Auditing Operations and Completing the Audit Study Guide
Auditing Operations and the Measurement of Income
Corporate earnings represent an extremely vital indicator of the overall health and well-being of a corporation. Within the field of accounting, the measurement of income is generally regarded as the single most important function. Many of the essential controls over revenues and expenses are established and described in conjunction with their related balance sheet accounts. To ensure the integrity of the financial statements, management utilizes management review controls, which are designed to help detect and correct misstatements that may have bypassed other existing controls.
Conservatism in Income Measurement
The measurement of income is significantly influenced by the concept of conservatism, which is particularly important due to the subjectivity involved in accounting estimates. This principle exerts a powerful influence on how revenues and expenses are recorded. Under the framework of conservatism, when accountants are faced with two or more reasonable alternative values for assets, they must choose the lower value. Conversely, for liabilities, the higher amount is chosen. This practice results in an income statement that reflects a low or conservative income figure, preventing the overstatement of a company's financial position.
Objectives for the Audit of Revenue and Expenses
The primary goals for auditors when examining revenue and expenses are multifaceted. First, auditors must use their understanding of the client and the specific business environment to consider inherent risks, including the potential for fraud. Second, they must evaluate the internal controls governing revenue and expense cycles. Third, auditors assess the risks of material misstatement to design further procedures. These procedures aim to establish the occurrence of recorded transactions, determine the completeness of these transactions, and establish their accuracy. Additionally, auditors must verify the proper cutoff of sessions and ensure that the presentation and disclosure of revenue and expense accounts—including proper classification and earnings-per-share data—are appropriate.
Relationships Between Balance Sheet and Income Statement Accounts
Auditors rely on the inherent relationships between balance sheet items and income statement accounts to verify financial data. For example, Accounts Receivable is directly linked to Sales, while Notes Receivable relates to Interest income. Securities and Investments are tied to interest, dividends, gains, and investee’s income. On the expense side, Accounts and Notes Receivable are linked to uncollectible accounts and notes. Inventories correspond to purchases, cost of goods sold, and payroll. Property, Plant, and Equipment accounts are associated with rent, gains, depreciation, and repairs. Intangible assets relate to royalties and amortization, while prepaid expenses and accrued liabilities encompass various expenses. Finally, interest-bearing debt is audited in conjunction with interest expense.
Examination of Miscellaneous Revenue
Miscellaneous revenue often consists of a mixture of minor items, some of which are nonrecurring and others received at regular intervals. Auditors must carefully analyze this account to identify items that may have been improperly recorded. Examples of items that should be reclassified include collections on previously written-off accounts or notes receivable, write-offs of old outstanding checks or unclaimed wages, proceeds from the sales of scrap, rebates or refunds of insurance premiums, and proceeds from sales of plant assets. Auditors should propose adjusting journal entries to correctly classify these items and use analytical procedures to investigate unusual fluctuations, which can reveal material amounts of unrecorded revenue or significant misclassifications.
Substantive Tests for Selling, General, and Administrative (SG&A) Expenses
To audit SG&A expenses, auditors perform analytical procedures by developing an expectation of the account balance using budgeted amounts, prior-year audited balances, industry averages, and relationships between financial and nonfinancial data. They must determine a materiality threshold for differences that can be accepted without further investigation. When the company’s balance compares unfavorably to the expectation, significant deviations must be investigated. The AICPA suggests a specific focus on analyzing advertising, research and development, legal expenses and other professional fees, maintenance and repairs, and rents and royalties. Auditors also analyze critical expenses reported in the income tax return.
Analysis of Professional Fees: Cheviot Corporation Case Study
In the audit of Cheviot Corporation for the year ended December 31, 20x3, the Professional Fees Expense (Account No. 547) was analyzed. The ledger balance was recorded at $40,800. The audit revealed a monthly retainer for legal services of $12,000 () paid to Hale and Hale, and an audit fee of $22,000 paid to Jay & Wall, CPAs on March 5, X3. A $6,000 payment to Hale and Hale on May 2, X3, related to the acquisition of real property for the Vancouver plant was identified. Because this was a cost of acquiring land, Adjusting Journal Entry (AJE) 41 was proposed to capitalize the $6,000 to the Land account and decrease Professional Fees. An additional $800 was paid to Hale and Hale on September 18, X3, for legal services regarding installment sales contract forms. After the $6,000 adjustment, the adjusted balance for professional fees was determined to be $34,800.
