AUDITING: A RISK

ANALYSIS APPROACH

5th edition

Larry F. Konrath

Electronic Presentation
by Harold
O. Wilson
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KEY CONCEPTS OVERVIEW
Purchases, production, inventories,
current debt, prepaids, accruals
Internal Controls for
Asset overstatements
Liability understatements
Audit Programs/Working papers, Debt
verifications (“The Search”),
extent & timing of tests/sampling
Audit risk & warning signs.

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Learning Objectives
Identify audit objectives related to
expenditures, liabilities
Develop expenditure cycle audit
programs.
Modify audit programs (internal
controls, warning signs, study of
industry, analytical procedures).

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 The Accounting Cycle:
What companies do!
SALES
Various*
Ac Rec Ac Pay
CASH

SALES CASH IN CASH OUT PURCHASES

SCHEMA FOR ACCOUNTING & TESTING!

* Inventories, Other Assets, Expenses of all kinds! 5
 Expenditure / Disbursement
Cycle: Basic Documentation!
INVENTORY &
PURCHASES Accts Payable CASH

DR CR DR
Bal. Bal. Bal.
PURCHASE PAYMENT
Purchase Invoices & Vouchers &
Receiving Cancelled
Reports Checks
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 Assets & Payables at FYE:
Basic Documentation!
ASSETS
& EXPENSES AcPay
CASH
DR CR DR
Bal. Bal. Bal.

Confirmations & Counts &

Subsequent Bank
Payments Reconciliations
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The CLIENT’S FYE
ASSERTIONS to VERIFY

The the items purchased exist (inventory,

equipment, buildings, etc.)
The debt lists are complete and controlled.
The accounting has been complete, current.
The prepaids and accruals are complete.
The valuations, classifications (e.g, finished
goods, LCM), and disclosures are complete
& proper (e.g., obsolete inventory, idle
equipment, items in transit).
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 Auditor’s Emphases in
Substantive Testing
Consider asset overstatements; liability
understatements (confirmations,
mathematics, GAAP)
Consider counts, cautions, suspicions)
“Smoothing” of reported earnings is
sensitive to prepaids, accruals reported.
A balanced audit approach (neutrality)
may be modified as cases demand.

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PURCHASES, PRODUCTION,
INVENTORY PROCESSING
Documentation (pre-numbered, etc.)
Authorizations, approvals, recording/input
Inventory movement, accountability,
physical security, count techniques
Effective Voucher System, cash
disbursement controls, access controls
Cost Accounting System functional, timely
Perpetual records encouraged
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PURCHASES, PRODUCTION,
INVENTORY PROCESSING
Factory paperwork (aids control)
Subsidiary ledger details current
Approvals of product mix, quotas, transfers,
processing steps and journalizing
Coding of debits by competent [plant]
personnel, and required & approved:
MRFs, Clock cards, Time tickets, OH rates
Consistency with GAAP

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 FAQ?
What’s between a PURCHASE and
the CASH DISBURSEMENT? …
paperwork?
After someone requests a
purchase, there is approval of a
purchase order (P.O.) and a
number of dealings subject to
audit:
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After a request … and before the
MONEY IS PAID!
Purchase Order (P.O.): selection of vendor,
confirmation of availability, approval of prices.
Receiving: Receiving Reports, inspections at
receipt of goods, unpacking & counting,
sorting, storing, securing.
Purchase Invoices/Vouchers: based on above,
reviewed for support, then recording debt.
Terms & price approvals of P.O./ invoices.
Approval for disbursement
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A/P FAQ?

If the accounting for debts is, in fact,

incomplete, are there specific
“search” techniques?
YES, many! Test controls & transactions
for completeness, then confirm the client’s
debt amounts, and review subsequent
vouchers & payments!

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 INTERNAL CONTROL
CHECKLIST: Expenditures

Requirements for Voucher (recording debt):

Approved purchase request, vendors, P.O..
Properly matching Receiving Reports.
Purchase Invoice (math & prices approved).
“Coding” of purchase invoices proper!

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 INTERNAL CONTROL
CHECKLIST: Expenditures

Requirements for “cutting” a check:

Vouchers matched, referenced to checks.
Completed Voucher, approved as such.
Specific approval of signing.
Mailing of signed checks by DIP.

Paid Vouchers promptly cancelled.

Bank accounts reconciled by DIP. 16
INTERNAL CONTROL
CHECK LIST: Expenditures
Debit Memos & noncash debits (e.g., pricing
adjustment) properly authorized.
Process “originals;” no duplicate documents.
Inventory: access to blank checks, forms,
signature plates, etc., controlled.
Purchase tabulations reviewed, approved,
and reconciled to vendors’ statements
and unfilled PO files, plans.
Monthly statement reconciliations (if
practical) by DIP. 17
INTERNAL CONTROL
CHECK LIST: Expenditures
All purchases of goods/services are to be
credited to Accounts Payable, with proper
voucher support.
Direct debits to assets or expenses offset by
direct credits to Cash are prohibited!

