Actg 460 Final PPT PDF

Chapter 11 Chapter 11 Actg 460 - Auditing Professor Lacy Willis Text - Auditing: A Practical Approach with Data Analytics Chapte...

Chapter 11 Chapter 11 Actg 460 - Auditing Professor Lacy Willis Text - Auditing: A Practical Approach with Data Analytics Chapter 11 Auditing the Revenue Process 1 Chapter 11 Chapter 11 Auditing Revenue is a Big Deal Why? What accounts and assertions are generally most at risk? Copyright ©2018 John Wiley & Sons, Inc. 2 2 Chapter 11 Chapter 11 Nature of the Revenue Process ILLUSTRATION 11.2 Key revenue process assertions Copyright ©2019 John Wiley & Sons, Inc. 3 3 Chapter 11 Chapter 11 Process of Auditing Revenue 4 4 Chapter 11 Chapter 11 Understanding the Client’s Revenue Process The process of earning and recognizing revenues will vary from entity to entity. Industry and nature of customers play a big role in understanding revenue Some common issues/concerns Sale of commodities and rapidly changing pricing and demand (ie. Oil & gas) Sale of goods in foreign countries Bundled products and collection in advance (ie. Software) Industries with tight margins (ie. Supermarkets) Collection risk Various revenue streams Client performance measurement Related party transactions Understanding how the entity earns and recognizes revenues assists the auditor in: 1. Developing an expectation of total revenues by understanding the client’s capacity, marketplace, and customers 2. Developing an expectation of gross margin by understanding the client’s market share and competitive advantage in the market 3. Developing an expectation of net receivables based on the average collection period for the client and for the industry 5 4. Determining inherent risk for revenue and related accounts 5 Chapter 11 Chapter 11 Analytical Procedures Analytical procedures commonly used to audit revenues Ratio Formula Audit Significance Sales to capacity Net sales Helpful in assessing the reasonableness of total revenues Nonfinancial measure of capacity Market share Helpful in assessing the reasonableness of both total Client's net sales revenues and gross margins. Larger market share is often Net sales of industry associated with larger gross margins. Sales to total Sales This ratio is useful for manufacturing and other asset- assets based companies. Describes the relationship between Average total assets assets and sales revenues. Accounts  Accounts receivableCurrent Year  Ratios larger than 1.0 indicate that receivables are growing   1 receivable growth  Accounts receivablePrior Year  faster than sales. Large ratios may indicate possible to Sales growth  SalesCurrent Year  collection problems.   1  SalesPrior Year  Accounts Useful in comparing with industry averages. Longer receivable  Net credit sales  collection periods may indicate collection problems. Prior 365 days    turnover in days  Average net receivables  experience and current sales volumes may be useful in estimating current net receivables. Copyright ©2019 John Wiley & Sons, Inc. 6 6 Chapter 11 Chapter 11 Analytical Procedures Analytical procedures commonly used to audit revenues Ratio Formula Audit Significance Uncollectible Uncollectible accounts expense Useful in evaluating the reasonableness accounts of uncollectible accounts expense. expense to net credit Net sales Smaller ratios may indicate an sales inadequate provision for uncollectible accounts. Uncollectible Uncollectible accounts expensePrior Year Useful in evaluating the reasonableness accounts of prior period’s uncollectible accounts Actual accounts receivable write-offs Current Year expense to accounts expense. Smaller ratios may indicate receivable write-offs an inadequate estimation process. New product Revenues from new products Companies with a high proportion of revenues to total revenues from new products may earn a revenues introduced during the year premium gross margin due to their ability Total revenues to innovate. Copyright ©2019 John Wiley & Sons, Inc. 7 7 Chapter 11 Chapter 11 LO# 9 Assertions about Classes of Transactions and Events– Revenue Transactions All revenue and cash receipt transactions and events Occurrence that have been recorded have occurred and pertain to the entity. All revenue and cash receipt transactions and events Completeness that should have been recorded have been recorded. All revenue and cash receipts transactions and events Authorization are properly authorized. Amounts and other data relating to recorded revenue Accuracy and cash receipt transactions and events have been recorded appropriately. Cutoff All revenue and cash receipt transactions and events have been recorded in the correct accounting period. Classification All revenue and cash receipt transactions and events have been recorded in the proper accounts. 10-8 8 Chapter 11 Chapter 11 Inherent Risks in the Revenue Process Factors that incent management to misstate revenue process assertions and commit fraudulent financial reporting include: 1. pressures to overstate revenues in order to achieve revenue or profitability targets that were not achieved in reality owing to such factors as global, national, or regional economic conditions; the impact of technological developments on the entity’s competitiveness; or ineffective management. 2. pressures to overstate cash and gross receivables, or understate the allowance for doubtful accounts, in order to report a higher level of working capital required to meet debt covenants. Areas where revenue can be manipulated Copyright ©2019 John Wiley & Sons, Inc. 9 9 Chapter 11 Chapter 11 Understanding Control Activities for Sales Example flow of transactions for credit sales Copyright ©2019 John Wiley & Sons, Inc. 10 10 Chapter 11 Chapter 11 Example Transaction Flows—Sales Process Credit sales transactions—WCGW and example controls Documents Transaction and Files Risks (WCGW) Example Control Initiating credit Customer Sales may be made to Only a limited number of individuals can change sales master File Unauthorized customers. the customer master file and all file changes are reviewed by appropriate levels of management. Sales order Sales may be made to The software application matches the customer Unauthorized customers. on the sales order with the customer master file. The software application matches amount of Sales order Sale may be made without sales order with credit authorization on the credit approval. customer master file. Appropriate level of regular review of sales analysis (by product, division, salesperson or region) and comparisons with budgets. Copyright ©2019 John Wiley & Sons, Inc. 11 11 Chapter 11 Chapter 11 Example Transaction Flows—Sales Process Credit sales transactions—WCGW and example controls Documents Transaction and Files Risks (WCGW) Example Control Delivering goods Perpetual Goods may be released The software application matches all goods inventory from warehouse for pulled from inventory (perpetual inventory) to unauthorized orders. approved sales orders. Products may be shipped The software application generates packing slip Bill of lading and without