • Proprietorship—capital account
• Dividends declared • Partnership—capital account
The methodology for designing tests of details of balances for accounts in the capital
acquisition and repayment cycle is the same as that followed for other accounts.(See |
Figure 16-1 on page 520. The only difference is the name of the account being audited.)
For example, in determining the tests of details of balances for notes payable, the auditor
considers business risk, tolerable misstatement, inherent risk, control risk, the results
of tests of controls and substantive tests of transactions, and the results of analytical
procedures.
712 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Auditors often set tolerable misstatement at a low level because it is usually possible
to completely audit the account balance and transactions affecting the notes payable
account balance. Typically, they also set inherent risk at a low level because the correct
account value is usually easy to determine. Auditors are normally most concerned about
the completeness objective for notes payable account balances and the completeness
objective for notes payable disclosures, such as collateral and covenant restrictions for
notes payable. Because the cycle usually contains few transactions, control risk and the
results of substantive tests of transactions are normally less important for designing
tests of details of balances for accounts such as notes payable.
To best understand the audit procedures for many of the accounts in the capital
acquisition and repayment cycle, representative accounts that are significant parts of
the cycle for a typical business are included in this chapter. The following sections
discuss (1) the audit of notes payable and related interest expense to illustrate interest-
bearing capital and (2) the audit of common stock, paid-in capital in excess of par,
dividends, and retained earnings to illustrate equity accounts.
NOTES PAYABLE
Anote payableis a legal obligation to a creditor, which may be unsecured or secured by OBJECTIVE 22-2
assets, and bears interest. Typically, a note is issued for a period somewhere between
Design and perform audit
one month and one year, but longer term notes exist. Notes are issued for different
tests of notes payable and
purposes, and the property pledged as collateral includes a wide variety of assets, such
related accounts and
as securities, accounts receivable, inventory, and fixed assets. The principal and interest transactions.
payments on the notes must be made in accordance with the terms of the loan agree-
ment. For short-term loans, a principal and interest payment is usually required only
when the loan becomes due. For loans over 90 days, the note usually calls for monthly
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or quarterly interest payments.
Figure 22-1 (p. 714) shows the accounts used for notes payable and related interest.
Auditors commonly include tests of principal and interest payments as a part of the
audit of the acquisition and payment cycle, because the payments are recorded in the
cash disbursements journal. But in many cases, because of their relative infrequency,
no capital transactions are included in the auditor’s sample for tests of controls and
substantive tests of transactions. Therefore, it is also normal to test these transactions
as a part of the capital acquisition and repayment cycle.
The objectives of the audit of notes payable are to determine whether:
• Internal controls over notes payable are adequate.
• Transactions for principal and interest involving notes payable are properly
authorized and recorded in accordance with the six transaction-related audit
objectives.
• The liability for notes payable and the related interest expense and accrued
liability are properly stated as defined by seven of the eight balance-related audit
objectives. (Realizable value is not applicable to liability accounts.)
There are four important controls over notes payable: Internal Controls
1. Proper authorization for the issue of new notes.Responsibility for the issuance of
new notes should be vested in the board of directors or high-level management
personnel. Generally, two signatures of properly authorized officials are
required for all loan agreements, which usually stipulate the amount of the
loan, the interest rate, the repayment terms, and the assets pledged. When notes |
are renewed, they need to be subject to the same authorization procedures as
those for the issuance of new notes.
2. Adequate controls over the repayment of principal and interest. The periodic
payments of interest and principal should be subject to the controls in the
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 713
FIGURE 22-1 Notes Payable and the Related Interest Accounts
Notes
payable Interest
Payments Beginning expense
of balance Interest
principal Issue of expense
new notes
Ending
balance
Interest
Cash payable
in bank
Beginning
Issue of Payments of balance
new principal
Payments Interest
notes
Payments of of expense
interest interest Ending
balance
acquisition and payment cycle. At the time the note was issued, the accounting
department should have received a copy of the note, much like it receives
vendors’ invoices and receiving reports. The accounts payable department should
automatically issue checks or electronic fund transfers for the notes when they
become due, again in the same manner in which it prepares payments for
Aacpquaisigtioons oPf gDooFds anEd nserhviacesn. Ac ceopry of the note provides the supporting
documentation for payment.
3. Proper documents and records. These include subsidiary records and control
over blank and paid notes by an authorized person. Paid notes should be
cancelled and retained under the custody of an authorized official.
4. Periodic independent verification. Periodically, the detailed note records should
be reconciled with the general ledger and compared with the note holders’ records
by an employee who is not responsible for maintaining the detailed records. At
the same time, an independent person should recompute the interest expense
on notes to test the accuracy of the record keeping.
Tests of Controls Tests of notes payable transactions involve the issue of notes and the repayment of prin -
and Substantive cipal and interest. These audit tests are a part of tests of controls and substantive tests of
Tests of Transactions transactions for cash receipts (see page 461in Chapter 14) and cash disburse ments (see
page 611 in Chapter 18). Additional tests of controls and substantive tests of trans -
actions are often done as a part of tests of details of balances because of the materiality
of individual transactions.
Tests of controls for notes payable and related interest should emphasize testing the
four internal controls we just discussed. In addition, auditors should verify the accurate
recording of receipts from note proceeds and payments of principal and interest.
Analytical Procedures Analytical procedures are essential for notes payable because tests of details for interest
expense and accrued interest can often be eliminated when results are favorable. Table 22-1
illustrates typical analytical procedures for notes payable and related interest accounts.
The auditor’s independent prediction of interest expense, using average notes
payable outstanding and average interest rates, helps the auditor evaluate the reason -
ableness of interest expense and also tests for omitted notes payable. Turn to page231
in Chapter 8 and review Figure 8-8 for an illustration of an auditor’s schedule where such
714 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 22-1 Analytical Procedures for Notes Payable
Analytical Procedure Possible Misstatement
Recalculate approximate interest expense on Misstatement of interest expense and accrued
the basis of average interest rates and overall interest or omission of an outstanding note
monthly notes payable. payable
Compare individual notes outstanding with those Omission or misstatement of a note payable
of the prior year.
Compare total balance in notes payable, interest Misstatement of interest expense and accrued
expense, and accrued interest with prior-year interest or notes payable
balances.
an analytical procedure has been performed. If actual interest expense is materially
larger than the auditor’s estimate, one possible cause is recorded interest payments on
unrecorded notes payable. |
The normal starting point for the audit of notes payable is a schedule of notes payable and Tests of
accrued interest, which the auditor obtains from the client. Figure 22-2 (pp. 716–717) Details of Balances
illustrates a typical schedule, including detailed information of all transactions that took
place during the entire year for principal and interest, the beginning and ending
balances for notes and interest payable, and descriptive information about the notes,
such as the due date, the interest rate, and the assets pledged as collateral.
When there are numerous transactions involving notes during the year, it may be
impractical for auditors to obtain such a schedule. In those situations, auditors are
likely to request the client to prepare Aa spchaedugleo of onPlyD thFos e nEotnes hwiath nuncpaeid rbalances
at the end of the year, showing a description of each note, its ending balance, and the
interest payable at the end of the year, including the collateral and interest rate.
Table 22-2 (p. 718) summarizesthe applicable balance-related audit objectives and
common audit procedures as they apply to the schedule of notes payable. Again, the
amount of testing depends heavily on the materiality of notes payable and the effective-
ness of internal controls.
The two most important balance-related audit objectives in notes payable are:
1. Existing notes payable are included (completeness).
2. Notes payable in the schedule are accurately recorded (accuracy).
DON’T FORGET Through a series of closely timed purchase trans- to the SEC, the quarterly reports failed to disclose
actions, NECO Enterprises, Inc., a public utility over $16 million in liabilities acquired as a result of
THE LIABILITIES!
holding company based in Providence, Rhode the purchases, which also led to overstatements
Island, rapidly expanded its holdings of other of NECO’s retained earnings and total capital
utilities in the New England area. Under the new balances.
leadership of David LaRoche as chairman and Following the SEC’s investigation, the company
chief executive officer, the company purchased restated the filings to comply with GAAP, relocated
the outstanding stock of several corporations to Vermont, and disposed of its utility subsidiary,
wholly owned by LaRoche, who also happened Newport Electric Company. LaRoche consented
to be NECO’s majority shareholder. to the issuance of a permanent injunction against
Within two years of the related party future violations of all the provisions of the
purchases, the SEC filed a complaint against the securities laws associated with the SEC’s
company and LaRoche accusing them of violating complaint.
the antifraudprovisions of federal securities laws Source:Accounting and Auditing Enforcement
in conjunction with quarterly financial statements Release No. 335, Commerce Clearing House, Inc.,
filed when the acquisitions were made. According Chicago.
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 715
FIGURE 22-2 Schedule of Notes Payable and Accrued Interest
XYZ Company, Inc. Schedule AA-4 Date
Notes Payable Prepared by Client/DB 1/12/12
12/31/11 Approved by JL 1/16/12
SECURITY
Balance at
Date Face Amount Beginning
Payee Made Due of Note Description Valuation of Period
First National Bank 9/30/10 9/30/11 10000 Investments 15000 10000
Second National Bank 9/30/11 9/30/12 10000 Investments 16000
Third National Bank 10/31/11 10/31/12 10000 Fixed Assets 22000
30000 53000 10000
Traced to prior year audit schedule. Traced to general ledger.
Obtained and reviewed copy of note included Recomputed expense and accrued interest;
in permanent file. no differences noted.
Examined cancelled note and/or check. Footed
Agreed to confirmation received from bank. Cross-footed
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These objectives are vital because a misstatement can be material if even one note
is omitted or incorrect. Table 22-2 on page 718 shows common procedures to test for
the complete ness objective for notes payable. When internal controls over notes
payable are deficient, auditors may need to perform extended procedures to test for |
omitted notes payable. For example, the auditor might send confirmations to creditors
that have held notes from the client in the past but are not currently included in the
notes payable schedule. The auditor might also analyze interest expense for payments
to creditors that are not included in the notes payable schedule and review the minutes
of the board of directors meetings for authorized but unrecorded notes.
In addition to balance-related objectives, the four presentation and disclosure-
related objectives are important for note payable because accounting standards require
that the footnotes adequately describe the terms of notes payable outstanding and the
assets pledged as collateral for the loans. If the loans require significant restrictions on
the activities of the company, such as compensating balance provisions or restrictions
on the payment of dividends, these must also be disclosed in the footnotes. As auditors
perform tests of details of balances for balance-related audit objectives, the evidence
obtained helps satisfy the notes payable presentation and disclosure objectives.
OWNERS’ EQUITY
OBJECTIVE 22-3 There is an important difference in the audit of owners’ equity between a publicly held
corporation and a closely held corporation. In most closely held corporations, which
Identify the primaryconcerns
typically have few shareholders, occasional, if any, transactions occur during the year for
in the audit of owners’ equity
capital stock accounts. The only transactions entered in the owners’ equity section are
transactions.
716 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 22-2 Schedule of Notes Payable and Accrued Interest(Cont.)
NOTES INTEREST
Balance Accrued at Accrued at
at End of Beginning End
Additions Payments Period Rate Paid to of Period Expense Paid of Period
10000 -0- 91 / % Maturity 238 712 950 -0-
2
10000 10000 10% Maturity 250 250
10000 10000 10% Maturity 167 167
20000 10000 20000 238 1129 950 417
likely to be the change in owners’ equity for the annual earnings or loss and the declaration
of dividends, if any. Closely held corporations rarely pay dividends, and auditors spend
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little time verifying owners’ equity, even though they must test the corporate records.
For publicly held corporations, however, the verification of owners’ equity is more
complex because of the larger numbers of shareholders and frequent changes in the
individuals holding the stock. The rest of this chapter deals with tests for verifying the
major owners’ equity accounts in a publicly held corporation, including:
• Capital and common stock
• Paid-in capital in excess of par
• Retained earnings and related dividends
Figure 22-3 (p. 719) provides an overview of the specific owners’ equity accounts
discussed. The objective for each is to determine whether:
• Internal controls over capital stock and related dividends are adequate
• Owners’ equity transactions are correctly recorded, as defined by the six
transaction-related audit objectives
• Owners’ equity balances are properly recorded, as defined by the eight balance-
related audit objectives, and properly presented and disclosed, as defined by the
four presentation and disclosure-related audit objectives for owners’ equity
accounts
Other accounts in owners’ equity are verified in much the same way as these.
Several internal controls are important for owners’ equity activities. We discuss several Internal Controls
of these in the following sections.
Proper Authorization of Transactions Because each owners’ equity transaction is
typically material, many of these transactions must be approved by the board of
directors. The following types of owners’ equity transactions usually require specific
authori zation:
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 717
TABLE 22-2 Balance-Related Audit Objectives and Tests of Details of Balances for Notes Payable
and Interest
Common Tests of Details
Balance-Related Audit Objective of Balances Procedures Comments
Notes payable in the notes payable Foot the notes payable list for notes payable and These are often done on a 100 percent |
schedule agree with the client’s accrued interest. basis because of the small population
notes payable register or master Trace the totals to the general ledger. size.
file, and the total is correctly Trace the individual notes payable to the master
added and agrees with the file.
general ledger (detail tie-in).
Notes payable in the schedule exist Confirm notes payable. The existence objective is not as
(existence). Examine duplicate copies of notes for important as completeness or
authorization. accuracy.
Examine corporate minutes for loan approval.
Existing notes payable are included Examine notes paid after year-end to determine This objective is important for
in the notes payable schedule whether they were liabilities at the balance uncovering both errors and fraud.
(completeness). sheet date. These three procedures are done
Obtain a standard bank confirmationthat on most audits. Additional procedures
includes specific reference to the existence of to search for omitted liabilities may
notes payable from all banks with which the be necessary if internal controls are
client does business. (Bank confirmations deficient.
are discussed more fully in Chapter 23.)
Review the bank reconciliationfor new notes
credited directly to the bank account by the
bank. (Bank reconciliations are also discussed
more fully in Chapter 23.)
Notes payable and accrued interest Examine duplicate copies of notes for principal In some cases, it may be necessary
on the schedule are accurate and interest rates. to calculate, using present-value
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(accuracy). Confirm notes payable, interest rates, and last techniques, the imputed interest rates
date for which interest has been paid with or the principal amount of the note.
holders of notes. An example is when equipment is
Recalculate accrued interest. acquired for a note.
Notes payable in the schedule are Examine due dates on duplicate copies of
correctly classified (classification). notes to determine whether all or part of the
notes are a noncurrent liability.
Review notes to determine whether any are
related party notes or accounts payable.
Notes payable are included in the Examine duplicate copies of notes to Notes should be included as current
proper period (cutoff). determine whether notes were dated on period liabilities when dated on or
or before the balance sheet date. before the balance sheet date.
The company has an obligation to pay Examine notes to determine whether the
the notes payable (obligations). company has obligations for payment.
• Issuance of Capital Stock.The authorization includes the type of equity to issue
(such as preferred or common stock), number of shares to issue, par value of
the stock, privileged condition for any stock other than common, and date of
the issue.
• Repurchase of Capital Stock.The repurchase of common or preferred shares, the
timing of the repurchase, and the amount to pay for the shares should all be
approved by the board of directors.
• Declaration of Dividends.The board of directors must authorize the form of the
dividends (such as cash or stock), the amount of the dividend per share, and
the record and payment dates of the dividends.
718 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 22-3 Owners’ Equity and Dividend Accounts
Capital stock—common
Beginning
(1) Redemption balance
of stock
Issue of Cash
stock in bank
Ending
balance
Paid-in capital
in excess Dividends Retained
ofpar—common payable earnings
Beginning Beginning Beginning
(1) Redemption balance Payment balance balance
of stock of
Issue of Dividends Dividends Net
dividends
stock declared declared earnings
Ending Ending Ending
balance balance balance
(1) Decrease cash
Proper Record Keeping and Segregation of Duties When a company maintains
its own records of stock transactions and outstanding stock, the internal controls
must be adequate to ensure that:
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• Actual owners of the stock are recognized in the corporate records
• The correct amount of dividends is paid to the stockholders owning the stock as
of the dividend record date |
• The potential for misappropriation of assets is minimized
The proper assignment of personnel, adequate record-keeping procedures, and
independent internal verification of information in the records are useful controls for
these purposes. The client should also have well-defined policies for preparing stock
certificates and for recording capital stock transactions.
When issuing and recording capital stock, the client must comply with both the
state laws governing corporations and the requirements in the corporate charter. The
par value of the stock, the number of shares the company is authorized to issue, and
state taxes on the issue of capital stock all affect issuance and recording.
As a control over capital stock, most companies maintain stock certificate books
and a shareholders’ capital stock master file. A capital stock certificate recordrecords
the issuance and repurchase of capital stock for the life of the corporation. The record
for a capital stock transaction includes the certificate number, the number of shares
issued, the name of the person to whom it was issued, and the issue date. When shares
are repurchased, the capital stock certificate book should include the cancelled
certificates and the date of their cancellation.
Ashareholders’ capital stock master fileis the record of the outstanding shares at
any given time. The master file acts as a check on the accuracy of the capital stock
certificate record and the common stock balance in the general ledger. It is also used as
the basis for the payment of dividends.
The disbursement of cash for the payment of dividends should be controlled in
much the same manner as the preparation and payment of payroll, which we described
in Chapter 20. Internal controls affecting dividend payments may include:
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 719
• Dividend checks are prepared from the capital stock certificate record by
someone who is not responsible for maintaining the capital stock records.
• After the checks are prepared, there is independent verification of the stockholders’
names and the amounts of the checks and a reconciliation of the total amount of
the dividend checks with the total dividends authorized in the minutes.
• A separate imprest dividend account is used to prevent the payment of a larger
amount of dividends than was authorized.
