Audit Chapter 13 Overall Audit Strategy and Audit Program

Procedures to obtain an understating of internal control

ocedures used by the auditor to gather evidence about the design and implementation of specific controls

State a test of control audit procedure to test the effectiveness of the following control: approved wage rates are used in calculating employee's earnings. State substantive test of transactions audit procedure to determine whether approved wage rates are actually used in calculating employee's earnings. 13-4

test of control audit procedure to test that approved wage rates are used to calculate employees' earnings would be to examine rate authorization forms to determine the existence of authorized signatures. A substantive test of transactions 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

Phases of the audit process

the 4 aspects of a complete audit: 1. Plan and design an audit approach, 2. Perform tests of controls and substantive tests of transactions 3. Perform substantive analytical procedures and tests of details of balances 4. Complete the audit and issue an audit report

Types of tests

the 5 categories of audit tests auditors use to determine whether financial statements are fairly stated; risk assessment procedures, test of controls, substantive tests of transactions, substantive analytical procedures, and tests of details of balances

Evidence mix

the combination of the types of tests to obtain sufficient appropriate evidence for a cycle; there are likely to be variations in the mix from cycle to cycle, depending on the circumstances of the audit

Why do auditors often consider it desirable to perform audit tests throughout the year rather than wait until year-end? List several examples of evidence that can be accumulated before year-end. 13-20

Auditors frequently consider it desirable to perform audit tests throughout the year rather than waiting until year-end because of the CPA firm's difficulty of scheduling personnel and the client's need for timely financial statements. 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 yearend are often dependent upon adequate internal controls and when the client will have the information available. Additionally, public company auditors must begin their testing of controls earlier in the year to ensure they are able to test a sufficient sample of controls for operating effectiveness. Some controls may only be performed monthly or quarterly. Thus, the public company auditor must begin testing early in the year so that there are a sufficient number of months or quarters to test. Procedures that may be performed prior to the end of the year are: 1. Update fixed asset schedules. 2. Examine new loan agreements and other legal records. 3. Vouch certain transactions. 4. Analyze changes in the client's accounting systems. 5. Review minutes of board of directors' meetings. 6. If the client has effective internal control, the following procedures may be performed with minor review and updating at year-end: (a) Observation of physical inventories; (b) Confirmation of accounts receivable balances; (c) Confirmation and reconciliation of accounts payable balances.

Table 13-3 illustrates variations in the emphasis on different types of audit tests. What are the benefits to the auditor of identifying the best mix of tests? 13-13

By identifying the best mix of tests, the auditor can accumulate sufficient appropriate evidence at minimum cost. The auditor can thereby meet the standards of the profession and still be cost effective and competitive.

In Figure 13-3 explain the differences among C3, C2, and C1. Explain the circumstances under which it would be a good decision to obtain audit assurance from substantive tests at point C1. Do the same for points C2 and C3.

C represents the auditor's assessment of the effectiveness of internal control. Tests of controls at the C1 level would support a minimum level of control risk. This would require more testing of the controls than would be required at either C2 or C3. Testing controls at the C1 level allows the auditor to obtain assurance from the controls, thereby allowing for a reduction in the amount of substantive testing that must be performed to meet the level of acceptable audit assurance. It would be a good decision to obtain assurance from tests of controls at point C1 especially if the cost of substantive testing is considerably greater than tests of controls. C3 represents the idea that it is not cost-effective to test internal controls and all assurance must come from substantive testing. This decision is optimal if controls do not exist or are not effective, or the cost of the additional substantive testing is less than the cost of control testing. At point C2, the auditor performs some tests of controls and is able to reduce control risk below maximum. Point C2 would be appropriate if it is cost beneficial for the auditor to obtain assurance at a level between the two extremes mentioned above (C1 and C3).