shipping and delivery documentation when order is packing slip documents being processed. generated. Bill of lading and Goods ordered may not The software application prints a report of all packing slip be shipped. unfilled sales orders. Copyright ©2019 John Wiley & Sons, Inc. 12 12 Chapter 11 Chapter 11 Example Transaction Flows—Sales Process ILLUSTRATION 11.8 Credit sales transactions—WCGW and example controls Transaction Documents and Files Risks (WCGW) Example Control Recording sales Sales invoice and Some shipments may not be billed. The software application prints a report of all sales process goods shipped but not billed. database Invoices are prenumbered and accounted for. The software application prints a report of all bills of lading not matched with sales invoices. Sales invoice and Billing may be made for fictitious The software application matches sales invoice sales process transactions, or duplicate information with underlying shipping database billing may be made. information. Sales invoice and Sales invoices may be recorded The software application matches sales invoice sales process in the incorrect accounting date with accounting period in which goods are database period. shipped. Sales invoice and Sales invoices may be recorded The software application matches sales invoice sales process in the incorrect amount quantities with shipping information and prices database (incorrect quantities or prices). with master price list. Copyright ©2019 John Wiley & Sons, Inc. 13 13 Chapter 11 Chapter 11 Example Transaction Flows—Sales Process ILLUSTRATION 11.8 Credit sales transactions—WCGW and example controls Transaction Documents Risks (WCGW) Example Control and Files Sales invoice and Invoices may not be The software application checks run-to-run total of sales process journalized or posted to beginning receivables, plus sales transactions with the sum database customer accounts. of ending receivables. Sales invoice and Sales invoices may be The software application matches customer number on sales sales process billed to the wrong invoice with customer number of sales order and bill of database customer. lading. Monthly receivable Customers may be billed An individual reviews monthly statements to customers statements incorrect amounts. before they are mailed, reporting any exceptions to a designated accounting supervisor not otherwise involved in the execution or recording of revenue process transactions. Statements are mailed monthly, with follow-up on customer complaints independent from the recording process. Copyright ©2019 John Wiley & Sons, Inc. 14 14 Chapter 11 Chapter 11 Example Tests of Controls for Revenue Assertion WCGW Client Control Test of Client Control 10-15 15 Chapter 11 Chapter 11 Example Tests of Controls for Revenue Assertion WCGW Client Control Test of Client Control 16 Chapter 11 Chapter 11 Example Tests of Controls for Revenue Assertion WCGW Client Control Test of Client Control 17 Chapter 11 Chapter 11 Example Transaction Flows—Cash Receipts The cash receipts function involves: 1. Receiving cash 2. Depositing cash 3. Recording the receipts Source Documents: 1. Remittance advice 2. Remittance report from the bank 3. Bank deposit slip Recording Cash Receipts: 1. Daily remittance report (or daily cash receipts journal). Important Databases or Other Documents: 1. Sales process database 2. Monthly statements of receivable balances. Copyright ©2019 John Wiley & Sons, Inc. 18 18 Chapter 11 Chapter 11 Example Transaction Flows—Cash Receipts Cash receipts transactions: WCGW and example controls Transaction Documents and Files Risks (WCGW) Example Control Receiving and Remittance advice Mail receipts may be lost or Electronic funds transfer directly to bank or depositing cash from customer, bank misappropriated after receipt. establish a lockbox arrangement with the bank. remittance report, deposit slip Cash may be taken (skimmed) or not be deposited intact daily. The client’s software application can recalculate Inappropriate cash discounts may be cash discounts taken by customers. taken by customers. Cash received Cash sales may not be recorded. Use of cash registers or point-of-sale devices. by the client Prelist of cash receipts Mail receipts may be lost or Immediate preparation of prelist of mail misappropriated after receipt. receipts. Restrictive endorsement of checks immediately upon receipt. Prelist of cash receipts, Checks received may not agree with Independent check of agreement of remittance remittance advices prelist of cash. advices with prelist of cash received. Cash deposited Bank deposit slip, Cash may not be deposited intact daily. Independent check of agreement of prelist of cash by the client prelist of cash receipts, receipts or bank remittance report with validated bank remittance report deposit slip. Recording cash Sales database, prelist of Cash receipts may be recorded in error. Software agreement of amounts journalized and receipts cash receipts, bank posted with the prelist of cash receipts or bank remittance report remittance report. Errors may be made in journalizing Preparation of periodic independent bank Independent bank cash receipts. reconciliations. Reconciliation Receipts may be posted to the wrong Mailing of monthly statements to customers. Monthly statement to customer account. customers 19 19 Chapter 11 Chapter 11 Control Activities for Sales Adjustments, and Revenue Process Disclosures Important documents and records used in processing sales adjustments include the following: 1. Sales return authorization 2. Authorization for accounts receivable write-off 3. Receiving report 4. Credit memo 5. Journal entry 6. Cash receipts journal Sales adjustment transactions involve the following sales adjustment transactions: 1. Granting sales returns and allowances 2. Determining uncollectible accounts Copyright ©2019 John Wiley & Sons, Inc. 20 20 Chapter 11 Chapter 11 Disclosures in the Revenue Process Common disclosures in the revenue process include: 1. Reclassification of material credit balances in accounts receivable as accounts payable 2. Segregation of short-term trade receivables from long-term trade receivables 3. Disclosure of major customers 4. Disclosure of sales by geographic regions or major product lines 5. Disclosure of receivables from officers, directors, employees, or related parties Copyright ©2019 John Wiley & Sons, Inc. 21 21 Chapter 11 Chapter 11 Fraud Risk Assessment After evaluating inherent risk and control risk, the auditor is in a position to evaluate fraud risk. The opportunity for a lapping scheme begins when a customer pays cash toward an accounts receivable balance. The auditor should be alert to the possibility of fraud when a cash receipt is credited to the wrong customer or there is little or no justification for a sales adjustment or receivable write-off. Copyright ©2019 John Wiley & Sons, Inc. 22 22 Chapter 11 Chapter 11 Substantive Tests for the Revenue Process At this stage, the auditor has evaluated inherent risks, evaluated and tested the system of internal control in