Independent Registrar and Stock Transfer Agent Any company with stock listed
on a securities exchange is required to engage an independent registraras a control to
prevent the improper issue of stock certificates. The responsibility of an independent
registrar is to make sure that stock is issued by a corporation in accordance with the
capital stock provisions in the corporate charter and the authorization of the board of
directors. When there is a change in the ownership of the stock, the registrar is respon -
sible for signing all newly issued stock certificates and making sure that old certificates
are received and cancelled before a replacement certificate is issued.
Most large corporations also employ the services of a stock transfer agentto main -
tain the stockholder records, including those documenting transfers of stock ownership.
The employment of a transfer agent helps strengthen control over the stock records by
putting the records in the hands of an independent organization and helps reduce the
cost of record keeping by using a specialist. Many companies also have the transfer agent
disburse cash dividends to shareholders, further improving internal control.
Audit of Auditors have four main concerns in auditing capital stock and paid-in capital in excess
Capital Stock of par:
and Paid-in Capital 1. Existing capital stock transactions are recorded (completeness transaction-related
objective).
OBJECTIVE 22-4 2. Recorded capital stock transactions occurred and are accurately recorded (occur -
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rence and accuracy transaction-related objectives).
Design and perform tests of
controls, substantive tests of 3. Capital stock is accurately recorded (accuracy balance-related objectives). |
transactions, and tests of 4. Capital stock is properly presented and disclosed (all four presentation and
details of balances for capital disclosure objectives).
stock and retained earnings.
The first two concerns involve tests of controls and substantive tests of transactions,
and the last two involve tests of details of balances and related disclosures.
Existing Capital Stock Transactions Are Recorded This objective is easily satisfied
when a registrar or transfer agent is used. The auditor can confirm with them whether any
capital stock transactions occurred and the accuracy of existing trans actions and then
determine if all of those transactions have been recorded. To uncover issuances and repur -
chasesof capital stock, auditors also review the minutes of the board of directors meet ings,
especially near the balance sheet date, and examine client-held stock record books.
Recorded Capital Stock Transactions Occurred and Are AccuratelyRecorded
Extensive auditing is required for transactions involving issuance of capital stock such as
the issuance of new capital stock for cash, the merger with another company through an
exchange of stock, donated shares, and the purchase of treasury shares. Regardless of the
controls, it is normal practice for auditors to verify all capital stock transactions because
of their materiality and permanence in the records. The occurrence transaction-related
objective can ordinarily be tested by examining the minutes of the board of directors
meetings for proper authorization.
Auditors can readily verify accurate recording of capital stock transactions for cash by
confirming the amount with the transfer agent and tracing the amount of the recorded
capital stock transactions to cash receipts. (In the case of treasury stock, the amounts are
traced to the cash disbursements journal.) In addition, the auditor must verify whether
the correct amounts were credited to capital stock and paid-in capital in excess of par by
referring to the corporate charter to determine the par or stated value of the capital stock.
720 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
ROLLER COASTER Activity surrounding initial public offerings (IPOs) new shares, uncertainty in the market, including
has been on a roller coaster ride for much of the the debt crisis in Greece and Spain, created some
IPO MARKETS
past decade. Coming off the craze of the dot.com volatility in the global IPO arena causing some
era in the late 1990s, the IPO market in the U.S. companies to postpone or withdraw their listings.
began to trail off soon after the passage of the According to Ernst & Young’s “Global IPO
Sarbanes–Oxley Act of 2002. Concerns about the Trends – 2010,” Asian companies, particularly
cost of compliance with many of the provisions of from China, will likely continue to dominate the
the Act caused some companies to undertake IPO recovery for a while given the country’s
their IPOs in overseas markets. The London Stock vigorous economic growth, as many former state-
Exchange actively sought many of the smaller U.S. owned enterprises in China and in other countries
companies that might be willing to take their such as Poland seek to raise capital in public
stocks public in the United Kingdom to avoid the markets. Global IPOs are expected to be highly
need to comply with many of the perceived costly diverse in geographies, sectors, and deal sizes,
provisions of the Act. Some public companies while most of the growth in the U.S. will be
even threatened to go private to avoid the hassles fueled by high tech and energy sectors.
of the new regulations. While there are cash-rich investors interested
By 2006 and 2007, the global IPO market was in providing equity capital, the recent economic
gaining strength again with $271.8 billion and crisis has caused them to be much more
$323.9 billion in priced IPOs globally. However, disciplined and valuation-driven. Investors are
the global economic crisis that began in 2008 requiring bigger IPO discounts as they take on
dried up most of the IPO activity. Total priced greater risks than years preceding the downturn. |
IPOs for 2008 and 2009 fell off to $114.8 billion
and $102.1 billion, respectively. While the IPO
Sources: Adapted from 1. Ken Sweet, “IPO Market
market was showing signs of gaining strength in Begins to Heat Up,” Fox Business, August 27, 2010
2010, with some big name deals such as General (www.foxbusiness.com); 2. Global IPO Trends 2010,
Motors, Toys “R” Us, and Dollar General issuing Ernst & Young (www.ey.com).
Auditing capital stock transactions such as stock dividends, acquisition of property
for stock, mergers, or similar noncash transfers is challenging because considerable
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technical expertise is required and there is often judgment involved to determine
proper valuations. For example, in the audit of a major merger transaction, the auditor
must often do considerable research to determine the appropriate accounting treatment
and proper valuation of the transaction, after considering all the facts in the merger.
Capital Stock Is Accurately Recorded Auditors verify the ending balance in the
capital stock account by first determining the number of shares outstanding at the
balance sheet date. A confirmation from the transfer agent is the simplest way to obtain
this information. When no transfer agent exists, the auditor must rely on examining
the stock records and accounting for all shares outstanding in the stock certificate
records, examining all cancelled certificates, and accounting for blank certificates.
After the auditor is satisfied that the number of shares outstanding is correct, the
recorded par value in the capital account can be verified by multiplying the number of
shares by the par value of the stock. The ending balance in the capital in excess of par
account is a residual amount. It is audited by verifying the amount of recorded trans -
actions during the year and adding them to or subtracting them from the beginning
balance in the account.
A major consideration when auditing the accuracy balance-related objective for
capital stock is verifying whether the number of shares used in the calculation of
earnings per share is accurate. It is easy to determine the correct number of shares to
use in the calculation when there is only one class of stock and a small number of
capital stock transactions. The problem becomes much more complex when there are
convertible securities, stock options, or stock warrants outstanding. Auditors must
have thorough understanding of requirements of relevant accounting standards before
verifying the number of shares for determining basic and diluted earnings per share.
Capital Stock Is Properly Presented and Disclosed The most important sources
of infor mation for determining whether all four presentation and disclosure-related
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 721
objectives for capital stock activities are satisfied are the corporate charter, the minutes
of board of directors meetings, and the auditor’s analysis of capital stock transactions.
The auditor should determine that each class of stock has a proper description, including
the number of shares issued and outstanding and any special rights of an individual
class. Auditors should also verify the proper presentation and disclosure of stock options,
stock warrants, and convertible securities by examining legal documents or other
evidence of the provisions of these agreements.
Audit of Dividends The emphasis in the audit of dividends is on dividend transactions rather than on the
ending balance. The exception is when there are dividends payable.
All six transaction-related audit objectives for transactions are relevant for
dividends. But typically, dividends are audited on a 100 percent basis. The most impor -
tant objectives, including those concerning dividends payable, are:
1. Recorded dividends occurred (occurrence).
2. Existing dividends are recorded (completeness).
3. Dividends are accurately recorded (accuracy).
4. Dividends are paid to stockholders that exist (occurrence).
5. Dividends payable are recorded (completeness). |
6. Dividends payable are accurately recorded (accuracy).
Auditors can verify the occurrence of recorded dividends by examining the minutes
of board of directors meetings for authorization of the amount of the dividend per
share and the dividend date. When doing so, the auditor should be alert to the possi-
bility of unrecorded dividends declared, particularly shortly before the balance sheet
date. A closely related audit procedure is to review the audit permanent file to
determine whether restrictions exist on the payment of dividends in bond indenture
agreements or preferred stock provisions.
The accuracy of a dividend declaration can be audited by recalculating the amount
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on the basis of the dividend per share times the number of shares outstanding. If the
client uses a transfer agent to disburse dividends, the total can be traced to a cash
disbursement entry to the agent and also confirmed.
When a client keeps its own dividend records and pays the dividends itself, the
auditor can verify the total amount of the dividend by recalculation and reference to
cash disbursed. In addition, auditors must verify whether the payment was made to the
stockholders who owned the stock as of the dividend record date. They can test this by
selecting a sample of recorded dividend payments and tracing the payee’s name on the
cancelled check to the dividend records. At the same time, auditors can verify the
amount and the authenticity of the dividend check.
Tests of dividends payable should be done in conjunction with declared dividends.
Any unpaid dividend should be included as a liability.
Audit of For most companies, the only transactions involving retained earnings are net earnings
Retained Earnings for the year and dividends declared. Other changes in retained earnings may include
corrections of prior-period earnings, prior-period adjustments charged or credited
directly to retained earnings, and the setting up or elimination of appropriations of
retained earnings.
To begin the audit of retained earnings, auditors first analyze retained earnings for
the entire year. The audit schedule showing the analysis, which is usually a part of the
permanent file, includes a description of every transaction affecting the account.
To accomplish the audit of the credit to retained earnings for net income for the year
(or the debit for a loss) auditors simply trace the entry in retained earnings to the net
earnings figure on the income statement. This procedure must, of course, take place fairly
late in the audit after all adjusting entries affecting net earnings have been completed.
In auditing debits and credits to retained earnings, other than net earnings and
dividends, auditors must determine whether the transactions should have been included.
722 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
For example, prior-period adjustments can be included in retained earnings only if
they satisfy the requirements of accounting standards.
After the auditor is satisfied that the recorded transactions were correctly classifi ed
as retained earnings transactions, the next step is to decide whether they were accurately
recorded. The audit evidence necessary to determine accuracy depends on the nature of
the transactions. For example, if an appropriation of retained earnings is required for a
bond sinking fund, auditors can determine the correct amount of the approp riation by
examining the bond indenture agreement. If there is a major loss charged to retained
earnings because of a material nonrecurring abandonment of a plant, the evidence
needed to determine the amount of the loss can be complex and include examining a
large number of documents and records, as well as discussions with manage ment.
Auditors must also evaluate whether any transactions should have been included
but were not. For example, if the client declared a stock dividend, the market value of
the securities issued should be capitalized by a debit to retained earnings and a credit to
capital stock. Similarly, if the financial statements include appropriations of retained |
earnings, the auditor should evaluate whether it is still necessary to have the appropri -
ation as of the balance sheet date.
Accounting standards require presentation and disclosure of information related to
retained earnings. The auditor’s primary concern in determining whether presentation
and disclosure objectives for retained earnings are satisfied primarily relates to disclosure
of any restrictions on the payment of dividends. Often, agreements with bankers, stock -
holders, and other creditors prohibit or limit the amount of dividends the client can
pay. These restrictions must be disclosed in the footnotes to the financial statements.
SUMMARY
This chapter discussed the audit of Athep caapigtalo ac quPisDitioFn anEd nrephayamnenct ceyclre, which
includes the primary sources of financing for most businesses. The cycle generally involves
few transactions, but the individual transactions are often material, which influences the
design and performance of tests in the cycle. The approach to auditing this cycle was
illustrated for notes payable, related interest expense and accrued interest, and for owners’
equity and related accounts.
ESSENTIAL TERMS
Capital acquisition and repayment cycle— charter and authorizations by the board
the transaction cycle that involves the of directors; required by the SEC for
acquisition of capital resources in the publicly held corporations
form of interest-bearing debt and owners’
Note payable—a legal obligation to a
equity, and the repayment of the capital
creditor, which may be unsecured or
Capital stock certificate record—a record secured by assets
of the issuance and repurchase of capital
Publicly held corporation—corporation
stock for the life of the corporation
with stock that is publicly traded; typically,
Closely held corporation—corporation there are many shareholders and frequent
changes in the ownership of the stock
with stock that is not publicly traded;
typically, there are only a few shareh olders Shareholders’ capital stock master file—
and few, if any, capital stock account a record of the issuance and repurchase
transactions during the year of capital stock for the life of a corporation
Independent registrar—outside person Stock transfer agent—outside person
engaged by a corporation to make sure engaged by a corporation to maintain the
that its stock is issued in accordance with stockholder records and often to disburse
capital stock provisions in the corporate cash dividends
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 723
REVIEW QUESTIONS
22-1 (Objective 22-1) List four examples of interest-bearing liability accounts commonly
found in balance sheets. What characteristics do these liabilities have in common? How do
they differ?
22-2 (Objectives 22-1, 22-2)Why are liability accounts included in the capital acquisition
and repayment cycle audited differently from accounts payable?
22-3 (Objective 22-2) It is common practice to audit the balance in notes payable in
conjunction with the audit of interest expense and interest payable. Explain the advantages
of this approach.
22-4 (Objective 22-2)Which internal controls should the auditor be most concerned about
in the audit of notes payable? Explain the importance of each.
22-5 (Objective 22-2)Which analytical procedures are most important in verifying notes
payable? Which types of misstatements can the auditor uncover by the use of these tests?
22-6 (Objective 22-2)Why is it more important to search for unrecorded notes payable
than for unrecorded notes receivable? Suggest audit procedures that the auditor can use to
uncover unrecorded notes payable.
22-7 (Objective 22-2)What is the primary purpose of analyzing interest expense? Given
this purpose, what primary considerations should the auditor keep in mind when doing
the analysis?
22-8 (Objective 22-2) Distinguish between (a) tests of controls and substantive tests of
transactions and (b) tests of details of balances for liability accounts in the capital acquisi -
tion and repayment cycle.
22-9 (Objective 22-2) List two types of restrictions long-term creditors often put on |
companies when granting them a loan. How can the auditor find out about these restrictions?
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22-10 (Objective 22-3) What are the primary objectives in the audit of owners’ equity
accounts?
22-11 (Objectives 22-3, 22-4)Evaluate the following statement: “The corporate charter and
the bylaws of a company are legal documents; therefore, they should not be examined by
the auditors. If the auditor wants information about these documents, an attorney should
be consulted.”
22-12 (Objective 22-3)What are the major internal controls over owners’ equity?
22-13 (Objective 22-3)How does the audit of owners’ equity for a closely held corporation
differ from that for a publicly held corporation? In what respects are there no significant
differences?
22-14 (Objective 22-3) Describe the duties of a stock registrar and a transfer agent. How
does the use of their services affect the client’s internal controls?
22-15 (Objective 22-4)What kinds of information can be confirmed with a transfer agent?
22-16 (Objective 22-4) Evaluate the following statement: “The most important audit
procedure to verify dividends for the year is a comparison of a random sample of cancelled
dividend checks with a dividend list that has been prepared by management as of the
dividend record date.”
22-17 (Objective 22-4)If a transfer agent disburses dividends for a client, explain how the
audit of dividends declared and paid is affected. What audit procedures are necessary to
verify dividends paid when a transfer agent is used?
22-18 (Objective 22-4) What should be the major emphasis in auditing the retained
earnings account? Explain your answer.
22-19 (Objectives 22-3, 22-4)Explain the relationship between the audit of owners’ equity
and the calculations of earnings per share. What are the main auditing considerations in
verifying the earnings per share figure?
724 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
22-20 (Objective 22-2) The following multiple choice questions concern interest-bearing
liabilities. Choose the best response.
a. The audit program for long-term debt should include steps that require the
(1) verification of the existence of the bondholders.
(2) examination of any bond trust indenture.
(3) inspection of the accounts payable master file.
(4) investigation of credits to the bond interest income account.
b. During the year under audit, a company has completed a private placement of a sub -
stantial amount of bonds. Which of the following is the most important step in the
auditor’s program for the audit of bonds payable?
(1) Recomputing the annual interest cost and the effective yield.
(2) Confirming the amount issued with the bond trustee.
(3) Tracing the cash received from the issue to the accounting records.
(4) Examining the bond records maintained by the transfer agent.
c. Which of the following controls will most likely justify a reduced assessed level of
control risk for the completeness assertion for notes payable?
(1) The accounting staff reviews board of director minutes for any indication of any
transactions involving outstanding debt to make sure all borrowings are included
in the general ledger.
(2) All borrowings that exceed $500,000 require approval from the board of directors
before loan contracts can be finalized.
(3) Before approving disbursement of principal payments on notes payable, the
treasurer reviews terms in the note.
(4) Accounting maintains a detailed schedule of outstanding note payable that is
reconciled monthly to the general ledger.
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d. In the audit of notes payable, which balance-related audit objective is generally one of
the most important for the auditor to verify?
(1) Notes payable reflected on the balance sheet at the end of the year exist.
(2) Notes payable due to related parties are properly reflected on the balance sheet.
(3) Existing notes payable are included on the balance sheet as of year end.
(4) Notes payable are reflected at net realizable value as of the balance sheet date. |
22-21 (Objectives 22-2, 22-3, 22-4)The following questions concern the audit of accounts
in the capital acquisition and repayment cycle. Choose the best response.
a. During an audit of a publicly held company, the auditor should obtain written con -
firmation regarding debenture transactions from the
(1) debenture holders. (3) internal auditors.
(2) client’s attorney. (4) trustee.
b. An audit program for the audit of the retained earnings account should include a step
that requires verification of
(1) market value used to charge retained earnings to account for a 2-for-1 stock split.
(2) approval of the adjustment to the beginning balance as a result of a write-down of
an account receivable.
(3) authorization for both cash and stock dividends.
