Chapter 10 Overall Audit Plan and Audit Program

Transcription

1 Chapter 10 Overall Audit Plan and Audit Program Review Questions 10-1 The four types of tests used by auditors to determine whether financial statements are fairly stated are; 1. procedures to obtain an understanding of internal control 2. tests of controls 3. analytical procedures 4. tests of details of balances The first two types are performed to assess control risk, and the last two types are performed to achieve planned detection risk. All audit procedures fall into one or more of these four categories Tests of controls are audit procedures designed to verify whether the client's controls are being applied in the manner described in the flowchart and internal control questionnaire. Examples include: 1. The examination of vendor invoices for indication that they have been clerically tested, compared to a receiver and purchase order, and approved for payment. 2. Examination of employee time cards for approval of overtime hours worked. 3. Examination of journal entries for proper approval. 4. Examination of approvals for the write-off of bad debts. Substantive tests are procedures designed to test for dollar errors directly affecting the fair presentation of financial statement balances. Examples are: 1. Reconciliation of balances indicated in vendor statements. 2. Examination of vendor invoices in support of amounts recorded for purchases of inventories. 3. Recalculation of payroll amounts. 4. Recalculation of amounts accrued for various liabilities A reperformance procedure is an audit procedure in which the auditor performs the same procedure that client personnel did, to make sure that the monetary amounts are correct. An example is to multiply unit selling prices times quantity on duplicate sales invoices to make sure the client calculated the amounts correctly. 10-1

2 10-4 A test of controls audit procedure to test that approved wage rates are used to calculate employee earnings would be to examine rate authorization forms to determine the existence of authorized signatures. A substantive test audit procedure would be to compare a sample of rates actually paid, as indicated in the earnings record, to authorized pay rates on rate authorization forms The auditor resolves the problem by making assumptions about the results of the tests of controls and performing both the tests of controls and substantive procedures (dual-purpose tests) on the basis of these assumptions. Ordinarily the auditor assumes effective internal control with few or no deviations planned. If the results of the tests of controls are as good as or better than the assumptions that were originally made, the auditor can be satisfied with the substantive procedures, unless the substantive procedures themselves indicate the existence of misstatements. If the tests of controls results were not as good as the auditor assumed in designing the original tests, expanded substantive procedures must be performed When the results of analytical procedures are different from the auditor's expectations and thereby indicate that there may be a misstatement in the balance in accounts receivable and sales, the auditor should extend his or her tests until he or she determines why the ratios are different from his or her expectations. Confirmation of accounts receivable and cut-off tests for sales are two procedures that can be used to do this. On the other hand, if the ratios are approximately what the auditor expects, the other tests can be reduced. This says that the auditor can satisfy the evidence requirements in different ways and that analytical procedures and confirmation are complementary when the results of the tests are both good The auditor must gain an understanding of internal control sufficient to plan the audit under either approach. In a combined audit approach, the auditor plans to assess control risk below maximum and perform tests of controls to confirm that assessment; reduced substantive testing will be required because of this reliance on internal control. In a substantive audit approach, the auditor assesses control risk at maximum and gains all his or her assurance from substantive procedures. A combined approach would be appropriate for the acquisitions and payment cycle if there were internal controls in place and working that provided assurance that all purchases made by the company were recorded in accounts payable; in this case the auditor would likely assess control risk below maximum with respect to the completeness assertion. If, on the other hand, controls over the recording of purchases were weak or non-existent, controls risk would be assessed at maximum and the auditor would verify the completeness assertion by substantive procedures. 10-2

