Auditing Operations and Completing the Audit Study Notes

Auditing Operations

• Significance of Corporate Earnings: Corporate earnings are widely regarded as an extremely important indicator of the health and well-being of a corporation. The measurement of income is generally considered the single most important function of accounting.
• Control Integration: Many of the essential controls over revenues and expenses are described in conjunction with the related balance sheet accounts.
• Management Review Controls: Management utilize management review controls to detect and correct misstatements that may not have been prevented or detected by other controls.

Conservatism in the Measurement of Income

• Influence on Revenue and Expenses: Conservatism exerts a powerful influence on the recording of revenue and expenses, largely due to the subjectivity involved with accounting estimates.
• Asset Valuation Rules: Accountants typically choose the lower of two or more reasonable alternative values for assets.
• Liability Valuation Rules: For liabilities, the higher amount among reasonable alternatives is chosen.
• Income Statement Result: This conservative approach results in an income statement with a low or conservative income figure.

Objectives for the Audit of Revenue and Expenses

• Inherent Risk Assessment: Use the understanding of the client and its environment to consider inherent risks, including fraud risks, specifically related to revenues and expenses.
• Internal Control Evaluation: Consider the internal control structure governing revenues and expenses.
• Material Misstatement Assessment: Assess the risks of material misstatement and design further audit procedures to:     - Establish Occurrence: Verify that recorded revenue and expense transactions actually occurred.     - Determine Completeness: Ensure that all revenue and expense transactions that should have been recorded are included.     - Establish Accuracy: Verify the mathematical accuracy of revenue and expense transactions.     - Verify Cutoff: Ensure transactions are recorded in the proper accounting period.     - Determine Presentation and Disclosure: Verify that revenue and expense accounts are appropriately classified and presented, including proper presentation of earnings-per-share (EPS) data.

Relationships Between Balance Sheet and Income Statement Accounts

• Accounts Receivable / Notes Receivable: Linked to Sales and Interest Revenue.
• Securities and Investments: Linked to Interest, Dividends, Gains, and Investee's Income.
• Uncollectible Accounts/Notes: Linked to Bad Debt Expenses and Losses.
• Inventories: Linked to Purchases, Cost of Goods Sold ($\text{COGS}$), and Payroll.
• Property, Plant, and Equipment (\text{PP&E}): Linked to Depreciation, Repairs, Rent Revenue, and Gains.
• Intangible Assets: Linked to Amortization and Royalties.
• Prepaid Expenses / Accrued Liabilities: Linked to Various Expenses and Interest Expense for interest-bearing debt.

Auditing Miscellaneous Revenue

• Nature of the Account: Miscellaneous revenue is often a mixture of minor items, including nonrecurring items and those received at regular intervals.
• Analysis Requirements: The auditor should analyze the account to identify items that may have been improperly recorded, such as:     - Collections on previously written-off accounts or notes receivable.     - Write-offs of old outstanding checks or unclaimed wages.     - Proceeds from sales of scrap materials.     - Rebates or refunds of insurance premiums.     - Proceeds from sales of plant assets.
• Auditor Actions:     - Propose adjusting journal entries ($\text{AJEs}$) to classify items correctly.     - Perform analytical procedures and investigate unusual fluctuations to detect material amounts of unrecorded revenue or significant misclassifications.

Substantive Tests for Selling, General, and Administrative (SG&A) Expenses

• Analytical Procedures Framework:     1. Develop an Expectation: Use budgeted amounts, prior-year audited balances, industry averages, and relationships between financial and nonfinancial data.     2. Define Acceptable Difference: Determine the amount of difference from the expectation that can be accepted without further investigation, based on estimates of materiality.     3. Compare Balances: Compare the company's actual account balance with the expected balance.     4. Investigate Deviations: Examine significant deviations from the expected balance.
• Selection of Selected Expense Accounts: Based on analytical results, specific accounts should be analyzed. The AICPA suggests analyzing:     - Advertising.     - Research and Development (\text{R&D}).     - Legal expenses and other professional fees.     - Maintenance and repairs.     - Rents and royalties.
• Tax Returns: Auditors must obtain or prepare analyses of critical expenses listed in the income tax return.

Case Study: Professional Fees Analysis (Figure 16-1)

• Entity: Cheviot Corporation.
• Account No.: 547.
• Period: Year Ended December 31, 20x3.
• Workpaper Findings:     - Monthly retainer for legal services: $12 \times \$1,000 = \$12,000$.     - Audit fee (Jay & Wall, CPAs): $\$22,000$.     - Legal fee for real property acquisition (Vancouver plant): $\$6,000$.     - Modification of installment sales contract forms: $\$800$.
• Adjustments Made:     - The $\$6,000$ legal fee for real property was identified as a capital expenditure rather than an expense.     - AJE 41: Debit Land $\$6,000$; Credit Professional Fees $\$6,000$.
• Final Totals:     - Balance per Ledger: $\$40,800$.     - Adjusted Balance: $\$34,800$.

Auditing Payroll

• Importance: Payroll is typically the largest operating cost for most corporations.
• Fraud Prevention: While payroll fraud was historically common, it is now harder to conceal due to:     - Extensive segregation of duties.     - Computerized systems with robust controls.     - Frequent payroll reports filed with government agencies.
• Segregation of Functions: Separate departments must handle:     1. Employment (Personnel/HR).     2. Timekeeping.     3. Payroll preparation and record keeping.     4. Distribution of pay to employees.
• Internal Control Questions:     - Are employees paid by check or direct deposit?     - Is the payroll bank account maintained on an imprest basis?     - Are time reports approved by supervisors?     - Is the payroll bank account reconciled monthly by an employee with no other payroll duties?     - Is there independent verification of all operations before paychecks are distributed?