the revenue process, and developed an audit strategy. Auditors will next be performing initial procedures, Substantive analytical procedures, ADA as a substantive test, tests of details of transactions, tests of details of account balances, and tests of details of presentation and disclosure assertions. Let’s Review a Typical Audit Program (in your text on pages 34-35) Copyright ©2019 John Wiley & Sons, Inc. 23 23 Chapter 11 Chapter 11 Test of Sales Cutoff Potential sales cutoff issues Date on the Shipping Documents Date on the Sales Invoice Potential Misstatement December 30, 2022 December 31, 2022 No problem December 30, 2022 January 3, 2023 Completeness of revenues and receivables January 3, 2023 December 30, 2022 Occurrence of revenues and existence of receivables Must consider FOB terms Copyright ©2019 John Wiley & Sons, Inc. 24 24 Chapter 11 Chapter 11 Confirmation of Accounts Receivable Confirmation of Accounts Receivable Confirmation of accounts receivable involves direct written communication between the client’s customers and the auditor. There is a presumption that the auditor will request the confirmation of receivables during an audit unless: accounts receivable are to the financial statements the use of confirmations would be the auditor’s assessed level of risk of material misstatement at the relevant assertion level is , and the other planned substantive procedures address the assessed risk Copyright ©2019 John Wiley & Sons, Inc. 25 25 Chapter 11 Chapter 11 Confirmation of Accounts Receivable The auditor should mail the confirmation requests outside the entity’s facilities. A record should be maintained of the confirmations mailed and those returned. A second request may be necessary in some cases. In many cases, exceptions result For each exception received, the from what are referred to as timing auditor should examine the reasons differences. Such differences occur for the difference between the because of delays in recording balance on the client’s books and transactions in either the client’s or the balance indicated by the the customer’s records. customer Remember, positive confirmations are key! 26 Chapter 11 Chapter 11 Confirmation of Accounts Receivable When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative procedures include: 1. Examination of specific subsequent cash receipts. 2. Examination of shipping documentation. 3. Examination of other client documentation. 10-27 27 Chapter 11 Chapter 11 Confirmation of Accounts Receivable Summarizing and Evaluating Results The auditor’s working papers should contain a summary of results from confirming accounts receivable. The summary should provide data on: 1. the number and dollar value of confirmations sent, and responses received 2. the proportion of the total population covered by the sample 3. the relationship between the audited and book values of items included in the sample Applicability to Assertions Confirmations are the primary source of evidence in testing the existence assertion for accounts receivable. The evidence about the completeness assertion is limited because: 1. unrecorded receivables cannot be confirmed 2. customers are more likely to report errors of overstatement than errors of understatement Copyright ©2019 John Wiley & Sons, Inc. 28 28 Chapter 11 Chapter 11 Evaluating the Allowance for Doubtful Accounts Audit tests of this accounting estimate include: 1. Using generalized audit software to foot and crossfoot the aged trial balance of accounts receivable, and agreeing the total to the general ledger balance. 2. Testing the accuracy of the client’s aging by vouching to underlying sales invoices and shipping documents. 3. Considering evidence concerning the collectability of past-due amounts by, for example, reading correspondence from customers. 4. Identifying customers with past-due balances, and calculating credit histories for customers with past-due balances. 5. Evaluating prior estimates of uncollectible accounts with subsequent experience and the benefit of hindsight. 6. Using the evidence obtained above to assess the reasonableness of the percentages used to compute the allowance component required for each aging category and the adequacy of the overall allowance. Copyright ©2019 John Wiley & Sons, Inc. 29 29 Chapter 11 Chapter 11 Tests of Details of Presentation and Disclosure Auditors should be alert to the following issues, if they are material: 1. Classification and disclosure requirements include proper identification and classification for receivables, such as separating trade receivables from other receivables that should be separately disclosed: receivables from employees, officers, affiliated companies, and other related parties. 2. Credit balances in accounts receivable (customers who overpay) should be reclassified as current liabilities. 3. GAAP requires proper classification of receivables not due within one year to be classified as noncurrent. 4. GAAP requires disclosures concerning the pledging, assigning, or factoring of receivables. 5. Disclosures may be required regarding significant customers or sales by significant lines of business. Copyright ©2019 John Wiley & Sons, Inc. 30 30 Chapter 11 Chapter 11 End of Chapter 11 31 31 Chapter 12 Chapter 12 Actg 460 - Auditing Professor Lacy Willis Text - Auditing: A Practical Approach with Data Analytics Chapter 12 Auditing the Purchasing and Payroll Processes 1 Chapter 12 Chapter 12 Nature of Purchase Transactions and Balances Purchasing transactions Purchasing Transactions Debit Credit Purchases on credit Merchandise Inventory Accounts Payable Raw Materials Inventory Plant Assets Other Assets Various Expenses Cash disbursements (primarily Accounts Payable Cash focused on payment of payables) Purchase Discounts Purchase adjustment transactions Purchase returns and allowances Accounts Payable Purchase Returns and Allowances We follow the same process for auditing all accounts. Let’s review the 5 step audit process we learned in Chapter 11 (Revenue) Copyright ©2019 John Wiley & Sons, Inc. 2 2 Chapter 12 Chapter 12 Control Activities and Tests of Controls – Purchase Transactions Assertions about Purchase and Cash Disbursement Transactions and Events, and related disclosures, for the Period under Audit All purchase and cash disbursement transactions and events that have been Occurrence recorded or disclosed have occurred, and such transactions and events pertain to the entity. All purchase and cash disbursement transactions and events that should have been Completeness recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included. All purchase and cash disbursement transactions and events have been properly Authorization authorized. Amounts and other data relating to recorded purchase and cash disbursement Accuracy transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described. Purchase and cash disbursement transactions and events have been recorded in the Cutoff correct accounting period. All purchase and cash disbursement transactions and events have been recorded in Classification the proper accounts. All purchase and cash disbursement transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are Presentation relevant and understandable in the context of the requirements of the applicable financial reporting framework. 