Noh Review's Special Edition: Concepts of Auditing
As requested by some of the subscribers, here is a special edition of Noh Review on Auditing. The following content will summarize the basic concepts of Auditing. For some readers, this may be a great refresher. And for others, this may be a good opportunity to have a taste of some Audit concepts.
What is the difference between Audit and Review?
- Audit is the evaluation and accumulation of audit evidence to see if the audited entity complied with the established criteria. Review is similar in this sense, except that it is less extensive than audit. Review is also less costly than audit because audit provides the most assurance, and review does not go as deep as audit.
Public Accountants' Ethical Dilemma
- Deciding whether or not to overlook a material overstatement of revenues to maintain a good client relationship
What are some of the threats?
- Self-interest Threat: E.g. The client could not pay their fees for the last 2 years, so the Public Accountant created a loan agreement covering the fees, with the client paying 10% interest on the fees.
- Advocacy Threat: E.g. The Public Accountant has been hired to manage the accounting department for 3 weeks while the corporate controller is on vacation.
- Familiarity Threat: E.g. The Public Accountant has been working with the client for 10 years, first as a manger, now as a partner.
- Intimidation Threat: E.g. Management threatens to change auditors if you do not let them overstate accounts receivable by $100,000.
What are the types of Audit evidence?
1)
Inspection: E.g. Audit Procedure: Count inventory items and record the amount in the audit working papers. Examine a piece of equipment to make sure a recent purchase of equipment was actually received and is in operation.
2)
Confirmation: E.g. Audit Procedure: Obtain a written statement from the client's bank stating the client's year-end balance on deposit.
3)
Recalculation: E.g. Audit Procedure: Re-foot entries in the sales journal to determine whether they were correctly totalled by the client
4)
Observation: E.g. Audit Procedure: Watch client employees count inventory to determine whether company procedures are being followed.
5)
Inquiry of the Client: E.g. Audit Procedure: Obtain information about the client's internal controls by asking questions of client personnel
6)
Re-performance: E.g. Audit Procedure: Trace totals from the cash disbursements journal to the general ledger
7)
Analytical Procedure: E.g. Audit Procedure: Review the total of repairs and maintenance for each month to determine whether any month's total was unusually large. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year.
What is the difference between Subjective Evidence and Objective Evidence?
Sujective Evidence: E.g. Inquiries of the credit manager about the collectability of non-current A/R
Objective Evidence: E.g. The physical count of securities and cash
General Transaction-Related Audit Objectives:
1)
Occurrence: Recorded transactions occurred.
2)
Completeness: Existing transactions are recorded.
3)
Accuracy: Recorded transactions are stated at the correct amounts.
4)
Classification: Transactions included in the client's records are properly classified.
5)
Posting and Summarization: Recorded transactions are updated to the master files and are correctly summarized.
6)
Timing: Transactions are recorded on the correct dates.
General Balance-Related Audit Objectives:
1)
Existence: Amounts included exist at the Balance Sheet date.
2)
Rights and Obligation: Assets and liabilities belong to the entity.
3)
Completeness: Existing amounts are included.
4)
Accuracy: Amounts included are correct.
5)
Valuation: Assets are included at the amounts estimated to be realized.
6)
Classification: Amounts are properly classified.
7)
Detail tie-in: Transaction details sum to the master file amounts, and subsidiary records agree with the balance in the General Ledger
8)
Cut-off: Transactions near the Balance Sheet date are recorded in the proper period.
General Presentation and Disclosure-Related Audit Objectives:
1)
Occurrence: Disclosed information has occurred.
2)
Rights and Obligations: Assets belong to the entity and obligations are owed on behalf of the entity.
3)
Completeness: Relevant disclosures should be included.
4)
Accuracy: Information should be mechanically accurate.
5)
Valuation: Information should be disclosed fairly.
6)
Classification: Information is appropriately described in the correct accounts.
7)
Understandability: Amount balances and related disclosure requirements are clearly presented in the financial statements.
