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Steps to Develop Audit Objectives
Understands objectives and responsibilities for the audit
Divide financial statements into cycles
Know management assertions about financial statements
Know general audit objectives for classes of transactions, accounts, and disclousers
Know specific audit objectives for classes of transactions, accounts and disclousers
Transaction Flow from Journal to Financial Statements
Allocation and adjusments
Sales
Cash Receipts
Cash Disbursements
Payroll Services and disbursements
Acquisition of goods and services
TRANSACTIONS
Sales journal
Cash receipts journal
Acquisitions journal
Cash disbursements journal
Payroll Journal
General Journal
General ledger and subsidiary records
General ledger trial balance
Financial statements
JOURNALS LEDGERS , TRIAL BALANCE, AND FINANCIAL STATEMENTS
Balance Sheet Income StatementSales Journal Cash In bank Advertising s
Cash disbursement journal Inventories Travel and entertainment s
General Journal Prepaid expenses Sales meetings and training s
Land Miscellaneous sales expense s
Building Sales and promotial literature s
Computer and other equipment Travel and entertainment A
Furniture and fixtures Stationery and supplies A
Accumulated despreciation Postage A
Trade accounts payable Telephone and fax A
Other accrued payables Computer maintence and supplies A
Accrued income tax Depreciation A
Deferred tax Rent A
Legal fees and retainers A
Auditing and related services A
Insurerance A
Offi ce repairs and maintenace expense A
Expense A
Miscellaneous offi ce expense A
Miscellaneous general expense A
Gain on sale of assetsIncome taxes
Payroll Payroll journal Cash in bank Salaries and commisions S
and personnel General journal Accrued payroll Sales payroll taxes S
Accrued payroll taxes Executive and offi ce salaries A
Adminastrative payroll taxes A
Inventory Acquisitions journal Inventories cost of goods soldand warehousing Sales journalCapital Acquisition Acquisition journal Cash in bank Interest expenseand repayment Cash disbursements journal Nites payable
General journal Long-term notes payableAccrued interestCapital stockcapital in excess of par valueRetained earningsDevidensDevidens payable
General Ledger Accounts Included in the Cycle (See Figure 6-4)Journals Included in the Cycle (See Figure 6-3, p.
170)CycleSales and Colection
Cycles Applied to Hillsburg Hardware Co.
Relationships Among Transaction Cycles
General cash
Sales and collection cycle
Acquisition and payment cycle
Payroll and personel cycle
Capital acquisition and repayment cycle
Inventory and warehousing cycle
Four Phase of a Financial Statement Audit
Phase l Plan and design an audit approach
Phase ll
Phase lll
Phase lV
Perform tests of controls and substantive tests of transactions
Perform analytical procedures and tests of details of balance
Complete the audit and issue an audit report
Relationships Among Auditing Standards, Types of Evidence, and the Four Audit Evidence Decisions
Broad guidelines concerning auditor qualifications and
conduct, evidence, accumulation, and reporting
Auditing standards
Qualifications and conduct
Evidence accumulation
Sample size and items to select
Reporting
Types of evidence
Audit procedures
Broad categories of evidence available for the
auditor’s accumulation
Specific instructions for the accumulation of types
of evidence
Timing of tests
FOUR AUDIT EVIDENCE DECISIONS
Physical examination confirmation
documentation analytical procedures
inquiries of client recalculation
reperformance observation
Information Source
AssetsCash In bank BankMarketable securities Investment custodianAccounts receivable CustomerNotes receivable MakerOwned inventory out on consignment ConsigneeInventory held in public warehouses Public warehouseCash surrender value of life insurance Insurance company
LiabilitiesAccounts payable CreditorNotes payable LenderAdvances from customers CustomerMortgages payable MortagagorBonds payable Bondholder
Owners EquityShares outstanding Registar and transfer agent
Other InformationInsurance coverage Insurance companyContingent liabilities Bank, lender, and client's legal counselbond indenture agreements BondholderCollateral held by creditors Creditor
Information Often Confirmed
Term and Definition Illustrative Audit Procedure Type of Evidence
Documentation
Analytical procedures
Documentation
Analytical procedures
Recalculation
Recalculation
Documentation
Reperformance
Documentation.
Physical examination
Observation
Inquiries of client
Documentation
Compute inventory turnover ratios and compare with those of previous years as a test of inventory obsolescence.
Recompute -A calculation done to determine whetever a client's calculation is correct.
Recompute the unit sales price times the number of units for a sample of duplicate sales invoices and compare the totals with the calculations.
Read the minutes of a board of directors meeting and summarize all information that is pertinent to the financial statements in an audit file.