(4) gain or loss resulting from disposition of treasury shares.
c. Which of the following internal controls is least likely to reduce risks related to the
occurrence transaction-related audit objective for issuances of stock?
(1) The board of directors must approve the distribution of cash dividends.
(2) The issuance of any shares of stock must be pre-approved by the board of directors.
(3) The company engages an independent registrar to issue stock certificates.
(4) The company maintains a capital stock certificate record that includes certificate
number, number of shares issued, issue date, and name of person to whom certifi -
cates are issued.
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 725
d. Which of the following audit procedures would be most relevant when examining the
completeness transaction-related audit objective for capital stock?
(1) The auditor examines minutes of the board of directors’ meetings to identify any
actions involving the issuance of capital stock.
(2) The auditor vouches entries in the client’s capital stock records to board minutes.
(3) Confirmations of new stock issuances are sent to the client’s stock transfer agent.
(4) The auditor traces entries of new stock issuances to the cash receipts journal.
DISCUSSION QUESTIONS AND PROBLEMS
22-22 (Objective 22-2) Items 1 through 6 are questions typically found in a standard
internal control questionnaire used by auditors to obtain an understanding of internal
control for notes payable. In using the questionnaire for a client, a “yes” response indicates
a possible internal control, whereas a “no” indicates a potential deficiency.
1. Are liabilities for notes payable incurred only after written authorization by a proper
company official?
2. Is a notes payable master file maintained?
3. Is a periodic reconciliation made of the notes payable master file with the actual notes
outstanding by an individual who does not maintain the master file?
4. Is the individual who maintains the notes payable master file someone other than the
person who approves the issue of new notes or handles cash?
5. Are paid notes cancelled and retained in the company files?
6. Are interest expense and accrued interest recomputed periodically by an individual
who does not record interest transactions?
Required a. For each of the preceding questions, state the purpose of the control.
b. For each of the preceding questions, identify the type of financial statement misstate-
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ment that can occur if the control were not in effect.
c. For each of the potential misstatements in part b, list an audit procedure that can be
used to determine whether a material misstatement exists.
22-23 (Objective 22-2) The following are frequently performed audit procedures for the
verification of bonds payable issued in previous years:
1. Analyze the general ledger account for bonds payable, interest expense, and unamor-
tized bond discount or premium.
2. Obtain a confirmation from the bondholder.
3. Obtain a copy of the bond indenture agreement and review its important provisions.
4. Determine that each of the bond indenture provisions has been met.
5. Test the client’s calculations of interest expense, unamortized bond discount or
premium, accrued interest, and bonds payable.
Required a. State the purpose of each of the five audit procedures listed. |
b. List the provisions for which the auditor should be alert in examining the bond
indenture agreement.
c. For each provision listed in part b, explain how the auditor can determine whether its
terms have been met.
d. Explain how the auditor should verify the unamortized bond discount or premium.
e. List the information that should be requested in the confirmation of bonds payable
with the bondholder.
22-24 (Objective 22-2) Your client, Red Horse Inc., prepared the following schedule for
long term debt for the audit of financial statements for the year ended December 31,
2011:
726 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
Notes 1/1/11 12/31/11
Payable Interest Due Beginning Ending
Description Rate Date Balance Additions Payments Balance
Mortgage Payable 6.25% 2020 $ 1,125,000 – $200,000 $ 925,000
Unsecured Notes
Payable 6.00% 2022 7,500,000 – 475,000 7,025,000
Secured Bonds 5.75% 2018 2,700,000 $ 1,250,000 300,000 3,650,000
Convertible
Debentures 5.25% 2025 — 10,000,000 — 10,000,000
___________ ___________ ________ ___________
Total $11,325,000 $11,250,000 $975,000 $21,600,000
a. What type of evidence would you examine to support the beginning balances in the Required
accounts?
b. What types of evidence would you use to support the additions to each account?
c. What types of evidence would you examine to support payments?
d. What procedures would you perform related to the ending balances in the accounts?
e. What evidence would you use to verify interest rates and due dates?
f. How might you use the information presented above to audit interest expense and
interest payable accounts?
22-25 (Objective 22-2)The ending general ledger balance of $186,000 in notes payable for
the Sterling Manufacturing Company is made up of 20 notes to eight different payees. The
notes vary in duration anywhere from 30 days to 2 years, and in amounts from $1,000 to
$10,000. In some cases, the notes were issued for cash loans; in other cases, the notes were
issued directly to vendors for the acquisition of inventory or equipment. The use of
relatively short-term financing is necessary because all existing properties are pledged for
mortgages. Nevertheless, there is still a serious cash shortage.
Record-keeping procedures for notes payable are not good, considering the large
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number of loan transactions. There is no notes payable master file or independent
verification of ending balances; however, the notes payable records are maintained by a
secretary who does not have access to cash.
The audit has been done by the same CPA firm for several years. In the current year, the
following procedures were performed to verify notes payable:
1. Obtain a list of notes payable from the client, foot the notes payable balances on the
list, and trace the total to the general ledger.
2. Examine duplicate copies of notes for all outstanding notes included on the listing.
Compare the name of the lender, amount, and due date on the duplicate copy with
the list.
3. Obtain a confirmation from lenders for all listed notes payable. The confirmation
should include the due date of the loan, the amount, and interest payable at the
balance sheet date.
4. Recompute accrued interest on the list for all notes. The information for determining
the correct accrued interest is to be obtained from the duplicate copy of the note. Foot
the accrued interest amounts and trace the balance to the general ledger.
a. What should be the emphasis in the verification of notes payable in this situation? Required
Explain.
b. State the purpose of each of the four audit procedures listed.
c. Evaluate whether each of the four audit procedures was necessary. Evaluate the sample
size for each procedure.
d. List other audit procedures that should be performed in the audit of notes payable in
these circumstances.
22-26 (Objective 22-2)The following covenants are extracted from the indenture of a bond
issue.The indenture provides that failure to comply with its terms in any respect auto-
matically makes the loan immediately due (the regular date is 20 years hence). List any audit |
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 727
steps or reporting requirements you think should be taken or recognized in connection
with each one of the following:
a. The debtor company shall endeavor to maintain a working capital ratio of 2 to 1 at all
times, and in any fiscal year following a failure to maintain said ratio, the company
shall restrict compensation of officers to $100,000 per individual. Officers for this
purpose shall include chairman of the board of directors, president, all vice presidents,
secretary, and treasurer.
b. The debtor company shall keep all property that is security for this debt insured
against loss by fire to the extent of 100% of its actual value. Policies of insurance
comprising this protection shall be filed with the trustee.
c. The debtor company shall pay all taxes legally assessed against property that is security
for this debt within the time provided by law for payment without penalty and shall
deposit receipted tax bills or equally acceptable evidence of payment of same with the
trustee.
d. A sinking fund shall be deposited with the trustee by semiannual payments of
$300,000, from which the trustee shall, in his discretion, purchase bonds of this issue.*
22-27 (Objective 22-2)The Redford Corporation took out a 20-year mortgage on June 15,
2011, for $2,600,000 and pledged its only manufacturing building and the land on which
the building stands as collateral. Each month subsequent to the issue of the mortgage, a
payment of $20,000 was paid to the mortgagor. You are in charge of the current year audit
for Redford, which has a balance sheet date of December 31, 2011. The client has been
audited previously by your CPA firm, but this is the first time Redford Corporation has had
a mortgage.
Required a. Explain why it is desirable to prepare an audit schedule for the permanent file for the
mortgage. What type of information should be included in the schedule?
b. Explain why the audit of mortgage payable, interest expense, and interest payable
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c. List the audit procedures that should ordinarily be performed to verify the issue of the
mortgage, the balance in the mortgage and interest payable accounts at December 31,
2011, and the balance in interest expense for the year 2011.
d. Identify the types of information that should be disclosed in the footnotes for this
long-term note payable to help the auditor determine whether the completeness
presentation and disclosure audit objective is satisfied.
22-28 (Objectives 22-3, 22-4)Items 1 through 6 are common questions found in internal
control questionnaires used by auditors to obtain an understanding of internal control for
owners’ equity. In using the questionnaire for a client, a “yes” response indicates a possible
internal control, whereas a “no” indicates a potential deficiency.
1. Does the company use the services of an independent registrar or transfer agent?
2. If an independent registrar and transfer agent are not used:
(a) Are unissued certificates properly controlled?
(b) Are cancelled certificates mutilated to prevent their reuse?
3. Are common stock master files and stock certificate books periodically reconciled
with the general ledger by an independent person?
4. Is an independent transfer agent used for disbursing dividends? If not, is an imprest
dividend account maintained?
5. Are issues and retirements of stock authorized by the board of directors?
6. Are all entries in the owners’ equity accounts authorized at the proper level in the
organi zation?
Required a. For each of the preceding questions, state the purpose of the control.
b. For each of the preceding questions, identify the type of potential financial statement
misstatements if the control is not in effect.
*AICPA adapted.
728 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
c. For each of the potential misstatements in part b, list an audit procedure that the
auditor can use to determine whether a material misstatement exists.
22-29 (Objectives 22-3, 22-4) The following audit procedures are commonly performed by |
auditors in the verification of owners’ equity:
1. Review the articles of incorporation and bylaws for provisions about owners’ equity.
2. Analyze all owners’ equity accounts for the year and document the nature of any
recorded change in each account.
3. Account for all certificate numbers in the capital stock book for all shares outstanding.
4. Examine the stock certificate book for any stock that was cancelled.
5. Review the minutes of the board of directors’ meetings for the year for approvals
related to owners’ equity.
6. Recompute earnings per share.
7. Review debt provisions and senior securities with respect to liquidation preferences,
dividends in arrears, and restrictions on the payment of dividends or the issue of stock.
a. State the purpose of each of these seven audit procedures. Required
b. List the type of misstatements the auditors can uncover by the use of each audit
procedure.
22-30 (Objectives 22-3, 22-4) You are engaged in the audit of a corporation whose records
have not previously been audited by you. The corporation has both an independent
transfer agent and a registrar for its capital stock. The transfer agent maintains the record of
stockholders and the registrar checks that there is no overissue of stock. Signatures of both
are required to validate certificates.
It has been proposed that confirmations be obtained from both the transfer agent and
the registrar as to the stock outstanding at the balance sheet date. If such confirmations
agree with the books, no additional work is to be performed as to capital stock.
If you agree that obtaining the confirm Aat pion as a gs s oug ge Pste Dd w Fil l be E su nff hicie ant n in c th eis c rase, give Required
the justification for your position. If you do not agree, state specifically all additional steps
you would take and explain your reasons for taking them.*
22-31 (Objective 22-4)You are a CPA engaged in an audit of the financial statements of
Pate Corporation for the year ended December 31, 2011. The financial statements and
records of Pate Corporation have not been audited by a CPA in prior years.
The stockholders’ equity section of Pate Corporation’s balance sheet at December 31,
2011, follows:
Stockholders’ Equity
Capital stock10,000 shares of $10 par value authorized; $ 50,000
5,000 shares issued and outstanding
Capital contributed in excess of par value of capital stock 32,580
Retained earnings ___4_7_,3_2_0_
Total stockholders’ equity $129,900
Pate Corporation was founded in 2004. The corporation has 10 stockholders and serves
as its own registrar and transfer agent. There are no capital stock subscription contracts in
effect.
a. Prepare the detailed audit program for the audit of the three accounts comprising the Required
stockholders’ equity section of Pate Corporation’s balance sheet. (Do not include in
the audit program the verification of the results of the current year’s operations.)
b. After every other figure on the balance sheet has been audited, it might appear that the
retained earnings figure is a balancing figure and requires no further verification. Why
does the CPA verify retained earnings as is done with the other figures on the balance
sheet? Discuss.*
*AICPA adapted.
Chapter 22 / AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE 729
22-32 (Objective 22-3)E-Antiques, Inc. is an Internet-based market maker for buyers and
sellers of antique furniture and jewelry. The company allows sellers of antique items to list
descriptions of those items on the E-Antiques Web site. Interested buyers review the Web
site for antique items and then enter into negotiations directly with the seller for purchase.
E-Antiques receives a commission on each transaction.
The company, founded in 2007, initially obtained capital through equity funding
provided by the founders and through loan proceeds from financial institutions. In early
2010, E-Antiques became a publicly held company when it began selling shares on a
national stock exchange. Although the company had never generated profits, the stock
offering generated large proceeds based on favorable expectations for the company, and the |
stock quickly increased to above $100 per share.
Management used the proceeds to pay off loans to financial institutions and to reacquire
shares issued to the company founders. Proceeds were also used to fund purchases of
hardware and software used to support the online market. The balance of unused proceeds
is currently held in the company’s bank accounts.
Required a. Before performing analytical procedures related to the capital acquisition and
repayment cycle accounts, consider how the process of becoming publicly held will
affect accounts at E-Antiques, Inc. Describe whether each of the following balances
would have increased, decreased, or experienced no change between 2009 and 2010
because of the public offering:
(1) Cash (7) Additional paid-in capital
(2) Accounts receivable (8) Retained earnings
(3) Property, plant, and equipment (9) Treasury stock
(4) Accounts payable (10) Dividends
(5) Long-term debt (11) Revenues
(6) Common stock
b. During 2011, the stock price for E-Antiques plummeted to around $19 per share. No
new shares were issued during 2011. Describe the impact of this drop in stock price on
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the following accounts for the year ended December 31, 2011:
(1) Common stock
(2) Additional paid-in capital
(3) Retained earnings
c. How does the decline in stock price affect your assessment of client business risk and
acceptable audit risk?
INTERNET PROBLEM 22-1: OVERVIEW OF THE NYSE
Many companies aspire to go public and have their shares traded on exchanges such as
the New York Stock Exchange (NYSE) and NASDAQ. Visit the Website of the NYSE
(www.nyse.com) and search for the “Guide to the NYSE Marketplace” to answer the
following questions.
Required a. What two U.S. securities exchanges does the NYSE Group Inc. operate? Briefly
describe each.
b. What is required to be able to trade securities on the NYSE trading floor?
c. How many shares does the NYSE have the capacity to trade in a single trading day?
d. How do most trade orders reach the NYSE trading floor?
e. What federal agency oversees the NYSE and its member organizations?
f. Describe the three widely cited stock market indexes described in the NYSE materials.
g. Describe the five basic categories of stock.
730 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
23
C H A P T E R
AUDIT OF CASH BALANCES
Fake Bank Confirmation Hides Massive Fraud
LEARNING OBJECTIVES
Calisto Tanzi formed Parmalat in 1961 at the age of 22 after inheriting a
After studying this chapter,
small family-run pasteurization plant in the Italian town of Parma. In 1990,
you should be able to
the company went public on the Milan stock exchange. By the end of that
decade, Parmalat employed more than 30,000 people in 30 countries, was 23-1 Show the relationship of cash
Italy’s eighth largest company, and a global consumer brand that sought to in the bank to the various
transaction cycles.
be the “Coca-Cola of milk.”
23-2 Identify the major types of cash
Parmalat began engaging in fraudulent transactions involving fictitious sales accounts maintained by business
as early as 1993, and investigators indicate that without the fraud, Parmalat entities.
would have reported losses every year from 1990 until the fraud was 23-3 Design and perform audit tests
revealed in 2003. During the period, the company took on increasing levels of the general cash account.
of debt to finance international acquisitions. To raise money and increase 23-4 Recognize when to extend audit
sales, Parmalat established three Caribbean shell companies. The shell tests of the general cash account
to test further for material fraud.
companies pretended to sell Parmalat products, and Parmalat used credit
notes from the shell companies to raise money from banks. 23-5 Design and perform audit tests
of the imprest payroll bank
In 1999 the activities of the shell companies were transferred to the Cayman account.
Islands. Two outside auditors allegedly came up with the audacious creation 23-6 Design and perform audit tests
of a bogus milk producer in Singapore that provided 300,000 tons of milk of imprest petty cash. |
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powder to a Cuban importer through the company’s Cayman Islands
subsidiary. Parmalat claimed that the Cayman Islands subsidiary held 3.95
billion in cash in a New York bank, but the account did not exist. A forged bank confirmation was sent to the subsidiary’s
auditors to support the fraudulent cash balance.
Parmalat’s losses totaled 12 billion, and in 2008, Tanzi was sentenced to 10 years in prison for his role in the fraud. The
company restructured and in 2005 was relisted on the Milan stock exchange.
Sources: Adapted from Peter Gumbel, “How It All Went So Sour,” Time(November 21, 2004) (www.time.com/time/magazine).
Cash is the only account included in every cycle except inventory and warehousing. It makes sense to study this
audit area last because the evidence accumulated for cash balances depends heavily on the results of the tests in
other cycles. For example, if the auditors’ understanding of internal control and tests of controls and substantive tests
of transactions in the acquisition and payment cycle cause them to believe that it is appropriate to reduce assessed
control risk to low, they can reduce detailed tests of the ending balance in cash. If, however, auditors conclude that
assessed control risk should be higher, extensive year-end testing may be necessary.
Cash is important because of its susceptibility to theft, and cash can also be significantly misstated as illustrated
in the case of Parmalat. This chapter highlights the linkage of cash in the bank to transaction cycles and describes
substantive tests of the cash balance.
CASH IN THE BANK AND TRANSACTION CYCLES
OBJECTIVE 23-1 A brief discussion of the relationship between cash in the bank and the other transaction
cycles serves a dual function:
Show the relationship of
cash in the bank to the 1. It shows the importance of audit tests of various transaction cycles on the audit
various transaction cycles. of cash.
2. It aids in further understanding the integration of the different transaction
cycles.