The auditor of Ferguson's, Inc., identified two internal controls in the sales and collection cycle for testing. In the first control, the computer verifies that a planned sale on account will not exceed the customer's credit limit entered in the accounts receivable master file. In the second control, the accounts receivable clerk matches bills of lading, sales invoices, and customer orders before recording in the sales journal. Describe how the presence of general controls over software programs and master file changes affects the extent of audit testing of each of these two internal controls. 13-9

Control #1 - Computer verification of the customer's credit limit. The presence of effective general controls over software programs and master file changes can significantly reduce the auditor's testing of automated controls such as control #1. Once it is determined that control #1 is functioning properly, the auditor can focus subsequent tests on assessing whether any changes have occurred that would limit the effectiveness of the control. Such tests might include determining whether any changes have occurred to the program and whether these changes were properly authorized and tested prior to implementation. These are all tests of general controls over software programs and master file changes. 2. Control #2 - The accounts receivable clerk matches bills of lading, sales invoices, and customer orders before recording in the sales journal. This control is not an automated control, but is rather a manual control performed by an employee. General controls over software programs and master file changes would have little effect on the auditor's testing of control #2. If the auditor identifies control #2 as a key control in the sales and collection cycle, he or she would most likely examine a sample of the underlying documents for the accounts receivable clerk's initials and reperform the comparisons.

Rank the following types of tests from most costly to least costly: substantive analytical procedures, tests of details of balances, risk assessment procedures, tests of controls, and substantive tests of transactions. 13-11

Going from most to least costly, the types of tests are: Tests of details of balances Substantive tests of transactions Tests of controls Risk assessment procedures Substantive analytical procedures

Explain the relationship of performance materiality, inherent risk, and control risk to planned tests of details of balances.

If performance materiality is low, and inherent risk and control risk are high, planned tests of details of balances that the auditor must perform will be high. An increase in performance materiality or a reduction of either inherent risk or control risk will lead to a reduction in the planned tests of details of balances.

Why is it desirable to design test of details of balances before performing tests of controls and substantive tests of transactions? State the assumptions that the auditor must make in doing so. What does the auditor do if the assumptions are wrong? 13-15

It is desirable to design tests of details of balances before performing tests of controls and substantive tests of transactions to enable the auditor to determine if the overall planned evidence is the most efficient and effective in the circumstances. In order to do this, the auditor must make assumptions about the results of the tests of controls and substantive tests of transactions. Ordinarily the auditor will assume no significant misstatements or control problems in tests of controls and substantive tests of transactions unless there is reason to believe otherwise. If the auditor determines that the tests of controls and substantive tests of transactions results are different from those expected, the amount of testing of details of balances must be altered.

What is the purpose of risk assessment procedures and how do they differ from the 4 other types of audit tests? 13-1

Risk assessment procedures are performed to assess the risk of material misstatement in the financial statements. Risk assessment procedures include procedures performed to obtain an understanding of the entity and its environment, including internal controls. Auditors use the results of the risk assessment procedures to design and perform further audit procedures. Further audit procedures (not risk assessment procedures) provide the auditor sufficient appropriate evidence.

Distinguish between substantive tests of transactions and tests of details of balances. Give 1 example of each for the acquisition and payment cycle. 13-6

Substantive tests of transactions are performed to verify the accuracy of a client's accounting system. This is accomplished by determining whether individual transactions are correctly recorded and summarized in the journals, master files, and general ledger. Substantive tests of transactions are also concerned with classes of transactions, such as payroll, acquisitions, or cash receipts. Tracing amounts from a file of vouchers to the acquisitions journal is an example of a substantive test of transactions for the acquisition and payment cycle. Tests of details of balances verify the ending balance in an individual account (such as inventory, accounts receivable, or depreciation expense) on the financial statements. An example of a test of details of balances for the acquisition and payment cycle is to physically examine a sample of the client's fixed assets.

What is the purpose of tests of controls? Identify specific accounts on the financial statements that are affected by performing tests of controls for the acquisition and payment cycle. 13-2

Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in support of a reduced assessed control risk, and provide the primary basis for the auditor's report on internal controls over financial reporting. Specific accounts affected by performing tests of controls for the acquisition and payment cycle include the following: cash, accounts payable, purchases, purchase returns and allowances, purchase discounts, manufacturing expenses, selling expenses, prepaid insurance, leasehold improvements, and various administrative expenses.

Distinguish between a test of control and a substantive test of transactions. Give 2 examples of each. 13-3

Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in support of a reduced assessed control risk. Examples include: 1. The examination of vendor invoices for indication that they have been clerically tested, compared to a receiving report and purchase order, and approved for payment. 2. Examination of employee time records 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 of transactions are audit procedures testing for monetary misstatements to determine whether the six transaction-related audit objectives have been satisfied for each class of transactions. Examples are: 1. Recalculation of amounts (quantity times unit selling price) on selected sales invoices and tracing of amounts to the sales journal. 2. Examination of vendor invoices in support of amounts recorded in the acquisitions journal for purchases of inventories. 3. Recalculation of gross pay for selected entries in the payroll journal. 4. Tracing of selected customer cash receipts to the accounts receivable master file, agreeing customer names, and amounts.