Read -An examination of written information to determaine facts pertinent to the audit.
Trace postings from the sales journal to the general ledger accounts.
Observe- The act of observation should be associated with the type of evidence defined as observation.
Inquire-The act of inquiry should be associated with the type of evidence defined as inquiry.
Inquire of management whetever there is any obsolete inventory on hand at the balance sheet date.
Foot the sales journal for a 1-month period and compare all totals with the general ledger.
Examine-A reasonably detailed study of a document or record to determine specific facts about it.
Examine a sample of vendor's inboices to determine whetever the goods or services received are reasonable and of the type normally used by the client's business.
Scan-A less-detailed examination of a document or record to determine whetever there is something unusual warranting further investigation.
Scan the sales journal, looking for large and unusual transactions.
Foot -Addition of a column of numbers to determine whetever the total is the same as the client's.
Compute -A calculation done by the auditor independent of the client.
Terms, Audit Procedures, and Types of Evidence
Vouch -The use of documents to verify recorded transactions or amounts.
Trace- An instruction normally associated with documentation or reperformance. The instruction should state what the auditor is tracing and where it is being traced from and to. Often, an audit procedure that includes the term trace will also include a second instruction, such as compare or recalculate.
Trace a sample of sales transactions from sales invoices to the sales journal, and compare customer name, date and the dollar value of the sale.
Vouch a sample of recorded acquisition transactions to vendor's invoices and receiving reports.
Observe whetever the two inventory caount teams independently count and record invntory counts.
Select a sample of sales invoices and compare the unit selling price as stated on the invoice to the list of unit selling prices authorized by management.
Compare -A comparison of information in two different locations. The instruction should state which information is being compared in as much detail as pratical.
Count a sample 100 inventory items and compare quantity and description to client's counts.
Count-A determination of assets on hand at a given time. This term should be associated with the type of evidence defined as physical examination.
Audit File Contents and Organization
Robinson associate trial balance 12/31/11
Cash Account Receivable Prepaid Insurance Interest Receivable
$ 165,237 275,050 37,795 20,493
Financial statements and audit report
Working trial balance
Adjusting journal entries
Contingent liabilities
Operations
Liabilities and equity
Assets
Analytical procedures
Tests of controls & substantive TOT
Internal control
General Information
Audit programs
Permanent files
Planning an Audit and Designing an Audit Approach
Accept client and perform initial audit plainnng
Understand the client’s business and industry
Asses client business risk
Set materiality and assess acceptable audit risk and
inherent risk
Perform preliminary analytical procedures
Understand internal control and assess control
risk
Gather information to assess fraud risks
Develop overall audit plan and audit program
Strategic Systems Understanding of the Client’s Business and Industry
Understand Client’s Business and lnustry
Industry and External Environment
Bussines Operations and Processes
Management and Governance
Objectives and Strategies
Measurement and Performance
Understanding the Client’s Business and Industry, Client Business Risk, and Risk of Material Misstatement
Industry and External Environment
Bussines Operations and Processes
Management and Governance
Objectives and Strategies
Measurement and Performance
Understand Cleint’s Business and Industry
Asess Client Business Risk
Assess Risk of Material Misstatements
Hillsburg is a continuing audit client. No circumstances were identified in the conticuation review to cause discontinuance
New client acceptance and continuance
There are two primary reasons. Company is publicly traded and audit is required by bank due to large notes payable outstanding
Obtained an engagement letter before starting field work.
Partner - Joe Anthony Manager - Leslie Franklin Senior - Fran Moore Assistant – Mich Bray and one person ro be named later
Iddentify client’s reasons for audit
Obtain an understanding with the client
Staff the engagement
Accept client and perform initial panning
Understand the client’s business and industry
Understand client’s industry and external environment
Understand client’s operations, strategies, and performance system
Assess client business risk
Assess client business risk
Evaluate management controls affecting business risk
Assess risk of material misstatements
See Figure 8-3 (p. 217). Moore discussed with CEO and CFO, read minutes, and reviewed other key reports and performance indicators
Anthony and Franklin subscride to industry publications. Moore reviewed industry data and reports in several database and online sources
Moore used her understanding of the client and industry to evaluate business risk.
Moore reviewed management and governance controls and their effct on business risk.
Moore used her assessment of client business risk and management controls to identify audit areas with increased risk of misstatement.
Perform preliminary analytical procedures
Moore compared 12-31-11 anaudited balances to the prior year. She calculated key ratios and compared them with prior years and industry averages. All significant differences were identified for follow-up.