Figure 23-1 illustrates the relationships of the various transaction cycles, the focal
point being the general cash account (“Cash in bank”). By examining Figure 23-1, it is
apparent why the general cash account is considered significant in almost all audits,
even when the ending balance is immaterial. The amount of cash flowinginto and out
of the cash account is often larger than that for any other account in the financial state-
ments. Furthermore, the susceptibility of cash to embezzlement is greater than for
other tAyppesa ofg asoset s bPecDauFse mEostn othhear ansscetse mrust be converted to cash to make them
usable.
In the audit of cash, auditors must distinguish between verifying the client’s
reconciliation of the balance on the bank statement to the balance in the general ledger,
and verifying whether recorded cash in the general ledger correctly reflects all cash
transactions that took place during the year. It is relatively easy to verify the client’s
reconciliation of the balance in the bank account to the general ledger, but a significant
part of the total audit of a company involves verifying whether cash transactions are
correctly recorded. For example, each of the following misstatements ultimately results
in the improper payment of or the failure to receive cash, but none will normally be
discovered as a part of the audit of the bank reconciliation:
• Failure to bill a customer
• An embezzlement of cash by intercepting cash receipts from customers before
they are recorded, with the account charged off as a bad debt
• Duplicate payment of a vendor’s invoice
• Improper payments of officers’ personal expenditures
• Payment for raw materials that were not received
• Payment to an employee for more hours than he or she worked
• Payment of interest to a related party for an amount in excess of the going rate
If these misstatements are to be uncovered in the audit, their discovery must occur
through tests of controls and substantive tests of transactions, which we discussed in
preceding chapters. The first two misstatements can be discovered as part of the audit |
of the sales and collection cycle (Chapter 14), the next three in the audit of the
acquisition and payment cycle (Chapter 18), and the last two in the tests of the payroll
and personnel cycle (Chapter 20) and the capital acquisition and repayment cycle
(Chapter 22), respectively.
732 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 23-1 Relationships of Cash in the Bank and Transaction Cycles
Capital Acquisition and Repayment Cycle* Acquisition and Payment Cycle
Capital stock—common Dividendspayable Accounts payable
(1)
Redemption Issue of Payment Payment
of stock stock of
dividends
Paid-in capital
in excess
ofpar—common
(1)
Redemption Issue of
of stock stock
(1) Decrease cash
Sales and Collection Cycle Payroll and Personnel Cycle
Accrued wages,
Cash salaries, bonuses,
Gross sales in bank and commissions
Cash Beginning Payment
sales Cash balance
discounts
Accounts receivable taken
CaA shpago PDF EnE dinn ghancer Withheld income taxes
receipts balance and other deductions
Payment
Accruedpayroll
tax expense
Payment
*For simplicity, only owners’ equity accounts are shown in this figure. For notes payable accounts, see Figure 22-1 on page 714.
Entirely different types of misstatements are normally discovered as a part of the
tests of the bank reconciliation. These include:
• Failure to include a check that has not cleared the bank on the outstanding check
list, even though it has been recorded in the cash disbursements journal
• Cash received by the client subsequent to the balance sheet date but recorded as
cash receipts in the current year
• Deposits recorded as cash receipts near the end of the year, deposited in the
bank in the same month, and included in the bank reconciliation as a deposit in
transit
• Payments on notes payable debited directly to the bank balance by the bank but
not entered in the client’s records
Chapter 23 / AUDIT OF CASH BALANCES 733
TYPES OF CASH ACCOUNTS
OBJECTIVE 23-2 Before dealing with audit tests of the client’s bank reconciliation, it is helpful to discuss
the types of cash accounts commonly used by most companies, because the auditing
Identify the major types of
approach to each varies. Auditors are likely to learn about the various types of cash
cash accounts maintained
balances when they obtain an understanding of the client’s business. The following are
by business entities.
the major types of cash accounts.
General Cash Account The general cash account is the focal point of cash for most organizations because
virtually all cash receipts and disbursements flow through this account. For example, the
disbursements for the acquisition and payment cycle are normally paid from this account,
while the receipts of cash in the sales and collection cycle are deposited in the account.
Imprest Accounts As discussed in Chapter 20 (p. 663), many companies establish a separate imprest pay -
roll account to improve internal control over payroll disbursements. A fixed balance,
such as $5,000, is maintained in the imprest payroll bank account. Immediately before
each pay period, one check or electronic transfer is drawn on the general cash account to
deposit the total amount of the net payroll into the payroll account. After all payroll
payments have cleared the imprest payroll account, the bank account should have a
$5,000 balance. The only deposits into the account are for the weekly and semimonthly
pay roll, and the only disbursements are payments to employees.
A somewhat different type of imprest account consists of one bank account for
receipts and a separate one for disbursements. There may be several of these in a
company for different divisions. All receipts are deposited in the imprest account, and
the total is transferred to the general account periodically. The disbursement account is
set up on an imprest basis, but in a different manner than an imprest payroll account. A
fixed balance is maintained in the imprest account, and the authorized personnel use
these Afunpdas fgor odi sbPurDsemFe ntEs ant thheair nowcn edirscretion as long as the payments are
consistent with company policy. When the cash balance has been depleted, a reim - |
bursementis made to the imprest disbursement account from the general account after
the expenditures have been approved, usually through an online transfer. The use of
such an imprest bank account improves controls over receipts and disbursements.
Branch Bank Account For a company operating in multiple locations, it is often desirable to have a separate
bank balance at each location. Branch bank accountsare useful for building banking
relations in local communities and permitting the centralization of operations at the
branch level.
In some companies, the deposits and disbursements for each branch are made to a
separate bank account, and the excess cash is periodically transferred electronically to
the main office general bank account. The branch account in this instance is much like
a general account, but at the branch level.
Imprest An imprest petty cash fundis not a bank account, but it is sufficiently similar to cash
Petty Cash Fund in the bank to merit inclusion. A petty cash account is often something as simple as a
preset amount of cash set aside in a cash box for incidental expenses. It is used for small
cash acquisitions that can be paid more conveniently and quickly by cash than by check,
or for the convenience of employees in cashing personal or payroll checks. An imprest
cash account is set up on the same basis as an imprest branch bank account, but the
expenditures are normally for much smaller amounts. Typical expenses include minor
office supplies, stamps, and employee meals. A petty cash account usually does not
exceed a few hundred dollars and is often reimbursed only once or twice each month.
Many organizations use pre-approved purchase cards (known as P-cards) to make
miscellaneous purchases instead of maintaining a petty cash fund. These purchase
cards function much like a credit card, but contain numerous restrictions on the nature
and amount of purchases that can be made.
734 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 23-2 Relationship of General Cash to Other Cash Accounts
Branch bank Imprest payroll
account account
General
cash
Imprest
Cash petty cash
equivalents fund
Companies often invest excess cash accumulated during certain parts of the operating Cash Equivalents
cycle that will be needed in the reasonably near future in short-term, highly liquid cash
equivalents. These may include time deposits, certificates of deposit, and money
market funds. Cash equivalents, which can be highly material, are included in the
financial statements as a part of the cash account only if they are short-term invest -
ments that are readily convertible to known amounts of cash, and there is insignificant
risk of a change of value from interest rate changes. Marketable securities and longer-
term interest-bearing investments are not cash equivalents.
Figure 23-2 shows the relationship of general cash to the other cash accounts. All
cash either originates from or is deApopsitaed gino ge nePraDl cFash . FEonr thhe arenmacinederr of this
chapter, the focus is on auditing three types of accounts: the general cash account,
imprest payroll bank account, and imprest petty cash. The other accounts are similar
enough to these that we need not discuss them separately.
AUDIT OF THE GENERAL CASH ACCOUNT
The trial balance of Hillsburg Hardware Co. on page 150 includes only one cash OBJECTIVE 23-3
account. Notice, however, that all cycles, except inventory and warehousing, affect cash
Design and perform audit
in the bank.
tests of the general cash
In testing the year-end balance in the general cash account, the auditor must
account.
accumulate sufficient appropriate evidence to evaluate whether cash, as stated on the
balance sheet, is fairly stated and properly disclosed in accordance with five of the eight
balance-related audit objectives used for all tests of details of balances (existence,
completeness, accuracy, cutoff, and detail tie-in). Rights to general cash and its classifi -
cation on the balance sheet are generally not of concern, and the realizable value of
cash is not appli cable. |
The methodology for auditing year-end cash is essentially the same as that for all
other balance sheet accounts and discussed in detail.
Most companies are unlikely to have significant client business risks affecting cash Identify Client
balances. However, client business risk may arise from inappropriate cash management Business Risks
policies or handling of funds held in trust for others. Affecting Cash
Client business risk is more likely to arise from cash equivalents and other types (Phase I)
of investments. Several financial services firms have suffered large trading losses
from the activities of individual traders that were hidden by misstating investment
Chapter 23 / AUDIT OF CASH BALANCES 735
and cash balances. The auditor should understand the risks from the client’s investment
policies and strategies, as well as management controls that mitigate these risks.
Set Tolerable The cash balance is not material on many audits, but cash transactions affecting the
Misstatement and balance are almost always extremely material. Therefore, the potential often exists for
Assess Inherent Risk material misstatement of cash.
(Phase I) Because cash is more susceptible to theft than other assets, there is high inherent risk
for the existence, completeness, and accuracy objectives. These objectives are usually the
focus in auditing cash balances. Typically, inherent risk is low for all other objectives.
Assess Control Risk Internal controls over year-end cash balances in the general account can be divided
(Phase I) into two categories:
1. Controls over the transaction cyclesaffecting the recording of cash receipts and
disbursements
2. Independent bank reconciliations
In preceding chapters, we discussed controls affecting the recording of cash trans -
actions, which are essential in assessing control risk for cash. For example, in the
acquisition and payment cycle (Chapter 18), major controls include adequate segrega -
tion of duties between the check signing and accounts payable functions, signing of
checks only by a properly authorized person, use of prenumbered checks printed on
special paper, careful review of supporting documentation by the check signer before
checks are signed, and adequate internal verification. Similar controls apply to electronic
payments. If controls affecting cash-related transactions are operating effectively,
control risk is reduced as are the audit tests for the year-end bank reconciliation.
A monthly bank reconciliation of the general bank account on a timely basis by
someone independent of the handling or recording of cash receipts and disbursements
is an essential control over the ending cash balance. Companies with significant cash
balances and large volumes of cash transactions may reconcile cash on a daily basis to
onlineA bpanakingg ore corPdsD. IFf a bEusinnehss adenfecrs eprerparing bank reconciliations for long
periods, the value of the control is reduced and may affect the auditor’s assessment of
control risk for cash. The reconciliation ensures that the account ing records reflect the
same cash balance as the actual amount of cash in the bank after considering recon-
ciling items. More important, the independentrecon ciliation provides an opportunity
for an internal verification of cash receipts and disbursements trans actions. If the bank
statements are received unopened by the reconciler, and physical control is maintained
over the statements until the recon ciliations are complete, copies of can celled checks,
duplicatedeposit slips, and other documents included in the statement can be examined
without concern for the possibility of alterations, deletions, or additions. A careful
bank reconciliation by competent client personnel includes the following actions:
• Compare cancelled checks or electronic bank records of payment with the cash
disbursements records for date, payee, and amount
• Examine cancelled checks or electronic bank records of payment for signature,
endorsement, and cancellation
• Compare deposits in the bank with recorded cash receipts for date, customer, |
and amount
POSITIVE Positive pay is an automated fraud detection tool provided by the company. All three components
offered by most banks. A company using positive of the check must match exactly for the check to
PAY REDUCES
pay sends a file of issued checks to the bank each be paid. When a check is presented that does not
CHECK FRAUD day that checks are written. The file sent to the match, it is reported as an exception and an image
bank includes the check number, account number, of the check is sent to the company. The company
issue date, and dollar amount. The positive pay reviews the image and instructs the bank to pay
service matches the account number, check or return the check.
number and dollar amount of each check Source: Adapted from “All About Positive Pay”
presented for payment against the list of checks (http://positivepay.net).
736 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
• Account for the numerical sequence of checks, and investigate missing ones
• Reconcile all items causing a difference between the book and bank balance and
verify their appropriateness for the client’s business
• Reconcile total debits on the bank statement with the totals in the cash disburse -
ments records
• Reconcile total credits on the bank statement with the totals in the cash receipts
records
• Review month-end interbank transfers for appropriateness and proper recording
• Follow up on outstanding checks and stop-payment notices
Most accounting software packages incorporate bank reconciliation as a part of
end-of-month procedures. Even though the software reduces the clerical efforts in per -
forming the bank reconciliations, the preparer still needs to do most of the procedures
listed above. The bank reconciliation control is enhanced when a qualified employee
reviews the monthly reconciliation as soon as possible after its completion.
Because the cash balance is affected by all other cycles except inventory and ware housing, Design and Perform
an extremely large number of transactions affect cash. In several earlier chapters, we Tests of Controls
discussed in detail the appropriate tests of controls and substantive tests of transactions and Substantive
for the audit of each cycle. For example, controls over cash receipts were studied in Tests of Transactions
Chapter 14, and controls over cash disbursements were studied in Chapter 18. Cash (Phase II)
transactions are audited through these transaction cycle tests.
In many audits, the year-end bank reconciliation is extensively audited. Using analytical Design and Perform
procedures to test the reasonableness of the cash balance is therefore less important than Analytical Procedures
it is for most other audit areas. (Phase III)
Auditors commonly compare the ending balance on the bank reconciliation, deposits
in transit, outstanding checks, and other reconciling items with the prior-year recon-
ciliation. Similarly, auditors normally compare the ending balance in cash with previous
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months’ balances. These analytical procedures may uncover misstatements in cash.
The starting point for the verification of the balance in the general bank account is to Design Tests of Details
obtain a bank reconciliation from the client for inclusion in the auditor’s documen - of Cash Balance
tation. Figure 23-3 (p. 738) shows a bank reconciliation after the client has made (Phase III)
adjustments to the account balance. Notice that the bottom figure in the audit schedule
is the adjusted balance in the general ledger, which is the balance that should appear on
the financial statements. The auditor must determine that the client has made adjust -
ments such as those at the bottom of Figure 23-3, if they are material.
To audit cash in the bank, the auditor verifies whether the bank reconciliation received
from the client is correct. The balance-related audit objectives and common tests of
details of balances in the audit of the cash account are shown in Table 23-1 (p.739). The
most important objectives are existence, completeness, and accuracy. Therefore, they |
receive the greatest attention. In addition to these balance-related objectives, the auditor
also performs tests related to the four presentation and disclosure objectives, such as
review of minutes and loan agreements to determine if there are restrictions on cash that
must be disclosed. As in all other audit areas, the actual audit procedures depend on
materiality and the risks in cash that the auditor has identified in other parts of the audit.
The following three procedures merit additional discussion because of their
importance and complexity: receipt of a bank confirmation, receipt of a cutoff bank
statement, and tests of the bank reconciliation.
Receipt of a Bank Confirmation Bankconfirmationsarenotrequiredforauditsof
non-public entities or under international auditing standards. However, auditors
usually obtain a direct receipt of a confirmation from every bank or other finan cial
institution with which the client does business, except when there is an unusually large
number of inactive accounts. If the bank does not respond to a confirmation request, the
auditor should send a second request or ask the client to communicate with the bank to
Chapter 23 / AUDIT OF CASH BALANCES 737
FIGURE 23-3 Audit Schedule for a Bank Reconciliation
Clawson Industries Schedule A-2 Date
Bank Reconciliation Prepared by Client / DED 1/10/12
12/31/11 Approved by SW 1/18/12
Acct. 101 – General account, First National Bank
Balance per Bank 109713
Add:
Deposits in transit
12/30 10017
12/31 11100 21117
Deduct
Outstanding checks
#7993 12/16 3068
8007 12/16 9763
8012 12/23 11916
8013 12/23 14717
8029 12/28 37998
8038 12/30 10000 <87462>
Other reconciling items: Bank error
Deposit for another bank custoAmepr caredgiteod PDF Enhancer
to General account by bank, in error <15200>
Balance per bank, adjusted 28168
Balance per books before adjustments 32584
Adjustments:
Unrecorded bank service charge 216
Nonsufficient funds check
returned by bank, not collectible
from customer 4200 <4416>
Balance per books, adjusted 28168
Traced and agreed to bank confirmation.
Traced deposit to the December 2011 cash receipts records and to the January 2012
bank cutoff statement, noting its proper classification as a deposit in transit at
12/31/11
Traced check to December 2011 cash disbursements records and to the January 2012
bank cutoff statement, noting its proper classification as an outstanding check at
12/31/11
Traced to 12/31/11 adjusted trial balance
Footed
ask them to complete and return the confirmation to the auditor. As a convenience to
auditors as well as to bankers who are requested to fill out bank confirmations, the
AICPA has approved the use of a standard bank con firmation form. Figure 23-4
(p. 740) illustrates a completed standard confirma tion, called a “standard form to
738 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
TABLE 23-1 Balance-Related Audit Objectives and Tests of Details of Balances for General Cash in
the Bank
Balance-Related Common Tests of Details
Audit Objective of Balances Procedures Comments
Cash in the bank as stated on the Foot the outstanding check and electronic These tests are done entirely on the bank
reconciliation foots correctly and payment list and deposits in transit. reconciliation, with no reference to
agrees with the general ledger Prove the bank reconciliation as to documents or other records except the
(detail tie-in). additions and subtractions, including general ledger.
all reconciling items.
Trace the book balance on the
reconciliation to the general ledger.
Cash in the bank as stated on the (See extended discussion for each of these.) These are the three most important objectives
reconciliation exists (existence). Receipt and tests of a bank confirmation. for cash in the bank. The procedures are
Existing cash in the bank is recorded Receipt and tests of a cutoff bank statement. combined because of their close inter-
(completeness). Tests of the bank reconciliation. dependence. The last three procedures
Cash in the bank as stated on Extended tests of the bank reconciliation. should be done only when there are |
the reconciliation is accurate Proof of cash. internal control deficiencies.
