Chapter 16 Audit
Litigation contingency
-Most common loss contingency - pending or threatened litigation
Frauds related to payproll may be more difficult to conceal beacause?
(1) extensive segregation of duties relating to payroll; (2) the use of computers, with proper controls, for preparation of payrolls; and (3) the necessity of filing frequent reports to the government listing employees' earnings and tax withholdings
Commitments
-A common characteristic of these commitments is the contractual obligation to enter into transactions in the future.EX: Inventory purchase commitments -All classes of material commitments may be described in a single note to financial statements, -Some commitments accounted for as derivatives, such as certain futures contracts -May need to record liability now if the fixed purchase price is greater than market price.
Audit of cash flows
-Amounts are audited in conjunction with the audit of balance sheet and income statement accounts -Presentation and disclosure important audit objective is important Operating Investing Financing
Loss contingency should be accured as a liability when:
-It is probable that a loss had been sustained before the balance sheet date -The amount of the loss can be reasonably estimated
Auditors' Procedures for Loss Contingencies
1.) Review the minutes of directors' meetings to the date of completion of fieldwork 2.) Send letter of inquiry to client's lawyer 3.) Send confirmation letters to financial institutions to request information on contingent liabilities of the company. 4. ) Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts receivable. 5.) Review reports and correspondence from regulatory agencies to identify potential assessments or fines. 6.) Obtain a representation letter from the client indicating that all liabilities known to officers are recorded or disclosed. 7.) Inquiries of management
Possible frauds relating to payroll
1.) listing fictitious persons on the payroll, 2.) overpaying employees, and 3.) continuing employees on the payroll after their separation from the company
Perform Procedures to Identify Loss Contingencies
1.)determine the existence of the loss contingencies 2.)appraise the probability that a loss has been incurred and its amount. -most loss contingencies do not appear in the accounting records -made difficult both by the uncertainty factor and also by the tendency of the client management to maintain at least an outward appearance of optimism.
Relationships Between Balance Sheet and Income Statement Accounts
A/R = Sales(Rev) = Uncollectible accounts(Exp) Notes = Interest = Uncollectibles Inventories = COGs PPE = Rent = Depreciation Intagibles = Royalties = Amortazation -most revenue accounts are verified by the auditors in conjunction with the audit of a related asset or liability.
When auditing the statement of cash flows, which of the following would an auditor not expect to be a source of receipts and payments?
Capitalazation
Miscellaneous Revenue
Common mistakes: -Collections on previously written-off accounts or notes receivable, which should properly be recorded as a reduction of the allowance -Write-offs of old outstanding checks. Should be credited to a liability to the state -Sales of scraps--, should reduce COGs. Not increase revenue -Refunds/Rebates of insurance premiums. Should offset a related expense or unexpired insurance. -Proceeds from sale of plant assets. Should be a gain/loss instead.
As a result of analytical procedures, the independent auditors determine that the gross profit percentage has declined from 30 percent in the preceding year to 20 percent in the current year. The auditors should:
Consider the possiblity of msitatement
The search for unrecorded liabilities for a public company includes procedures usually performed through the:
Date of the auditors report
Subsequent to the issuance of the auditor's report, the auditor became aware of facts existing at the report date that would have affected the report had the auditor then been aware of such facts. After determining that the information is reliable, the auditor should next:
Determine whether there are persons relying or likely to rely on the financial statements who would attach importance to the information. -Is it material?
Likely misstatements
Due to extrapolation from audit evidence or differences in accounting estimates
The aggregated misstatement in the financial statements is made up of:
Known, projected and other
Qualitative Materiality Factors
Likely to be material when: -Arise from an item capable of precise measurement (e.g., the amount of a sale) rather than from an estimate (e.g., the amount in the allowance for doubtful accounts). -Mask a change in earnings or other trends. -Hide a failure to meet analysts' consensus expectations for the company. -Change a loss into income, or vice versa. -Concern a particularly important segment or other portion of the registrant's business. -Affect compliance with regulatory requirements, loan covenants, or other contractual requirements. -Increase management's compensation. -Involve concealment of an unlawful transaction. -Are of an amount that management or the auditors believe would affect the stock's price.
Which of the following is the best way for the auditors to determine that every name on a company's payroll is that of a bona fide employee presently on the job?
Make a surprise observation of the company's regular distribution of paychecks on a test basis.
Most important control: segregation of payroll activities which include:
Payroll activities include the functions of (1) employment (human resources), (2) timekeeping, (3) payroll preparation and record keeping, and (4) distribution of pay to employees.
An unasserted claim should be on the list if
Should assert claim if legal counsel has devoted substantive attention to it and if it is (1) probable that a claim will be asserted and (2) reasonably possible that a loss will result. - if management fails to list an unasserted claim, legal counsel is not required to describe the claim in the reply to the auditors; the lawyer is, however, generally required to inform the client of the omission and to consider resignation if the client fails to inform the auditors
Known misstatements are
Specific misstatements identified during the course of the audit (e.g., the amount of misstatement in a particular account receivable that was confirmed)
Items that have/are always disclosed
Such items include notes receivable discounted and guarantee endorsements.