Phase(Required) Planning
Phase Testing Phase(Required)
Completion PhasePurpose
Timing and Purposes of Analytical Procedures
Understand the client's business and industry
Indicate possible misstatements (attetion directing)
Primary purpose
Primary purpose Secondary purpose Primary purpose
Assess going concern Secondary purpose Secondary puprpose
Reduce detailed tests Secondary purpose Primary purpose
Each of the individual manufacturing expenses as a percent of total
Bad debt expense devided by net sales
Misstatement in the allowance for bad debts
Misstatement of sales commissions
Raw material turnover a manufacturing company
Mistatement of inventory or cost of goods sold or obolance of raw meterial inventory
Significant misstatement of individual expenses within a total
Sales commissions devided by net sales
Misclassified sales return and allowances or unrecorded returns or allowances subsequent to yeear-end
Sales rerturns and allowances devided by gross sales
Ratio or Comparison Possible Misstatement
Internal Comparisons and Relationships
Hilssburg Hardware Co.Overall Test of Interest Expense Schedule N-3 date
Prepared by TM 3/06/12Approved by JW 3/12/12
Expectation of recorded interest eexpense :Shrt-terms loans :
Month Month & Balance 1 Rate 2
Jan. 5,900,000.00$ 5.50%Feb 6,368,000 5.50%Mar. 6,824,000 5.75%Apr. 7,536,000 5.75%May 5,208,000 5.25%June 3,748,000 5.50%July 2,800,000 5.25%Aug. 2,490,000 5.50%Sept. 2,092,000 5.25%Oct. 1,708,000 5.50%Nov. 5,062,000 5.75%Dec. 4,180,000 5.50%
Total 53,916,000 66.00%
Average Monthly Balance $ 4.493.000 5.50% 247.115$ And Interest Rate(Total 12 )
Long-Term Loans : Beginning Balance $ 26.520.000Ending Balance 24.120.000
$ 50.640.000 8.50%
Average $ 25.320.000 8.50% 2.152.200
Auditor expectation of interest expense 2.399.315
Recorded interest expense per general ledger 2.408.642
Difference-over (under) expectation 9.327
Conclusion : Interest expense appears fairly stated as recordedAmount is within 9.327 (4.%) of expected amount.
Tickmark Legend :
1. Monthly balances obtained from general ledger for each month2. Estimated based on examination of several notes outsanding each month3. Agreed to prior year audit workpapers4. Agrees with December 31, 2011 general ledger and working trial balance5. Agrees with permanent file schedule of long-term debt.
12/13/2011
Hilssburg Hardware Overall Test of Interest Expense December 31, 2011
Cash + marketable securitiesCurrent liabilities
Current liabilities 13,126
Current assetscurrent liabilities
Quick ratio =
8,2813,216
828 + 18,957 + 945 =
51,02713,216
= 3.86
Short Term Debt Paying Ability
Cash Ratio =
Cash + marketable + securities + net accounts receivable
Current ratio =
157
Account receivable Net salesturnover average gross receivable
Days to collect 365 daysreceivable account receivable turnover
Inventory Cost of goods soldTurnover Average inventoy
Current assetsCurrent liabilities
7.59((18,957 + 1,240) + (16,210 + 1,311)) /2
103,241
=
Liquidity Activity Ratios
=
=
=
143,086
48.09 days
3
=
Days to sell inventory
=
7.59365 days
108.63 days
=
=
365 days3.36
(29,865 + 31,600) /2
Total liabilitiesTotal equity
operating incomeinterest expense
13,216 + 25,68822,463
=
=
1.73
3.06
Ability to Meet Long-term Debt Obligations
=Debt to equity
Times interset earned
= 7,3702,409
3,9345,000
Net sales - cost of goods sold
7,370143,086
5,681(91,367 + 60,791)/2
(22,463 + 20,429)/2
= 27.85%
= 0.05
=
= 0.26
0.09
5,681 - 0Common equity
= Income before taxes-preferred dividendsAverage stockholders equity
Return on assets
= Income before taxesAverage total assets
=
143,086143,086 - 103,241
0,79
Profit Margin
=Net sales
Operating Income
Earning per share
=
Gross profit percent
=Net sales
Net incomeAverage common shares outstanding
Steps in Applying Materiality
Step 1
Set preminary judgement about materiality
Step 2
Allocate preliminary judgment about materiality to segemnts
Planning extent of tests
Estimate total misstatement in segment
Step 3
Estimate the combined misstatement
Step 4
Compare combined estimate with preliminary or revised judgment about materiality
Step 5
Evaluating results
Audit Risk Model and Understanding the Client’s Business and Industry
Industry and External Environment
Business Operations and Processes
Management and Governance
Objectives and Strategies
Measurenment and Performance
Understand Client’s Business and Industry
Understand Client’s Business and Industry
Understand Client’s Business and Industry
Inherent Risk (IR)
Control Risk (CR)
AUDIT RISK MODEL
PDR = AAR IR x CR
(medium) (high) (Low) (high) (low)
(medium) (Low) (Low) (high) (medium)
(Low) (Low) (Low) (Low) (Low)
(medium) (medium) (high) (Low) (medium)
Capital Acquisition and Repaymeny
Cycle
AExpect some
misstatemensExpect many
misstatementsExpect few
misstatementsExpect many
misstatements
High effectiveness
Medium effectiveness
low effectiveness
Illustration of Differing Evidence Among Cycles
Sales and Collection Cycle
Acquisition and Payment Cycle
Payroll and Personel Cycle
Inventory and Warehousing
Cycle
Expect few misstatements
