Audit Operations and Completing the Audit Study Notes

Auditing Operations

• Importance of Corporate Earnings: Corporate earnings are considered an extremely important indicator of the health and well-being of corporations.
• Role of Income Measurement: The measurement of income is generally regarded as 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 employs review controls to assist in detecting and correcting misstatements that were not prevented or detected by other internal controls.

Conservatism in the Measurement of Income

• Influence of Subjectivity: Conservatism exerts a powerful influence on revenue and expenses because of the inherent subjectivity involved with accounting estimates.
• Valuation Rules for Financial Statement Items:     * Assets: Accountants choose the lower of two or more reasonable alternative values.     * Liabilities: The higher amount among reasonable alternatives is chosen.
• Resulting Financial Impact: These practices result in an income statement with a low or conservative income figure.

Objectives for the Audit of Revenue and Expenses

1. Risk Consideration: Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to revenues and expenses.
2. Internal Control: Consider the internal control over revenues and expenses.
3. Risk Assessment and Audit Design: Assess the risks of material misstatement of revenues and expenses and design further audit procedures to:     * Occurrence: Establish the occurrence of recorded revenue and expense transactions.     * Completeness: Determine the completeness of recorded revenue and expense transactions.     * Accuracy: Establish the accuracy of revenue and expense transactions.     * Cutoff: Verify the cutoff of revenue and expense transactions.     * Presentation and Disclosure: Determine that the presentation and disclosure of revenue and expense accounts are appropriate, including proper classification of amounts and the proper presentation of earnings-per-share data.

Relationships Between Balance Sheet and Income Statement Accounts

• Accounts Receivable / Notes Receivable: Linked to Sales and Interest revenue; associated with Uncollectible accounts and Uncollectible notes expenses.
• Securities and Investments: Linked to Interest, dividends, gains, and investee’s income revenue; associated with Losses.
• Inventories: Linked to Purchases, cost of goods sold, and payroll expenses.
• Property, Plant, and Equipment: Linked to Rent revenue and Gains; associated with Depreciation and Repairs expenses.
• Intangible Assets: Linked to Royalties revenue; associated with Amortization expenses.
• Prepaid Expenses: Associated with Various expenses.
• Accrued Liabilities: Associated with Various expenses.
• Interest-bearing Debt: Associated with Interest expense.

Audit of Miscellaneous Revenue

• Nature of Account: A mixture of minor items, including some nonrecurring items and others received at regular intervals.
• Analysis for Misclassifications: The auditor should analyze the account for items improperly recorded as miscellaneous, 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.     * Rebates or refunds of insurance premiums.     * Proceeds from sales of plant assets.
• Required Auditor Actions:     * Propose adjusting journal entries 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 Process:     * Develop an Expectation: Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data, and relevant nonfinancial data to form an expected account balance.     * Determine Acceptable Difference: Determine the amount of difference from the expectation that can be accepted without investigation based on estimates of materiality.     * Compare Balances: Compare the company’s actual account balance with the expected balance.     * Investigate Deviations: Investigate significant deviations from the expected balance.
• Account Selection for Analysis: Examine accounts based on analytical procedure results. The AICPA suggests specific attention to:     * Advertising.     * Research and development.     * Legal expenses and other professional fees.     * Maintenance and repairs.     * Rents and royalties.
• Tax Compliance: Obtain or prepare analyses of critical expenses required for the income tax return.

Professional Fees Analysis Case Study (Figure 16-1)

• Client Name: Cheviot Corporation.
• Period: Year Ended December 31, $20x3$.
• Account Number: $Acct.\,No.\,547$.
• Reference: $R-3-7$.
• Analysis of Transactions:     * Hale and Hale (Various Dates): Monthly retainer for legal services (12 \times $1,000) totaling $12,000.     * Jay & Wall, CPAs (Mar. 5, X3): Audit fee totaling $22,000 (Reference: $CD\,411$).     * Hale and Hale (May 2, X3): Fee for legal services relating to the acquisition of real property adjoining the Vancouver plant totaling $6,000 (Reference: $CD\,602$).     * Hale and Hale (Sept. 18, X3): Fee for legal services relating to modification of installment sales contract forms totaling $800 (Reference: $DC\,1018$).
• Ledger Balance (Dec. 31, X3): $40,800.
• Adjusting Journal Entry 41 (AJE 41): To capitalize the disbursement for land acquisition fee.     * Debit: Land $6,000.     * Credit: Professional Fees $6,000.
• Adjusted Balance: $34,800.
• Conclusion: Professional fees expense is fairly presented in the adjusted amount of $34,800.

Internal Control and Audit of Payroll

• Significance: Payroll is typically the largest operating cost for a company.
• Fraud Considerations: While historically common and substantial, payroll fraud is now difficult to conceal due to:     * Extensive segregation of duties.     * Use of computer controls for payroll preparation.     * Frequent filing of payroll reports with the government.
• Functional Segregation of Duties: Separate departments should handle the following:     1. Employment (Personnel).     2. Timekeeping.     3. Payroll preparation and record keeping.     4. Distribution of pay to employees.
• Internal Control Questionnaire Items:     * Are employees paid by check or direct deposit?     * Is the payroll bank account maintained on an imprest basis?     * Is there separation of duties between timekeeping, compilation, check signing, and distribution?     * Are time reports approved by supervisors?     * Is the bank account reconciled monthly by an employee with no other payroll duties?     * Is there independent verification before paychecks are distributed?