Internal Control and Substantive Procedures for Payroll
Payroll is typically a company's largest operating cost. While payroll fraud was historically common, it is now more difficult to conceal due to the extensive segregation of duties, computer controls, and frequent government reporting. Effective internal control requires the separation of four functions: employment (human resources), timekeeping, payroll preparation and record keeping, and the distribution of pay. Key control questions include whether an imprest bank account is used, whether supervisors approve time reports, and whether the payroll bank account is reconciled monthly by an independent employee. All payroll operations should undergo independent verification before checks are distributed.
Audit Procedures and Data Analytics for Payroll
Auditors perform tests of controls by comparing names and wage rates to HR records, comparing payroll time to approved time cards, and reconciling piecework earnings with production records. They test extensions and footings and compare total payroll to checks issued and cost accounting summaries. If paid in cash, receipts are compared to records; if paid by check, endorsements are compared to tax forms; for direct deposit, authorizations are verified. Observation of time clock usage is also required. Data analytics are used to identify duplicate payments, multiple payments to the same bank account, payments to accounts matching vendor files, invalid social security numbers, and discrepancies in union agreements. Analytical procedures serve as the primary substantive procedure for payroll.
Auditing the Statement of Cash Flows and Completing Fieldwork
The Statement of Cash Flows is audited in conjunction with balance sheet and income statement accounts, focusing on the classification of operating, investing, and financing activities. As fieldwork nears completion, auditors perform a series of critical procedures: searching for unrecorded liabilities, reviewing meeting minutes, performing final analytical procedures, identifying loss contingencies, reviewing for subsequent events, obtaining a representation letter, communicating misstatements to management, and evaluating overall audit findings.
Audit of Loss Contingencies and Litigation
Loss contingencies must be reflected in the financial statements if a loss is probable and the amount can be reasonably estimated (). If a loss is reasonably possible, it must be disclosed in the notes. No disclosure is required if the possibility is remote. Litigation is the most common loss contingency. Auditors must send a letter of inquiry to the client’s legal counsel to gather evidence on pending or threatened litigation and unasserted claims. Other contingencies include income tax disputes, guarantees of indebtedness (accommodation endorsements), accounts receivable sold with recourse, environmental issues, and general risk contingencies. Auditors also review regulatory reports and bank correspondence for evidence of these liabilities.
Subsequent Events and the Representation Letter
Auditors are responsible for identifying subsequent events that occur between the balance sheet date and the date of the audit report. Procedures include reviewing the latest available interim financial statements, reading minutes of meetings held after year-end, and inquiring of management and legal counsel. Toward the end of the audit, auditors must obtain a representation letter from the client’s principal officers. This letter serves to have management acknowledge their primary responsibility for the fairness of the financial statements. The letter must be dated as of the date of the audit report, though it is not a substitute for other necessary audit procedures.
Evaluation of Audit Findings and Misstatements
Auditors categorize misstatements into three types: factual misstatements (no doubt exists), judgmental misstatements (disagreements over management's estimates or accounting policies), and projected misstatements (derived from sampling results). Total likely misstatement is evaluated against materiality. Qualitative factors may make a small misstatement material, such as when it masks a change in earnings trends, hides a failure to meet analyst expectations, changes a loss into income, affects loan covenants, increases management compensation, or involves illegal acts.
Applying Materiality: SAB 108 and Uncorrected Misstatements
According to SEC Staff Accounting Bulletin (SAB) 108, auditors must consider the effect of prior-year uncorrected misstatements on the current year. For example, if a company has a $70,000 current-year understatement of warranty payable and a $60,000 carryover from the prior year, the total misstatement is $130,000. If either the $70,000 or the $130,000 is material, an adjustment is required. If the $60,000 is material to the current year, the prior-year financial statements must be adjusted. If the $60,000 is immaterial to the current year but the $70,000 is material, the current year income is decreased by the relevant amount.
Review, Communication, and Post-Audit Responsibilities
The audit process concludes with a hierarchical review of working papers by seniors, managers, and partners, followed by a second partner review before the report is issued. Auditors must communicate specific matters to those charged with governance, including fraud, material weaknesses in internal control, the scope of the audit, significant findings, audit difficulties, and critical audit matters (CAMs). If the auditor subsequently discovers facts that existed at the report date, they must advise the client to disclose them or notify regulatory agencies if the client refuses. If an audit procedure was omitted, the auditor must assess its importance and attempt to perform it if the ability to support the opinion is impaired.