Tests of Controls for Payroll

• Standard Procedures:     - Compare names and wage/salary rates to human resources records.     - Compare time on payroll to time cards/reports approved by supervisors.     - For piecework, reconcile earnings with production records.     - Verify basis and authorization of payroll deductions.     - Test extensions and footings of payroll documents.     - Compare total payroll to the total of checks issued.     - Compare payroll totals to labor cost summaries from the cost accounting department.     - If paid in cash, compare employee receipts with records.     - If paid by check, compare endorsements to signatures on withholding tax exemption certificates.     - If paid by direct deposit, compare listing of payments with authorizations.     - Observe employee use of time clocks and investigate unused time cards.

Data Analytics Tests for Payroll

• Identify duplicate payroll checks, direct deposits, or cash payments within pay periods.
• Identify multiple payments to the same bank account under different employee names.
• Identify pay deposited into a bank account matching a vendor in the master file.
• Search for false, invalid, or duplicate Social Security numbers.
• Identify differences between union agreement rates and actual payments.
• Summarize costs for special pay, overtime, and premiums.

Audit of the Statement of Cash Flows

• Integrated Auditing: Amounts are audited in conjunction with the audit of balance sheet and income statement accounts.
• Core Objectives: Presentation and disclosure are the primary audit objectives.
• Categories: Verification of classification into Operating, Investing, and Financing activities.

Audit Procedures Completed Near the End of Fieldwork

• Search for unrecorded liabilities.
• Review minutes of board and committee meetings.
• Perform final analytical procedures.
• Perform procedures to identify loss contingencies.
• Perform the review for subsequent events.
• Obtain the management representation letter.
• Communicate misstatements to management.
• Evaluate overall audit findings.

Loss Contingencies

• Recording Criteria: A loss contingency is reflected in the financial statements if:     - It is probable that a loss was sustained before the balance sheet date.     - The amount of the loss can be reasonably estimated.
• Disclosure Criteria:     - Disclosed in notes if a loss is at least reasonably possible.     - No disclosure is necessary if the possibility of loss is remote.
• Litigation: This is the most common loss contingency. Auditors use letters of inquiry to the client’s legal counsel regarding pending/threatened litigation and unasserted claims.
• Other Contingencies: Income tax disputes, accommodation endorsements/guarantees, accounts receivable sold with recourse, environmental issues, commitments, and general risk contingencies.
• Audit Procedures for Contingencies:     - Review director meeting minutes through the end of fieldwork.     - Confirm contingent liabilities with financial institutions.     - Review correspondence with lenders for guarantees or assignments.     - Review reports from regulatory agencies for potential fines.     - Obtain representation letters from client officers.

Subsequent Events

• Timeline: Responsibility spans from the balance sheet date to the date of the audit report.
• Procedures to Identify:     - Review the latest available interim financial reports.     - Review board/committee minutes.     - Inquire of management regarding meeting matters where minutes are unavailable.     - Obtain a lawyer’s letter and management representations.

Management Representation Letter

• Purpose: To have principal officers acknowledge their primary responsibility for the fairness of the financial statements.
• Dating: Must be dated as of the date of the audit report.
• Nature: It is not a substitute for performing necessary audit procedures.

Types of Misstatements

• Factual Misstatements: Specific misstatements where there is no doubt.
• Judgmental Misstatements: Differences arising from management judgments that the auditor considers incorrect (e.g., accounting estimates).
• Projected Misstatements: The auditor's best estimate of misstatements in populations, projected from audit samples.
• Total Likely Misstatement: The sum of the above to determine if overstatements or understatements are material.

Materiality and Evaluation

• Qualitative Materiality Factors: Items may be material if they:     - Arise from precise measurement rather than estimates.     - Mask a change in earnings trends.     - Hide a failure to meet consensus analyst expectations.     - Convert a loss into income.     - Affect a particularly important business segment.     - Affect compliance with loan covenants or regulatory requirements.     - Increase management compensation.     - Involve concealment of unlawful transactions.
• Evaluating Previos Year Uncorrected Misstatements (SEC SAB 108):     - Example: Understated warranty payable current year $\$70,000$ plus balance sheet carryover from preceding year $\$60,000$. Total $\$130,000$.     - If either the current year misstatement ($\$70,000$) or the aggregate ($\$130,000$) is material to the current year, an adjustment must be made.     - If the $\$60,000$ is material to the prior year, prior financial statements should be adjusted.

Review of the Engagement

• Process: Seniors review the work of audit staff; managers and partners review higher-risk accounts.
• Timing: Often not completed until near or after the completion of fieldwork.
• Second Partner Review: A partner not otherwise involved in the engagement must perform a review prior to the issuance of the audit report.

Communication with Those Charged with Governance

• Mandatory Disclosures:     - Fraud and illegal acts.     - Significant deficiencies and material weaknesses in internal control.     - Auditor responsibility under Generally Accepted Auditing Standards ($\text{GAAS}$).     - Overview of planned scope and timing.     - Significant findings: qualitative aspects of accounting, difficulties encountered, uncorrected misstatements, disagreements with management, and management's consultations with other accountants.     - Auditor independence issues.     - Critical Audit Matters ($\text{CAMs}$).

Post-Audit Responsibilities

• Subsequent Discovery of Facts: If facts existing at the report date are discovered later, the auditor advises the client to disclose these to parties relying on the report. If the client refuses, the CPA notifies the board and regulatory agencies.
• Omitted Audit Procedures: If discovered (e.g., during peer review), the auditor assesses if the omission impairs the opinion. If so, they attempt to perform the omitted or alternative procedures.