Tests of Controls for Payroll

1. Selection and Testing of Transactions: Perform tests over payroll transactions for selected pay periods:     * a. Compare names and salary rates to human resources records.     * b. Compare time on payroll to supervisor-approved time cards or reports.     * c. Reconcile piecework earnings with production records if applicable.     * d. Compare payroll deductions with employee authorizations.     * e. Test extensions and footings of payroll calculations.     * f. Compare total payroll to total checks issued.     * g. Compare total payroll to labor cost summaries from the cost accounting department.     * h. Compare employee receipts for cash wages with payroll records.     * i. Compare paid checks with payroll and compare endorsements to withholding tax exemption certificates.     * j. Compare listing of employee payments to payroll and direct deposit authorizations.     * k. Observe use of time clocks and investigate unused time cards.

Data Analytics Tests for Payroll

• Identify duplicate payroll checks, direct deposits, or cash payments within a pay period.
• Identify multiple payments to the same bank account within a pay period (checking for same or different employee names).
• Identify pay deposits to a bank account matching a vendor in the master file.
• Identify false, invalid, or duplicate Social Security numbers.
• Identify differences between union agreements and actual payments.
• Summarize costs for special pay, overtime, and premiums.

Audit Procedures Near Completion of Field Work

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

Evaluation of Loss Contingencies

• Financial Statement Recognition: Loss contingencies should be reflected in the amounts when:     1. It is probable a loss was sustained before the balance sheet date.     2. The loss amount can be reasonably estimated.
• Note Disclosure: Required when it is at least "reasonably possible" a loss has been sustained.
• No Disclosure: Not required if the possibility of loss is "remote."
• Litigation (The most common contingency):     * Auditors send a letter of inquiry to the client's legal counsel to gather evidence of pending and threatened litigation.     * Unasserted claims must be disclosed if they are probable and reasonably possible.     * SAS 12: Auditors must obtain a list from management describing and evaluating threatened or pending litigation.
• Other Examples of Contingencies:     * Income tax disputes.     * Accommodation endorsements and guarantees of indebtedness.     * Accounts receivable sold or assigned with recourse.     * Environmental issues.     * Commitments.     * General risk contingencies.
• Secondary Procedures for Contingencies:     * Review minutes of directors’ meetings through the completion date of field work.     * Send confirmation letters to financial institutions regarding contingent liabilities.     * Review correspondence with financial institutions for guarantees.     * Review regulatory reports for potential fines or assessments.     * Obtain a representation letter regarding known liabilities.

Subsequent Events

• Timeline of Responsibility (Figure 16.4): Spans from the Balancing Sheet Date to the Date of the Audit Report, eventually reaching the Report Release Date.
• Identification Procedures:     * Review latest financial reports and board/committee minutes.     * Inquire about matters from meetings without available minutes.     * Inquire of management.     * Obtain a lawyer's letter.     * Obtain representations from management.

Management Representation Letter

• Purpose: To have the client's principal officers acknowledge their primary responsibility for the fairness of the financial statements.
• Timing: Dated as of the date of the audit report.
• Auditor Caveat: This letter is not a substitute for the application of necessary audit procedures.

Types of Misstatements and Materiality

• Categorization of Misstatements:     * Factual Misstatements: Specific items identified where there is no doubt.     * Judgmental Misstatements: Differences arising from management judgments deemed incorrect by the auditor.     * Projected Misstatements: Arise from projecting sample results to the entire population.
• Qualitative Materiality Factors: An item is likely material if it:     * Arises from precise measurement rather than estimate.     * Masks a change in earnings trends.     * Hides failure to meet analysts’ expectations.     * Changes a loss into income, or vice versa.     * Concerns an important business segment.     * Affects compliance with regulatory or loan covenants.     * Increases management compensation.     * Involves concealment of an unlawful transaction.     * Affects the stock price.
• SEC SAB 108 (2006) on Uncorrected Misstatements:     * Example Scenario: Understated warranty payable of $70,000 in current year with a $60,000 carryover from the preceding year.     * Requirement: If either the current year amount ( $70,000) or the total cumulative amount ( $130,000) is material to the current year, an adjustment is required.     * Current year income is decreased by at least $70,000.     * If the $60,000 carryover is material to the current year, prior year financial statements should be adjusted.

Review and Communication Responsibilities

• Review Process:     * Work of audit staff is reviewed through working papers by seniors.     * Working paper review is completed near the end of fieldwork.     * Partners and managers focus on high-risk accounts.     * A second partner review is required prior to issuing the audit report.
• Required Communications with Governance:     1. Fraud and illegal acts.     2. Significant deficiencies and material weaknesses.     3. Auditor/Management responsibilities under GAAS.     4. Planned scope and timing of the audit.     5. Significant findings: Qualitative accounting practices, audit difficulties, uncorrected misstatements, disagreements with management, consultations with other accountants, auditor independence, and critical audit matters.
• Post-Audit Discovery of Facts:     * If facts existing at the report date are discovered later, the auditor advises the client to disclose these to those relying on the report.     * If the client refuses, the CPA informs the board of directors and notifies regulatory agencies.
• Omitted Audit Procedures discovered Post-Audit:     * Assess the importance of the omitted procedure to the issued opinion.     * If the omission impairs the opinion, attempt to perform the procedure or an alternative procedure.