UNIT 3

AUDITING PRINCIPLES AND TOOLS

Unit Objective
The main objectives of this unit are to acquaint students with auditing principles and tools.
Therefore, after completing the unit, you are expected to:
 Describe Generally Accepted Auditing Standards(GAAS)
 Distinguish audit procedures from audit techniques
 Explain the different auditing approaches
 Distinguish between management assertions and audit objectives
 Explain the steps in audit planning and audit program
 Understand the benefit of documenting audit working paper
3.1 Auditing Procedures and Techniques
Procedures are steps of action taken in the process of verification or accomplishing specific tasks
to be performed. Auditing procedures are identified and selected in relation to particular item to
be verified i.e. each, accounts receivables, inventory etc. The auditor is supposed to assume full
responsibility for selection of these procedures according to circumstances. They should not be
considered exhaustive and conclusive and are at times intermixed with techniques. The
followings are examples of auditing procedures which we will discuss them in detail in the
second part of auditing

 Vouching  Scanning
 Comparing  Analyzing
 Checking  Testing
 Reconciling  Inquiry
 Inspection  Observation

Auditing Technique: is defined as any technique used by auditors to determine deviations from
actual accounting and controls established by a business or organization as well as uncovering
problems in established processes and controls. Auditing techniques can be used to aid
organizations by uncovering errors in business practices and providing a means of correction.
Some businesses have used irregular accounting methods to hide certain monetary transactions
and non-compliant behavior which has been uncovered by the use of varied auditing techniques.
Other businesses have found new ways to save money and streamline business practices through
various auditing techniques which have found waste in certain processes.

Auditing techniques can be used to uncover these issues in order to ensure ethical business
practices and to minimize waste or possible oversights within an organization. The applied
techniques can determine if any income is hidden or improperly categorized or reported;
transactions are being completed between the organization and regulated or prohibited persons,
groups, or countries; uncovering of environmental waste discrepancies; finding of data
inconsistencies; or any other business practice that can be considered as a process error,
oversight, or violation of ethics, regulations, and laws. The followings are some example of audit
techniques:
 comparing employee addresses with vendor addresses to identify employees that are also
vendors
 searching for duplicate check numbers to find photocopies of company checks
 analyzing the sequence of all transactions to identify missing checks or invoices
 identifying vendors with more than one vendor code or more than one mailing address
 finding several vendors with the same mailing address

Activity
1. What are audit procedures and auditing techniques? What is their difference?
2. Give examples of audit procedures

3.2 Audit Approaches

Audit approach is a point of view, an attitude or a deposition, which influence the procedures and
techniques adapted to circumstances. Different approaches could be adapted for different
purpose and circumstances or objects. The followings are some approaches commonly identified
as influencing verification process.
Defensive Approach: In this approach, the auditor is very cautious; she/he is suspicious that
there is always fraud or an error, which might be concealed from her/him, or someone is trying
to hide from being discovered. Thus, the auditor is prepared to fight fraudulent efforts to conceal
and becomes highly keen on methods that help detect fraud. Hence, the auditor may at times not
be satisfied unless manages to find one. The auditor adapts an attitude that the auditee is guilty
unless proven innocent. The drawback of this approach is it may further the entire negative
image on an auditor in the public.
Positive Approach: In this case, the auditor has a constructive attitude: based on the premise
that a person is innocent until proven guilty. Rather than directing efforts to detecting error,
efforts are directed to establishing its conditions, which lead to what should be acceptable.
She/he looks for explanations and possibilities that lead to conclusion. This approach may lead
the auditor to be easily fooled unless she/he is careful.
Inventory Approach: this approach directs the auditor to find evidences by retracting to or
corroborating figures with physical evidence and reconciling documentary evidences to physical
evidences. Such techniques are usually applicable in cash, and inventory counts
Transaction Approach: the auditor in this case concentrates the efforts on transactions or
events, reconstructing accounts of transactions or tracing amounts back to initial events.
Analytical Approach: In this approach, the auditor performs the audit work through the review
of internal control analysis. This approach involves studying and analyzing circumstantial
evidences or indirect evidences, which leads to developing techniques of evaluating internal
control system and procedures.
Business Approach: the auditor’s attitude in this approach is not just to establish figures by
tracing to books, but rather to assess whether the figures on financial statements and accounts
make sense from the point of view of market conditions, business and economic sense.
Vouching Approach: Under the vouching approach, the auditor looks for supporting
documentary evidences, whether of primary or secondary sources. Usually she/he relies on
source documents.

System Based Approach: as its name designates, the process involves systematic approach to
understanding the operational system and its control devices; and testing whether the system
works as it should, or audits or controls itself, to establish its strength and weakness and
determines reliability of its inputs and out results. Internal control review is part and parcel of
this process although the development and use of this approach has become popular with
information technology development and flow charting
Risk Based Approach: This is the most recent approach to audit. Risk associated with various
audits activities and related decisions are assessed to select audit procedures to determine time to
be applied and identify quality of supporting evidence. This is important to establish extent of
audit program and plans. Area of focus is determined by risk weight. Risks assumed are guided
by the level of assurance needed to obtain evidence and concomitant cost. Thus the higher the
risk object, the more intensive the audit is, and costly too.

 Activity 3.3
1. List and explain the different audit approaches?
3.3 Financial Statement Assertions
Assertions are expressed or implied representation by the management that are reflected in the
financial statement components. For example, when the balance sheet contains account
receivable of Br. 5 million, management asserts that receivables exist and have a net realizable
value of Br. 5 million. Management also asserts that the account receivable balances arose from
selling goods or services on credit in the normal course of the business. In general, the assertions
relates to the requirements of GAAP. These assertions are parts of the criteria management uses
to record and disclose accounting information in financial statements. Auditors must there for
understand the assertions to adequately audit. That is to confirm client’s financial statements to
GAAP. Auditing standard classifies assertions in to five categories
1. Existence or Occurrence Assertion: these deals with whether transactions recorded in
journal or balances in the ledger have actually occurred during a given period and whether assets
or liabilities of the entity actually exist at a given date. For example, management asserts that
inventory shown on the balance sheet physically exists and is available for sales. Similarly,
management asserts that revenue reported in the income statement represents valid sales that
occurred during the period
2. Completeness: assertion about completeness address whether all transactions and accounts
that should be presented in the financial statement are included. For example, management
asserts that inventory represent all items on hand at the balance sheet date. Managements also
implicitly asserts that the amount shown for account payable on the balance sheet includes all
such liabilities on the balance sheet date
3. Right and Obligation: assertion about rights and obligation address whether assets are the
rights to the entity and liabilities are obligations of the entity at a given date. For example,
management asserts that the entity has legal title or rights of ownership to the inventory shown
on the balance. Similarly amounts capitalized for lease reflects assertions that the entity has right
to leased property and that the corresponding lease labiality represents an obligation of the entity.
4. Valuation or Allocation: assertions about valuation and allocation address whether assets,
liabilities, equities, revenue and expense components have been included in the financial
statements at appropriate amount. For example, management asserts that inventory is carried at
the lower of cost or market value on the balance sheet date. Similarly, managements assert that
the cost of property, plants and equipments is systematically allocated to appropriate accounting
periods by recognizing depreciation expense.
5. Presentation and Disclosure: assertion about presentation and disclosure address whether
particular components of financial statements are properly classified, described and disclosed.
For example, management asserts that the portion of long term debt shown as current liability
will mature in the current year. Similarly, managements assert, through footnote disclosure that
all major restriction on the entity resulting from debt covenants is disclosed.