Explain the relationship between the methodology for designing tests of controls and substantive tests of transactions in Figure 13-4 and the methodology for designing tests of details of balances in figure 13-14

The approach to designing tests of controls and substantive tests of transactions (Figure 13-4) emphasizes satisfying the transaction-related audit objectives developed in Chapters 6 and 12. Recall that these objectives focus on the proper functioning of the accounting system. The methodology of designing tests of details of balances (Figure 13-6) emphasizes satisfying the balance-related audit objectives developed in Chapter 6. The primary focus of these objectives is on the fair presentation of account balances in the financial statements. The extent of testing depends, in part, on the results of the tests of controls and substantive tests of transactions.

Assume that the client's i.c. over the recording and classifying of fixed asset additions are considered deficient because the individual responsible for recording new acquisitions has inadequate technical training and limited experience in accounting. How will this situation affect the evidence you should accumulate in auditing fixed assets as compared with another audit in which the controls are excellent? Be specific. 13-12

The audit of fixed asset additions normally involves 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 is known to have inadequate training and limited experience in accounting, the sample size for 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 fixed 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 acquisition.

A considerable portion of the tests of controls and substantive tests of transactions are performed simultaneously as a matter of audit convenience. But the substantive tests of transactions procedures and sample size, in part, depend on the results of the tests of controls. How can the auditor resolve this apparent inconsistency? 13-5

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 tests of transactions on the basis of these assumptions. Ordinarily the auditor assumes an effective system of internal control with few or no exceptions 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 planned extent of substantive tests of transactions, unless the substantive tests of transactions 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 tests must be performed.

List the 9 balance-related audit objectives in the verification of the ending balance in inventory and provide 1 useful audit procedure for each of the objectives. 13-16

The eight balance-related audit objectives and related procedures are as follows: GENERAL BALANCERELATED AUDIT OBJECTIVE SPECIFIC OBJECTIVE AUDIT PROCEDURE Detail tie-in Inventory on the inventory summary agrees with the physical count, the extensions are correct, and the total is correctly added and agrees with the general ledger. Check extensions of price times quantity on a sample basis, foot the detailed inventory summary, and trace the balance to the general ledger and financial statements. Existence Inventory as stated in financial statements actually exists. Trace inventory from final inventory summary to actual inventory and physically count selected items. Completeness Existing inventory items have been counted and included in the financial statements. Select items from the physical inventory and trace to the client's final summary to make sure that all items are included. BALANCERELATED AUDIT OBJECTIVE SPECIFIC OBJECTIVE AUDIT PROCEDURE Accuracy Inventory items included in the financial statements are stated at the correct amounts. Perform price tests of inventory by examining supporting vendors' invoices for selected inventory items and reverify price times quantity. Classification Inventory as included in the financial statements is properly classified. Compare the classification of inventory into raw materials, work in process, and finished goods by comparing description on physical inventory count tags with the client's final inventory listing. Cutoff Inventory cutoff is properly recorded at the balance sheet date. Trace selected receiving reports several days before and after the balance sheet date to determine whether inventory purchases are recorded in the proper period and related physical inventory counts are included or excluded from inventory. Realizable value Inventory on the financial statements excludes unusable items. Inquire of factory employees and management regarding obsolescence of inventory, and examine storeroom for evidence of damaged or obsolete inventory. Rights and obligations Inventory items in the financial statements are owned by the client. Review contracts with suppliers and customers for the possibility of the inclusion of consigned or other nonowned inventory.

What are the 5 types of tests auditors use to determine whether financial statements are fairly stated? Identify which tests are performed to reduce control risk and which tests are performed to reduce panned detection risk.

The five types of tests auditors use to determine whether financial statements are fairly stated include the following: Risk assessment procedures Tests of controls Substantive tests of transactions Substantive analytical procedures Tests of details of balances While risk assessment procedures (procedures to gain an understanding of the entity and its environment, including internal control) help the financial statement auditor obtain information to make an initial assessment of control risk, tests of controls must be performed to support an assessment of control risk that is below maximum. Because substantive tests of transactions provide evidence about whether transactions have been correctly recorded, these tests also provide evidence about the effectiveness of controls. Substantive evidence is obtained to reduce detection risk. Substantive evidence includes evidence from substantive tests of transactions, substantive analytical procedures, and tests of details of balances.