3 10-8 The audit of permanent asset additions normally entails the examination of invoices in support of the additions and possibly the physical examination of the additions. These procedures are normally performed on a test basis with a concentration on the more significant additions. If the individual responsible for recording new acquisitions were known to have inadequate training and limited experience in accounting, the sample size of the audit procedures should be expanded to include a larger sample of the additions for the year. In addition, inquiry as to what additions were made during the year may be made by the auditor of plant managers, the controller, or other operating personnel. The auditor should then search the financial records to determine that these additions were recorded as permanent assets. Care should also be taken when the repairs and maintenance expense account is analyzed since lack of training may cause some depreciable assets to be expensed at the time of purchase The following shows which types of evidence are applicable for the four types of tests. Type of Evidence Physical examination Confirmation Documentation Observation Inquiries of the client Reperformance Analytical procedures Types of Tests Tests of details of balances Tests of details of balances All except analytical procedures Procedures to obtain an understanding of controls and tests of controls All four types Tests of controls, tests of details of balances, and substantive tests of transactions Analytical procedures Before a reduction in substantive procedures is permitted, internal controls must be effective and the auditor must have found the results of the tests of controls satisfactory. Cost effectiveness of reduced assessed level of control risk should be considered in making the decisions as to whether to test controls. The cost effectiveness of reduced control risk is an audit efficiency issue The three-step approach to designing tests of transactions is as follows: 1. Apply the detailed internal control objectives to the class of transactions being tested. 2. Identify specific controls that should reduce control risk for each objective. 3. Develop tests of controls for each key control. 10-3

4 10-12 The approach to designing tests of transactions (Figure 10-5) emphasizes satisfying the internal control objectives developed in chapter 9. Recall that these objectives focus on the proper functioning of the accounting system. The methodology of designing tests of details of balances (Figure 10-7) emphasizes satisfying the audit objectives developed in chapter 5. The primary focus of these objectives is on the fair presentation of account balances in the financial statements It is desirable to design tests of details of balances before performing tests of controls to enable the auditor to determine if the overall planned evidence is the most efficient and effective in the circumstances. In order to do that the auditor must make assumptions about the results of the tests of controls. Ordinarily the auditor will assume no significant errors or control problems in tests of controls unless there is reason to believe otherwise. If the auditor determines that the tests of controls results are different from those expected, the amount of testing of details of balances must be altered If tolerable misstatement is low, and inherent risk and control risk are high, planned tests of details of balances which the auditor must perform will be high. An increase in tolerable misstatement or a reduction of either inherent risk or control risk will lead to a reduction in the planned tests of details of balances Auditors frequently consider it desirable to perform audit tests throughout the year rather than waiting until year-end because of the public accounting firm's difficulty of scheduling personnel. Due to the uneven distribution of the year-end dates of their clients, there is a shortage of personnel during certain periods of the year and excess available time at other periods. The procedures that are performed at a date prior to year-end are often dependent upon adequate internal control and when the client will have the information available. Procedures which may be performed prior to the end of the year are: 1. Update permanent asset schedules. 2. Examine new loan agreements and other legal records. 3. Vouch certain transactions. 4. Analyze changes in the client's system. 5. If the client has strong internal control so that the auditor may assess control risk at less than maximum, the following procedures may be performed with minor review and updating at year-end: 6. Observation of physical inventories; 7. Confirmation of accounts receivable balances; 8. Confirmation and reconciliation of accounts payable balances. 10-4

5 Multiple Choice Questions a. (4) b. (4) c. (3) d. (1) a. (3) b. (3) c. (4) Discussion Questions and Problems a. b. 1. TD of B Reperformance 2. TD of B Documentation 3. AP Analytical procedures 4. Test of Controls Inquiry and observation 5. TD of B Confirmation 6. TD of B Documentation and reperformance 7. Test of Controls Documentation 8. Test of Controls Documentation 9. AP Analytical procedures 10. TD of B Documentation 11. Test of Controls Documentation a. b. c. d. e f. 1 Acquisition Reper- Substantive T D Posting and and payment formance of B Summariza- N/A tion 2 Acquisition Documen- Test of control and Payment tation or Substantive Existence Occurrence 10-5