Activity
1. What does management assertion means and what are the five management assertions?
2. What is the difference between Existence and Completeness assertions?
3.4 Audit Objectives
In obtaining evidence to support the assertion contained in the financial statements, the auditor
develops audit objectives that relates to each management assertion. Audit objectives tests the
assertions contained in the components of financials statements. These objectives are both
general and specific audit objectives. Once the auditor has sufficient evidence that the set audit
objectives are met, he or she has reasonable assurance that the financial statement is fairly stated.
The following section discusses the general and specific audit objectives in more detail.
1. Validity: the validity objective relates to the existence or occurrence assertion and is
concerned with whether the transactions included in the account are valid or that they exist. The
auditor’s main concern is that the account balances are not overstated due to fictitious amounts.
For example, to test the validity of account receivable, the auditor might confirm the customers
balance. A customer’s acknowledgment that the amount is owed provides evidence on the
validity of the recorded accounts receivable.
2. Completeness: the completeness objective relates to the management assertion of
completeness and address whether all transaction are included in the account. For example, if the
client fails to record sales or purchase transaction, the financial statement will be misstated. Note
that, the auditor’s concern with completeness is opposite to the concern for validity. Failure to
meet the completeness objective results in an understating an account, while invalid recorded
amount results in an account being overstated. For example, to test the completeness objectives
for accounts receivable, the auditor compares the total of the accounts receivable subsidiary
ledger to the account receivable control account in the general ledger. If the totals do not agree,
some sales transactions and the related account receivables may not have included in the clients
accounting records.
3.Cutoff: the cutoff objectives is primarily related to the completeness assertion and is
concerned with whether the transaction included in the account, if valid are recorded in the
proper period. The audit procedure must ensure that transactions occurring near the year end are
recorded in the financial statement in the proper period.
4. Ownership: this objective addresses whether the asset and liability belong to the entity and
relates to management’s assertion about right and obligation. If the entity does not have rights to
an asset, or if a liability is not the entity’s obligation, it should not be included in the financial
statements.
5. Accuracy: the accuracy objective relates to the valuation or allocation assertion and addresses
proper accumulation of transaction and amounts from journals and ledgers. For example,
auditors frequently use aged trail balances to document the detailed in accounts receivable
subsidiary ledger. To test the aged trail balance accuracy, the auditors foot the aged trail balances
and traces selected customer accounts from the aged trail balances to the account receivable
subsidiary ledger for proper amount and aging
6. Valuation: the valuation objective relates to the valuation or allocation assertion and is
concerned with ensuring that the account shown in the financial statements are recorded at the
proper amount. Generally accepted accounting principles establish the valuation method for a
particular transaction or account balance. For example, account receivable are accounted for at
net realizable value; that is, the allowance for doubtful accounts is used to adjust gross account
receivable to the balance excepted to be collected. The auditor tests the adequacy of the
allowance for uncollectible accounts by examining the entities past bad debt experience relatives
to the current balance in the allowance account.
7. Detail Tie In: Account balances on financial statements are supported by details in master
files and schedules prepared by clients. The detail tie in objective is concerned that the details on
lists are accurately prepared, correctly added and agree with the general ledger. For example,
individual accounts receivables on a listing of accounts receivable should be the same in the
accounts receivable master file and the total should equal the general ledger control account.
8. Classification: it is important that transaction be included in the correct account and the
account is properly presented in the financial statements. For example, in auditing accounts
receivable, the auditor examines the listing of account receivables to ensure that receivables from
affiliates, officers, directors, or other related parties are classified separately form trade
receivables. The classification objectives relates to the presentation and disclosure assertions.
9. Disclosure: This audit objective relates directly to the presentation and disclosure assertion
and is concerned with ensuring that all required financial statements and footnote disclosures are
made. For example, if account receivables are pledged as security for debt, such information
should be disclosed in the financial statements. Similarly, if a long term debt agreement contains
major covenant (such as limits on payments of dividend or issuance of additional debt), that
information should be disclosed.
The following table shows management assertions, general audit objectives and specific audit
objectives for inventory.

Management General Specific Audit Objective

Assertion Objective
Existence or Validity All recorded inventory exist at the balance sheet date
Occurrence
Completeness Completeness All existing inventory has been included in the account
Rights and Obligations Ownership The company has title to all inventory items listed
Valuation or Valuation Inventory quantity agrees with items physical on hand
Price used to value inventory are correct
Allocation
Classification Inventory items are properly classified to raw material,
 work in process and finished goods
Cutoff Purchase and sales cut off at the end is proper
Detail tie in Total of inventory items agree with general ledger
Accuracy Inventory quantity on clients perpetual record agree with
items physically on hand
Presentation and Disclosure The pledge and consignment of inventory is disclosed
Disclosure

Activity
1. What is the difference between management assertions and audit objectives?
2. Why management assertions are five and audit objectives are nine in number?
3.5 Audit Planning
The first Generally Accepted Auditing Standards of fieldwork requires adequate planning to be
made before auditing is carried out. Reasons for proper audit plan includes
 To enable the auditor obtain sufficient competent evidence
 To help keep audit costs reasonable
 To avoid misunderstanding with the client
Obtaining sufficient competent evidence is essential if the CPA wants to minimize legal liability
and maintain a good reputation in the business community keeping costs reasonable. It helps the
firm remains competitive and thereby retains or expands its client base, assuming the firm has a
reputation for doing high-quality work. Avoiding misunderstanding with the client is important
for good client relations and for facilitating high-quality work at reasonable cost. The followings
are the elements of audit planning:
1. Preplanning
2. Obtain background information
3. Obtain information about clients legal obligation
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent risk
6. Understand internal control and assess control risk
7. Develop overall audit plan or audit program
As shown above, there are seven major parts of Audit planning. Each of the first six parts are
intended to help the auditor develop the last part, an effective and efficient overall audit plan and
audit program.
1. Preplan the Audit: Preplanning the audit involves four things, all of which should be done
early in the audit.
 A decision whether to accept a new client or continue serving an existing one
 Identification of why the client needs an audit
 Obtaining an understanding with the client about the terms of engagement to avoid
misunderstandings.
 Select staff for engagement
Investigation of new client and re-evaluation of existing ones is important to assess the integrity
of the client and to assess the acceptable financial risk it will assume. If the CPA firm decides
that acceptable risk is extremely low, it may choose not to accept the engagement. If the CPA
firm concludes that acceptable audit risk is low but the client is still acceptable, it is likely to
affect result and the fee proposed to the client, Audits with low acceptable audit risk will
normally result in higher audit costs, which should be reflected in higher audit fees.
Obtaining an understanding with the client is expressed by the use of engagement letter, even
though it is not required. Engagement letter is an agreement between the CPA firm and the client
for the conduct of the audit and related services. It should specify whether the auditor will
perform an audit, a review, or a compilation, plus any other service such as tax returns or
management consulting. It should also state any restriction to be provided for the audit, an
agreement on fees. The engagement letter is also a means of informing the client that the auditor
cannot guarantee that all acts of fraud will be discovered. Selection of staff for engagement
involves the assignment of appropriate staff to the engagement if the CPA firm decides to accept
the client and conduct the audit. Selection of audit staff is important to meet the first requirement
of generally accepted auditing standard and to promote audit efficiency. The first GAAS stats
“that the audit is performed by a person or persons having adequate technical training and
proficiency as an auditor”.

2. Obtain Background Information: An extensive understanding of the client business and

industry and knowledge about the company’s operation are essential for doing adequate audit.
There are three reasons for obtaining a good understanding of the clients industry. First, many
industries have unique accounting requirement that the auditor must understand to evaluate
whether the clients financial statement are in accordance with GAAP. Second, auditors can often
 identify risks that may affect the auditor’s assessment of acceptable audit risk, or even whether
auditing companies in the industry is advisable.

Finally, there are inherent risks that are typically common to all clients in certain industry.
Understanding those risks aids the auditor in identifying the client’s inherent risk. Knowledge of
the clients industry can be obtained in different ways. These include:
 Discussion with previous auditor
 Discussion with clients personnel
 Tour the plant and office of the clients
 Discussion with outside specialists.

3. Obtain Information about Client’s Legal Documents: Early knowledge of the legal
documents and records enables auditors to interpret related evidence throughout the engagement
and to make sure there is proper disclosure in the financial statement. Three closely related types
of legal documents and records should be examined early in the engagement.
 The Corporate Charter and the Bylaws: The corporate charter is granted by the state in
which the company is incorporated and is the legal document necessary for recognizing a
corporation as a separate entity. It includes the exact name of the corporation, the date of
incorporation, the kind and amount of capital stock the corporation is authorized to issue and
the types of business activities the corporation is authorized to conduct. The bylaw includes the
rules and procedures adopted by stockholders of the corporation; they specify such things as the
fiscal year of the corporation, the frequency of stockholders meetings, and the methods of
voting for directors, and the duties and power of the corporate offices.