Adjusting misstatements
The auditors should request that management record the adjustment needed to correct all known misstatements other than those considered trivial. Evaluation -Material misstatements must be corrected -Quantitative and qualitative factors Qualitative example: 1 dollar less means management doesn't make bonus
The client's representation letter normally would be dated:
When the auditor completes the audit
Extrapolation differences
are generally projected misstatements determined through the use of sampling. -EX: if the book value of accounts receivable is $6,250,000 and the auditors, using audit sampling, estimate the audited value to be $6,100,000, the projected misstatement is $150,000 ($6,250,000 - $6,100,000). -amount should be decreased by the amount of the known misstatement (the actual misstatements identified in the sample). -When the auditors identify a likely misstatement due to an extrapolation difference, they should request that management examine the accounts involved in order to identify and correct other misstatements.
Type 2 Subsequent events
conditions come into existence following the balance sheet date. Need to disclose. Customer goes bankrupt after balance sheet date due to natural disaster occurring after balance sheet date.
Type 1 Subsequent Events
conditions existed at the balance sheet date and affects the financial statements, but information surfaces after balance sheet date. Need to adjust financial statements. EX: Customer goes bankrupt after balance sheet date due to financial difficulties existing before the balance sheet date.
Substantive procedures for payroll
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Conservatism
in the valuation of assets means that when two (or more) reasonable alternative values are indicated, the accountant will choose the lower amount. -Higher amount for liabilities -Beacause of legal liabilitiy to third parties -Rejected by FASB but basically still applied.
Evaluation Materiality: Considering Previous Year Uncorrected Misstatements
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Typical internal control questions
-Are employees paid by check or direct deposit? -Is payroll bank account maintained on an imprest basis? -Are the activities of timekeeping, payroll compilation, payroll check signing, and paycheck distribution performed by separate departments or employees? -Are all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed? -Are employee time reports approved by supervisors? Is the payroll bank account reconciled monthly by an employee having no other payroll duties?
2. Obtain or Prepare Analyses of Selected Expense Accounts.
-Based on results of analytical procedures (AICPA) has suggested investigation of (1) advertising, (2) research and development, (3) legal expenses and other professional fees, (4) maintenance and repairs, and (5) rents and royalties. -Obtain or prepare analyses of critical expenses in the income tax return
Letter of inquiry
-Communicate with the client's external legal counsel through a letter of inquiry prepared by management and sent by the auditors. -The letter should ask legal counsel to reply as of a date approximating the estimated date of the audit report to allow the auditors to receive the most current information possible. - letter of inquiry asks legal counsel to corroborate the information provided by management and to comment on those areas where their views differ from those of management. -Include a list of certain unasserted claims (future possible legal action)
Tests of controls for payroll
-Compare names and wage or salary rates to records maintained by the human resources department. -Compare time shown on payroll to time cards and time reports approved by supervisors. -If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production records. -Determine basis of deductions from payroll and compare with records of deductions authorized by employees. -Test extensions and footings of payroll.
Auditing Operations
-Corporate earnings are considered as an extremely important indicator of health and well-being of corporations -Measurement of income is generally regarded as the single most important function of accounting -Although we audit using balance sheet approach, income statement is equally important to investors.
Employment (Human Resources) controls:
-Department manager and HR manager approve hire of new employee and the initial pay rate. -New employee completes form authorizing deductions (insurance, 401(k), etc.) -Changes in pay rates authorized by department manager and HR manager. -HR notifies payroll immediately following termination of an employee. -addition and removal of names from the company payroll, as well as rate changes and reclassification of employees, be evidenced by written approval of an executive in the human resources department and by the head of the operating department concerned.
audit procedures to identify litigation
-Inquiring about these matters with management -Obtaining from management a description and evaluation of litigation, claims, and assessments -Reviewing (1) minutes of meetings of those charged with governance, (2) documents in management's possession regarding litigation, claims, and assessments, and (3) correspondence with legal counsel. -Reviewing legal expense accounts and invoices from legal counsel.
Payroll
-Largest operating cost -Affects many accounts
When to disclose a loss contingency
-Loss contingencies should be disclosed in the notes to the financial statements when it is at least reasonably possible that a loss has been sustained -Loss contingencies need not be disclosed when the possibility of loss is remote
Accounts Receivable Sold or Assigned with Recourse
-Means that guarantee of collectibility is given -Authorization revealed during the auditors' reading of the minutes, and evidence found during examination of transactions and correspondence with financial institutions -Confirmation by direct communication with the purchaser or assignee is necessary for any receivables sold or assigned.