(accuracy). Tests for kiting.
Cash receipts and cash disbursements Cash receipts: When cash receipts received after year-end
transactions are recorded in the Count the cash on hand on the last day are included in the journal, a better cash
proper period (cutoff). of the year and subsequently trace to position than actually exists is shown. It is
deposits in transit and the cash receipts called “holding open” the cash receipts
journal. Trace deposits in transit to journal. Holding open the cash disburse-
subsequent period bank statement ments journal reduces accounts payable
(cutoff bank statement). and usually overstates the current ratio.
Cash disbursements: The first procedure listed for receipts and
Record the last check number used on the disbursements cutoff tests requires the
last day of the year and subsequently auditor’s presence on the client’s premises
Aptraace gto othe ouPtstaDndFing chEeckns ahnd athen cerat the end of the last day of the year.
cash disbursements journal.
Trace outstanding checks to subsequent
period bank statement.
confirm account balance information with financial insti tutions.” This standard form
has been agreed upon by the AICPA and the American Bankers Association. As discussed
in the text insert on page 741, bank confirmations are often sent electronically, and
some banks will only respond to confirmation requests sent electronically through a
designated third-party intermediary.
The importance of bank confirmations in the audit extends beyond the verifi -
cation of the actual cash balance. Typically, the bank confirms loan information and
bank balances on the same form, such as the three outstanding loans in Figure 23-4.
Information on liabilities to the bank for notes, mortgages, or other debt typically
includes the amount and date of the loan, the loan due date, interest rate, and the
existence of collateral.
Banks are not responsible for searching their records for bank balances or loans
beyond those included on the form by the CPA firm’s client. A statement near the
bottom of the form obligates banks to inform the CPA firm of any loans not included
on the confirmation about which the bank has knowledge. The effect of this limited
responsibility is to require auditors to satisfy themselves about the completeness
objective for un recorded bank balances and loans from the bank in another manner.
Similarly, banks are not expected to inform auditors of such things as open lines of
credit, compen sating balance requirements, or contingent liabilities for guaranteeing
the loans of others. If auditors want confirmation of this type of information, they
should obtain a separate confirmation from the financial institution addressing the
matters of concern.
Chapter 23 / AUDIT OF CASH BALANCES 739
FIGURE 23-4 Standard Confirmation of Financial Institution Account Balance
Information
Clawson Industries
Schedule A-2/1 Date
Bank Confirmation Prepared by DED 1/10/12
12/31/11 Approved by SW 1/18/12
STANDARD FORM TO CONFIRM ACCOUNT
BALANCE INFORMATION WITH FINANCIAL INSTITUTIONS
Clawson Industries
CUSTOMER NAME
[ ] We have provided to our accountants the following information as of
the close of business on December 31, 2011, regarding our deposit
Financial and loan balances. Please confirm the accuracy of the information,
noting any exceptions to the informationprovided. If the balances
Institution’s First National Bank have been left blank, please complete this form byfurnishing the
Name and 200 Oak Street balance in the appropriate space below.* Although we do not request
nor expectyou to conduct a comprehensive,detailed search of
Address Midvale, Illinois 40093 your records, ifduring the process of completing this confirmation
additional information about other deposit and loan accounts we
may have with you comes to your attention, please include such
information below. Please use the enclosed envelope to return the
[ ] formdirectly to our accountants.
1. At the close of business on the date listed above, our records indicated the following deposit balance(s): |
ACCOUNT NAME ACCOUNT NUMBER INTEREST RATE BALANCE*
Generalaccount 19751-974 None 109,713.11
2. We were directly liable to the financial institution for loans at the close of business on the date listed above as follows:
ACCOUNT NO./ DATE THROUGH WHICH DESCRIPTION OF
DESCRIPTION BALANCE* DATE DUE INTEREST RATE INTEREST IS PAID COLLATERAL
N/A 50,000.00 1/9/12 4.75% N/A General
N/A 90,000.00 1/9/12 4.625% N/A Security
N/A 60,000.00 1/23/12 4.75% N/A Agreement
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(Customer’s Authorized Signature) (Date)
The informationpresented above by the customer is in agreement with our records. Although we have not conducted
a comprehensive,detailed search of our records, no other deposit or loan accounts have come to our attention
except as noted below.
(Financial Institution Authorized Signature) (Date)
(Title)
EXCEPTIONS AND/OR COMMENTS
None
Please return this formdirectly to our accountants:
Jones and Smith CPAs
2111 First Street
Detroit, Michigan 48711
Approved 1990 by American Bankers Association, American Institute of Certified Public Accountants,
and Bank Administration Institute. Additional forms available from: AICPA-Order Department, 1-888-777-7077
*Ordinarily, balances are intentionally left blank if they are not available at the time the form is prepared.
After auditors receive the completed bank confirmation, the balance in the bank
account confirmed by the bank should be traced to the amount stated on the bank
reconciliation. Similarly, all other information on the reconciliation should be traced
to the relevant audit schedules. If the bank confirmation does not agree with the audit
schedules, auditors must investigate the difference.
740 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
ELECTRONIC As illustrated by the Parmalat fraud (see page 731), firm, client, and financial institution). A secure
one of the shortcomings of the confirmation value-added network with digital signatures and
CONFIRMATIONS
process is difficulty authenticating the confirmation encryption technology are used to allow the client
OF BANK respondent. Although auditors generally confirm to authorize the confirmation requests and the
bank balances because they are considered a auditor to communicate directly with the
BALANCES
highly reliable source of evidence about cash in confirming parties. Interpretation No. 1 of AU 330,
the bank, obtaining bank confirmations can be a “Use of Electronic Confirmations,” states that
time-consuming process. Organizations may not when secure and properly controlled, electronic
respond to confirmation requests, and it may take confirmations may be considered sufficient, valid
several weeks to receive confirmation responses confirmation responses.
through the mail.
Sources: Adapted from 1. George Aldhizer and
Automated confirmations using a third-party
JamesCashell “Automating the Confirmation
intermediary can address many of these short-
Process: How to Enhance Audit Effectiveness and
comings and improve confirmation efficiency and Efficiency,” The CPA Journal(April 2006) p.6-10;
effectiveness. Authentication checks are performed 2. AICPA Practice Alert 2003-1 (June 2007)
on all parties to the confirmation process (audit (www.aicpa.org).
Receipt of a Cutoff Bank Statement A cutoff bank statement is a partial-period
bank statement and the related copies of cancelled checks, duplicate deposit slips, and
other documents included in bank statements, mailed by the bank directly to the CPA
firm’s office. The purpose of the cutoff bank statement is to verify the reconciling items
on the client’s year-end bank reconciliation with evidence that is not accessible to the
client. To fulfill this purpose, the auditor requests the client to have the bank send the
statement for 7 to 10 days subsequent to the balance sheet date directly to the auditor.
Many auditors verify the subsequent period bank statement if a cutoff statement is
not received directly from the bank. The purpose is to test whether the client’s employees
have omitted, added, or altered any of the documents accompanying the statement. |
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Obviously, this tests for intentional misstatements. The auditor performs the following
verification in the month subsequent to the balance sheet date:
• Foot the lists of all cancelled checks, debit memos, deposits, and credit memos
• Verify that the bank statement balances when the footed totals are used
• Review the items included in the footings to make sure that they were cancelled
by the bank in the proper period and do not include any erasures or alterations
Tests of the Bank Reconciliation A well-prepared independent bank reconciliation is
an essential internal control over cash. Auditors test the bank reconciliation to determine
whether client personnel have carefully prepared the bank reconciliation and to verify
whether the client’s recorded bank balance is the same amount as the actual cash in the
bank except for deposits in transit, outstanding checks, and other recon ciling items.
In verifying the reconciliation, the auditor uses information in the cutoff bank
statement to verify the appropriateness of reconciling items. The auditor’s verification
of the reconciliation involves several procedures:
• Verify that the client’s bank reconciliation is mathematically accurate.
• Trace the balance on the bank confirmation and/or the beginning balance on
the cutoff statement to the balance per bank on the bank reconciliation to
ensure they are the same.
• Trace checks written and recorded before year-end and included with the cutoff
bank statement to the list of outstanding checks on the bank reconciliation and
to the cash disbursements journal in the period or periods prior to the balance
sheet date. All checks that cleared the bank after the balance sheet date and were
included in the cash disbursements journal should also be included on the
outstanding check list. If a check was included in the cash disbursements
journal, it should be included as an outstanding check if it did not clear before
Chapter 23 / AUDIT OF CASH BALANCES 741
FIGURE 23-5 Types of Audit Tests Used for General Cash in the Bank
Cash in bank
Beginning balance
Cash receipts Cash disbursements
Audited by Audited by
TOC-T, STOT, and AP TOC-T, STOT, and AP
Ending balance
Audited by
TOC-B, AP, and TDB
Tests of controls
Tests of controls Substantive Tests of
over bank Analytical Sufficient
in transaction tests of details of
+ reconciliation + + procedures* + = appropriate
cycles* transactions* balances
process (AP) evidence
(TOC-T) (STOT) (TDB)
(TOC-B)
*Tests of controls in transaction cycles, substantive tests of transactions, and analytical procedures are
done for the four transaction cycles included in Figure 23-1 (p. 733). The primary tests of the ending cash
balance are tests ofdetails of balances.
the balance sheet date. Similarly, if a check cleared the bank before the balance
sheet date, it should not be on the bank reconciliation.
• Investigate all significant checks included on the outstanding check list that have not
cleared the bank on the cutoff statement. The first step in the investigation should
Abep toa trgaceo th e PamDouFnt ofE anny ihtemasn noct celearring to the cash disbursements journal.
The reason for the check not being cashed should be discussed with the client, and
if the auditor is concerned about the possibility of fraud, the vendor’s accounts
payable balance should be confirmed to determine whether the vendor has
recognized the receipt of the cash in its records. In addition, a copy of the cancelled
check should be examined before the last day of the audit if it becomes available.
• Trace deposits in transit to the cutoff bank statement. All cash receipts not deposited
in the bank at the end of the year should be traced to the cutoff bank statement to
make sure that they were deposited shortly after the beginning of the new year.
• Account for other reconciling items on the bank statement and bank recon -
ciliation. These include such items as bank service charges, bank errors and
corrections, and unrecorded transactions debited or credited directly to the
bank account by the bank. These reconciling items should be investigated to be |
sure that they have been treated properly by the client.
Figure 23-5 illustrates how the types of audit tests are used to audit the general cash
account. Observe in the figure that tests of controls, substantive tests of transactions, and
analytical procedures are done for each transaction cycle involving the cash account.
FRAUD-ORIENTED PROCEDURES
OBJECTIVE 23-4 A major consideration in the audit of the general cash balance is the possibility of
fraud. The auditor must extend the procedures in the audit of year-end cash to deter -
Recognize when to extend
mine the possibility of a material fraud when there are inadequate internal controls,
audit tests of the general
especially the improper segregation of duties between the handling of cash and the
cash account to test further
for material fraud. recording of cash transactions in the accounting records and the lack of an inde -
pendently prepared monthly bank reconciliation.
742 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
In designing procedures for uncovering fraud, auditors should carefully consider
the nature of the deficiencies in internal control, the type of fraud that is likely to result
from the deficiencies, the potential materiality of the fraud, and the audit procedures
that are most effective in uncovering the fraud.
When auditors are specifically testing for fraud, they should keep in mind that
audit procedures other than tests of details of cash balances can also be useful.
Procedures that may uncover fraud in the cash receipts area include:
• Confirmation of accounts receivable
• Tests performed to detect lapping
• Review of the general ledger entries in the cash account for unusual items
• Comparison of customer orders to sales and subsequent cash receipts
• Examination of approvals and supporting documentation for bad debts and
sales returns and allowances
Similar tests can be used for testing for the possibility of fraudulent cash dis -
bursements.
Even with reasonably elaborate fraud-oriented procedures, it is extremely difficult to
detect thefts of cash, as well as fraudulent financial reporting involving cash, especially
omitted transactions and account balances. If, for example, a company has illegal offshore
cash accounts and makes deposits to those accounts from unrecorded sales, it is unlikely
that an auditor will uncover the fraud. Nevertheless, auditors are responsible for making
a reasonable effort to detect fraud when they have reason to believe it may exist. The
following procedures for uncovering fraud are directly related to year-end cash balances:
extended tests of the bank reconciliation, proofs of cash, and tests of interbank transfers.
When the auditor believes that the year-end bank reconciliation may be intentionally Extended Tests of the
misstated, it is appropriate to perform extended tests of the year-end bank recon - Bank Reconciliation
ciliation. The extended procedures verify whether all transactions included in the
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journals for the last month of the year were correctly included in or excluded from the
bank reconciliation and verify whether all items in the bank reconciliation were
correctly included. Let’s assume that there are material internal control weaknesses and
the client’s year-end is December 31. Using a common approach, auditors:
1. Start with the bank reconciliation for November and compare all reconciling
items with cancelled checks and other documents in the December bank
statement.
2. Compare all remaining cancelled checks and deposit slips in the December
bank statement with the December cash disbursements and receipts journals.
3. Trace all uncleared items in the November bank reconciliation and the
December cash disbursements and receipts journals to the client’s December31
bank reconciliation to make sure they are included.
4. Verify that all reconciling items in the December 31 bank reconciliation repre-
sent items from the November bank reconciliation and December’s journals
that have not yet cleared the bank.
In addition to these four tests, the auditor must carry out procedures subsequent to |
the end of the year with the use of the bank cutoff statement. These tests are the same
as previously discussed.
Auditors sometimes prepare a proof of cash when the client has material internal Proof of Cash
control weaknesses in cash. The auditor uses a proof of cash to determine whether the
following were done:
• All recorded cash receipts were deposited
• All deposits in the bank were recorded in the accounting records
• All recorded cash disbursements were paid by the bank
• All amounts that were paid by the bank were recorded
Chapter 23 / AUDIT OF CASH BALANCES 743
Aproof of cashincludes the following four reconciliation tasks:
1. Reconcile the balance on the bank statement with the general ledger balance at
the beginning of the proof-of-cash period.
2. Reconcile cash receipts deposited per the bank with receipts recorded in the
cash receipts journal for a given period.
3. Reconcile electronic payments and cancelled checks clearing the bank with
those recorded in the cash disbursements journal for a given period.
4. Reconcile the balance on the bank statement with the general ledger balance at
the end of the proof-of-cash period.
A proof of cash of this nature is commonly called a four-column proof of cash that
contains one column for each of the four types of information listed above. A proof of
cash can be performed for one or more interim months, the entire year, or the last month
of the year. The concern in an interim-month proof of cash, as shown in Figure23-6, is
not with the ending cash balance. Rather, the auditor’s focus is on reconciling the
amounts recorded in the books with the amounts included in the bank statement.
When doing a proof of cash, the auditor is combining substantive tests of trans -
actions and tests of details of balances. A proof of cash receipts is a test of recorded
transactions, whereas a bank reconciliation is a test of the balance in cash at a point in
time. A proof of cash is an excellent method of comparing recorded cash receipts and
disbursements with the bank account and with the bank reconciliation. However, the
proof of cash disbursements is not effective for discovering checks written for an
improper amount, fraudulent checks, or other misstatements in which the dollar
amount appearing on the cash disbursements records is incorrect. Similarly, a proof of
cash receipts is not useful for uncovering the theft of cash receipts or the recording and
deposit of an improper amount of cash.
Tests of Embezzlers occasionally cover a theft of cash by a practice known as kiting: trans -
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Interbank Transfers ferring money from one bank to another and incorrectly recording the transaction.
Near the balance sheet date, a check is drawn on one bank account and immediately
deposited in a second account for credit before the end of the accounting period. In
making this transfer, the embezzler is careful to make sure that the check is deposited
at a late enough date so that it does not clear the first bank until after the end of the
period. If the interbank transfer is not recorded until after the balance sheet date, the
amount of the transfer is recorded as an asset in both banks. Although there are other
ways to commit this fraud, each involves increasing the bank balance to cover a shortage
by the use of interbank transfers.
To test for kiting, as well as for unintentional errors in recording interbank
transfers, auditors can list all interbank transfers made a few days before and after the
balance sheet date and trace each to the accounting records for proper recording.
Figure 23-7 (p. 746) shows an interbank transfer schedule with four interbank transfers
made shortly before and after the balance sheet date. There are several things that
should be audited on the interbank transfer schedule.
• The accuracy of the information on the interbank transfer schedule should be
verified.The auditor should compare the disbursement and receipt information
on the schedule to the cash disbursements and cash receipts records to make
sure that it is accurate. Similarly, the dates on the schedule for transfers that were |
received and disbursed should be compared with the bank statement. Finally,
cash disburse ments and receipts records should be examined to make sure that
all transfers a few days before and after the balance sheet date have been included
on the schedule. (The tick mark ex planations on the schedule in Figure 23-7
indicate that these steps have been taken.)
• The interbank transfers must be recorded in both the receiving and disbursing banks.
If, for example, there was a $10,000 transfer from Bank A to Bank B but only the
disbursement was recorded, this is evidence of an attempt to conceal a cash theft.