 The Corporate Minutes: are the official records of the meetings of the boards of directors
and stockholders. They include summaries of the most important decision made by the
directors and stockholders. The auditors should read the minute to obtain information that is
relevant to perform the audit including the authorization and discussion by the board of
directors affecting inherent risk.
 Contracts: clients involved in different types of contracts that are interested to the auditors.
These can include various items such as long term notes and bonds payable, stock option,
pension plan, contracts of manufactured products, contracts with vendors for future deliveries
of supplies, government contacts and leas.
4. Performing Preliminary Analytical Procedures: Auditors are required to perform analytical
procedures while planning the audit to assist the auditor in determining the nature, timing and
extent of auditing procedures. Analytical procedures made during the planning phase enhance
the auditors understanding of the client’s business and events occurring since the prior year’s
audit. Planning analytical procedures also help the auditor identify areas that may represent
specific risks of material misstatement warranting further attention.
5. Audit Risk Assessment and Materiality: Audit risk represent the risk that the auditor will
conclude that financial statement are fairly stated and unqualified opinion can be issued when in
fact they are misstated. Audit risk refers to the possibility that the auditor may unknowingly fail
to appropriately modify their opinion on financial statement that is materially misstated. Audit
risks are divided in to four:
a) Inherent Risk
b) Control Risk
c) Detection Risk
d) Acceptable Audit Risk
a. Inherent Risks: is a measure of the sensitivity or susceptibility of the financial statement
account to material misstatement before considering the effectiveness of internal control,
accounting controls, policies or procedures. Internal control is ignored in setting inherent risk
because they are considered separately in audit risk assessment as control risk.

b. Control Risk: is the risk that a material misstatement will not be prevented or detected on
timely basis by the clients internal control structure. Control risk represent an assessment of
whether clients internal control structure is effective for prevention or detecting error and the
more effective the internal control, the lower the control risk

c. Detection Risk: is the audit risk that the auditor will fail to detect material misstatement with
their audit procedures. It is the possibility that audit procedures will lead them to conclude that a
material misstatement does not exist in an account, in fact such misstatement does exist.
Detection risk is a function of the procedures auditors perform for testing assertions.

d. Acceptable Audit Risk: is the measure of how willing the auditor is to accept that the
financial statement may be martially misstated after the audit is completed and unqualified
opinion has been issued. When the auditor decides on lower acceptable risk, the auditor wants to
be more certain that the financial statement will not materially misstated. Zero acceptable risk
would be high certainty and 100% acceptable audit risk would be complete uncertainty. The
primary way that the auditors deal with risk in planning audit evidence is through the application
of the audit risk model. The audit risk model is used primarily for planning purpose in deciding
how much evidence to accumulate in each cycle.

PDR = __AAR_
IR X CR

Where:
PDR = Planned Detection Risk
AAR = Acceptable Audit Risk
IR = Inherent Risk
CR = Control Risk
Example: Assume that the auditor have assessed inherent risk for a particular assertion at 50%
and control risk at 40%. In addition, they have performed audit procedures that they believe have
a 20% risk of failing to detect a material misstatement in the assertion. Compute the acceptable
audit risk.
Solution
PDR = __AAR_
IR X CR
0.20 = __AAR_
0.50 X 0.40

AAR = 0.04 = 4%
6. Understand internal control and assess control risk (This will be discussed in detail in unit
four)
7. Develop an Over All Audit Plan
The last step in the planning the audit is to develop an over all strategy. This involve about the
nature, extent, and timing of audit test to be conducted. The audit strategy is normally
documented in an audit plan and audit program containing specific audit procedures. The audit
program for most audits is designed in three parts:
1. Test of transactions
2. Analytical procedures
3. Test of details of balance

Activity
1. List and explain the seven steps in auditing planning
2. Define audit risk and explain its components
3.6 Audit Program

An audit program is a set of polices and procedures that dictate how auditing is to be
implemented. It usually involves audit software as well as internal work that are manually
performed by an auditor. These measures are generally employed to determine what, and how
much, evidence must be collected and evaluated — as well as who will collect and evaluate it,
and when this should be done.

Organizations typically prepare audit programs based on the operational planning activities of
the evidence collected and evaluated by an auditor. Audit program is prepared and, if need be,
revised in accordance with this evidence. It is documented in the AUDIT WORKING PAPERS ,
which are the official record that contains the planning and execution of the audit agreement.
While the formality of an audit program largely depends on the size of the organization, all
programs require certain elements in order to be effective.

The audit program establishes the procedures necessary to complete an efficient and effective
audit. It includes a detailed plan of the work to be performed as well as the steps required to
achieve the audit objectives. There should be sufficient detail for less experienced staff to
perform the steps, however, it should not be overly detailed whereby it might cause auditors to
execute steps routinely and override their judgment.
 A well designed audit program provides an outline of the work to be performed encouraging a
thorough understanding of the unit audited. It acts as a guide for assigning work and thereby
controlling the project from beginning to end. It creates documentation and evidence that the
work was completed. It assists management review to ensure quality. It assures management that
all risk areas were adequately addressed.

 Areas that should be covered by the audit program include the audit objectives, test procedures,
sample size, sample selection, time period, reports for sample selections, and reports and
documents subject for review as well as attributes for testing.

 The program should be prepared before the beginning of the fieldwork and approved by audit
management. Audit programs are not set in stone and therefore modified during the course of the
audit depending on test results or new information obtained. However any changes to the audit
program or procedures should be reviewed and approved.

Risk assessment is one of the most critical components of an audit program. Through this
process, risks for specific areas of the business are identified and analyzed. Auditors are
encouraged to conduct risk assessment on a consistent basis to keep pace with changes to
internal control and various work processes. An organization's level of risk is considered a key
aspect in determining how often audits should be performed.

An effective audit program also includes an audit cycle, which simply refers to the frequency of
audits. As mentioned above, this frequency is normally determined by conducting risk
assessment. There are some factors that could impact the audit cycle, mainly time and audit staff.
Even with this knowledge, it is advisable for organizations to not allow such factors to reduce the
periods, at which audits are performed, especially for areas susceptible to great risk. Doing so
could leave the organization vulnerable to substantial risks that have yet to be identified.

Another essential component of an audit program is audit planning. Although strategies are
generally devised with respect to individual organizations, a well-rounded plan is often viewed
as one that covers scheduling, audit staff needs, reporting, and the overall goals of the audit.
Many organizations find that this planning is most efficient when the results of risk assessment
are combined with the resources needed to determine the timing and frequency of audits.
Activity
1. What do we mean by audit program?

3.7. Auditor’s Working Paper

Working papers are the records kept by the auditor of the procedures applied, the test
performance, the information obtained and the pertinent conclusions reached in the engagement.
The overall objectives of working paper are to aid the auditor in providing reasonable assurance
that an adequate audit was conducted in accordance with GAAS. The working papers as they
pertains to the current years has the following purpose
 Provide a base for planning the audit, because the working papers describe information
about internal control structure, a time budget for individual audit areas, the audit
program and the results of the preceding year’s audit.
 A record of the evidence accumulated and the result of the test
 Data for determining the proper type of audit
 Basis for review by supervisor and partner. The working papers are the primary frame
of reference used by supervisory personal to evaluate weather sufficient competent
evidence was accumulated to justify audit reports.
Working papers contain virtually every thing involved in the examination. The filling of
working paper is classified in to the following.

1. Permanent Files: are intended to contain data of a historical or continuing nature

pertinent to the current examination. The permanent files typically include the following.
 Extracts or copies such as articles of in corporation, by laws and contracts.
 Analysis from previous years of accounts that have continuing importance to the
auditor such as long term debt, stock holders equality accounts, good will and fixed
asset.
 Information related to the understanding of the internal control structure and
assessment of control risks such as organization charts, flowcharts questioners etc.
  Result of analytical procedures from previous year’s audit such as ratio and
percentage computed by the auditor.
 Total balance for selected accounts.
 Others

2. Current Files: The current files include all working papers applicable to the years under
audit. The types of information included in the current file are:
 Audit program
 General information like planning memos, copies of minutes, agreements notes on
discussion with client etc.
 Working trial balance, listing of the general ledger account and their year end balance
including subsidiary balance and account.
 Adjusting and reclassification entries
 Supporting schedule such as analysis of account trail balance, reconciliation of
amounts, test of reasonableness, summary of procedures, examination of supporting
documents, outside documentation.
 Others
The working paper prepared during the engagement, including those prepared by the client
for the auditor are the property of the auditor. The only time any one including the client has
legal right to examine the paper is, when they are subpoenaed by the court as legal evidence.
At the completion of the engagement, working paper is kept at the auditors premise for future
reference. The working paper can be provided to some one else with expressed permission of
the client

CHAPTER 5
AUDIT REPORTS
Audit reports communicate auditor’s findings. Users of financial statements rely on the auditors
report to provide assurance on the company's financial statements. Report is the final stage in
audit process.

Contents of standard auditor's report

Standard unqualified audit report. To enable users to understand audit report, professional
standards provide uniform wording for auditor's report. Standard unqualified reports have seven
parts.

1. Report title: -

The title is required and includes the word independent.

2. Audit report address: -

The report may be addressed to stockholders, board of directors or the company. But addressing
to stockholders is becoming customary.

3. Introductory paragraph: -

The first paragraph of the report does three things: -

A/ It makes a sample statement that CPA firm has conducted an audit to distinguish it from
review or compilation.
B/ It state financial statements that were audited in the wordings given by management
together with exact dates or periods
C/ It shows that the statements are the responsibilities of managers and the auditors work is
to give an opinion to indicate that the selection of GAAP is up to managers.