Distributing pay
-Performed by an individual who performs no other payroll activity. -Use of a separate imprest payroll account -paymaster will require proof of identity when distributing checks or cash to employees and require them to sign -All checks/pay for absent employee should be retained and neither returned to the payroll department nor turned over to another employee for delivery. -Unclaimed wages should be deposited in the bank and credited to a special liability account
Why do we observe conservatism in income?
-Reduce litigation risk -Offset managers' inclination to exaggerate good news and hide bad news. -Users of information, especially debt holders, are more concerned with bad news than good. -Reduce / defer tax costs -Regulators wish to appear that they are keeping companies under -control.
Procedures to Identify Subsequent Events
-Review latest available financial statements and minutes of the board and selected committees -Inquiry about matters dealt with at meetings for which minutes are not available -Inquiry of management -Obtain lawyer's letter -Obtain representations from management
To be effective, certain audit procedures described in previous chapters cannot be completed before the end of the audit. Among those procedures are the following:
-Search for unrecorded liabilities. -Review the minutes of meetings. -Perform final analytical procedures. -Perform procedures to identify loss contingencies. -Perform the review for subsequent events. -Obtain the representation letter.
Environmental issues
-Superfund and other legislation require those who harm the environment to pay for remediation. -Record liability if they will probably have to pay for clean up in the future.
Obtain Representation Letter
-The primary purpose of the representation letter is to have the client's principal officers acknowledge that they are primarily responsible for the fairness of the financial statements. -Letter should be dated as of the date of the audit report. -They are NOT a substitute for the application of other necessary audit procedures
Timekeeping controls
-Timecards or electronic time recording aids in accurate reporting of hours worked. -Supervisors watch and often approve time reports. -If pay based on production, need a process to track units integrated into conversion cycle. -Department manager approves PTO and ensures that it is reported to payroll.
Analytical procedure: Develop an expectation of the account balance
-Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data and relevant nonfinancial data -Determine the amount of difference from the expectation that can be accepted without investigation -Use estimates of materiality -Compare the company's account balance with the expected account balance -Investigate significant deviations from the expected account balance
Controlling payroll costs:
-delegate to department heads/supervisors responsibility for the control of costs in their respective units - monthly reports to top management comparing the budgeted labor costs and the actual labor costs for each department
Perform analytical procedures to test the reasonableness of payroll expense
-develop an expectation about the amount of payroll expense by multiplying the amount of one pay period by the number of pay periods in the year. -Investigate any extraordinary fluctuations in salaries, wages, and commissions. -Obtain or prepare a summary of compensation of officers for the year and compare to contracts, minutes of directors' meetings, or other authorization. -Test the period end accrual of payroll expense. -Test computations of compensation earned under profit-sharing or bonus plans. -Test commission earnings by examination of contracts and detailed supporting records. -Test pension obligations by reference to authorized pension plans and supporting records.
Accounting estimate differences
-differences between management's and the auditors' judgment concerning the appropriate amounts of accounting estimates. - For these items, the estimated (likely) misstatement is the difference between management's estimate and the closest amount that the auditors consider reasonable. -When accounting estimates include what the auditors believe to be likely misstatements, the auditors should request that management review the assumptions and methods used in developing their estimate
Analysis of legal and professional fees
-disclose legal and audit fees properly chargeable to costs of issuing stock of debt instruments, or to costs of business combinations. -Furnish the name of the lawyer who may be able to disclose contingent liabilities
Other contingency: Guarantees of indebtedness
-estimate the noncontingent and contingent portion of guarantee Noncontingent - the fee paid to the guarantor or the benefit realized by the guaranteed party due to the presence of the guarantee. Record as liability at fair value at inception of guarantee Contingent - if payout/loss becomes more probable, need to record a liability. Concern: Guarantees easy to hide. Enron had guaranteed debt of its SPEs.
Payroll Preparation and Record Keeping
-important that the payroll department not perform the related functions of timekeeping, employment, or distribution of pay to employees The output of the payroll department may be thought of as (1) the payroll checks or direct deposits (or pay envelopes, if wages are paid in cash); (2) individual employee statements of earnings and deductions; (3) a payroll journal; (4) an employees ledger, summarizing earnings and deductions for each employee; (5) a payroll distribution schedule, showing the allocation of payroll costs to direct labor, overhead, and various departmental expense accounts; and (6) quarterly and annual reports to the government showing employees' earnings and taxes withheld.
Auditors obtain evidence about many income statement accounts concurrently with
-related balance sheet accounts. EX:Depreciation expense is most conveniently verified along with the PPE accounts. Once the existence and cost of depreciable assets are established, the verification of depreciation expense is just an additional step.
General Risk Contingencies
-represents a loss that might occur in the future, as opposed to a loss contingency that might have occurred in the past. EX: threat of a strike or consumer boycott of their product -general risk contingencies ordinarily need not be disclosed in financial statements. (Beacause they're basically normal business risks)