6 3 Inventory Analytical Substantive A P N/A N/A and Procedure Warehousing 4 Capital Acqui- Confirmation Substantive TD N/A Existence sition and of B accuracy Repayment Presentation and Disclosure 5 Acquisition Reperform- Substantive T D N/A Detail and Payment ance of B Tie-in Accuracy 6 Acquisition Docu- Substantive T D and Payment mentation of B N/A Cut-off 7 Sales and Observation Test of N/A Complete- N/A Collection Controls ness 8 Sales and Collection Inquiry Substantive T D N/A Realizaof B ble value a. b. c. d. 1. Accuracy Examine vendors' invoices for indication of recalculation 2. Accuracy Determine existence of approved price lists for acquisitions 3. Existence Completeness Account for a numerical sequence of receiving reports 4. Timing Examine vendors' invoices for indication of comparison An error in calculation of a vendor's invoice Unauthorized prices could be paid for acquisitions Unrecorded acquisitions exist Cutoff errors Recalculation of the vendor's invoice Obtain prices from purchasing department and compare to vendors' invoices Confirm accounts payable, especially vendors with small zero balances Confirm accounts payable 10-6

7 5. Posting Summarization 6. Classification Examine indication of reconciliation of the subsidiary ledge and control account Examine vendors' invoices for indication of internal verification 7. Existence Examine cancelled cheques for signature 8. Existence Accuracy Examine vendors' invoices for indication of comparison 9. Existence Examine supporting documents for indication of cancellation 10. Existence Observe cheque mailing procedures and inquire about normal procedures Errors in subsidiary records or control account Account classification errors Invalid or unauthorized payment Invalid or unauthorized payment Duplicate payment for an acquisition Bookkeeper takes signed cheques and changes payee name Foot subsidiary records and compare to control account Compare vendors' invoices to acquisitions journal for reasonableness of account classification Examine supporting documents for appropriateness of expenditures Examine supporting documents for appropriateness of expenditures Examine supporting documents for every payment to selected vendors Compare payee name on cancelled cheque to supporting documents a. The performance of interim tests of controls is an effective means of keeping overtime to a minimum where many clients have the same year-end date. However, this approach requires additional start-up time each time the auditor enters the field to perform additional tests during different times of the year. In the case of a small client, start up costs and training time may require more total time than waiting until after December 31. b. Schaefer may find that it is acceptable to perform no additional tests of controls work as a part of the year-end audit tests under the following circumstances: 1. The results of the tests of the interim period indicate the accounting system is reliable. 2. Inquiries concerning the remaining period may indicate there were no significant changes in internal control and accounting procedures. 10-7

8 3. The transactions occurring between the completion of the tests of controls and the end of the year are not unusual compared to the transactions previously tested and to the normal operations of the company. 4. Other tests performed at the end of the year do not indicate that internal control is less effective than the auditor has currently assessed. 5. The remaining period is not too long in the circumstances. (Some consensus exists in the profession requiring the remaining period to be three months or less, depending upon the circumstances.) 6. Other matters of concern to the auditor indicate that the limitation of tests of controls is appropriate (i.e., risk of exposure to legal sanction is not too great; the auditor will probably be familiar with the client's operations and will determine that a reduced control risk is justified; the auditor has appropriate confidence in the competence of personnel and the integrity of management). c. If Schaefer decides to perform no additional tests of controls, depending upon the circumstances, she may wish to perform analytical procedures, such as reviewing interim transactions for reasonableness or tracing them to their source, comparing balances to previous periods, or other such procedures, for the remaining period to year end Substantive Tests of Analytical Tests of Audit Controls Procedures Balances 1 E E S 2 N M E 3 E E S, E* E = Extensive amount of testing. M = Medium amount of testing. S = Small amount of testing. N = No testing done. S,E* = Small amount of testing for the gross balance in accounts receivable; extensive testing done for the collectibility of the accounts. a. For audit 1 the recommended strategy is to maximize the testing of internal controls and minimize the testing of the details of all ending balances in inventory. The most important objective would be to minimize the number of locations that need to be visited. The justification for doing this is the quality of internal control and the results of prior year audits. Assuming that some of the locations have a large portion of the ending inventory balance and others smaller portions, the auditor can likely completely eliminate tests of physical counts of some locations and emphasize the locations with larger dollar balances. The entire strategy is oriented to minimizing the need to visit locations. 10-8