3 Chapter 12 Chapter 12 Understanding the Client’s Purchasing Process The purchasing process will vary from company to company. The auditor must consider the following in assessing inherent risk: Availability of supplies and number of vendors (ie. Supply chain management) Price volatility and availability of supplies International vendors - regulatory issues and time-lag in receiving supplies Quality control issues Related party transactions Pressure to understate expenses and/or liabilities The expenditure process is also particularly prone to the risk of employee fraud through unauthorized cash disbursements. Management and the auditor also must be alert for risk of collusion with vendors and vendor kickbacks to employees. Copyright ©2019 John Wiley & Sons, Inc. 4 4 Chapter 12 Chapter 12 Inherent Risks in the Purchasing Process Factors that may contribute to misstatements in the purchasing process include: A high volume (very material amount) of transactions. Unauthorized purchases and cash disbursements. Purchased assets may be misappropriated. Duplicate payment of vendor invoices. Cutoff problems due to failure to accrue liabilities when goods have been received but vendor invoices have not yet arrived. Copyright ©2019 John Wiley & Sons, Inc. 5 5 Chapter 12 Chapter 12 Analytical Procedures for Purchasing, Payables, and Disbursement Audits Analytical procedures (risk assessment) commonly used to audit purchases Ratio Formula Audit Significance Accounts payable  Costof sales  Prior experience in accounts payable turnover in days combined turnover in days 365    with knowledge of current purchases can be useful in estimating  Averageaccountspayable  current payables. A reduction of the period may indicate completeness problems. Cost of goods sold Cost of goods sold Unless the company has changed its payment policy, this ratio to average Average Accounts payable should be about the same percentage from year to year. accounts payable Payables as a Accounts payable Common-sized percentages in accounts payable are useful to percentage of total Total assets compare with industry data. A significant decline in payables assets as a percent of total assets may indicate completeness problems. Current ratio Current assets A significant increase in the current ratio compared to prior years Current liabilities may indicate a completeness problem. However, this ratio may also be influenced by changes in current asset accounts. Copyright ©2019 John Wiley & Sons, Inc. 6 6 Chapter 12 Chapter 12 Inherent Risks in the Purchasing Process $000 in Percentage in $000 in Prior Year in Current Year Current Year Prior Year Percentage Revenues $5,638 100.0% $3,780 100.0% Cost of goods sold $2,691 $000 in Current 47.7% in Percentage $1,975 $000 in Prior 52.2% in Percentage Year Current Year Year Prior Year Gross profit $2,947 52.3% $1,805 47.8% Accounts payable, net $ 180 $ 164. Revenue growth 49% 33% Accounts payable growth 9% 30% Cost of goods sold growth 36% 34%. Accounts payable turnover 24 days 31 days in days Inventory turnover in days 180 days 189 days Copyright ©2019 John Wiley & Sons, Inc. 7 7 Chapter 12 Chapter 12 Example Transaction Flows—Cash Disbursements Supporting Documents Voucher—an internal document used to authorize recording and paying a liability Report of vendor invoices due—a report of vendor invoices listed by due date Report of cash balances—a report of daily cash balances Recording Cash Disbursements Check or electronic funds transfer (EFT)—a formal order to a bank to pay the payee the indicated amount Cash disbursements journal—a daily report showing checks written or electric funds transferred to vendors and amount paid Copyright ©2019 John Wiley & Sons, Inc. 8 8 Chapter 12 Chapter 12 Example Transaction Flows—Cash Disbursements Important Databases or Other Documents Purchasing database—electronic files that accumulate data on purchases, accounts payable, and cash disbursements Monthly bank statement—statement from the bank showing transactions in the bank account Bank reconciliation—a reconciliation of the cash amount shown in the general ledger with the cash amount shown on the bank statement Monthly statements received from vendors—a monthly statement often sent by vendors that shows the beginning payable balance, transactions during the month, and the ending payable balance Copyright ©2019 John Wiley & Sons, Inc. 9 9 Chapter 12 Chapter 12 Example Transaction Flows—Credit Purchases Purchase transactions: WCGW and example controls Transaction Documents and Files Risks (WCGW) Example Control Authorizing Vendor master file Purchases may be made Only a limited number of individuals can change the vendor master purchases from unauthorized file, and these duties are segregated from receiving goods or vendors. recording transactions. All file changes are reviewed by appropriate levels of management. The master vendor file is also reviewed to remove old vendors or duplicate vendors. Purchase requisition Unauthorized purchases The software application determines individuals who have authority may be made. to initiate a purchase. Budgetary responsibility and account numbers for items purchased are established at this time. Purchase order Unauthorized purchases Purchases can only be made from approved vendors. Purchase may be made. order establishes evidence of items ordered and price agreed with vendor. Purchase orders are prenumbered and accounted for. Receiving Perpetual inventory Goods received may not The software application matches all goods received to approved goods have been ordered. purchase order. Receiving report Products may be The software application prints a report of all unfilled purchase received without orders for follow-up by ordering department. Receiving reports are generating a receiving also prenumbered and accounted for. report. Receiving report Goods ordered may not The software application prints a report of all unfilled purchase be received. orders for follow-up by ordering department. Copyright ©2019 John Wiley & Sons, Inc. 10 10 Chapter 12 Chapter 12 Example Transaction Flows—Credit Purchases Transaction Documents and Files Risks (WCGW) Example Control Recording Voucher and Purchases may not be recorded The software application prints a report of goods received purchases purchasing database that have not resulted in a voucher. A month-end accrual is made for items received in the warehouse, but the vendor’s invoice has not been received. Vouchers are prenumbered and accounted for. Voucher and Purchases may be made for Vouchers are only recorded when a vendor’s invoice is purchasing database fictitious transactions, or received. The software application matches voucher and duplicate payments may be made. vendor invoice information with the receiving report. The purchase order and vendor’s invoice are marked as