Auditor's assessment of expectation of material mistatement before considering internal control (inherent risk)
B
Auditor's willingness to permit material misstatements to exist after completing the audit (acceptable audit risk)
C
Extent of evidence the auditor plan accumulate (planned detection risk)
Medium level Medium levelD
Auditor's assessment of effectiveness of internal controls to prevent or detect material misstatements (control risk)
Medium effectiveness
High effectiveness
Low level High level Medium level
Low willingness Low willingness Low willingness Low willingness Low willingness
Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence
Reliance by external users Likelihood of financial failure Intergrity of management
Nature of business Results of previous audit Initial versus repeat
engagement Related parteis Nonroutine transactions Judgement required Makeup of population Factors related to
misstatements arising from fraudelent financial reporting *
Susceptibility of assets to misappropriation*
Acceptable audit risk
Planned audit
evidence
Planned detection
risk
Inherent
risk
Effectiveness of internal controls
Planned reliance
Control risk
D = Direct relationship ; l = inverse relationship
*Fraud risk factors. These may also affect acceptable audit risk and controls risk
l
l l
l D
D D
1 High Low Low High Low2 Low Low Low Medium Medium3 Low High High Low High4 Medium Medium Medium Medium Medium5 High Low Medium Medium Medium
Planned Detection
Risk
Amount of Evidence Required
Relationships of Risk to Evidence
SituationAcceptable Audit Risk
Inherent Risk
Control Risk
Deta
il tie
-in
Exis
tenc
e
Com
plet
ense
ss
Accu
ranc
y
Clas
sific
ation
Cuto
ff
Real
izab
le v
alue
Righ
ts
LowLow Low Medium
Evidence-Planning Worksheet to decide Tests of Details of Blances for Hillsburg Hardware CO. - Accounts Receivable
Subtantive tests of transaction-salesSubtantive tests of transactions-cash receiptsAnalytical proceduresPlanned detection risk for tests of details of balances
Acceptable audit risk
Medium Medium Medium Medium
Planned audit evidence for tests of details of balances
Medium Medium Medium Medium
Control risk- sales
Medium
Control risk- Additional controls
Control risk- cash receipts
inherent risk Low Medium Low
Relationship of Tolerable Misstatement and Riks to Planned Evidence
Acceptable audit risk
Inherent Risk
Control Risk
Tolerable misstatement
Planned detection risk
Planned audit evidence
D = Direct Relationship ; l = Inerverse relationship
D
D I
D
I
I
I
I
TOLERABLE MISSTATEMENT AND RISKS
PLANNED AUDIT EVIDENCE
Five Components of Internal Control
Risk Assesment
Control Activities
Information and Communication
Monitoring
Control Environment
Component Description of Component Further Subdivision (if applicable)Control Enivronment Subcomponents of the control environment :
Intergrity and ethical values Commutment to competence Board of director and audit committee participation Management's philosophy and operating style Organizational sturture Human Resource policies and practices
Riks Assessment Risk assessment processes : Identify factors affecting risks Assess significance of risks and likelihood of occurrence Determine actions necesarry to manage risks
Categories of management assertions that must be satisfied : Assertions about classes of transactions and other events Assertions about account balances Assertions about presentation and disclosure
Control Activities Types of specific control activities : Adequate separation of duties Proper authorization of transaction and other occurence Adequate documents and records Physical control over assets and records Independent checks on performance
Transaction-related audit objectives that must be satisfied : Occurrence Completeness Accuracy Posting and summarization Classification Timing
Monitoring Not Applicable
Information and communication
Methods used to initiate, record, process, and report an entity's transactions and to maintain accountability for related assets
Management's on going and periodic assessment of the quality of internal control performance to determine whether contorls are operating as intended and are modified when needed
COSO Components of Internal Control
INTERNAL CONTROL
Actions, policies and procedures that reflect the overall attitude of top management, directors, and owners of an entity about internal control and its importance
Management's identification and analysis of risks relevant to the preparation of financial statements in accordance with appropriate accounting frameworks such as GAAP or IFRS
Policies and procedures that management has established to meet its objectives for financial reporting
Obtain and document understanding of internal
control desihn and operation
Assess control risk
Design, perform and evaluate tests of controls
Decide planned detection risk and substantive tests
Phase 1
Phase 4
Phase 3
Phase 2
Process for Understanding Internal Control and Assessing Control Risk
INTERNAL CONTROL Re
cord
ed
sa
les
are
fo
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ipm