9 b. Audit risk for this audit should be low (that is, assurance because of the plans to sell the business, severe under-financing and a first year audit.) The lack of controls over accounts payable and the large number of adjusting entries in accounts payable indicate the auditor cannot consider internal control effective. Therefore the plan should be to do extensive tests of details of balances, probably through accounts payable confirmation and other end of year procedures. No tests of controls are recommended because of the impracticality of reduced assessed control risk. Some analytical procedures are recommended to verify the correctness of acquisitions and to obtain information about the reasonableness of the balances. c. The most serious concern in this audit is the evaluation of the allowance for uncollectible accounts. Given the adverse economic conditions, significant increase of loans receivable, the auditor must be greatly concerned about the adequacy of allowance for uncollectible accounts and the possibility of uncollectible accounts being included in loans receivable. Given internal control, the auditor is not likely to be greatly concerned about the gross accounts receivable, except for accounts that need to be written off. Therefore, for the audit of gross accounts receivable there will be a greatly reduced assessed control risk and relatively minor confirmation of accounts receivable. In evaluation of the allowance for uncollectible accounts the auditor should test the controls over granting loans and follow up on collections, however given the changes in the economy it will be necessary to do significant additional testing of the allowance for uncollectible accounts. Therefore an S is included as a test of details of balances for gross accounts receivable and an E for the tests of net realizable value a. The balances in the accounts included in the income statement and statement of changes in financial position result from the transactions during the period which affect the asset and liability accounts. If the beginning balances are not audited, the auditor cannot be sure that the intervening transactions are correct. A qualified opinion on the income statement and statement of changes in financial position will be required, though an unqualified opinion for the balance sheet is possible. b. To verify the beginning balance in accounts receivable, Jackson could: 1. Confirm the balance directly with customers (although most customers may not have sufficient records to reply). 2. Examine supporting documents for the beginning balances. These would include verifying shipments by examining bills of lading and payments by tracing to the cash receipts journal and bank statement showing deposits. c. Beginning balances on continuing audit engagements have been verified as ending balances during the previous audit. 10-9

10 10-24 a. Factors which could explain the difference in the amount of evidence accumulated in different parts as well as the total time spent on the engagement are: a. Internal control; b. Materiality of the account balance; c. Size of the populations; d. Make-up of populations; e. Initial vs. repeat engagement; f. Results of the current and previous audits; g. Existence of unusual transactions; h. Motivation of the client to misstate the financial statements; i. Degree of client integrity. For an example, in the first audit, the auditor has apparently made the decision to emphasize tests of controls and minimize substantive procedures. That implies effective internal control and a low expectation of misstatement (low inherent and control risk.) In the third audit, the auditor apparently has a high expectation of misstatements, and therefore believes it is necessary to do both extensive tests of controls and substantive procedures. Audit two is somewhere between. b. The audit partners could have spent time discussing the audit approach and scope with Bryan prior to the beginning of the field work. c. The nature of these three engagements and the different circumstances appear to be excellent examples of the tailoring of audit procedures to appropriate levels considering the circumstances a. The following is a time line for the audit procedures, showing the sequence of the parts of an audit in a typical audit. July 31 Audit Report Date 5, 9, 7, Parts 5, 9, and 7 are all a part of planning and are therefore done early. These are in the sequence shown in chapter 5. As part of planning the audit, the auditor obtains an understanding of internal control and initially assesses control risk. The auditor then tests the internal controls and confirms or disconfirms his or her assessment of control risk. Ideally most analytical procedures are performed after the client has prepared financial statements, but before tests of details of balances are performed. Therefore, they should be done before confirmation of accounts payable, to provide information about the expectation of misstatement