recorded, so they cannot be recorded again. Voucher and Purchases may be recorded in the The software application matches the voucher date purchasing database incorrect accounting period. with the accounting period in which goods are received. Voucher and Purchases may be recorded in the The software application matches voucher quantities with purchasing database incorrect amount (incorrect receiving information and prices with the purchase order. quantities or prices). Voucher and Vouchers may be posted to The software application checks account numbers on purchasing database incorrect accounts. the voucher to underlying purchase requisition and purchase order. Voucher and Payable may be posted to the purchasing database wrong vendor. The software application matches vendor number on voucher with vendor number on the purchase order. Vendor’s monthly Vendors invoices may be Monthly statements from vendors are compared with statements recorded in incorrect amounts. the accounts payable subsidiary ledger. Copyright ©2019 John Wiley & Sons, Inc. 11 11 Chapter 12 Chapter 12 Identify What Can Go Wrong (WCGW) and Identify Potential Controls—Cash Disbursements (1 of 2) Cash disbursement transactions: WCGW and example controls Transaction Documents and Files Risks (WCGW) Example Control Paying the liability Purchasing process A check (EFT) may The software application reports any breaks in the sequence and recording cash database not be recorded. of a prenumbered check series and electronic funds transfers. disbursements Report of vendor’s The software application compares the daily total in the cash invoices due disbursements journal with the total vouchers submitted for Cash disbursements payment. journal Access to blank checks and signature plates is controlled. There is an independent bank reconciliation. Purchasing process A check (EFT) may The software application prints a report of checks due but not database not be recorded yet paid. Report of vendor promptly. Run-to-run totals compare beginning cash less cash invoices due disbursements with ending cash balance; beginning accounts Cash disbursements payable less disbursements with ending accounts payable are journal also compared. Purchasing process Checks (EFT) may The software application compares check information with database be issued for purchase order and receiving information or other unauthorized authorization. purchases. The software application performs a limit test on any large disbursement and checks for such disbursements must be manually signed. Copyright ©2019 John Wiley & Sons, Inc. 12 12 Chapter 12 Chapter 12 Identify What Can Go Wrong (WCGW) and Identify Potential Controls—Cash Disbursements (2 of 2) ILLUSTRATION 12.9 Cash disbursement transactions: WCGW and example controls Transaction Documents and Files Risks (WCGW) Example Control Purchasing process A vendor’s invoice may The software application has a field that identifies a database be paid twice. vendor’s invoice has been paid and the voucher number cannot be reused. Purchasing process A check (EFT) may be Manual control requires check signers control the database issued for the wrong mailing of checks. Bank reconciliation amount. There is an independent bank reconciliation. Purchasing process A check (EFT) may be The software application compares information on database posted to the wrong check summary with related voucher information. account. Copyright ©2019 John Wiley & Sons, Inc. 13 13 Chapter 12 Chapter 12 Evaluated Receipt Settlement (ERS) Evaluated receipts settlement (E R S) is a highly automated business process between suppliers and purchasers to exchange data electronically, and to electronically execute a purchase transaction. 1) Initiate the Transaction – the parties enter a contract and determine how data is exchanged, time period, verification, terms of payment 2) Initiate electronic purchase order (prenumbered) and acknowledgement of order with an ASN (advanced shipping notice) 3) Receive Goods – using prenumbered receiving report 4) Record Payables – Once goods received are matched to PO and ASN. Many times this entry is recorded automatically once the receiving report is created and approved. If a vendor invoice is received, it is matched to the receiving report and PO. 5) Electronic payment – typically using an electronic invoice presentment and payment system (EIPP) using a third party to settle the payment Copyright ©2019 John Wiley & Sons, Inc. 14 14 Chapter 12 Chapter 12 Control Activities for Purchase Adjustments and Purchasing Process Disclosures Important documents and records used in processing purchase adjustments in traditional or ERS systems include: 1. Purchase return authorization—form showing the description, quantity, and other data pertaining to the goods the vendor has authorized the purchaser to return 2. Shipping report—report prepared on the shipment of goods to vendors showing the kinds and quantities of goods shipped 3. Debit memo—form stating the particulars of a debit to accounts payable, including the specific items returned, prices, and amount debited Copyright ©2019 John Wiley & Sons, Inc. 15 15 Chapter 12 Chapter 12 Tests of Controls in the Purchasing Process Public company auditors test controls to support an opinion on internal control. If the client relies on IT controls and the auditor plans to assess control risk as low for purchasing process assertions, the auditor will usually: Test the effectiveness of general controls Use computer assisted audit techniques (CAATs) to evaluate the effectiveness of IT application controls Test the effectiveness of manual procedures to follow-up on exceptions identified by IT application controls Copyright ©2019 John Wiley & Sons, Inc. 16 16 Chapter 12 Chapter 12 Fraud Risk Assessment Procurement fraud risks include: A key aspect of fraud risk relates to the opportunity that may or may not present itself based on the quality of the system of internal control. Copyright ©2019 John Wiley & Sons, Inc. 17 17 Chapter 12 Chapter 12 Audit Reasoning Example: Audit Data Analytics in the Purchasing Cycle Cecily has just returned from a staff training session on data analytics. She is auditing a mining company with a high volume of purchases, and she is concerned about the risk of her client paying a fictitious vendor. She asks herself, “How would I determine if an employee is submitting invoices from a fictitious vendor to pay himself or herself extra money?” Copyright ©2019 John Wiley & Sons, Inc. 18 18 Chapter 12 Chapter 12 Substantive Procedures for the Purchasing Process At this stage, the auditor has evaluated inherent risks, evaluated and tested the system of internal control in the purchasing process, and developed an audit strategy (reliance or substantive). Auditors will next be performing initial procedures, Substantive analytical procedures, ADA as a substantive test, tests of details of transactions, tests of details of account balances, and tests of details of presentation and disclosure assertions. Let’s Review a Typical Audit Program (in your text on pages 29-30) Copyright ©2019 John Wiley & Sons, Inc. 19 19 Chapter 12 Chapter 12 Tests of Details of Payables Transactions Search for Unrecorded Liabilities The search for unrecorded liabilities consists of procedures designed to detect significant unrecorded obligations at the balance sheet date. 1. Obtain a listing of payments made after the balance sheet date up to the current date 2. Select items to test and obtain supporting documents for the payment 3. Review the documents to determine which time period the liability should have been recorded based on service/shipment date 4. Determine if the liability was properly recorded in the correct period. 