Advertising 1,000
Cash 1,000
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 INTERNAL CONTROL
CHECKLIST: Inventory
Physical safeguards over inventories; off-
premises inventory controlled
and counted.
Cycle counts of inventories; required reports
on obsolete items, etc., by DIP.
Inventory tabulations reviewed, approved,
reconciled periodically.
Approved “change memos” for adjustments
to perpetual records, cost data.
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Inventory Audit Programs &
Evidence: Inventory Observation
Evaluating controls & inventory
instructions
Test counts (high value items, need for
specialists
Cautions: hollow stacks, consignments,
test for obsolete goods
Tag control (by auditor), physical controls
movements during counts

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Inventory Audit Programs &
Evidence: Inventory Observation
Working papers: location(s), Ids, count per
client, count per auditor, exceptions
(and “inconspicuous” tick marks)
Purchases/Sales cutoffs, FOB points
Confirmations, activity around FYE
Costing (GAAP, theory, techniques, match
to tested quantity on hand)

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Summarized Audit Program:
Testing the Inventory Cycle

Acquire a knowledge of the client’s

products, processing, and cost system.
Test vouch [selected periods] for
raw materials & supplies purchases
for production.
Trace transfer documents [RM, WP,
FG] to perpetual records & journals,
noting proper approvals.
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Summarized Audit Program:
Testing FYE Inventory

Obtain the FYE inventories’ tabulations. *

Gain control of, or observe, the tagging
system (to avoid omissions or double
counting).
Observe the physical counting, making *
test counts as considered necessary.
Trace test counts from/to perpetual
records and subsidiary tabulations.
Investigate “quantity” exceptions. *
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Summarized Audit Program:
Testing FYE Inventory

Ascertain that physical controls were

effective; tour plant observing for the
unusual (obsolescence, slow movers).
Test for proper cutoffs with receiving
(raw materials), and shipping (FG). *
Test costing of FYE balances (GAAP).
Investigate “costing” exceptions.
Confirm off-premises inventories, and
tie-in classifications to G/L.
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 FAQ?

What makes an item a “fixed asset?”

The are FOUR required characteristics:
1. It’s tangible.
2. It’s used in the operations.
3. It’s relatively long-lived.
4. It’s not intended for resale.
(Holding it for resale would make it ... ?)
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 FAQ?
What’s the main difference in
processing the purchase of a plant
asset, as versus buying inventory?
The approvals are more demanding for
long-lived and expensive assets. Capital
budgeting models get complex. Note:
Manufacturing either one is complex!

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Selected INTERNAL
CONTROLS: Plant Assets
Control of properties, movements,
by competent personnel.
Proper coding/documentation of plant assets
manufactured by the client (DM,DL,OH)
Cost calculations consistent with GAAP.
Physical access controlled, safeguards
effective.
“Follow up” studies.
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Major concerns in auditing
PLANT ASSETS
Ownership & Obligations
Acquisition, placed in service
Disposals (timing, recording,
losses & gains)
“Lease” considerations
Related indebtedness
Valuations (proper costing, correct
accumulated depreciation,
impairments)
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Major concerns…
Presentations and Disclosures
Depreciation methods, statistics, pledging
Adequate footnote information, statistics
Working Papers
Lead Schedules (analyses, changes, ending
balances, summaries)
Supporting schedules
(vouched, critiqued)
Correlated with other captions
(repairs, insurance, R&D, etc.)
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Major concerns…
Analytical Procedures (trends on items
below, consider operations/economy)
Vouching additions/disposals, especially
“scrap sales,” cash collected, approvals
Depreciation verification/calculation (GAAP
and TAX complications)
Repairs & Maintenance, R&D (reasonable,
consistent, not manipulated)

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Summarized Audit Program:
Plant Assets

Acquire a knowledge of the client’s firm,

accounting system and asset needs.
Obtain an analysis of plant assets and *
schedules of repairs during the year.
Trace acquisitions/dispositions & larger
repairs to supporting documents & to
subsidiary records & journals, officers’
approvals, insurance coverage.
Consider physical inspections.
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Summarized Audit Program:
Plant Assets

Trace MRFs, Clock Cards, Time Tickets,

and OH applied to/from Job or Cost
Sheets, for plant assets constructed.
*
Investigate exceptions discovered.
*
Ascertain that physical controls were
effective; tour plant scanning for the
unusual (changes, obsolescence, etc.).
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Summarized Audit Program:
Plant Assets

Test depreciation math & methods, and

consistency; compare to aggregate data. *
Ascertain that entries for dispositions *
losses/gains are journalized, per GAAP;
obtain tax related data.
Test for proper cutoffs with *
receiving/shipping of fixed assets.
Tie-in details to GL control accounts
by classification.
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 FAQ?