4. Scope paragraph: -

It is a factual statement about what the auditor did in the audit. The statements in this paragraph
should consist: -

 Compliance of with GAAS

 The audit design to obtain reasonable assurance about the freedom from material
misstatement
 Discuss audit evidence
 Included the word ‘test basis’ to indicate sampling.

5. Opinion Paragraph
The final paragraph includes conclusion. The opinion should be expressed as opinion rather than
the absolute facts (guarantee). This term "present fairly" is used to show the investigation is
beyond GAAP.

6. Name of CPA Firm

Identifies the firm that conducts the audit.

7. Audit Report date

This is the end of significant audit procedure and marks the end of auditor’s responsibility.

Types of Audit Report

There are four types of Audit Report:

1. Unqualified Audit Report

2. Qualified
3. Adverse
4. Disclaimer

I. Unqualified audit Report

Unqualified Audit Report Can be Standard or with explanations:

A) Standard unqualified Audit Report

Conditions for standard unqualified opinion

1.All statements: - balance sheets, income statements, retained earnings and cash flow statements
are included in the financial statements

The three general standards have been followed in all respects.

The three standards of fieldwork are met and sufficient evidence has been accumulated.
GAAP is practiced with adequate disclosure.

5. There are no circumstances requiring the addition of an explanatory paragraph or

modification of the wording of the report.

Standard unqualified report is sometimes called clean report that needs no modification of
auditor's opinion. This is most common audit opinion.

B) Unqualified Audit Report with explanatory paragraph /modified wording

This meets the criteria of complete audit with satisfactory results and financial statements that
are fairly presented, but the auditor believes it is important or is required to provide additional
information. This requires additional explanatory paragraph. The causes for the addition of
explanatory paragraph are:-

Lack of consistent application of GAAP

In case of material change, explanatory paragraph is added after opinion paragraph to show the
change.

The changes must affect consistency instead of comparability to be included in the fourth
(explanatory) paragraph.

Consistency refers to changes in: -

Accounting principles (LIFO to FIFO),

In reporting entities
Correction of errors involving principles,

Whereas, comparability is: -

Change in all estimate variation in format (presentation of financial information) Changes due to
different transactions (events).

Substantial doubt about going concern

Recurring operating losses, deficiencies of working capital, inability to pay obligation, loss of
major customers and legal proceedings are major cause of this doubt. The reasonable period of
continuation is 1 year from the date of financial statements.

Auditor agrees with a departure from standard

The auditor must justify that adhering to Standards may lead to misstatement in a separate
paragraph

Emphasis of Matter

While giving unqualified opinion, the auditor may add explanatory information for matters that
he gave emphasis such as significant and after balance sheet dates transactions etc.

Reports involving other auditors

In many companies having different branches may give the audit engagement to more than one
CPA firm. Each units (branches) audit results are compiled to form an over all report about the
company as a whole. The principal auditor, the one who does most of the audit, prepares this
report in three different ways: -
A No reference of the other auditor in the report

When the principal auditor knows or closely supervises the other auditor or the other auditor
audited an immaterial portion of the audit, the principal auditor doesn't refer the other auditor.

B Make reference in the report (modified wording)

This report is called a Shared Opinion (Report). If the other auditor audits immaterial portion of
the statement and it is difficult to review his/her work, the principal auditor refers him/her in the
introductory, scope and opinion paragraphs.

C Qualify the opinion

If the principal auditor isn't willing to assume any responsibility for the work of the other
opinion, he/she may give a qualified or disclaimer opinion.

Reasons for departure from unqualified opinion

The auditor may issue a type of report other than unqualified opinion (qualified, disclaimer or
adverse)
For the following reasons:-

Scope limitations:- If the auditor is restricted from obtaining sufficient evidence

GAAP departure:- If the client's practice departed from GAAP,

The auditor isn't independent:- this violated rule 101

II. Qualified opinion

This is when there is a limitation on the scope of the audit or when GAAP isn't followed, this
opinion may results. In fact the auditor must believe that the overall financial statements are
fairly stated. The qualification may be both the scope and the opinion or the opinion alone. The
former arises only when all evidences as required by GAAS aren't accumulated, while the later is
issued when GAAP is violated.

The unique feature of a qualified opinion is the inclusion of the term ' except for ' in opinion
paragraph.

III. Adverse opinion

This is used only when the auditor believes that overall financial statements are so materially
misstated or misleading. This happens only when the auditor knows or believes, after adequate
investigation, that lack of conformity with GAAP. This opinion, however, is rare.

IV. Disclaimer Opinion

This is issued when the auditor has been unable to satisfy himself / herself that the overall
financial statements are fairly presented. Disclaimer happens when sever limitation on the scope
and non-independent relationship arises. It can be issued in case of going concern problem.

In the adverse opinion, the auditor must have the knowledge that financial statements are
materially misstated while in disclaimer he lacks such knowledge.

Materiality

If the misstatement is immaterial, unqualified opinion can be given. Other wise, adverse or
disclaimer opinion should be issued. Materiality is a misstatement of financial statements that
would affect a decision of reasonable uses of statements.

Levels of materiality

There are three levels:-

Immaterial amount

If the misstatement is immaterial, unqualified report could be issued.

Material amount that doesn't overshadow the financial statements.

Here qualified opinion (using "except for") is issued. This affects decision only in specific areas
and the overall statements are presented fairly.

Material amount that affects the overall fairness of financial statements. This affects users to
make incorrect decisions. So, disclaimer or adverse opinion may be issued. In addition, in the
extent to which the misstatement affects different parts of financial statements must be
considered. This is called pervasiveness.

If misstatement is pervasive, adverse opinion is appropriate while lack of independence Bach to

disclaim opinion. Any deviation from independence is considered material.

Materiality can also be looked in terms of failure to follow GAAP or scope Limitations.

CHAPTER 6
AUDITING CASH
 Cash is the only account that is included in several cycles. It is a part of every cycle except
Learning Objectives:
After studyinginventory and students
this chapter, warehousing therefore
should be able the
to: audit of cash balance depends heavily on the results of
the tests in other cycles.
 Evaluate internal control over cash according to acceptable
procedures. Cash is important primarily because of the potential for fraud but also because there may be
 Audit cash audit cash receipts applying the standard audit procedures
errors.
for cash receipts.
 Audit cash payments according to the standard audit procedures for
cash payments.
In the audit of cash, it is important to distinguish between verifying the client’s reconciliation of
 Audit cash on hand and in bank according to the standard cash audit
the
procedures for cashbalance onin the
on hand and bank.bank statement to the balance in the general ledger. Verifying whether
recorded cash in the general ledger correctly reflects all cash transactions that took place during
the year. This is because there are some misstatements ultimately results in the improper
payment of the failure to receive cash, but none will normally be discovered as a part of the audit
of the bank reconciliation; such as

Failure to bill a customer

Billing a customers at lower price
A defalcation of cash, before they are recorded
Duplicate payment of a vendor’s invoice
Payment for row material that were not received
Payment to an employee for more hours than he or she worked
Payment of interest to a related party for an amount in excess of the going rate.

Types of Cash Accounts

The general cash account

Is the focal point of cash because all cash receipts and disbursements flow through this account.
The disbursements for the acquisition and payment cycle are normally paid from this account,
and the receipt of cash in the sales and collection cycle are deposited in this account in addition,
the deposits and disbursements for all other cash accounts are normally made through the general
account.

Imprest payroll Account

Is established for such things as making payroll payments to employees or separate cash receipts
and disbursements accounts for branch banking.
In an imprest account a fixed balance, is maintained in a separate account and this amount should
always be shown as a balance.
The use of imprest payroll account can improve internal control and reduce the time needed to
reconcile bank accounts.

Branch Bank Account

For a company operating in multiple locations, it is often desirable to have a separate bank
balance at each location.
Branch bank accounts are useful for building public relations in local communities and
permitting the centralization of operations at the branch level.

Imprest Petty cash fund

Is actually not a bank account, but it is sufficiently similar to cash or deposit to merit inclusion.
A petty cash account is often something as simple as a present amount of cash set aside in a
strong box for incidental expenses.

It is used for small cash acquisitions that can be paid more conveniently & quickly by cash than
by check, or for the convenience of employees in cashing personal or payroll checks

An imprest cash account is set up on the same basis as an imprest branch0 bank account, but the
expenditures are normally for a much smaller amount

Typical expenses include minor office supplies, stamps, and small contributions to local
charities.

A petty cash account usually does not exceed a few hundred dollars and may not be reimbursed
more than once or twice each month.

Cash Equivalent

Highly liquid cash equivalents are excess cash accounted during certain parts of the operating
cycle that are invested in short-term and needed in a reasonable near future

Examples: - time deposits, certificates of deposit and money market funds

Cash equivalent, which can be highly material, are included.