11 Confirmation of accounts payable should be done as early after the balance sheet date as possible to facilitate getting responses back, performing alternative procedures for non- responses and reconciling differences before the audit is completed. Tests for review of subsequent events is normally the last thing done on the engagement before the auditor's report date. The audit report is issued after the auditor's report date. b. The time line shows that 5, 9, 7 and 2 are frequently done before the balance sheet date. Cases a. Further information required: 1. The names and relationships of related parties, either individuals or corporations, in order to:! Identify any intercompany transactions and balances that should be eliminated on consolidation! Identify related party transaction so that the disclosure requirements related to the transaction, balances and other matters may be considered! Enable Fairly, Small & Co to report on its independence to Giant and Co. 2. Additional information regarding the accounting policies and other matters that would affect YPL. To identify differences, if any, and adjust the financial statements. 3. General information regarding the business philosophy and other business matters that would affect YPL. This would gain an insight into the operations and its overall philosophy. General business information would provide data on product lines and transfer prices. 4. Information regarding the requirements for nine month statements. This would be necessary for consolidation purposes. 5. Information on Many Conglomerate Limited s income tax classification to verify if YPL has lost its small business deduction and is therefore required to pay Part VI income tax on previous small business deduction credits

12 6. Whether Giant and Co. require any particular information, such as a special presentation of fixed assets, the salaries of executives or analyses of certain accounts. b. Memorandum to audit senior General matters 1. An introduction outlining the change in control including the date of change, name of and general information about the acquiring company and an indication of how this change in control will specifically affect the audit as to related party transactions. 2. The new reporting package with which YPL must now comply. Internal control 1. The early reporting deadline for the financial statements, and the earlier attendance at inventory. The audit senior will have to evaluate the new internal control system to determine whether it is possible to rely upon it. 2. The early inventory attendance will necessitate reliance on the new inventory system and on the accounts receivable and accounts payable systems as well. 3. The review procedures for the evaluation of internal control and the compliance procedures of the system should include tests to examine: Cut-off Payroll and purchase entries to inventory accounts Cost of goods sold entries Transfers between inventory accounts Physical controls that safeguard the inventories The recording of sales, including shipping and billing procedures Control over cash receipts and deposits Because the inventory count date has been moved forward, certain cut-off procedures must now be completed. 1. Verify that the client has instituted effective procedures with his staff for this early cut-off. 2. To ensure an effective cut-off, the interrelated accounts of inventory, receivables and payables will have to be verified

13 3. The sending of accounts receivable and accounts payable confirmations should be completed at the time of attendance at the inventory count. Post cut-off 1. For transactions between November and December it will be necessary to carry out analytical review and substantive tests to ensure that accounts receivable, accounts payable and inventories are properly recorded. 2. For November and December procedures should include: A comparison of results with budgets and with previous years results Testing of entries to the various related accounts. Other important matters 1. Certain aspects of the year-end audit involving prepaid expenses, fixed assets, capital stock and goodwill can be carried out in October. 2. Other confirmation letters, such as lawyers letters and long-term debts, should be prepared in January. 3. The reporting package for YPL should be reviewed as soon as possible and problem areas highlighted. The reporting package should be reconciled to the statutory financial statements as soon as the statements are prepared Memo to: From: Subject: Partners in charge CA Audit planning for Canadian Chocolate Company (CCC) Inherent audit risk is high and is affected by the following factors: Both auditors are new to this client and therefore have no previous experience to rely on. CCC has a number of locations, some of them foreign, with their own accounting system and has intercompany transactions among locations. CCC has had some financial problems such as a shrinking market and unsuccessful new product launching. It is also facing major lawsuits, from the extortion attempt. These increase the risk of manipulation by management of the financial results