Can you list some potential errors or

frauds that might exist because of
exceptions to internal control
procedures and/or audit procedures
… for inventories?
… for fixed assets?

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 Major Audit Considerations:
INTANGIBLE
ASSETS
Purchased intangibles capitalized?
Impaired intangibles expensed?
Proper documents? Any related liabilities,
e.g., at acquisition, for royalties?
Costs proper? R&D excluded? Evidence
of future benefits?
Amortization proper?
GAAP followed as to life, net valuation?
Disclosure information adequate, reliable?
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Major Audit Considerations in
CURRENT LIABILITIES
Are liabilities understated?
Are accruals correct, inclusive (especially
at FYE)?
Are taxes, pensions, profit sharing,
bonuses, etc., fully reported?
Are contingent liabilities proper, “still
contingent?”
Are warranty, litigation, and other loss
contingencies estimated adequately?
Are management classifications reliable?
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AUDIT PROGRAM: Search for
Unrecorded Liabilities

Examine purchase invoices and Voucher

Register, cutoffs, just before/after FYE.
Trace subsequent payments, compare
to FYE tabulations.
Verify authorizations: write-offs & non-
cash dealings; trace postings.
Compare statistical data from past year;
make forecasts.
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AUDIT PROGRAM: Search for
Unrecorded Liabilities

Every check written in the new year *

should be either in the A/P list at
FYE, OR be an item with the FOB
point in The Happy New Year!
Scan for the unusual;
discuss with officials.
Consider tax scenario.
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 FAQ?

In the subsequent transactions tests, if

an AJE is proposed (e.g., a credit to
Accounts Payable), what is the debit?
Work papers should have multiple
columns for the associated debits for
every unrecorded purchased invoice
discovered, or you’ll be embarrassed.
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 AUDIT PROGRAM: Accounts
Payable Credits
• Interim work compared documents
(e.g., vouchers) to bookkeeping
outputs, account postings, etc.
• Audit trail is known.
• Working papers support many,
but not all, account balances.

• All material account balances

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AUDIT PROGRAM:
Accounts Payable

Test controls for compliance, cutoffs.

Mail confirmations to banks, attorneys,
selected A/P, & zero-balance accounts:
Use positives for larger accounts. *
Use negatives for smaller accounts. *
Trace subsequent payments for non-
respondents, document same.
*
Mail second, third requests.
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AUDIT PROGRAM:
Accounts Payable

Obtain a schedule of accounts payable; *

tie-in to GL); test mathematics.
Discuss payables/details with officials; *
compare to prior statistics.
Perform the “Search for Unrecorded
* Liabilities” tests. [Long list!]
Clear all exceptions; project samplings.
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AUDIT PROGRAM includes…
Perform analytical procedures (scan for
the unusual, unreasonable, unexpected,
triggers for extended testing; scrutinize
ratios, trends:
Days’ purchases in Accounts Payable.
Trends in payments to vendors.
Puzzling ratio information (prepaids,
accruals).
Pressure times for client.
Consider fraud implications.
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CURRENT LIABILITIES:
AUDIT RISKS & CLUES:
Cross-corroborations of purchases,
payables, prepaids, accruals.
Potential for payment of “fake” payables.
Timeliness of payments to vendors.
Relationships with vendors--maybe “too
good;” variations with/among vendors.
Access to cash, currency.

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CURRENT LIABILITIES:
AUDIT RISKS & CLUES
Idle capacity
Guarantees
Related party dealings
Special charges; “smoothing”
Franchisor & franchisee problems!
Asset impairments
Environmental regulations: EPA! OSHA!
FCC! SEC! IRS! ETC.!

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Notes on ACCRUALS
Any new types of accruals? (Similar to
prior year’s accruals? Tax accruals
adequate?)
Any large accrued items?
Reasonable time frames for
booking, then paying?
Are accruals and calculations consistent?
Best evidence may be prior payments?

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STATISTICAL SAMPLING &
SUBSTANTIVE TESTS in A/P
The population in Accounts Payable
is THE LIST of claims by creditors.
A major concern: An incomplete
listing. N = ?
The lower the [revised] CR, the fewer
the [positive] confirmation.
Random selection of VENDORS, or
PPS sampling is advisable.
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AFTER ALL CAPITONS, the
In-charge CPA will…
Review for GAAP consistency and/or
violations.
Consider materiality, potential for
fraud, misleading data.
Make decisions as to Presentations,
Footnotes, Disclosures.
Write Opinion on caption.
Draft the Audit Report.
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CRITICAL KEY TERMS
Inventory tags; Obsolescence
instructions Bank cutoff
Inventory cutoff; statements
test counts Inventory in transit
Positive/Negative Plant assets lead
confirmations schedule
Attorneys’ Sales, Purchases
confirmations cutoffs
Consignments in, out Expenditure cycle
Bank confirmations
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End of Chapter 12

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