Included in the financial statements as a part of the cash account only if they are short-term
investments that are readily convertible to known amounts of cash either a short time and there is
insignificant risk of a change of value form interest rate changes.
Marketable securities and long – term interest bearing investments are not cash equivalents.

Audit of the General cash account

In testing the year-end balance in the general cash account, the auditor must accumulate
sufficient evidence to evaluate whether cash, as stated on the balance sheet, is fairly stated and
properly disclosed in accordance with six of the nine balance-related audit objectives used for
tests of details of balances. Rights to general cash, its classification on the balance sheet, and the
realizable value of cash are not a problem.

Methodology for auditing-year-end-cash

Set tolerable misstatement and assess

inherent risk for cash in bank
 Phase I

Phase I

Assess control risk for cash in bank Phase I

Design and perform tests of control &

substantive tests of transactions for Phase II
several cycles

Phase II

Deign and perform analytical

procedures for cash in bank balance Phase III

Design tests of details of cash inPhase

bank III Audit procedures
balance to satisfy balance related audit Sample size
objectives. Phase III
Items to select

Timing

Cycle affected include sales & collection, acquisition & payment, payroll
Personnel and capital acquisition and repayment.

Set Tolerable Misstatement & Assess Inherent Risk (Phase1)

Because cash is more susceptible to theft other than assets, there is a high inherent risk for
the existence, completeness, and accuracy objections, and after there is a potential for a
misstatement of cash. Therefore these objectives should be the focus of in auditing cash
balances.

Assess control risk (Phase 1)

Internal controls over year-end cash balance in the general account can be divided into two
categories
Control over the transaction cycles affecting the recording of cash receipts and
disbursements.
Independent bank reconciliation.

Major controls over transactions cycle affecting cash receipts and payments include:

 Segregation of duties between the check signing and accounts payable functions
 Signing of check only by proper authorized person
 Use of pre-numbered check printed on special paper
 Adequate control over blank and void check.
 Careful review of supporting documentation by the check signers before checks are
signed
 Adequate internal verifications

Generally if controls affecting cash related transactions are adequate, it is possible to

reduce control risk and therefore the audit tests for the year-end-bank reconciliation

Careful bank reconciliation by competent client personnel includes:

 Compare cancelled check with cash disbursements records for date, payee, and
amount.
 Examine cancelled checks for signature endorsement, and cancellation.
 Compare deposits in the bank with recorded cash receipts for date, customer, and
amount
 Account for the numerical sequence of checks, and investigate missing ones.
 Reconcile all items causing a difference between the bank and the bank balance and
verify their property.
 Reconcile total debits on the bank statement with the totals in the cash disbursement
record.
 Reconcile total credits on the bank statement with the totals in the cash receipts
records.
 Review month –end inter banks transactions for propriety and proper recording
 Follow up on outstanding checks & stop payment notice.
Design and perform tests of controls and substantive tests of transactions
(Phase II)

As a cash balance is affected by all other cycles except inventory and warehousing, an extremely
large number of transactions affected cash, appropriate tests of control and substantive tests of
transactions should be maintained.

Design and perform analytical procedures (phase II)

Since in many organizations, the year-end bank reconciliation is extensively audited, using
analytical procedures to test the reasonableness of the cash balance will be less important than it
is for most other audit areas.

Design tests of details of cash balance (phase III)

A detail test of cash balance i.e. test of the component parts that are used in the computation of
the ending balance of cash should properly designed and tested.

Fraud – Oriented Procedures

Are procedures in the audit of year-end cash to determine the possibility of a material fraud exist
when there are inadequate internal controls, especially the improper segregation of duties
between the handling of cash and the recording of cash transactions in the accounting records

Fraud oriented procedures include:

1. Extended tests of the bank reconciliation

 It is performed when the auditor believes that the year-end bank reconciliation is
intentionally misstated.
 The purpose of this procedure is to verify whether all transactions included in the
journal for the last month of the year were correctly included in or excluded from the
bank reconciliation and to verify whether all items in the bank reconciliation were
correctly included.

2. Proof of cash

Is a four-column working paper prepared by the auditor to reconcile the bank’s record of the
client’s beginning balance cash deposit, cleared checks and ending balance for the period, with
the client’s records.

The auditor uses a proof of cash to determine whether the following were done.

 All recorded cash receipts were deposited

  All deposit in the bank were recorded in the accounting records
 All recorded cash disbursements were paid by the bank
 All amounts that were paid by the bank were recorded

A proof of cash includes the following.

 A reconciliation of the balance on the bank statement with the general ledger balance
at the beginning of the proof-of-cash period.
 A reconciliation of cash receipts deposited per the bank with the cash receipt journal
for a given period
 A reconciliation of cancelled checks clearing the bank with the cash disbursements
journal for a given period
 A reconciliation of the balance on the bank statement with the general ledger balance
at the end of the proof of-cash period.

3. Test of Inter bank transactions

 This procedure is helpful in preventing embezzlements that may occur when the
client to has accounts in more than one bank
 Embezzlers occasional cover a defalcation of cash by transferring money form one
bank to another an improperly record the transaction, such practice is known as
kiting.
 A useful approach to test for kiting, as well as for errors in recording inter bank
transfers, is to list all inter-bank transfers made a few days before and after the
balance sheet date and to trace each to the accounting records for proper recording.

The following should be done on the audit of inter bank transfers:

 The accuracy of the information on the inter-bank transfer schedule should be

verified.
 The inter-bank transfer must be recorded in both the receiving and disbursing banks
 The date of the recording of the disbursements and receipts for each transfer must be
in the same fiscal year.
 Disbursements on the inter-bank transfer schedule should be correctly included in or
excluded from year-end bank reconciliation as outstanding check.
 Receipt on the inter-bank transfer schedule should be correctly included in or
excluded from year-end bank reconciliation as deposits in transit.

Audit of the Imprest payroll Bank account

 It is a bank account to which the exact amount of payroll for the pay period is
transferred by check from the employer’s general cash account.
  The audit includes a reconciliation like those described in the general cash account to
reconcile outstanding checks.

Audit of Imprest Petty cash

Imprest petty cash fund is a fund of cash maintained within the company for small cash
acquisitions or to cash employees’ checks; the fund’s fixed balance is comparatively small and is
periodically reimbursed / replenished.

Internal control over petty cash include

 The use of imprest funds that is the responsibility of one individual.

 Not to mingle /mix petty cash with other receipts
 Keep the fund separate from all other activities
 There should be limits on the amount of any expenditure from petty cash, as well as
on the total amount of the fund.
 The typical expenditure that can be made from petty cash transactions should be well
defined by company policy.
 Appropriate official should approach a disbursement from a petty cash fund.
 Use pre-numbered petty cash form.

Audit tests for petty cash include:

 Determining the client’s procedures for handling the fund

 Understand the client’s internal control over petty cash
 Examine the documentation of few transactions

There are two important procedures to be performed whenever an auditor decides to test petty
cash:
1. To count the petty cash balance
2. To carry out detailed tests of one or two reimbursement transaction in such a case the
primary procedures should include finding of petty cash vouchers supporting the amount
of the reimbursement, accounting for a sequence of petty cash vouchers, examining the
petty cash vouchers for authorization and cancellation, and examining the attached
documentation for reasonableness.
The typical supporting documentation includes
 Cash register tapes
 Invoices, and
 Receipts.
-Petty cash test can ordinarily be performed at any time during the year, but as a mater of
convenience they are typically done on an interim date.
 CHAPTER 7
AUDITING RECEIVABLES

Audit Objective Tests of Account Balance

Validity Confirmation of selected accounts receivable

Performance of alternative procedures for accounts receivable

confirmation exceptions and no responses
Completeness Obtaining of aged trial balance of accounts receivable and
ageing of total to general ledger

Review of results of testing the completeness objective for

assessing control risk; tracing of shipping documents into
sales journal and to accounts receivable subsidiary ledger if
such testing was not performed as a test of controls
Cutoff Examination of a sample of sales invoices and shipping
documents for a few days before and after year-end for
recording sales in proper period

Performance of analytical procedures for reasonableness of

sales returns cutoff or examination of a sample of receiving
documents for a few days before and after year-end for
recording sales returns in proper period
Ownership Review of bank confirmations for any liens on receivables

Inquiry of management, review of any loan agreements, and

review of board of directors' minutes for any indication that
accounts receivables have been sold
Mechanical accuracy Obtaining of an aged trial balance of accounts receivable and
agreeing of total to general ledger control account
 Tracing of selected items from the aged trial balance 10 the
subsidiary records and sales invoices for proper amount and
aging

Obtaining of an analysis of the allowance for uncollectible

accounts and bad-debt expense; tracing of totals to general
ledger and individual items to subsidiary records
Valuation Examination of the results of the confirmations of selected
accounts receivable

Examination of the adequacy of the allowance for

uncollectible accounts
Classification Review of aged trial balance for material credits, long-·term
receivables, and non-trade receivables
Disclosure Inquiry about related-party receivables and ensure that they
are property disclosed

Review of receivables for any accounts that have been

pledged, assigned, or discounted

Validity

The validity of accounts receivable is one of the more important audit objectives because the
auditor wants assurance that this account balance is not overstated through the inclusion of
fictitious customer' accounts or' amounts, The major audit procedure for the validity objective for
accounts receivable is confirmation of customers' account balances, If a customer does not
respond to the auditor’s confirmation request, additional audit procedures may be necessary.