5. Review unpaid/open invoices at fieldwork for the same Copyright ©2019 John Wiley & Sons, Inc. 20 20 Chapter 12 Chapter 12 Tests of Details of Accounts Payable Balances Confirmation of Accounts Payable Confirmations offers assurance that unrecorded payables will be discovered. External evidence in the form of invoices and vendor monthly statements should be available to substantiate the balances. Confirmation of accounts payable is recommended when the detection risk is , there are individual creditors with relatively large balances, or a company is experiencing difficulties in meeting its obligations. Confirmations should be sent to major vendors who: were used in the prior year but not current year do not send monthly statements Blank confirmations will be more useful Copyright ©2019 John Wiley & Sons, Inc. 21 21 Chapter 12 Chapter 12 Tests of Details of Transactions, Account Balances Accrued Liabilities Usually must be tested differently than accounts payable: Is it evidenced by supporting documentation? Is it a calculation or estimate? Some may require specialists 11-22 22 Chapter 12 Chapter 12 Common Disclosures in the Purchasing Process 1. Reclassification of material debit balances in accounts payable as accounts receivable 2. Segregation of short-term payables from long-term payables 3. Dependence on a single vendor or a small number of vendors 4. Disclosure of purchase commitments and long-term purchase contracts 5. Expenses reportable by business segment or geographic region 6. Disclosure of payables to officers, directors, employees, or related parties Copyright ©2019 John Wiley & Sons, Inc. 23 23 Chapter 12 Chapter 12 Auditing Payroll in 1 Slide Testing includes payroll expense and payroll taxes Inherent risk assessment: Consider nature and complexity of compensation, bonuses, etc. Compliance with laws and regulatory issues Using analytical procedures is helpful here due to logical relationships Control risk assessment: Consider controls over hiring, authorizing changes, review of time data, processing payroll Frauds can occur in fictitious employees, incorrect pay rates, duplicate payments Test of controls usually involve testing time cards, payroll records, timeliness, etc. Very useful here because of redundancy Substantive testing involves vouching to supporting documents Copyright ©2019 John Wiley & Sons, Inc. 24 24 Chapter 12 Chapter 12 End of Chapter 12 25 25 Chapter 13 Chapter 13 Actg 460 - Auditing Professor Lacy Willis Text - Auditing: A Practical Approach with Data Analytics Chapter 13 Auditing Cash, Inventory, and Related Income Statement Accounts 1 Chapter 13 Chapter 13 Auditing Cash and Cash Equivalents Copyright ©2019 John Wiley & Sons, Inc. 2 2 Chapter 13 Chapter 13 Understanding the Flow of Transactions Cash and cash equivalents include: 1. Cash in the bank. 2. Imprest bank accounts. 3. Cash equivalents. It is important for the auditor to understand: 1. Management’s cash budgeting practices 2. The influence of seasonal activity on cash balances 3. The level of minimum cash balances the company expects to keep on hand 4. The company’s policies regarding the investment of excess cash in cash equivalents or long-term investments Copyright ©2019 John Wiley & Sons, Inc. 3 3 Chapter 13 Chapter 13 Understanding the Results of Analytical Procedures Because of the residual nature of the cash account, the auditor’s use of substantive analytical procedures for auditing cash is limited to... comparisons with comparisons with prior years’ cash budgeted amounts. balances. This limited applicability of substantive analytical procedures is normally offset by (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and disbursements or (2) extensive tests of the entity’s bank reconciliations. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 4 4 Chapter 13 Chapter 13 Assessing Control Risk and Fraud Risk Controls for Controls for Cash Cash Receipts Disbursements The reliability of the entity’s controls over cash affects the nature and extent of the auditor’s tests of details. Completion of Monthly Bank Reconciliation It is important for auditors to design appropriate audit procedures when control risk is high or maximum, and fraud risk is high. 16-5 5 Chapter 13 Chapter 13 Determining an Audit Strategy Example preliminary audit strategies for cash assuming strong internal controls Assertion Inherent Risk Control Risk Risk That Analytical Risk That Detail Testing Procedures Will Fail to Will Fail to Detect Detect Material Material Misstatements Misstatements Existence Maximum: Cash involves a high Low: Strong controls High: Comparing year- High: The auditor will volume of transactions and it is over cash disbursements to year financial data confirm bank balances. susceptible to misappropriation. and cash receipts & and comparing cash Tests of bank rec depend monthly bank rec. balances with budgets. on controls. Completeness Moderate: Completeness Low: Strong controls High: Comparing year- High: The auditor will problems are more likely with over cash disbursements to year financial data usually confirm bank cash transactions than with cash and cash receipts & and comparing cash balances. Tests of bank balances. Cash will more likely monthly bank rec balances with budgets. rec depend on controls. be overstated than under. Rights and Low: Significant rights issues do N/A Maximum: Analytical High: The auditor will obligations not exist with respect to cash procedures are not usually confirm bank balances. directed at rights and balances and any obligations restriction on cash. Accuracy, Low: Significant valuation Low: Strong controls High: Comparing year- High: The auditor will Valuation and issues do not exist with over cash disbursements to year financial data usually confirm bank allocation respect to cash balances. and cash receipts & and comparing cash balances. Tests of bank monthly bank rec. balances with budgets. rec depends on controls. Presentation Moderate: Usually no significant Moderate or Low: Maximum: Analytical Moderate to High: The Disclosures unless cash Primary control is the procedures are not auditor will often Restrictions due to covenants or involvement of an directed at disclosures. perform tests of details compensating balance effective disclosure to evaluate financial LO 1 arrangements. committee. statement disclosures. 