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ts a
ctu
all
y m
ad
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to n
oti
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occ
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en
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Ex
isti
ng
sa
les
tra
nsa
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n a
re r
eco
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d
(co
mp
lete
ne
ss)
Re
cord
ed
sa
les
are
fo
r th
e a
mo
un
t o
f g
oo
ds
ship
pe
d a
nd
are
co
rre
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bil
led
an
d r
eco
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d
(acc
ura
cy)
Sa
les
tra
nsa
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ns
are
co
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ctly
in
clu
de
d i
n t
he
acc
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re
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ab
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ast
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file
an
d a
re c
orr
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ly
sum
ma
rize
d (
po
stin
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nd
su
mm
ari
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on
)
Sa
les
tra
nsa
ctio
n a
re c
orr
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ly c
lass
ifie
d
(cla
ssifi
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)
Sa
les
are
re
cord
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e c
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tes
(tim
ing
)
SALES TRANSACTION-RELATED AUDIT OBJECTIVES
Control Risk Matrix for Hillsburg Hardware Co.-Sales
Credit is approved automatically by computer by comparison to authorized credit limits (C1).
C
CO
NT
RO
LS
Separation of duties exists among billing, recording of sales, and handling of cash receipts (C3).
Shipping documents are prenumbered and accounted for weekly (C5).
Shipping documents are forwarded to billing daily and are billed the subsequent day (C4).
Batch totals of quantities shipped are compared with quantities biled (C6).Unit selling prices are obtained from the price list master file of approved prices (C7).
Sales Transaction are internally verified (C8).
C C C
Recorded sales are supported by authorized shipping documents and approved customer orders (C2).
C C
C C
Statements are mailed to customers each month (C9).Computer automatically posts transactions to the accounts receivable subsidiary records and to the general ledger (C10).Account receivable master file is reconciled to the general ledger on monthly basis (C11).
C
C
CC
C
C
C
C
C C C
C
DE
FIC
IEN
CE
S
Med. Low Low Low Low * Med.
DThere is lack of internal verification for the possibility of sales invoices being recorded more than once (D1).
There is a lack of control to test for timely recording (D2).
Assessed control risk
Evaluating Significant Control Deficiencies
SIGNIFICANCE
Material
Reasonably Possible
Material Weakness
Remote
LIKELIHOOD
Immaterial
Source : Adapted from Michael Ramos,”Section 404 Compliance in the Annual Report,”Journal of accountancy, October 2004, pp. 43-48
Differences in Scope of Controls Tested in an Audit of Internal Control and an Audit of Financial Statements
Internal Controls Over Financial Reporting
Internal Controls Used to Assess Control Risk Below Maximum
Controls that must be tested in an audit of financial statements
Controls that must be tested in an audit of internal controls
Summary of Understanding Internal Control and Assessing Control Risk
Intergrated Audit of Financial Statements and Internal Control over Financial Reporting
Sufficient to audit internal control over financial reporting
Financial Statement Audit
Sufficient to audit financial statements
Obtain an understanding of internal control design
and operation
Decide control risk at the objective level for each
transaction type
Varies depending on extent and effectiveness of controls and the auditor’s planned reliance on controls
Decide low for all objectives unless there are significant deficiencies or material weaknesses
Intermediate
Three alternatives
Maximum Low PHASE 2
PHASE 1
Plan and perform tests of controls and evaluate
results
Revise assessed control risk if appropriate
Varies depending on assessed level of controls risk
Revise for tests of controls results
Extensive tests for all objectives
Revise for tests of controls results
Likely to be more reliance on substantive tests, depending on assessed control risk option selected
Must communicate in writing to those charged with governance describsing significant deficiencies or material weaknesses
Plan detection risk and perform substantive tests considering control risks
and other audit risk model factors
Issue internal control report or letter
Likely to be less reliance on substantive tests due to extentive tests of controls
Must issue report on internal control over financial reporting and issue a written communication to audit commutte describing significant deficiencies or material weakness
PHASE 3
PHASE 4