Completeness

The auditor's concern with completeness is whether all accounts receivable have been included
in the accounts receivable subsidiary ledger and the general ledger accounts receivable account.
The reconciliation of the aged trial balance to the general ledger account should detect an
omission of a receivable from either the accounts receivable subsidiary ledger or the general
ledger account. If the client's accounting system contains proper control totals and
reconciliations, such errors should be detected and corrected by the relevant control procedures,
For example, in the sales system control totals exist for daily shipping and billing, Personnel in
the Billing Department would be responsible for reconciling the two totals. If such control
procedures do not exist in a client's accounting system or if they are not operating effectively, the
auditor will ha\'e to trace a sample of shipping documents to sales invoices, the sales journal and
the accounts receivable subsidiary ledger to ensure that the transactions were included in the
accounting records.

Cutoff

The cutoff objective attempts to determine whether all sales transactions and elated accounts
receivable are recorded in the proper period. On most audits, sales cutoff is coordinated with
inventory cutoff because the shipment of goods normally indicates that the earnings process is
complete. The auditor wants assurance that if goods have been shipped in the current period, the
resulting sale has been recorded and also that if the sales have been recorded, the corresponding
inventory has been removed from the accounting records. In addition, the auditor needs to
determine if there is proper cutoff for sales returns.

Sales cutoff

If there is not a proper cutoff of sales transactions, both revenue and accounts receivable will be
misstated for the current and following years. In most instances, errors related to sales cutoff are
unintentional and are due to delays in recognizing, the shipment of goods or the recognition of
the sale. In other instances, the client may intentionally fail to recognize sales transactions in the
current period or may recognize sales from the next period in the current period. The first
situation can occur by the sales transactions not being recorded in the sales journal until the next
period. For example, sales that take place on the last two days of the current year are recorded as
sales in the next year by delaying entry until the current-year sales journal is closed. Leaving the
sales journal “open” and recognizing sales from the first few days of the next period as current -
period sales generally accomplish the second situation.

Sales Returns Cutoff The processing of sales returns may differ across entities. When sales
returns are not material, or if they occur on a regular basis, the entity may recognize a sales
return at the time the goods are returned. However, for other entities, sales returns may represent
a material amount or may occur on an irregular basis. In this instance, the client may estimate an
allowance for sales returns. When sales returns represent a material amount, the auditor needs to
test for proper cutoff.

Analytical procedures may be used to test cutoff for sales returns. The ratio of sales returns to
sales may indicate to the auditor that ·sales returns are consistent with expectations and therefore
that the sales returns cutoff is adequate. If the auditor decides to conduct more detailed tests, the
receiving documents used to acknowledge receipt of the returned goods must be examined.
Using procedures similar to those for testing sales cutoff, a sample of receiving documents for a
few days prior to and subsequent to the end of the period is selected. The receiving documents
are traced to the related credit memoranda. Sales returns recorded in the wrong period should be
corrected if material.

Ownership

The auditor must determine whether the accounts reachable are owned by the entity because
accounts receivable that have been sold should not be included in the entity's financial
statements. For most audit engagements, this does not represent a problem since the client owns
all the receivables. However in some instances a client may sell its accounts receivable. The
auditor can detect such an action by reviewing bank confirmations, cash receipts for payments
from organizations that factor accounts receivable, or corporate minutes for authorization of the
sale or assignment of receivables.

Valuation
There are two major valuation issues related to accounts receivable. The first issue relates to the
valuation of the revenue and cash receipts transactions that make up· the details of the gross
amount of accounts receivable. The concern here is with the quantity and pricing of the items
included on the sales invoices and the proper recording of cash received, including any
discounts. This affects the gross amount of accounts receivable as well as sales. Tests of controls'
and substantive tests of transactions are normally used to provide evidence about these types of
pricing errors. Pricing errors, especially when the customer has been overcharged or proper
payment has not been recorded, may also be detected via confirmations.

The second valuation issue relates to the net realizable value of accounts receivable. The auditor
is concerned with determining that the allowance for uncollectible accounts, and thus bad-debt
expense, is fairly stated. The allowance for uncollectible accounts is affected toy internal factors
such as the client's credit-granting and cash collection policies and external factors such as the
state of the economy, conditions in the client's industry, and the financial strength of the client's
customer's.

Classification

The major tissues related to the classification objective are (1) identifying and reclassifying any
material credits contained in accounts receivable, (2) segregating shot-term and long-term
receivables and (3) ensuring that different types of receivables are properly classified. In many
entities when a customer pays in advance or a credit is issued, the amount is credited to the
customer accounts receivable account. The auditor should determine the amount of such credits
and, if material, reclassify them as either a deposit or, another type of liability. The second issue
requires that the auditor ratify and separate short-term receivables from long-term receivables.
Long-term receivables should not be included with trade accounts receivable; the auditor must
also ensure that no trade officers employees or related parties should not be included with trade
accounts receivable because users might be misled if such receivable are combined. The last two
issues are also related to the disclosures audit objective.

Disclosure
Disclosure is an important audit objective for revenue-related accounts. While management
responsible for financial statements, the auditor must ensure that all necessity’s discourses are
made. Disclosure is normally included in a footnote, which describes significant recounting
policies. Most public accounting firms use some type of financial statement reporting checklist to
ensure that all necessary disclosures are made for each account. The following table presents
some examples of disclosure items for the revenue cycle and related financial statements
accounts.

Table 10. Example of Disclosure Items for the Sales and Receivable Cycle

• Sales revenue recognition basis

• Sales revenue recognized under the percentage-of-completion method
• Long-term sales contracts
• Sales revenue by reportable segment of the business
• Sales and receivables from related parties
• Receivables by type (trade officer, employee, affiliate, etc.)
• Short and long-term receivables
• Pledged or discounted receivables

Activities and transaction cycle in sales and receivable.

Types of Documents and Records Included
Table 11 contains a list of the more important documents and records that are normally contained
in the revenue cycle. Each of these items is discussed briefly. The reader should keep in mind
that in advanced EDP systems some of these documents and records may exist for only a short
period of time or may be maintained only in machine-readable form.

Customer Sales Order. This document contains the details of the type and quantity of products
or services ordered by the customer. The customer sales order may be mailed or faxed to the
client, or the relevant information may be received over the telephone. When a telephone order is
accepted, some entities record the information onto a sales order form or enter it directly into a
computerized order entry program.

Credit Approval Form. When a customer purchases products on credit from the client for the
first time, the client should have a formal procedure for investigating the creditworthiness of the
customer. The result of this procedure should be documented on some type of credit approval
form. When the customer plans to purchase additional products in the future, this procedure
should be used to establish the customer's credit limit. The amount of the credit limit should be
documented on the approval form. When credit limits are included in the client's EDP files, the
approval forms represent the source documents authorizing the amounts contained in the EDP
system.

Open-Order Report. This is a report of all customer orders for which processing has not been
completed. In the typical revenue cycle, once a customer's order has been accepted, the order is
entered into the system. After the goods have been shipped and billed, the order should be noted
as filled. This report should be reviewed on a daily or weekly basis, and any old orders should be
investigated to determine if any goods have been shipped but not billed. Testing for shipments
for which the customer has not been billed provides evidence as to the completeness objective.

Table 11 Documents and records included in the sales cycle

• Customer sales order

• Credit approval forms

• Open-order report

• Shipping document

• Sales invoice

• Sales journal

• Customer statement

• Accounts receivable subsidiary ledger

• Aged trial balance of accounts receivable

• Remittance advice
 • Cash receipts journal

• Credit memorandum

• Write-off authorization

Shipping Document. A shipping document must be prepared anytime goods are shipped to a
customer. This document generally serves as a bill of lading and contains information on the type
of product shipped, the quantity shipped, and other relevant information. In some revenue
systems, the shipping document and bill of lading are separate documents. A copy of the
shipping document is sent to the customer, while another copy of the shipping document is used
to initiate the billing process.