Real Life Example #1: How to Audit Accounts Receivables
Your goal as the auditor is to detect audit risks, such as 1) receivables do not exist 2) recorded receivable balances are inaccurate 3) it may not be possible to collect A/R 4) the derivation of the allowances for doubtful accounts may not properly reflect bad debt experience 5) sales transactions were not processed in the correct periods 6) revenue was incorrectly recognized.
1)
Trade receivables report to G/L: Trace the grand total of A/R Aging Report to the A/R total amount in the G/L. If these totals do not match, there could be a journal entry in the G/L which should not be there.
2)
Calculate the receivables report total: Add up the invoices on the A/R aging report to verify that the total traced to G/L is correct.
3)
Investigate reconciling items: If you have A/R-related journal entries in the G/L, review the justification for the larger amounts.
4)
Test invoices listed in receivables report: Select some invoices from the A/R Aging Report and compare them to supporting documentation to see if they were billed in the correct amounts, to the correct customers, and on the correct dates.
5)
Match invoices to shipping log: Match invoice dates to the shipment dates for those items in the shipping log, to see if sales are being recorded in the correct accounitng period.
6)
Confirm A/R: Select some larger account balances and contact your customers directly and ask them to confirm the amounts of unpaid A/R as of the end of the reporting period.
7)
Review cash receipts: Verify that customers have paid the invoices.
8)
Assess the allowance for doubtful accounts: Review the process with a consistency comparison with the method you used last year, and a determination of whether the method is appropriate for the business environment.
9)
Assess bad debt write-offs: Compare the proportion of bad debt expense to sales for this year in comparison to prior years, to see if the current expense appears reasonable.
10)
Review credit memos: See if credit memos were properly authorized, whether they were issued in the correct period, and whether the circumstances of their issuance may indicate other problems.
11)
Assess bill and hold sales: Examine your supporting documentation to determine whether a sale has actually taken place.
12)
Review receiving log: See if the receiving log records an inordinately large amount of customer returns after the audit period, which would suggest that the company may have shipped more goods near the end of the audit period than customers had authorized.
13)
Related party receivables: Review them for collectability.
14)
Trend Analysis: Review a comparison of A/R and sales over time to see if there are any unusual trends.
Real Life Example #2: How to Audit Inventory
1)
Cut-off Analysis: Examine the procedures for halting any further receiving into the warehouse or shipments from it at the time of the physical inventory count so that extraneous inventory items are excluded.
2)
Observe the Physical Inventory Count: Familiarize with the procedures used to count the inventory.
3)
Reconcile the Inventory Count to the G/L: Trace the valuation compiled from the physical inventory count to the company's G/L to verify that the counted balance was carried forward into the company's accounting records.
4)
Test High-value Items: Ensure that high-value items are valued correctly and trace them to G/L.
5)
Test Error-prone Items: If you notice an error trend in prior years for specific inventory items, test these items again.
6)
Test Item Costs: Find out where purchased costs in the accounting records come from, so you can compare the amounts in recent supplier invoices to the costs listed in the inventory valuation.
7)
Test for LoCM (Lower of Cost or Market): Compare a selection of market prices to their recorded costs
8)
Finished Goods Cost Analysis: Review the bill of materials for a selection of finished goods items, and test them to see if they show an accurate compilation of the components in the finished goods items and correct costs.
9)
Direct Labour Analysis: Trace the labour charged during production on time cards to the cost of the inventory. Investigate to see if labour costs listed in the valuation are supported by payroll records.
10)
Overhead Analysis: Verify that the company is consistently using the same G/L accounts as the source for overhead costs, check for abnormal costs, and test the validity and consistency of the method used to apply overhead costs to inventory.
12)
Work-in-Process Testing: Test how the company determines a % of completion for WIP items.
13)
Inventory Ownership: Review purchase records to ensure that the inventory in the warehouse is actually owned by the company.
14)
Inventory Layers: If the company is using a FIFO or LIFO inventory valuation system, test the inventory layers recorded to verify that they are valid.
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