744 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
FIGURE 23-6 Interim Proof of Cash
Clawson Industries Schedule A-5 Date
Interim Proof of Cash Prepared by JG 7/15/11
6/30/11 Approved by RP 7/17/11
Acct. 101 – General account, First National Bank
5/31/11 Receipts Disbursements 6/30/11
Balance per Bank 121782.12 627895.20 631111.96 118565.36
Deposits in transit
5/31 21720.00 <21720.00>
6/30 16592.36 16592.36
Outstanding checks
5/31 <36396.50> <36396.50>
6/30 14800.10 <14800.10>
NSF checks <4560.00> <4560.00>
To allow for effect of a cash disburse-
ment recorded as a credit item
in cash receipts journal <8500.00> <8500.00>
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Balance per bank, adjusted 107105.62 609707.56 596455.56 120357.62
Balance per books, unadjusted 107105.62 609707.56 597957.04 118856.14
Bank debit memos 120.00 <120.00>
Payroll checks erroneously entered
in General Disbursements Journal <1621.48> 1621.48
Balance per books, adjusted 107105.62 609707.56 596455.56 120357.62
Per 6/30/11 bank statement.
Detailed listing filed below; traced to subsequent bank statements.
Outstanding-check list filed below: examined cancelled checks.
Detailed listing filed below; all NSF items were redeposited in June and had all cleared as of 6/30/11.
Safety deposit rentals; traced to recording via journal entry.
Traced to journal entry correcting error.
• The date of the recording of the disbursements and receipts for each transfer must be
in the same fiscal year.In Figure 23-7, the dates in the two “date recorded in books”
columns [(4) and (7)] are in the same period for each transfer; therefore, they are
correct. If a cash receipt was recorded in the current fiscal year and the disburse -
ment in the subsequent fiscal year, it may be an attempt to cover a cash shortage.
• Disbursements on the interbank transfer schedule should be correctly included in or
excluded from year-end bank reconciliations as outstanding checks.In Figure23-7,
the 12-31-11 bank reconciliation for the general cash account should include
outstanding checks for the second and third transfers but not the other two.
[Compare the dates in columns (4) and (5).] Understatement of outstanding
checks on the bank reconciliation indicates the possibility of kiting.
Chapter 23 / AUDIT OF CASH BALANCES 745
FIGURE 23-7 Interbank Transfer Schedule
Clawson Industries Schedule A-7
Schedule of Interbank Transfers Prepared by Client / DED 1/10/12
December 31, 2011 Approved by SW 1/18/12
Disbursements Receipts
Check Date Recorded Date Paid Date Recorded Date Received
No. Bank Amount in Books by Bank Bank in Books by Bank
(1) (2) (3) (4) (5) (6) (7) (8)
EFT First National - general $20,642 12-26-11 12-26-11 Federal Charter - payroll 12-26-11 12-27-11
#8029 First National - general $37,998 12-28-11 01-02-12 Federal Charter - savings 12-29-11 12-29-11
#8038 First National - general $10,000 12-30-11 01-04-12 Federal Charter - savings 12-30-11 01-03-12
#8045 First National - general $21,014 01-02-12 01-04-12 Federal Charter - payroll 01-03-12 01-04-12
Traced to cash disbursements records.
Traced to cash receipts records.
Check included as outstanding on bank reconciliation.
Check or EFT (Electronic Funds Transfer) not included as outstanding on bank reconciliation.
Receipt included as a deposit in transit.
Traced to bank statement.
Receipt not included as a deposit in transit.
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Note: Examined cash disbursements and cash receipts records for checks to and deposits from bank accounts. None included except those listed above. |
• Receipts on the interbank transfer schedule should be correctly included in or
excluded from year-end bank reconciliations as deposits in transit.In Figure23-7,
the 12-31-11 bank reconciliations for the savings and payroll accounts should
indicate a deposit in transit for the third transfer but not for the other three.
(Compare the dates for each transfer in the last two columns.) Overstating
deposits in transit on the bank reconciliation indicates the possibility of kiting.
Even though audit tests of interbank transfers are usually fraud oriented, they are
often performed on audits in which there are numerous bank transfers, regardless of
internal controls. In addition to the possibility of kiting, inaccurate handling of transfers
can result in a misclassification between cash and accounts payable. The materiality of
transfers and the relative ease of performing the tests make many auditors believe they
should always be performed.
AUDIT OF THE IMPREST PAYROLL BANK ACCOUNT
OBJECTIVE 23-5 Tests of the payroll bank reconciliation should take only a few minutes if there is an
imprest payroll account and an independent reconciliation of the bank account, such
Design and perform audit
as that described for the general account. Typically, the only reconciling items are out -
tests of the imprest payroll
standing checks. For most audits, the great majority of those clear shortly after the
bank account.
checks are issued. In testing the payroll bank account balances, auditors must obtain
746 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
the bank reconciliation, a bank confirmation, and a cutoff bank statement. The
reconciliation procedures are performed in the same manner as those described for
general cash except that tests of the outstanding checks are normally limited to a
reasonableness test. Naturally, extended procedures are necessary if the controls are
inadequate or if the bank account does not reconcile with the general ledger imprest
cash balance.
AUDIT OF IMPREST PETTY CASH
Petty cash is a unique account. Although it is often immaterial in amount, many OBJECTIVE 23-6
auditors verify petty cash primarily because of the potential for embezzlement and the
Design and perform audit
client’s expectation that auditors will examine the account, even when the amount is
tests of imprest petty cash.
immaterial.
The most important internal control for petty cash is the use of an imprest fund that is Internal Controls
the responsibility of one individual. In addition, petty cash funds should not be mingled Over Petty Cash
with other receipts, and the fund should be kept separate from all other activities.
There should also be limits on the amount of any expenditure from petty cash, as well
as on the total amount of the fund. The types of expenditures that can be made from
petty cash transactions should be well defined by company policy.
When a disbursement is made from petty cash, adequate internal controls require
a responsible official’s approval on a prenumbered petty cash form. The total of the
actual cash and checks in the fund, plus the total unreimbursed petty cash forms that
represent expenditures, should equal the total amount of the petty cash fund stated in
the general ledger.
When the petty cash balance runs low, a check payable to the petty cash custodian
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should be written on the general cash account for the reimbursement of petty cash.
The check should be for the exact amount of the prenumbered vouchers that are
submitted as evidence of actual expenditures. These vouchers should be verified by the
accounts payable clerk and cancelled to prevent their reuse.
The emphasis in verifying petty cash should be on testing controls over petty cash Audit Tests
transactions rather than the ending balance in the account. Even if the amount of the for Petty Cash
petty cash fund is small, the potential exists for numerous improper transactions if the
fund is frequently reimbursed.
When control risk is assessed as low and few reimbursement payments occur during |
the year, it is common for auditors not to test petty cash, for reasons of immateriality.
When auditors do test petty cash, the two most common procedures are to count the
petty cash balance and to carry out detailed tests of one or two reimbursement trans-
actions to determine that they are properly supported.
SUMMARY
In this chapter, we have seen that transactions in most cycles affect the cash account.
Because of the relationship between transactions in several cycles and the ending cash
account balance, the auditor typically waits to audit the ending cash balance until the
results of tests of controls and substantive tests of transactions for all cycles are completed
and analyzed. Tests of the cash balance normally include tests of the bank reconciliations of
key cash accounts, such as the general cash account, imprest payroll account, and imprest
petty cash fund. If auditors assess a high likelihood of fraud in cash, they may perform
additional tests such as extended bank reconciliation procedures, a proof of cash, or tests of
interbank transfers.
Chapter 23 / AUDIT OF CASH BALANCES 747
ESSENTIAL TERMS
Bank reconciliation—the monthly recon- Imprest petty cash fund—a fund of cash
ciliation, usually prepared by client per - maintained within the company for small
sonnel, of the differences between the cash cash acquisitions or to cash employees’
balance recorded in the general ledger and checks; the fund’s fixed balance is com -
the amount in the bank account paratively small and is periodically reim -
bursed
Branch bank accounts—separate bank
accounts maintained at local banks by Kiting—the transfer of money from one
branches of a company bank to another and improperly record ing
Cash equivalents—excess cash invested in the transfer so that the amount is recorded
short-term, highly liquid investments such as an asset in both accounts; this practice
as time deposits, certificates of deposit, is used by embezzlers to cover a theft of
and money market funds cash
Cutoff bank statement—a partial-period Proof of cash—a four-column audit
bank statement and the related cancelled schedule prepared by the auditor to
checks, duplicate deposit slips, and other reconcile the bank’s record of the client’s
documents included in bank statements, beginning balance, cash deposits, cleared
mailed by the bank directly to the auditor; checks, and ending balance for the period
the auditor uses it to verify reconciling with the client’s records
items on the client’s year-end bank recon-
Standard bank confirmation form—
ciliation
a form approved by the AICPA and
General cash account—the primary bank American Bankers Association through
account for most organizations; virtually which the bank responds to the auditor
all cash receipts and disbursements flow about bank balance and loan information
through this account at some time provided on the confirmation
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REVIEW QUESTIONS
23-1 (Objectives 23-1, 23-2) Explain the relationships among the initial assessed control
risk, tests of controls and substantive tests of transactions for cash receipts, and the tests of
details of cash balances.
23-2 (Objectives 23-1, 23-2) Explain the relationships among the initial assessed control
risk, tests of controls and substantive tests of transactions for cash disbursements, and the
tests of details of cash balances. Give one example in which the conclusions reached about
internal controls in cash disbursements will affect the tests of cash balances.
23-3 (Objective 23-3) Why is the monthly reconciliation of bank accounts by an inde -
pendent person an important internal control over cash balances? Which individuals will
generally not be considered independent for this responsibility?
23-4 (Objective 23-3)Evaluate the effectiveness and state the shortcomings of the prepara-
tion of a bank reconciliation by the controller in the manner described in the following
statement: “When I reconcile the bank account, the first thing I do is review the sorted list
of returned checks and find which numbers are missing. Next I determine the amount of |
the uncleared checks by referring to the cash disbursements journal. If the bank account
reconciles at that point, I am all finished with the reconciliation. If it does not, I search for
deposits in transit, checks from the beginning outstanding check list that still have not
cleared, other reconciling items, and bank errors until it reconciles. In most instances, I can
do the reconciliation in 20 minutes.”
23-5 (Objective 23-3) How do bank confirmations differ from positive confirmations of
accounts receivable? Distinguish between them in terms of the nature of the information
confirmed, the sample size, and the appropriate action when the confirmation is not
748 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
returned after the second request. Explain the rationale for the differences between these
two types of confirmations.
23-6 (Objective 23-3) Evaluate the necessity of following the practice described by an
auditor: “In confirming bank accounts, I insist upon a response from every bank the client
has done business with in the past 2 years, even though the account may be closed at the
balance sheet date.”
23-7 (Objective 23-3) Describe what is meant by a cutoff bank statement and state its
purpose.
23-8 (Objective 23-3) Why are auditors usually less concerned about the client’s cash
receipts cutoff than the cutoff for sales? Explain the procedure involved in testing for the
cutoff for cash receipts.
23-9 (Objective 23-2) What is meant by an imprest bank account for a branch operation?
Explain the purpose of using this type of bank account.
23-10 (Objective 23-4) Explain the purpose of a four-column proof of cash. List two types
of misstatements it is meant to uncover.
23-11 (Objective 23-3) When the auditor fails to obtain a cutoff bank statement, it is
common to verify the entire statement for the month subsequent to the balance sheet date.
How is this done and what is its purpose?
23-12 (Objective 23-4) Distinguish between lapping and kiting. Describe audit procedures
that can be used to uncover each.
23-13 (Objective 23-5) Assume that a client with excellent internal controls uses an
imprest payroll bank account. Explain why the verification of the payroll bank recon -
ciliation ordinarily takes less time than the tests of the general bank account, even if the
number of disbursements exceeds those for the general account.
23-14 (Objective 23-6) Distinguish between the verification of petty cash reimbursements
and the verification of the balance inA thpe faungd. oEx plaPinD hoFw eaEchn is hdoanen. Wcheichr is more
important?
23-15 (Objectives 23-3, 23-4) Why is there a greater emphasis on the detection of fraud in
tests of details of cash balances than for other balance sheet accounts? Give two specific
examples that demonstrate how this emphasis affects the auditor’s evidence accumulation
in auditing year-end cash.
23-16 (Objective 23-3) Explain why, in verifying bank reconciliations, most auditors
emphasize the possibility of a nonexistent deposit in transit being included in the recon -
ciliation and an outstanding check being omitted rather than the omission of a deposit in
transit and the inclusion of a nonexistent outstanding check.
23-17 (Objective 23-3) How will a company’s bank reconciliation reflect an electronic
deposit of cash received by the bank from credit card agencies making payments on behalf
of customers purchasing products from the company’s online Web site, but not recorded in
the company’s records?
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
23-18 (Objectives 23-3, 23-4) The following questions deal with auditing year-end cash.
Choose the best response.
a. A CPA obtains a January 10 cutoff bank statement for a client directly from the bank.
Very few of the outstanding checks listed on the client’s December 31 bank recon -
ciliation cleared during the cutoff period. A probable cause for this is that the client
(1) is engaged in kiting.
(2) is engaged in lapping.
(3) transmitted the checks to the payees after year-end.
(4) has overstated its year-end bank balance. |
Chapter 23 / AUDIT OF CASH BALANCES 749
b. The auditor should ordinarily send confirmation requests to all banks with which the
client has conducted any business during the year, regardless of the year-end balance,
because
(1) this procedure will detect kiting activities that would otherwise not be detected.
(2) the confirmation form also seeks information about indebtedness to the bank.
(3) the sending of confirmation requests to all such banks is required by auditing
standards.
(4) this procedure relieves the auditor of any responsibility with respect to non -
detection of forged checks.
c. The usefulness of the standard bank confirmation request may be limited because the
bank employee who completes the confirmation may
(1) be unaware of all the financial relationships that the bank has with the client.
(2) not believe the bank is obligated to verify confidential information to a third party.
(3) sign and return the confirmation without inspecting the accuracy of the client’s
bank reconciliation.
(4) not have access to the client’s bank statement.
23-19 (Objective 23-4) The following questions deal with discovering fraud in auditing
year-end cash. Choose the best response.
a. Which of the following is one of the better auditing techniques to detect kiting?
(1) Review composition of authenticated deposit slips.
(2) Review subsequent bank statements and cancelled checks received directly from
the banks.
(3) Prepare year-end bank reconciliations.
(4) Prepare a schedule of bank transfers from the client’s books.
b. Which of the following cash transfers results in a misstatement of cash at December31,
2011?
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Disbursements Receipt
Recorded Paid by Recorded Received
Transfer in books bank in books by bank
(1) 12/31/11 1/4/12 12/31/11 12/31/11
(2) 1/4/12 1/5/12 12/31/11 1/4/12
(3) 12/31/11 1/5/12 12/31/11 1/4/12
(4) 1/4/12 1/11/12 1/4/12 1/4/12
c. A cash shortage may be concealed by transporting funds from one location to another or
by converting negotiable assets to cash. Because of this, which of the following is vital?
(1) Simultaneous bank confirmations.
(2) Simultaneous bank reconciliations.
(3) Simultaneous four-column proofs of cash.
(4) Simultaneous surprise cash counts.
DISCUSSION QUESTIONS AND PROBLEMS
23-20 (Objectives 23-3, 23-4)The following are misstatements that might be found in the
client’s year-end cash balance (assume that the balance sheet date is June 30):
1. The outstanding checks on the June 30 bank reconciliation were underfooted by
$2,000.
2. A loan from the bank on June 26 was credited directly to the client’s bank account.
The loan was not entered as of June 30.
3. A check was omitted from the outstanding check list on the June 30 bank recon -
ciliation. It cleared the bank July 7.
750 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
4. A check was omitted from the outstanding check list on the bank reconciliation. It
cleared the bank September 6.
5. Cash receipts collected on accounts receivable from July 1 to July 5 were included as
June 29 and 30 cash receipts.
6. A bank transfer recorded in the accounting records on July 1 was included as a deposit
in transit on June 30.
7. A check that was dated June 26 and disbursed in June was not recorded in the cash
disbursements journal, but it was included as an outstanding check on June 30.
a. Assuming that each of these misstatements was intentional (fraud), state the most Required
likely motivation of the person responsible.
b. What control can be instituted for each fraud to reduce the likelihood of occurrence?
c. List an audit procedure that can be used to discover each fraud.
23-21 (Objectives 23-3, 23-4)The following audit procedures are concerned with tests of
details of general cash balances:
1. Obtain a standard bank confirmation from each bank with which the client does
business.
2. Compare the balance on the bank reconciliation obtained from the client with the
bank confirmation.
3. Compare the checks returned along with the cutoff bank statement with the list of
outstanding checks on the bank reconciliation. |
4. List the check number, payee, and amount of all material checks not returned with
the cutoff bank statement.
5. Review minutes of the board of directors meetings, loan agreements, and bank
confirmation for interest-bearing deposits, restrictions on the withdrawal of cash,
and compensating balance agreements.
6. Prepare a four-column proof of cash.
7. Compare the bank cancellationA daptea wigtho th e dPateD oFn t heE cannchellead nchcecke forr checks
dated on or shortly before the balance sheet date.
8. Trace deposits in transit on the bank reconciliation to the cutoff bank statement and
the current year cash receipts journal.
Explain the objective of each. Required
23-22 (Objective 23-3) You are auditing general cash for the Pittsburgh Supply Company
for the fiscal year ended July 31, 2011. The client has not prepared the July 31 bank
reconcilia tion. After a brief discussion with the owner, you agree to prepare the recon-
ciliation, with assistance from one of Pittsburgh Supply’s clerks. You obtain the following
information:
General Ledger Bank Statement
Beginning balance 7/1/11 $ 6,400 $ 8,378
Deposits 25,474
Cash receipts journal 26,874
Checks cleared (25,307)
Cash disbursements journal (23,171)
July bank service charge (107)
Note paid directly (6,400)
NSF check ________ ____(_5_1_6_)
Ending balance 7/31/11 $ 10,103 $ 1,522
June 30 Bank Reconciliation
Information in General Ledger and Bank Statement
Balance per bank $8,378
Deposits in transit 600
Outstanding checks 2,578
Balance per books 6,400
Chapter 23 / AUDIT OF CASH BALANCES 751
Additional information obtained is as follows:
1. Checks clearing that were outstanding on June 30 totaled $2,411.
2. Checks clearing that were recorded in the July disbursements journal totaled $21,120.
3. A check for $1,130 cleared the bank but had not been recorded in the cash disburse-
ments journal. It was for an acquisition of inventory. Pittsburgh Supply uses the
periodic-inventory method.