Sales Invoice. This document is used to bill the customer. The sales invoice contains information
on the type of product or service, the quantity, the price, and the terms of trade. The original
sales invoice is forwarded to the customer, and copies are distributed to other departments within
the organization. The sales invoice is typically the source document that signals the recognition
of revenue.

Sales Journal. Once a sales invoice has been issued, the sale needs to be recorded in the
accounting records. The sales journal is used to record the necessary information for each sales
transaction. Depending on the complexity of the entity's operation, the sales journal may contain
information classified by type of sale (e.g. product line, inter company sales, related parties). The
sales journal contains columns for debiting accounts receivable and crediting the various sales
accounts.

Customer Statement. This is a document that is usually mailed to a customer on a monthly

basis. It contains the details of all sales, cash receipts, and credit memorandum transactions
processed through the customer's account for the period.
Accounts Receivable Subsidiary' Ledger. The accounts receivable subsidiary ledger contains
an account and the details of transactions with each customer. A transaction recorded in the sales
journal and cash receipts journal is posted to the appropriate customer's account in the accounts
receivable subsidiary ledger.

Aged Trial Balance of Accounts Receivable. This report, which is normally prepared on a
monthly basis, provides a summary of all the customer balances in the accounts receivable
subsidiary ledger. Customers' balances are reported in categories (e.g. less than 30 days, 30-60
days, 60-90 days, greater than 90 days old) based on the time expired since the date of the sales
invoice. The aged trial balance of accounts receivable is used to monitor the collection of
receivables and to ensure that the details of the accounts receivable subsidiary ledger agree with
the general ledger control account. The auditor uses this report for conducting much of the
substantive audit work in accounts receivable.

Remittance Advice. This document is usually mailed with the customer's bill and returned with
the customer's payment for goods or services. A remittance advice contains information
regarding which the customer is paying invoices. Many entities use turnaround documents,
where a portion of the sales invoices selves as a remittance advice that is returned with the
customer's payment.

Cash Receipts Journal. This journal is used to record the entity's cash receipts. The cash
receipts journal contains columns for debiting cash, crediting accounts receivable, and crediting
other accounts such as 'scrap sales or interest income.

Credit Memorandum. This document is used to record credits for the return of goods in a
customer's account or to record allowances that will be issued to the customer. Its form is
generally very similar to that of a sales invoice, and it may be processed through tile system in
the same way as a sales invoice.

Write off Authorization. This document authorizes the write-off of an uncollectible account. It
is normally initiated in the Credit Department, with final approval for the write-off coming from
the treasurer. Depending on the entity's accounting system, this type of transaction may be
processed separately or as part of the nm-mal stream of sales transactions.

The Major Functions

The principal objective of the revenue cycle is the cycle of the entity's goods or services at prices
and terms that are consistent with management's policies. Table 12 summarizes the functions that
normally take place in a typical revenue cycle.

Table 12 Functions in the Revenue Cycle

• Order entry: Acceptance of customer orders for goods and

services into the system in accordance with
management criteria
• Credit authorization: Appropriate approval of customer orders for
creditworthiness
• Shipping: Shipping of goods that has been authorized
• Billing: Issuance of sales invoices to customers for
goods shipped or services provided; also,
processing of billing adjustments for
allowances, discounts, and returns
• Collections Processing of the receipt of cash from
customers

• Accounts receivable: Recording of all sales invoices, collections,

and credit memoranda in individual customer
accounts
• General ledger: Proper accumulation, classification, and
summarization of revenues, collections, and
receivables in the financial statement accounts
Order Entry. The initial function in the revenue cycle is the entry of new sales orders into the
system. New orders may be submitted by sales personnel, received through the mail or by fax,
taken over the telephone, or received directly by electronic transmission. It is important that sales
or services be consistent with management's authorization criteria before entry into the revenue
cycle.
Credit Authorization. The credit authorization function must determine that the customer is
able to pay for the goods or services. Failure to perform this function properly may result in bad-
debt losses. In many entities, customers have preset credit limits. The credit authorization
function must ensure that the credit limit is not exceeded without additional authorization. Where
credit limits are programmed into the computer system, a sale that causes a customer's balance to
exceed the authorized credit limit should not be processed. An exception report should also be
generated by the system for review by the credit function prior to further processing.
Periodically, each customer's credit limits should be reviewed to ensure that the amount is
consistent with the customer's ability to pay.

Shipping. Goods should not be shipped, nor should services be provided, without proper
authorization. The main control that authorizes shipment of goods or performance of services is
payment or proper credit approval for the transaction. For example, requiring credit approval
before shipment helps prevent shipment of goods to fictitious customers. The shipping function
must also ensure that customer orders are filled with the correct product and quantities. To
ensure prompt billing of customers, completed orders must be forwarded to the billing function
on a timely basis.

Billing. The main responsibility of the billing function is to ensure that all goods shipped and all
services provided are billed' authorized prices and terms. The entity's controls should prevent
goods from being shipped to customers who are not being billed. In an EDP system, an open-
order report should be prepared and reviewed for orders that have not been filled on a timely
basis. In other systems, all prenumbered shipping documents should be accounted for and
matched to their related sales invoices. Billing Department or Sales Department personnel should
investigate any open or unmatched transactions.
The billing function is also responsible for handling goods returned for credit. The key control
here is that a credit memorandum should not be issued unless the goods have been returned. A
receiving document should be first issued by the Receiving Department to acknowledge receipt
of the returned goods.

Collections. The collection function must ensure that all cash collections are properly identified
and promptly deposited intact at the bank. Many companies use a lockbox system, in which
customers' payments are sent directly to the entity's bank. The bank then forwards a file of cash
receipts transactions and remittance advices to the entity. In situations where payments are sent
directly to the entity, the checks should be restrictive\v endorsed and a "prelisting" or control
listing prepared. All checks should be deposited daily.

Accounts Receivable. The accounts receivable function is responsible for ensuring that all
billings, adjustments, and cash collections are properly recorded in customers' accounts
receivable records. Any entries in customers' accounts should be made from authorized source
documents such as sales invoices, remittance advices, and credit memoranda. In an EDP system,
the entries to the customers' accounts receivable records may be made directly as part of the
normal processing of 'these transactions. The use of control totals and daily activity reports
provides the control for ensuring that all transactions are properly recorded.

General Ledger. The main objective of the general ledger function in terms of a revenue cycle
is to ensure that all revenues, collections, and receivables are properly accumulated classified,
and summarized in the accounts. In an EDP system, the use of control or summary totals ensures
that this function is performed correctly. One important function is the reconciliation of the
accounts receivable subsidiary ledger to the general ledger control account. The general ledger
function is also normally responsible for mailing the monthly customer account statements.

Major activities

Selling the Goods and Billing the Customers

(a) Processing customer orders - the cycle begins when the customer makes an order. The
company may have preprinted order forms, or the customer may make a verbal or
informal written request.
(b) Credit approval – If the order is on account (on credit), credit should be approved by
producing credit approval form for approving credit, limit, terms of credit and (credit
worthiness of the customer).
 (c) Shipping goods – this is a key part of the process, because this is when the companies
assets are actually given up. A shipping document (such as bill of lading) is prepared
giving the description, the quantity, the receivers, freight costs, and other information
the sales invoice is prepared of this stage. It should show the description, quantity and
prices including shipping charges – Transport cash, Insurance, etc.
(d) Bill customers and recording sales – the sales invoice is the most important document
in this activity – The sales invoice is the basis for recording sales and for billing the
customer. The monthly statement should be prepared and sent to each customer who
has an account. This monthly statement should list the invoices and payments for the
period, with the necessary information about each transaction will used for
confirmation by the auditor.
(e) Processing and recording cash receipts – A remittance advice should be sent to the
customer with the sales invoice. The customer should return that advice which contains
customers name invoice number, and amount paid. When cash arrives, prelisting of
cash receipts should be prepared. It should be by some one with out access to cash, and
with no knowledge of A/R. All cash receipts should be prepared. And recorded in cash
receive Journal.
(f) Charging off uncollectible accounts – uncollectible authorization form should be
needed for charging –off uncollectible expenses.
Control procedure over sales and receivables.
Control Procedures and Tests of Control
Table 13 provides a summary of the internal control objectives, possible misstatements, control
procedures, and selected tests of controls for sales and receivables.
The auditor's decision process on planning and performing tests of controls invokes considering
the seven internal control objectives and the pos-

Table 13. Summary of Internal Control Objectives, Possible Misstatements, Control

Procedures, and Test of controls for Sales and Receivable Transactions.