6 6 Chapter 13 Chapter 13 Testing Transactions and Balances - Cash 16-7 7 Chapter 13 Chapter 13 Balance-Related Assertions - Cash 16-8 8 Chapter 13 Chapter 13 Substantive Tests of Cash Balances Bank cutoff statement: A bank statement for the period subsequent to the date of the balance sheet. Auditor requires the client request the bank to send the bank cutoff statement directly to the auditor. The client must request the cutoff statement from the bank and instruct that it should be sent directly to the auditor. Upon receipt of the cutoff statement, the auditor should: 1. Trace a sample of all checks dated in the prior year to the outstanding checks listed on the bank reconciliation 2. Vouch a sample of deposits in transit on the bank reconciliation to deposits on the cutoff statement 3. Scan the cutoff statement and enclosed data for unusual items LO 1 Copyright ©2019 John Wiley & Sons, Inc. 9 9 Chapter 13 Chapter 13 Substantive Tests of Cash Balances Example bank confirmation LO 1 Copyright ©2019 John Wiley & Sons, Inc. 10 10 Chapter 13 Chapter 13 Substantive Tests of Cash Balances Review of client-prepared bank reconciliation LO 1 Copyright ©2019 John Wiley & Sons, Inc. 11 11 Chapter 13 Chapter 13 Substantive Tests of Cash Balances Proof of Cash. When fraud risk is high, the auditor might consider performing a proof of cash. A proof of cash not only reconciles the ending balance, it also reconciles cash receipt transactions between the accounting records and the bank, and the cash disbursement transactions between the accounting records and the bank. Tests of Details of Presentation and Disclosure Cash should be correctly identified and classified in the balance sheet. The auditor determines the appropriateness of the statement presentation from a review of the draft of the client’s statements and the evidence obtained from the foregoing substantive tests. The auditor should review the minutes of board of directors’ meetings and make inquiry of management for evidence of restrictions on the use of cash balances. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 12 12 Chapter 13 Chapter 13 Proof of Cash 16-13 13 Chapter 13 Chapter 13 Lapping v. Kiting –Cash Fraud Cash is stolen (skimmed) before it is recorded on the company’s books (ie. Stealing cash receipts) Will usually be hidden by Lapping – covering the cash shortage by applying cash receipts from other customer accounts, and eventually through write off of accounts Cash is stolen after recorded on the company’s books Will hide by Kiting: transferring funds between accounts and recording improperly on books. Will record on one side in one year and the other side in another 14 Chapter 13 Chapter 13 Substantive Tests of Cash Balances ILLUSTRATION 13.3 Bank transfer schedule – Test for Kiting LO 1 Copyright ©2019 John Wiley & Sons, Inc. 15 15 Chapter 13 Chapter 13 Auditing Inventory Copyright ©2019 John Wiley & Sons, Inc. 16 16 Chapter 13 Chapter 13 Understanding the Flow of Transactions The focus of this section of the chapter is on auditing the costs assigned by the client to ending inventory We must understand the flow of inventory and whether the client uses perpetual or periodic inventory What are the controls over the quantity of inventory? (frequent counts?) What are the controls over the quality of inventory? (damage?) How does the client track inventory values? (typically with a listing of all inventory quantities, costs by item number Key assertion concerns are typically LO 2 Copyright ©2019 John Wiley & Sons, Inc. 17 17 Chapter 13 Chapter 13 Understanding the Results of Analytical Procedures ILLUSTRATION 13.7 Analytical procedures commonly used to audit inventory Ratio Formula Audit Significance Inventory turnover in days Prior experience in inventory turnover in days, combined with knowledge of cost  Costof goodssold  of sales, can be useful in estimating current inventory levels. A lengthening of 365     Averageinventory  inventory turnover in days may indicate existence or valuation (lower-of-cost-or- net-realizable-value) problems. Inventory growth to cost of  Inventory Currentyear  Ratios larger than 1.0 indicate that inventories are growing faster    1 sales growth  Inventory Prior year  than sales. Large ratios may indicate possible inventory obsolescence problems.  cost of sales Current year     1  costof sales Prior year  Finished goods produced to Finished goods quantities Useful in estimating the efficiency of the manufacturing process. May be helpful in raw material used Raw material quanties evaluating the reasonableness of production costs. Finished goods produced to Finished good quanties Useful in estimating the efficiency of the manufacturing process. May be helpful in direct labor Direct labour hours evaluating the reasonableness of production costs. Product defects per million Useful in estimating the effectiveness of the manufacturing process. May be Number of product defects helpful in evaluating the reasonableness of production costs and warranty Each million produced expenses. LO 2 Copyright ©2019 John Wiley & Sons, Inc. 18 18 Chapter 13 Chapter 13 Assessing Inherent Risk The inherent risk of material misstatement arising from inventory transactions depends on the industry. Why? Inherent risk for inventory with a manufacturer, wholesaler, or retailer may be assessed at or near the maximum because: 1. The volume of purchases, manufacturing, and sales transactions that affects these accounts is generally high, increasing the opportunities for misstatements to occur. 2. There is a lot of judgment in identification, measurement, and allocation of costs related to inventory, such as indirect materials, labor, and manufacturing overhead, joint product costs, cost variances, scrap, or inventory shrinkage. 3. The wide diversity of inventory items sometimes requires the use of special procedures to determine inventory quantities. 4. Inventories are often stored at multiple sites, adding to the difficulties associated with maintaining physical controls over theft and damages, and properly accounting for goods in transit between sites. 5. The wide diversity of inventory items may present special problems in determining their quality and market value. 