4. A check for $646 was charged to Pittsburgh Supply but had been written on a
different company’s bank account.
5. Deposits included $600 from June and $24,874 for July.
6. The bank charged Pittsburgh Supply’s account for a nonsufficient check totaling
$516. The credit manager concluded that the customer intentionally closed its
account and the owner left the city. The check was turned over to a collection
agency.
7. A note for $6,000, plus interest, was paid directly to the bank under an agreement
signed4 months ago. The note payable was recorded at $6,000 on Pittsburgh Supply’s
books.
Required a. Prepare a bank reconciliation that shows both the unadjusted and adjusted balance
per books.
b. Prepare all adjusting entries.
c. What audit procedures would you use to verify each item in the bank reconciliation?
d. What is the cash balance that should appear on the July 31, 2011, financial statements?
23-23 (Objectives 23-3, 23-4) In the audit of the Regional Transport Company, a large
branch that maintains its own bank account, cash is periodically transferred to the central
account in Cedar Rapids. On the branch account’s records, bank transfers are recorded as a
debit to the home office clearing account and a credit to the branch bank account.
Similarly, the home office account is recorded as a debit to the central bank account and a
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credit to the branch office clearing account. Gordon Light is the head bookkeeper for both
the home office and the branch bank accounts. Because he also reconciles the bank
account, the senior auditor, Cindy Marintette, is concerned about the internal control
deficiency.
As a part of the year-end audit of bank transfers, Marintette asks you to schedule the trans-
fers for the last few days in 2011 and the first few days of 2012. You prepare the following list:
Date Recorded in Date Recorded in Date Deposited
the Home Office the Branch Office in the Home Date Cleared
Amount of Cash Receipts Cash Disbursements Office Bank the Branch
Transfer Journal Journal Account Bank Account
$17,000 12-27-11 12-29-11 12-26-11 12-27-11
28,000 12-28-11 01-02-12 12-28-11 12-29-11 |
16,000 01-02-12 12-30-11 12-28-11 12-29-11
10,000 12-26-11 12-26-11 12-28-11 01-03-12
21,000 01-02-12 01-02-12 12-28-11 12-31-11
22,000 01-07-12 01-05-12 12-28-11 01-03-12
39,000 01-04-12 01-06-12 01-03-12 01-05-12
Required a. In verifying each bank transfer, state the appropriate audit procedures you should
perform.
b. Prepare any adjusting entries required in the home office records.
c. Prepare any adjusting entries required in the branch bank records.
d. State how each bank transfer should be included in the December 31, 2011, bank
reconciliation for the home office account after your adjustments in part b.
e. State how each bank transfer should be included in the December 31, 2011, bank
reconciliation of the branch bank account after your adjustments in part c.
752 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
23-24 (Objective 23-4)The following are various potential misstatements due to errors or
fraud (1 through 7), and a list of auditing procedures (a through h) the auditor would
consider performing to gather evidence to determine whether the error or fraud is present.
Possible Misstatements Due to Errors or Fraud
1. The auditor suspects that a lapping scheme exists because an accounting department
employee who has access to cash receipts also maintains the accounts receivable
ledger and refuses to take any vacation or sick days.
2. The auditor suspects that the entity is inappropriately increasing the cash reported on its
balance sheet by drawing a check on one account and not recording it as an outstanding
check on that account and simultaneously recording it as a deposit in a second account.
3. The entity’s cash receipts of the first few days of the subsequent year were properly
deposited in its general operating account after the year-end. However, the auditor
suspects that the entity recorded the cash receipts in its books during the last week of
the year under audit.
4. The auditor noticed a significant increase in the number of times that petty cash was
reimbursed during the year and suspects that the custodian is stealing from the petty
cash fund.
5. The auditor suspects that a kiting scheme exists because an accounting department
employee who can issue and record checks seems to be leading an unusually
luxurious lifestyle.
6. During tests of the reconciliation of the payroll bank account, the auditor notices
that a check to an employee is significantly larger than other payroll checks.
7. The auditor suspects that the controller wrote several checks and recorded the cash
disbursements just before year-end but did not mail the checks until after the first
week of the subsequent year.
List of Auditing Procedures
a. Send a standard bank confirmation confirming the balance in the bank at year-end.
b. Compare the details of the casAh preaceigptso jo uPrnaDl Fen triEes nwihth athne cdeteairls of the
corresponding daily deposit slips.
c. Count the balance in petty cash at year-end.
d. Agree gross amount on payroll checks to approved hours and pay rates.
e. Obtain the cutoff bank statement and compare the cleared checks to the year-end
reconciliation.
f. Examine invoices, receipts, and other documentation supporting reimbursement of
petty cash.
g. Examine payroll checks clearing after year-end with the payroll journal.
h. Prepare a bank transfer schedule.
For each possible misstatement, identify one audit procedure that would be most effective Required
in providing evidence regarding the potential misstatement. Listed auditing procedures
may be used once, more than once, or not at all.*
23-25 (Objective 23-3) In connection with an audit you are given the following works heet:
Bank Reconciliation, December 31, 2011
Balance per ledger December 31, 2011 $27,253.85
Add:
Cash receipts received on the last day of December and
charged to “cash in bank” on books but not deposited 3,715.27
Debit memo for customer’s check returned unpaid (check
is on hand but no entry has been made on the books) 450.00
Debit memo for bank service charge for December ____3__5_.0_0_
$31,454.12
(continued on following page) |
*AICPA adapted.
Chapter 23 / AUDIT OF CASH BALANCES 753
Deduct:
Checks drawn but not paid by bank (see detailed list below) $3,295.15
Credit memo for proceeds of a note receivable that had
been left at the bank for collection but which has not
been recorded as collected 1,200.00
Checks for an account payable entered on books as
$297.50 but drawn and paid by bank as $694.50 ___3_9_7_.0_0_ _(_4_,8_9__2_.1_5_)
Computed balance 26,561.97
Unlocated difference ___4_1__6_.4_4_
Balance per bank (checked to confirmation) $26,978.41
Checks Drawn but Not Paid by Bank
No. Amount
573 $ 267.27
724 39.92
903 454.67
907 291.80
911 648.29
913 737.52
914 529.10
916 36.00
917 _____1_1_7_.2_6_
$3,295.15
Required a. Prepare a corrected reconciliation.
b. Prepare journal entries for items that should be adjusted prior to closing the books.*
23-26 (Objective 23-4)You are doing the first-year audit of Sherman School District and
have been assigned responsibility for doing a four-column proof of cash for the month of
October 2011. You obtain the following information:
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1. Balance per books September 30 $ 10,725
October 31 5,836
2. Balance per bank September 30 6,915
October 31 8,276
3. Outstanding checks September 30 1,811
October 31 2,615
4. Cash receipts for October per bank 28,792
per books 20,271
5. Deposits in transit September 30 5,621
October 31 996
6. Interest on a bank loan for the month of October, charged by the bank but not
recorded, was $596.
7. Proceeds on a note of the Jones Company were collected by the bank on October 28
but were not entered on the books:
Principal $ 2,900
Interest ____3_9_6_
$ 3,296
8. On October 26, a $1,144 check of the Billings Company was charged to Sherman
School District’saccount by the bank in error.
9. Dishonored checks are not recorded on the books unless they permanently fail to clear
the bank. The bank treats them as disbursements when they are dishonored and
deposits when they are redeposited. Checks totaling $1,335 were dishonored in
October; $600 was redeposited in October and $735 in November.
Required a. Prepare a four-column proof of cash for the month ended October 31. It should show
both adjusted and unadjusted cash.
b. Prepare all adjusting entries.
*AICPA adapted.
754 Part 4 / APPLICATION OF THE AUDIT PROCESS TO OTHER CYCLES
INTERNET PROBLEM 23-1:
CHECK CLEARING FOR THE 21ST CENTURY ACT
The Check Clearing for the 21st Century Act (Check 21 Act) allows recipients of paper
checks to create a digital image of the original check, eliminating the need for further
handling of the actual check. The Federal Reserve Board has created a consumer guide
(www.federalreserve.gov/pubs/check21/consumer_guide.htm). Locate the guide to answer
questions about Check 21.
a. What is a “substitute check”? Does it constitute a legal copy of the check? Required
b. How does Check 21 affect the payment of your checks?
c. Do banks have to return actual cancelled checks? Explain.
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Chapter 23 / AUDIT OF CASH BALANCES 755
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T
R
A
P
C H A P T E R
2 4
5
COMPLETING THE AUDIT
Part 5includes only one chapter and covers the fourth and final phase of an
audit: completing the audit. Even when auditors perform the other phases of an
audit well, if they do a poor job carrying out the completion phase, the quality
of the audit will be low. When auditors perform the planning phase (phase I)
and the two testing phases (phases II and III) well, the completion phase is
typically relatively easy.
24
C H A P T E R
COMPLETING THE AUDIT
Good Review Requires More
LEARNING OBJECTIVES
Than Looking At Audit Files
After studying this chapter,
Larry Lenape, an audit senior of Santro, Best & Harmon, assigned staff
you should be able to
assistant Clawson Little the audit of accounts payable for Westside Industries,
a large equipment manufacturer.Accounts payable is a major liability account 24-1 Design and perform audit tests
related to presentation and
for a manufacturing company, and testing accounts payable cutoff is an
disclosure audit objectives.
important audit area. Testing primarily involves reviewing the liability |
24-2 Conduct a review for contingent
recorded by the client by examining subsequent payments to suppliers and
liabilities and commitments.
other creditors to ensure that they were correctly recorded.
24-3 Obtain and evaluate letters from
the client’s attorneys.
Lenape observed that Little was spending a lot of time on the phone,
apparently on personal matters. Shortly before the audit was completed, 24-4 Conduct a post-balance-sheet
review for subsequent events.
Little announced that he was leaving the firm. Despite Little’s distractions
due to his personal affairs, he completed the audit work he was assigned 24-5 Design and perform the final
steps in the evidence-
within the budgeted time.
accumulation segment of the
audit.
Because of Lenape’s concern about Little’s work habits, he decided to review
the audit files with extreme care. Every schedule he reviewed was properly 24-6 Integrate the audit evidence
gathered and evaluate the overall
prepared, with tick marks entered and explained by Little, indicating that he
audit results.
had made an extensive examination of underlying data and documents and
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24-7 Communicate effectively with
had found the client’s balance to be adequate as stated. Specifically, there
the audit committee and
were no payments subsequent to year-end for inventory purchases received
management.
during the audit period that had not been accrued by the company.
24-8 Identify the auditor’s
responsibilities when facts
When Lenape finished the audit, he notified Kelsey Mayburn, the engagement
affecting the audit report are
audit manager, that the files were ready for her review. She had considerable
discovered after its issuance.
knowledge about equipment manufacturers and also about Westside
Industries. Mayburn reviewed all of the audit files, including analytical
proceduresperformed during the audit. After calculating additional analytical
procedures during her review, she contacted Lenape and told him accounts payable did not seem reasonable to her. She
asked him to do some additional checking. Lenape went back and looked at all the documents that Little had indicated
in the audit files that he had inspected. It was quickly apparent that Little had either not looked at the documents or did
not know what he was doing when he inspected them. There were almost $5 million of purchases applicable to the
December 31, 2010, audit period that had not been included as liabilities. Mayburn’s review probably saved Santro, Best
& Harmon significant embarrassment or worse.
Starting with Chapter 6, the first three phases of the audit process were studied, as outlined by the flow chart in the
margin. Attention is now given to the fourth and final phase which is shaded in the figure: completing the audit.
As the chapter-opening case illustrates, the final phase of the audit demands careful and thoughtful review of the
audit by an experienced and knowledgeable person. In addition to reviewing the results, several other aspects of
completing the audit are critical to the success of an audit. In this chapter, the seven parts of completing the audit
outlined by the flow chart in the margin on page 759are covered.
PERFORM ADDITIONAL TESTS FOR PRESENTATION AND DISCLOSURE
OBJECTIVE 24-1 Chapter 6 described the need to perform procedures to satisfy the three categories of
audit objectives: transaction-related objectives, balance-related objectives, and
Design and perform audit
presentation and disclosure-related objectives. Our discussion of the first three phases
tests related to presentation
of the audit explained how auditors design and perform audit tests to obtain sufficient
and disclosure audit
objectives. appropriate evidence to support each of these categories of audit objectives. Our
illustrations of transaction cycle testing emphasized performing audit tests to support
the six transaction-related and the eight balance-related audit objectives. We’ve
discussed how those procedures also provide evidence about the four presentation and
disclosure objectives, which are summarized in the first column of Table 24-1. |
As part of phase IV of the audit, auditors evaluate evidence they obtained during
the first three phases of the audit to determine whether they should perform addi tional
procedures for presentation and disclosure-related objectives. Auditors approach
obtaining evidence for presentation and disclosure objectives consistent with how they
Summary of the
approach obtaining evidence for transaction-related and balance-related objectives.
Audit Process
• Perform procedures to obtain an understanding of controls related to presenta -
PHASE I
tion and disclosure objectives as a part of risk assessment procedures.
Plan anddesign
an audit approach • ACponadugct otes tsP ofD coFnt roEls nrelhatead ntoc diesclrosures when the initial assessment of
con trol risk is below maximum.
PHASE II • Perform substantive procedures to obtain assurance that all audit objectives are
Perform tests of achieved for information and amounts presented and disclosed in the financial
controls and
statements.
substantive tests
of transactions
The second column of Table 24-1 includes examples of substantive pro cedures
related to the presentation and disclosure objectives.
PHASE III
Often, procedures for presentation and disclosure-related objectives are integrated
Perform analytical
procedures and with the auditor’s tests for transaction-related and balance-related objectives. For
tests ofdetails example, as part of the audit of accounts receivable, auditors evaluate the need to
of balances
separate notes receivable and amounts due from affiliates and trade accounts due from
customers. They must also determine that current and noncurrent receivables are
PHASE IV
Complete the classified separately and any factoring or discounting of notes receivable is disclosed.
audit and issue While much of the information presented and disclosed in the financial statements is
an audit report
audited as part of the auditor’s testing in earlier phases of the audit, in phase IV auditors
evaluate evidence obtained during the first three phases of the audit to assess whether
additional evidence is needed for the presentation and disclosure objectives. In phase IV,
auditors also evaluate whether the overall presentation of the financial statements and
related footnotes complies with accounting standards. This includes an evaluation of
whether individual financial statements reflect the appropriate classification and descrip -
tion of accounts consistent with requirements and that the information is presented in
proper form and with the proper terminology required by accounting standards.
One of the auditor’s primary concerns related to presentation and disclosure-
related objectives is determining whether management has disclosed all required
information (completeness objective for presentation and disclosure). To assess risks
that the completeness objective for presentation and disclosure is not satisfied,
758 Part 5 / COMPLETING THE AUDIT
TABLE 24-1 Presentation and Disclosure Audit Objectives
Audit Objectives Examples of Substantive Procedures
Occurrence and rights and obligations— Review debt contracts to determine that accounts
Disclosed events and transactions have receivable are pledged as collateral.
occurred and pertain to the entity.
Completeness—All disclosures that should Use a disclosure checklist to determine if the
have been included in the financial financial statements include all disclosures Phase IV—
statements have been included. required by accounting standards. Completing the Audit
Classification and understandability— Review financial statements to determine if Perform additional
Financial information is appropriately assets are properly classified between current tests for presenta-
tion anddisclosure
presented and described and disclosures and non-current categories. Read the footnotes
are clearly expressed. for clarity.
Review for
Accuracy and valuation—Financial and other Reconcile amounts included in the long-term contingent liabilities
information are disclosed fairly and at debt footnotes to information examined and |
appropriate amounts. supported in the auditor’s long-term debt audit
Review for
working papers. subsequent events
Accumulate
final evidence
auditors consider information obtained during the first three phases of audit testing
to determine if they are aware of facts and circumstances that should be disclosed. Evaluate results
Due to the unique nature of disclosures related to contingent liabilities and
subsequent events, auditors often assess the risks as high that all required informa- Issue audit report
tion may not be completely disclosed in the footnotes. Audit tests performed in
earlier audit phases often do not provide sufficient appropriate evidence about Communicate with
audit committee
contingent liabilities and subsequenAt epveantgs. oTh erPefoDreF, a udEitonrsh deasignn caned rperform
andmanagement
procedures in every audit to review for contingent liabilities and subsequent events as
part of their phase IV testing. These procedures are discussed next.
REVIEW FOR CONTINGENT LIABILITIES AND COMMITMENTS
A contingent liability is a potential future obligation to an outside party for an OBJECTIVE 24-2
unknown amount resulting from activities that have already taken place. Material
Conduct a review for
contingent liabilities must be disclosed in the footnotes. Three conditions are required
contingent liabilities and
for a contingent liability to exist:
commitments.
1. There is a potential future payment to an outside party or the impairment of
an asset that resulted from an existing condition
2. There is uncertainty about the amount of the future payment or impairment
3. The outcome will be resolved by some future event or events
For example, a lawsuit that has been filed but not yet resolved meets all three
conditions.