14 Inventory prices are volatile, and the nature of the inventory makes its existence difficult to audit. CCC relies on perpetual records and does not perform a physical count. New product line The introduction of the new product lines has several audit implications, as follows: 1. Product 4 will not recover all development costs until at least the seventh year. There are two alternative accounting treatments that may be considered. a. In Canada and on consolidation of the U.S. subsidiary, it may be appropriate to defer only the amount of development costs considered recoverable in a reasonable period. (5 years) b. If the four new items are considered collectively as a single new product, all development costs can be recovered in a shorter period. 2. Outstanding contracts for advertising the new products should be properly accrued and disclosed. 3. The costs associated with obtaining the market research data can be deferred, as party of the development costs, but advertising costs cannot. 4. The development costs will have to be examined in detail to ensure that they are costs that qualify for capitalization. 5. In the U.S. development costs must be expensed. For consolidation purposes, the information from the U.S. auditors is needed to adjust development costs to Canadian GAAP. 6. The coupon campaign will create a liability and CCC should accrue these liabilities as it makes sales to retailers. 7. The capitalization of development costs and the accrual of the coupon liability will result in deferred taxes, as the tax treatment of these items is not the same as the accounting treatment. Extortion loss The net book value of the equipment taken out of service, the cost of the destroyed products, and the public relations cost do not represent future benefits so they should not be capitalized. CCC should recognize them as extraordinary losses. It is necessary to review the insurance claim for reasonableness and confirm with the insurance company the amounts paid and due to the company

15 A letter is required from CCC s lawyers concerning the outstanding lawsuit, to decide whether CCC should accrue a liability or merely disclose the fact that liability may exist. CCC s insurance coverage should be checked to se if any of the costs of this lawsuit will be covered by insurance. Product discontinuance costs Ensure that any capital items or inventory supplies that will no longer be used are valued at no more than net realizable value. Any related deferred costs should be written off and adequate provision made for any other related disposition costs that may be incurred. Inventories The potential inventory problems can be segregated under physical existence and valuation. 1. Physical existence A physical count of the main raw materials, cocoa beans and sugar, stored at each subsidiary should be conducted. It will be necessary to ascertain the degree of accuracy of the perpetual records because they are the basis on which the year-end balances will be determined. The only significant audit problem posed by work in process might be obtaining satisfaction about semi-process chocolate in transit between subsidiaries. Finished goods do not appear to present any problems. If a specialist is required to aid in the audit, the provisions of Handbook Section 5360 must be followed. 2. Valuation Valuation of sugar and cocoa beans could be difficult; they are valued at the lower of cost and replacement cost. Any valuation problem with regard to semi-processed chocolate transferred from another company should be eliminated on consolidation, as any intercompany profits must be eliminated. Purchase contract losses Review all outstanding purchase contracts at year-end for disclosure in the notes to the financial statements. Ascertain whether any contract might lead to a loss that should be accrued at the year-end in accordance with Section 3290 of the Handbook

16 Segment information CCC only operates in one industry segment (chocolate); the company cannot present information on an industry-segment basis. Disclosure of the fact that dominant segment exists will be required. The major audit problems will be in obtaining satisfaction that all inter-segment transfers have been appropriately priced and that such transfers reflect any consolidated profit eliminations. Ensure that all common costs have been allocated on a reasonable basis. Reliance on other auditors Use the Handbook Section 6930 to determine if the auditing procedures performed by the foreign auditors is acceptable. Reliance on internal auditors Use CCC s internal audit team when doing the annual audit. Their participation should result in a more effective and efficient audit. Transfer pricing CCC does not have a formal policy for transfer pricing. A formal policy should be issued using either a cost or a market-based approach to eliminate the problem of determining a price for each shipment. Research and Development cost allocation Research, development and other common costs are being allocated among the subsidiaries on the basis of asset values. This basis is not reasonable, especially in cases where the subsidiary is not manufacturing or marketing the bar. For the new product line, costs should be shared between the two subsidiaries that have been created to manufacture the line. Taxation issues Ensure that cross-border transfer-pricing is at fair market value to satisfy Canada Customs and Revenue Agency