6. Inventories are vulnerable to spoilage, obsolescence, and other factors such as general economic conditions that may affect demand and salability, and thus the proper valuation of the inventories. LO 2 Copyright ©2019 John Wiley & Sons, Inc. 19 19 Chapter 13 Chapter 13 Assessing Control Risk and Fraud Risk Inventory: WCGW and example controls Risks (WCGW) Example Controls Inventory may not exist. Physical controls over inventory (fences, a secure warehouse, and additional physical controls in the warehouse depending on the size and value of inventory). Warehouse and store organization such as numbered locations and identification of each item in inventory using SKU (Stock Keeping Unit) numbers and barcodes or UPC (Universal Product Codes) numbers and barcodes. Regular comparison of perpetual records with actual inventory using frequent counts of a small proportion of inventory, or cycle counts. Inventory counts may be inflated. Regular independent comparison of perpetual records with actual inventory. Accurate recording of all scrap transactions or spoilage. Inventory may not be recorded. Regular count of physical inventory for comparison with perpetual records. Investigation of negative balances in inventory records. Inventory may be valued incorrectly Costs compared with recent purchases. at historical cost. Internal controls over purchases of raw materials and manufacturing labor charged to inventory. Regular review of manufacturing overhead charged to inventory. Inventory may be valued incorrectly Regular review of obsolete inventory. at net realizable value. Regular comparisons of inventory costs to sales prices. Consignment out may not be included. Consignment out periodically inspected by company. Consignment in may be included in Consignment inventory segregated from other inventory and accounted for inventory. separately. LO 2 Copyright ©2019 John Wiley & Sons, Inc. 20 20 Chapter 13 Chapter 13 Control Risk, Fraud Risk and ADA Control Risk: Consider if the client has controls related to the prior slide, focusing on Existence: like regular physical counts or cycle counts Completeness: like comparing physical counts to perpetual records Accuracy/Valuation: like performing a regular review of obsolete or slow moving inventory Rights and Obligations: like having strong controls over consignment inventory Auditors can typically test controls over physical quantities and inventory pricing fairly easily (which may also be dual purpose tests of controls and balances) Fraud Risk: There is typically not as large of a concern related to fraud risks for inventory but, we must remember the relationship between inventory and cost of goods sold. Misstatements in inventory will also create misstatements in cost of goods sold. Also, inventory can be held as collateral for loans so there may be pressure to overstate. ADA: Can be used well in inventory testing for the following: Slow-moving/obsolete inventory by testing sales and quantities on hand or reviewing inventory turnover by product line Once risk is determined and the audit strategy is set, we will perform substantive testing of inventory. Let’s look at a sample audit program in the text. Illustration 13.11 Copyright ©2018 John Wiley & Sons, Inc. 21 21 Chapter 13 Chapter 13 Observing Physical Inventory The observation of inventories has been a generally accepted auditing procedure for 80 years. It gives us comfort as to existence, accuracy, and quality of inventory (including valuation) Timing and extent of inventory observations. The timing of an inventory observation depends on the effectiveness of the client’s internal controls over inventory. LO 2 Copyright ©2019 John Wiley & Sons, Inc. 22 22 Chapter 13 Chapter 13 Observing Physical Inventory Inventory-taking plans. The taking of a physical inventory count by a client is usually done according to a plan or a list of instructions. The client’s instructions should include such matters as: 1. Names of employees responsible for supervising the inventory taking 2. Date of the counts 3. Locations to be counted 4. Detailed instructions on how the counts are to be made (e.g., manual counts versus electronic counts) and instructions for controlling inventory counts (e.g., whether manual counts are double counted or the basis for testing electronic counts) 5. Use and control of electronic count media, prenumbered inventory tags, or summary count sheets 6. Provisions for handling the receipt, shipment, and movement of goods during the counts if such activity is unavoidable 7. Segregation or identification of goods not owned LO 2 Copyright ©2019 John Wiley & Sons, Inc. 23 23 Chapter 13 Chapter 13 Observing Physical Inventory In observing inventories, the auditor should: 1. Scrutinize the care with which client employees are following the inventory plan. 2. Observe that all merchandise is counted once, and only once. If inventory is tagged, no items should be double tagged. 3. Determine that the electronic count media, prenumbered inventory tags, or compilation sheets are properly controlled. 4. Perform some test counts and trace quantities to final count. The direction of testing matters here! Sheet to floor v. floor to sheet 5. Be alert for empty containers and hollow squares (empty spaces) that may exist when goods are stacked in solid formations. 6. Identify the last receiving and shipping documents used and determine that goods received during the count are properly segregated. Note that cutoff of inventory is usually tested along with cutoff of purchases/liabilities. 7. Watch for damaged and obsolete inventory items, and evaluate the general condition of the inventory (e.g., inventory caked with dust or cobwebs). 8. Inquire of employees about the existence of slow-moving inventory items. 9. Ensure consignment inventory is properly separated and marked LO 2 Copyright ©2019 John Wiley & Sons, Inc. 24 24 Chapter 13 Chapter 13 Observing Physical Inventory Regarding physical quantities, the auditor should also consider the need to Count locations outside the entity OR confirm with those locations Examine consignment contracts or agreements Auditor working papers should document: 1. Departures from the client’s inventory-taking plan 2. The extent of test counts and any material discrepancies resulting therefrom 3. Conclusions on the accuracy of the counts 4. Conclusions regarding slow-moving or obsolete inventory noted while at the client’s location LO 2 Copyright ©2019 John Wiley & Sons, Inc. 25 25 Chapter 13 Chapter 13 Substantive Tests of Inventory Inventory test counts working paper LO 2 Copyright ©2019 John Wiley & Sons, Inc. 26 26 Chapter 13 Chapter 13 Auditing Inventory Costs The three components of inventory cost are: Materials Labor Test the quantity and Gather evidence about type of materials the type and amount of included in the product labor needed for and the price of the production and the labor materials. rate. Overhead Review the entity’s method of overhead allocation for reasonableness, compliance with GAAP, and consistency. 13-27 27 Chapter 13 Chapter 13 Testing Valuation of Inventory – Inventory Price Testing Our primary method of testing valuation is to test inventory costing (from raw material costing through finished goods). Especially helpful when a company uses a perpetual average cost system. Testing includes: 1) Obtaining a detailed listing of inventory and select a sample for testing 2) For the sample selected, obtain original purchase documents to verify cost if inventory item 3) Recalculate average cost in inventory and compare to the cost shown on the inventory listing 4) Recalculate finished goods costs by assessing labor and overhead components as necessary 28 Chapter 13 Chapter 13 Inventory Obsolescence The auditor obtains evidence of general condition or obsolescence of inventory by: 1. Observing the client’s inventory taking 2. Scanning perpetual inventory records for slow-moving items or items where the client has a quantity of