The uncertainty of the future payment can vary from extremely likely to highly
unlikely. Accounting standards describe three levels of likelihood of occurrence and the
appro priate financial statement treatment for each likelihood. These requirements are
summarized in Table 24-2 (p. 760). To evaluate whether the client has applied the
appropriate treatment, the auditor must exercise considerable professional judg ment.
Contingency footnotes should describe the nature of the contingency to the extent
it is known and the opinion of legal counsel or management as to the expected outcome.
Figure 24-1 (p. 760) is an illustration of a footnote for pending litigation and company
guaran tees of debt.
Chapter 24 / COMPLETING THE AUDIT 759
TABLE 24-2 Likelihood of Occurrence and Financial Statement Treatment
Likelihood of Occurrence of Event Financial Statement Treatment
Remote (slight chance) No disclosure is necessary.
Reasonably possible (more than remote, Footnote disclosure is necessary.
but less than probable)
Probable (likely to occur) • If the amount can be reasonably estimated,
financial statement accounts are adjusted.
• If the amount cannot be reasonably estimated,
footnote disclosure is necessary.
Auditors are especially concerned about certain contingent liabilities:
• Pending litigation for patent infringement, product liability, or other actions
Phase IV—
• Income tax disputes
Completing the Audit
• Product warranties
Perform additional • Notes receivable discounted
tests for presenta-
• Guarantees of obligations of others
tion anddisclosure
• Unused balances of outstanding letters of credit
Review for Auditing standards make it clear that management, not the auditor, is responsible for
contingent liabilities
identifying and deciding the appropriate accounting treatment for contingent liabilities.
In many audits, it is impractical for auditors to uncover contingencies withoutmanage -
Review for
ment’s cooperation.
subsequent events
The auditor’s primary objectives in verifying contingent liabilities are:
Accumulate • Evaluate the accounting treatment of known contingent liabilities to determine
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final evidence whether management has properly classified the contingency (classification
presentation and disclosure objective).
Evaluate results
• Identify to the extent practical any contingencies not already identified by |
management (completeness presentation and disclosure objective).
Issue audit report
Closely related to contingent liabilities are commitments. They include such things
Communicate with as agreements to purchase raw materials or to lease facilities at a certain price and to sell
audit committee merchandise at a fixed price, as well as bonus plans, profit-sharing and pension plans,
andmanagement
and royalty agreements. The most important characteristic of a commitment is the
agreement to commit the firm to a set of fixed conditionsin the future, regardless of what
happens to profits or the economy as a whole. Presumably the entity agrees to commit -
ments to better its own interests, but they may turn out to be less or more advantageous
than originally anticipated. Companies ordinarily describe all commitments either in a
separate footnote or combine them with a footnote related to contingencies.
Audit Procedures for Many of these potential obligations are verified as an integral part of various segments
Finding Contingencies of the audit rather than as a separate activity near the end of the audit. For example,
FIGURE 24-1 Contingent Liability Footnote
760 Part 5 / COMPLETING THE AUDIT
auditors test for unused balances in outstanding letters of credit as a part of confirming
bank balances and loans from banks. Similarly, auditors consider the possibility of income
tax disputes as a part of analyzing income tax expense, reviewing the general corres -
pondence file, and examining revenue agent reports. Even if contingencies are verified
separately, auditors commonly perform the tests well before the last few days of
completing the audit to ensure their proper verification. Tests of contingent liabilities
near the end of the audit are more of a review than an initial search.
The first step in the audit of contingencies is to determine whether any contingencies
exist (occurrence presentation and disclosure objective). As you know from studying
other audit areas, it is more difficult to discover unrecorded transactions or events than
to verify recorded information. Once the auditor knows that contingencies exist,
evaluating their materiality and the footnote disclosures can ordinarily be satisfactorily
resolved.
The following are some audit procedures commonly used to search for contingent
liabilities, but not all are applicable to every audit:
• Inquire of management (orally and in writing) about the possibility of unrecorded
contingencies. In these inquiries, the auditor must be specific in describing the
different kinds of contingencies that may require disclosure as reminders to
management of contingencies they overlooked or do not fully understand. If
management overlooked a contingency or does not fully comprehend accounting
disclosure requirements, the inquiry can be helpful to identify required dis -
closures. At the completion of the audit, auditors typically ask management to
make a written statement as a part of the letter of representation (discussed later
in this chapter) that it is aware of no undisclosed contingent liabilities. Naturally,
inquiries of management are not useful in uncovering the intentional failure to
disclose contingencies.
• Review current and previous years’ internal revenue agent reports for income tax
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settlements. The reports may indicate areas or years in which there are unsettled
dis agreements. If a review has been in progress for a long time, there is an increased
likelihood of a tax dispute.
• Review the minutes of directors’ and stockholders’ meetings for indications of
lawsuits or other contingencies.
• Analyze legal expense for the period under audit and review invoices and state -
ments from legal counsel for indications of contingent liabilities, especially
lawsuits and pending tax assessments.
• Obtain a letter from each major attorney performing legal services for the client
as to the status of pending litigation or other contingent liabilities. This procedure
is examined in more depth shortly.
• Review audit documentation for any information that may indicate a potential |
contingency. For example, bank confirmations may indicate notes receivable
discounted or guarantees of loans.
• Examine letters of credit in force as of the balance sheet date and obtain a con -
firmation of the used and unused balances.
If auditors conclude that there are contingent liabilities, they must evaluate the signifi - Evaluation of Known
cance of the potential liability and the nature of the disclosure needed in the financial Contingent Liabilities
statements to obtain evidence about the occurrence and rights and obligations presen -
tation and disclosure objective. In some instances, the potential liability is sufficiently
well known to be included in the statements as an actual liability. In other instances,
disclosure may be unnecessary if the contingency is highly remote or immaterial.
CPA firms often obtain a separate evaluation of the potential liability from its own
legal counsel, especially highly material ones, rather than relying on manage ment or
management’s attorneys. Because they are advocates for the client, the client’s attorneys
may lose perspective in evaluating the likelihood of losing the case and the amount of
Chapter 24 / COMPLETING THE AUDIT 761
the potential judgment. For those contingencies that require disclosure, the auditor
also reviews the draft footnote to ensure that the disclosed information is understandable
and fairly states the conditions of the contingency.
Audit Procedures for The search for unknown commitments is usually performed as a part of the audit of
Finding Commitments each audit area. For example, in verifying sales transactions, the auditor should be alert
for sales commitments. Similarly, commitments for the purchase of raw materials or
equipment can be identified as a part of the audit of each of these accounts. The auditor
should also be aware of the possibility of commitments when reading minutes,
contracts and correspondence files.
Inquiry of Inquiry of the client’s attorneys is a major procedure auditors rely on for evaluating
Client’s Attorneys known litigation or other claims against the client and identifying additional ones. The
auditor relies on the attorney’s expertise and knowledge of the client’s legal affairs to
OBJECTIVE 24-3 provide a professional opinion about the expected outcome of existing lawsuits and the
likely amount of the liability, including court costs. The attorney is also likely to know
Obtain and evaluate letters
of pending litigation and claims that management may have overlooked.
from the client’s attorneys.
Many CPA firms analyze legal expense for the entire year and have the client send a
standard inquiry letter to every attorney the client has been involved with in the
current or preceding year, plus any attorney the firm occasionally engages. In some
cases, this involves a large number of attorneys, including some who deal in aspects of
law that are far removed from potential lawsuits.
The standard inquiry to the client’s attorney, prepared on the client’s letterhead
and signed by one of the company’s officials, should include the following:
• A list including (1) pending threatened litigation and (2) asserted or unasserted
claims or assessments with which the attorney has had significant involvement.
This list is typically prepared by management, but management may request
that the attorney prepare the list.
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• A request that the attorney furnish information or comment about the progress of
each item listed. The desired information includes the legal action the client
intends to take, the likelihood of an unfavorable outcome, and an estimate of
the amount or range of the potential loss.
• A request of the law firm to identify any unlisted pending or threatened legal
actions or a statement that the client’s list is complete.
• A statement informing the attorney of the attorney’s responsibility to inform
manage ment of legal matters requiring disclosure in the financial statements and to
respond directly to the auditor.If the attorney chooses to limit a response, reasons |
for doing so are to be included in the letter.
Figure 24-2 provides an example of a typical standard letter sent to the attorney
for return directly to the CPA’s office. Notice the first paragraph requests that the
attorney communicate about contingencies up to approximately the date of the
auditor’s report.
Attorneys in recent years have become reluctant to provide certain information to
auditors because of their own exposure to legal liability for providing incorrect or
confidential information. To learn more about attorneys’ concerns, read the boxed
feature “The Legal View” on page 764. The nature of the refusals by attorneys to provide
auditors with complete information about contingent liabilities falls into two categories:
1. The attorneys refuse to respond due to a lack of knowledge about matters
involving contingent liabilities.
2. The attorneys refuse to disclose information that they consider confidential.
For example, the attorney might be aware of a violation of a patent agreement that
could result in a significant loss to the client if it were known (unasserted claim). Such
an instance falls under the second category. The inclusion of the information in a
footnote could actually cause the lawsuit and therefore be damaging to the client.
762 Part 5 / COMPLETING THE AUDIT
FIGURE 24-2 Typical Inquiry of Attorney
HILLSBURG HARDWARE CO.
2146 Willow St.
Gary, Indiana 46405
March 1, 2012
Bailwick & Bettle, Attorneys
11216 Michigan Avenue
Chicago, IL 60606
Our auditors, Berger and Anthony, CPAs (P.O. Box 8175, Gary, Indiana 46405), are conducting an
audit of our financial statements for the fiscal year ended December 31, 2011. In connection
with their audit, we have prepared andfurnished to them a description and evaluation of certain
contingencies, including those attached, involving matters with respect to which you have been
engaged and to which you have devoted substantive attention on behalf of the company in the
form of legal consultation or representation. For the purpose ofyour response to this letter, we
believe that as to each contingency an amount in excess of$100,000 would be material, and in
total, $700,000. However, determination of materiality with respect to the overall financial
statements cannot be made until our auditors complete their audit. Your response should
includematters that existed at December 31, 2011, andduring the periodfrom that date to the
date of the completion of their audit, which is anticipated to be on or about March 15, 2012.
Please provide to our auditors the following information:
(1) Such explanation, if any, that you consider necessary to supplement the listed
judgments rendered or settlements made involving the companyfrom the beginning
of this fiscal year through the date ofyour reply.
(2) Such explanation, if any, that you consider necessary to supplement the listing of
pending or threatened litigation, inAclupdinag agn eoxp lanPatiDon Fof thoEse nmahttears ans tco er
which your views maydiffer from those stated and an identification of the omission of
anypending or threatened litigation, claim, and assessment or a statement that the
list of such matters is complete.
(3) Such explanation, if any, that you consider necessary to supplement the attached
information concerning unasserted claims and assessments, including an explanation
of those matters as to which your views maydiffer from those stated.
We understand that whenever, in the course of performing legal services for us with
respect to a matter recognized to involve an unassertedpossible claim or assessment that may
call for financial statement disclosure, you have formed a professional conclusion that we should
disclose or consider disclosure concerning such possible claim or assessment, as a matter of
professional responsibility to us, you will so advise us and will consult with us concerning the
question of such disclosure and the applicable requirements of accounting standards. Please
specifically confirm to our auditors that our understanding is correct.
Please specifically identify the nature of and reasons for any limitations in your response. |
Yours very truly,
Hillsburg Hardware Co.
Rick Chulick, Pres.
If an attorney refuses to provide the auditor with information about material
existing lawsuits (asserted claims) or unasserted claims, auditors must modify their
audit report to reflect the lack of available evidence(a scope limitation, which requires a
qualified or disclaimer of opinion). This requirement in the auditing standards has the
Chapter 24 / COMPLETING THE AUDIT 763
THE LEGAL VIEW The lawyer is the expert on litigation, yet outcome—either likelihood or amount of loss. The
differences in lawyers’ and CPAs’ responsibilities net effect is CPAs generally can obtain relatively
with respect to common clients have resulted in complete responses on the existence of litigation
contentious difficulties. Although CPAs are and the dates when the underlying cause occurred …
responsible for determining there is “adequate but less complete responses on the likelihood of
disclosure” under accounting standards … lawyers an unfavorable outcome and the amount of
are responsible for “winning the case.” Because potential loss.
information provided by lawyers may affect a case In addition to an implicit hesitancy to provide
adversely, these responsibilities may conflict. evidential matter on likelihood and amount of
Many lawyers believe that, despite a client’s loss, the ABA statement gives lawyers definitions
request that they provide the auditor with infor - ofprobableandremotethat are different from
mation, they should be less than candid in letters those in accounting standards:
to CPAs because of concern their replies may ◆Remote.The ABA says an unfavorable outcome
◆Impair the client–lawyer confidentiality is remote if the prospects for the client not
privilege succeeding in its defense are judged to be
◆Disclose a client confidence or secret extremely doubtful and the prospects of success
◆Prejudice the client’s defense of a claim by the claimant are judged to be slight.
◆Constitute an admission by the client ◆Probable.The ABA says an unfavorable
The authoritative guidance for lawyers … outcome for the client is probable if the
warns lawyers they must be careful in communi - claimant’s prospects of not succeeding are
cations with auditors. Indeed, the first sentence judged to be extremely doubtful and the
of the ABA statement says, “The public interest client’s prospects for success in its defense
in protecting theconfidentiality of lawyer–client are judged to be slight.
communications is fundamental.” Source: Excerpted from an article by Bruce K. Behn
The ABA statement also says lawyers normally and Kurt Pany, “Limitations of Lawyers’ Letters,”
should refrain from expressing judgments on Journal of Accountancy(February 1995), pp. 62–63.
effect of requiring management to give its attorneys permission to provide contingent
liabilityinformation to auditors and to encourage attorneys to cooperate with auditors
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in obtaining information about contingencies.
As directed by the Sarbanes–Oxley Act, rules require attorneys serving public companies
to report material violations of federal securities laws committed by the company. An attor -
ney must report violations to the public company’s chief legal counsel or chief executive
officer. If the legal officer or CEO fails to appropriately respond, the attorney must report
violations to the company’s audit committee. Responding to these requirements, the
American Bar Association subsequently amended its attorney–client confidentiality rules
to permit attorneys to breach confidentiality if a client is committing a crime or fraud.
REVIEW FOR SUBSEQUENT EVENTS
OBJECTIVE 24-4 The third part of completing the audit included in the sidebar is the review for subse -
quent events. The auditor must review transactions and events that occurred after the
Conduct a post-balance-
balance sheet date to determine whether any of these transactions or events affect the fair
sheet review for subsequent
presentation or disclosure of the current period statements. The auditing procedures
events. |
required by auditing standards to verify these transactions and events are commonly
called the review for subsequent eventsorpost-balance-sheet review.
The auditor’s responsibility for reviewing subsequent events is normally limited to
the period beginning with the balance sheet date and ending with the date of the
auditor’s report.Because the date of the auditor’s report corresponds to the completion
of the important auditing procedures in the client’s office, the subsequent events
review should be completed near the end of the audit.1 Figure 24-3 shows the period
covered by a subsequent events review and the timing of that review.
1When the auditor’s name is associated with a registration statement under the Securities Act of 1933, the
auditor’s responsibility for reviewing subsequent events extends beyond the date of the auditor’s report to the
date the registration becomes effective.
764 Part 5 / COMPLETING THE AUDIT
FIGURE 24-3 Period Covered by Subsequent Events Review
Clients ending Audit Date client
balance sheet report issues financial
date date statements
12-31-11 3-11-12 3-26-12
Period to which review Periodfor processing
for subsequent events applies the financial statements
The auditor is responsible for reviewing for subsequent events occurring between 12-31-11
and 3-11-12, but not later than the audit report date. Most subsequent events audit
procedures are performed near the audit report date.
Two types of subsequent eventsrequire consideration by management and evaluation Types of
by the auditor: those that have a direct effect on the financial statements and require Subsequent Events
adjustment of the current year’s financial statement amounts and those that have no
direct effect on the financial statement amounts but for which disclosure is required.
Those That Have a Direct Effect on the Financial Statements and Require
Adjustment Some events that occur after the balance sheet date provide additional
information to management that helps them determine the fair presentation of account
balances as of the balance sheet date. Information about those events helps auditors in
verifying the balances. For example, if the auditor is having difficulty determining the Phase IV—
Completing the Audit
correct valuation of inventory becauAsep ofa obgsoole scePncDe, Fth e sEalen ofh raawn mcateeriarl inven-
tory as scrap in the subsequent period will indicate the correct value of the inventory as Perform additional
of the balance sheet date. tests for presenta-
tion anddisclosure
Subsequent period events, such as the following, require an adjustment of account
balances in the current year’s financial statements if the amounts are material:
Review for
• Declaration of bankruptcy by a customer with an outstanding accounts receivable contingent liabilities
balance because of the customer’s deteriorating financial condition
• Settlement of litigation at an amount different from the amount recorded on Review for
subsequent events
the books
• Disposal of equipment not being used in operations at a price below the current
Accumulate
book value
final evidence
• Sale of investments at a price below recorded cost
When subsequent events are used to evaluate the amounts included in the year- Evaluate results
end financial statements, auditors must distinguish between conditions that existed at
the balance sheet date and those that came into being after the end of the year. The Issue audit report
subsequent information should not be incorporated directly into the statements if the
Communicate with
conditions causing the change in valuation took place after year-end. For example, assume
audit committee
one type of a client’s inventory suddenly becomes obsolete because of a technology andmanagement
change after the balance sheet date. The sale of the inventory at a loss in the subsequent
period is not relevant in the valuation of inventory for obsolescence in this case.
Auditors of accelerated filer public companies must inquire about and consider any
information about subsequent events that materially affects the effectiveness of internal |