For each of the 8 types of evidence discussed in Chapter 7, identify whether it is applicable for risk assessment procedures, tests of controls, substantive tests of transactions, substantive analytical procedures, and tests of details of balances. 13-10

The following shows which types of evidence are applicable for the five types of tests (see Table 13-2 on p. 414). TYPE OF EVIDENCE TYPES OF TESTS Physical examination Tests of details of balances Confirmation Tests of details of balances Inspection All except substantive analytical procedures Observation Risk assessment procedures and tests of controls Inquiries of the client All five types Reperformance Tests of controls, substantive tests of transactions, and tests of details of balances Analytical procedures Substantive analytical procedures Recalculation Substantive tests of transactions and tests of details of balances

Indicate the 4 phases of the audit process. In which phase does the auditor perform tests of controls? 13-19

The four phases of the audit process are: Phase I Plan and design and audit approach Phase II Perform tests of controls and substantive tests of transactions Phase III Perform substantive analytical procedures and tests of details of balances Phase IV Complete the audit and issue an audit report As indicated above, auditors perform tests of controls in Phase II.

State the 4 step approach to designing tests of controls and substantive tests of transactions.

The four-step approach to designing tests of controls and substantive tests of transactions is as follows: 1. Apply the transaction-related audit objectives to the class of transactions being tested. 2. Identify specific control policies and procedures that should reduce control risk for each transaction-related audit objective. 3. Develop appropriate tests of controls for each key control. 4. Design appropriate substantive tests of transactions considering deficiencies in internal control and expected results from 3 above.

Evaluate the following statement: "Tests of sales and cash receipts transactions are such an essential part of every audit that I like to perform them as near the end of the audit as possible. By that time I have a fairly good understanding of the client's business and its internal controls because confirmations, cutoff tests, and other procedures have already been completed" 13-8

The primary purpose of testing sales and cash receipts transactions is to evaluate the internal controls so that the scope of the substantive tests of the account balances may be set. If the auditor performs the tests of details of balances prior to testing internal controls, no benefit will be derived from the tests of controls. The auditor should attempt to understand the entity and its environment, including internal controls, as early as practical through the analysis of the accounting system, tests of controls, and substantive tests of transactions.

Explain the relationship between the occurrence transaction-related audit objective and the existence and completeness balance-related audit objectives. 13-17

There is a direct relationship of the occurrence transaction-related audit objective to the existence balance-related audit objective if a class of transactions increases the related account balance (e.g., sales transactions increase accounts receivable). There is a direct relationship of the occurrence transaction-related audit objective to the completeness balance-related audit objective if a class of transactions decreases the related account balance (e.g., cash receipts transactions decrease accounts receivable).

Explain how the calculation and comparison to previous years of the gross margin percentage and the ratio of accounts receivable to sales are related to the confirmation of accounts receivable and other tests of accuracy of accounts receivable. 13-7

When the results of substantive analytical procedures are different from the auditor's expectations and thereby indicate that there may be a misstatement in the balance in accounts receivable or sales, the auditor should extend the tests to determine why the ratios are different from expectations. Confirmation of accounts receivable and cutoff 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, expansion in planned tests is not required. This means that the auditor can satisfy the evidence requirements in different ways and that substantive analytical procedures and confirmation are complementary when the results of the tests are both good.

Substantive analytical procedure

an analytical procedure in which the auditor develops an expectation of recorded amounts or ratios to provide evidence supporting an account balance

Substantive tests

audit procedures designed to test for dollar (monetary) misstatements of financial statement balances

Substantive test of transaction

audit procedures testing for monetary misstatements to determine whether the 6 transaction-related audit objectives have been satisfied for each class of transactions

Tests of details of balances

audit procedures testing for monetary misstatements to determine whether the 8 balance-related audit objectives have been satisfied for each significant account balance

Tests of controls

audit procedures to test the effectiveness of controls in support of a reduced assessed control risk

Further audit procedures

combinations of tests of controls, substantive tests of transactions, substantive analytical procedures, and tests of details of balances performed in response to risks of material misstatement identified by the auditor's risk assessment procedures

Analytical procedures

evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data