Internal Possible Control Procedure Test of Controls

control Misstatements
objective
Validity Fictitious sales Segregation of duties Observation and
evaluation of proper,
segregation of duties

Sales recorded only

Testing of a sample of
with approved customer
sales invoices for the
order and shipping
presence of authorized
document
customer order and
shipping document

Review and testing of

Accounting for
client procedures for
numerical sequences of
accounting for numerical
sales invoices
sequence of sales invoices

Review and testing of

Monthly customer client procedures for
statements; complaints mailing and handling
handled independently complaints about monthly
statements
Same control
Sales recorded, procedures as above Sales test of controls as
goods not shipped, above
or services not
performed
Completen Goods shipped or Accounting for Review of client’s
ess services performed, numerical sequences of procedures for accounting
revenue not shipping documents and for numerical sequence of
recorded sales invoices shipping documents and
sales invoices

Tracing of a sample of
Shipping documents
shipping documents to
 matched to sales their respective sales
invoices invoices and to the sales
journal

Testing of a sample of
Sales invoices
daily reconciliations
reconciled to daily sales
report Examination of the open-
order file for unfilled
An open-order file that
orders
is maintained currently
and viewed periodically
Timeliness Revenue All shipping documents Comparison of the dates
transactions forwarded to the billing on sales invoices with the
recorded in the function daily dates of the relevant
wrong period shipping documents

Comparison of the dates

Billing of goods
on sales invoices with the
shipped on a daily basis
dates they were recorded
in the sales journal
Authorizati Goods shipped or Proper procedures for Review of client's proce-
on services performed authorizing credit and dures for granting credit
for a customer who shipment of goods
Examination of sales
is a bad credit risk
orders for evidence of
proper credit approval; if
EDP application,
examination of
programmed controls for
 credit limits
Shipments made or
services performed
Authorized price list Comparison of prices and
at unauthorized
and specified terms of terms on sales invoices to
prices or on
trade authorized price list and
unauthorized terms
terms of trade; if EDP
application, examination
of programmed controls
for authorized prices and
terms
Valuation Revenue Authorized price list Same as above
transaction and specified terms of
recorded at an trade
incorrect dollar
Examination of sales
Each sales invoice
specified terms of
invoice for evidence that
agreed to shipping
trade
client personnel verified
document and customer
mathematical accuracy
order for product type
and quantity;
Recompilations of the
mathematical accuracy
information on a sample
of sales invoice verified
of sales invoices; if EDP
application examination
of programmed controls
and consideration of use
of computer-assisted audit
techniques
Classificati Sales transaction Chart of accounts Review of sales journal
on not properly and general ledger for
classified proper classification

Proper codes for

Examination of sales
different types of
invoices for proper classi-
 products or services fication: if EDP applica-
tion, testing of pro-
grammed controls for
proper codes
Posting and Sales transactions Sales invoices Examination of
summarizat not posted correctly reconciled to daily sales reconciliation of sales
ion to the sales journal report invoices to daily sales
or customers’ report
Daily postings to sales
accounts in
journal reconciled with Examination of
accounts receivable
posting to subsidiary reconciliation of entries to
subsidiary ledger
ledger sales journal with entries
to subsidiary ledger

Amounts from sales Review of reconciliation

Subsidiary ledger
journal not posted of subsidiary ledger to
reconciled to general
correctly to general general ledger control
ledger control account
journal account

Monthly customer
Review and testing of
statements with
client procedures for
independent review of
mailing and handling
complaints
complaints related to
monthly statements

Validity

The validity internal control objective relates to management's assertion about existence or
occurrence. Auditors are concerned about the validity objective for revenue transactions because
clients are more likely to overstate sales than to understate them. The auditor is concerned about
two major types of material misstatements: sales to fictitious customers and recording of revenue
when goods have not been shipped or services have not been performed. T

The major control for preventing fictitious sales is proper segregation of duties between the
shipping function and the order entry and billing functions. If these functions are not properly
segregated, it is possible that unauthorized shipments can be made to fictitious customers by
circumvention of normal billing control procedures. Requiring an approved customer sales order
and shipping document before revenue is recognized also minimizes the recording of fictitious
sales in a c1ienl's records. Accounting for the numerical sequence of sales invoices can be
accomplished manually or by a computer. The use of monthly customer statements also reduces
the risk of revenue being recorded before goods are shipped or services are performed since
customers are unlikely to recognize an obligation to pay in such a circumstance.

Completeness

The completeness internal control objective relates to the completeness, assertion. The major
misstatement that concerns both management and the auditor is that goods are shipped or
services are performed and no revenue is recognized. Failure to recognize revenue means that the
customer may not be billed for goods or services and the client does not receive payment.
Control procedures that provide assurance that the completeness internal control objective is
being met include accounting for the numerical sequence of shipping documents and sales
invoices, matching shipping documents with sales invoices. Reconciling the sales invoices to the
daily sales report, and maintaining and reviewing the open-order file. For example, control totals
would exist in the system to provide " reconciliation of the daily shipping listing and the daily
sales report. Additionally, the open-order file should be reviewed periodically with follow up on
any order than some predetermined date.

Timeliness

The timeliness internal control objective relates to the completeness assertion. If the, client does
not have adequate controls to ensure that revenue transactions are recorded on a timely basis,
sales may be recorded in the wrong accounting period. The client should require that all shipping
documents be forwarded to the billing function daily for processing on a timely basis. The
auditor can test this control by comparing the date on a bill of lading with the date on the
respective sales invoice and the date the sales invoice was recorded in the: sales journal. All
billing should occur with only a minimum delay, the Shipping Department forwards the
approved shipping order to the Billing Department for entry into the billing program. In such a
system, sales should be billed and recorded within one or two days of shipment.

Authorization

The authorization internal control objective relates to the valuation assertion. Possible
misstatements due to improper authorization include shipping goods to or performing services
for customers who are bad credit risks and making sales at unauthorized prices or terms. As
discussed earlier in this chapter, management should establish procedures for authorizing credit,
prices, and terms. Additionally, no goods should be shipped unless there is a properly authorized
sales order.

Valuation

The valuation internal control objective also relates to the valuation assertion. Valuation is an
important internal control objective because revenue transactions that an: not properly valued
result in misstatements that directly affect the amounts reported in the financial statements.
Again, the presence of an authorized price list and terms of trade reduces the risk of improper
valuation. There should also be controls that ensure proper verification of the information
contained on the sales invoice, including type of goods and quantities shipped, price, and terms.
The sales invoice should also be verified for mathematical accuracy before being sent to the cus-
tomer. In a manual system, the sales invoice may contain the initials of the client personnel who
verified the mathematical accuracy. In an EDP application, most of these controls would be
programmed. For example, a price list would normally be maintained in a master file. However,
the client still needs controls to ensure that the authorized price list is updated promptly and that
only authorized changes are made to the master file. The auditor can verify the programmed and
processing controls by using CAATs as tests.

Classification

The classification internal control objective relates to the presentation and disclosure assertion.
For most entities this is not an important internal control objective in the revenue cycle. The use
of a chart of accounts and proper codes for recording transactions should provide adequate assur-
ance about this objective. The auditor can review the sales journal and general ledger for proper
classification. Sales invoices can be tested for proper classification by examining programmed
controls to ensure that sales invoices are coded by type of product or service.

Posting and Summarization

The posting and summarization internal control objective relates to the presentation and
disclosure assertion. In any accounting system there is always a possibility that transactions are
not properly summarized from source documents or posted properly from journals to the
subsidiary and general ledgers. In the revenue cycle, control totals should be utilized to reconcile
sales invoices to the daily sales report, and the daily recordings in the sales journal should be
reconciled with the posting to the accounts receivable subsidiary ledger. The accounts receivable
subsidiary ledger should periodically be reconciled to the general ledger control account.

In a properly designed computerized revenue system, such controls are programmed and
reconciled by the control groups in the EDP Department and the user departments. The auditor
can examine and test the programmed controls and various reconciliations. The use of monthly
customer statements may also identify posting errors.

Control procedure over sales and receivables

CHAPTER 8
AUDITING INVENTORIES

 Lack of information held on stock holdings resulting in poor decision and inability to
meet the demands and objectives of the business
1. Internal controls
1. 1. internal controls expected for stock
 The controls should be appropriate to manage the risks associated with stock. For
companies heavily reliant on stock holding,
there can be significant levels of risk and therefore very robust controls are required. Both
internal and external auditors will be
involved in audits of stock and will need an understanding of risks and the following
internal controls:
 Formal, documented procedures for stock controls that are monitored regularly to ensure
compliance.
 Trained and experienced staff, familiar with stock control requirements
 Stock control planning processes
 Active records of stock control and of future requirements, with regular verification of
such records
 Regular liaison with other areas of the business to maintain an awareness of future needs
 authorization procedures for stock changes, including purchases
 controls over stock inwards, including logging and recording and reconciliation of
expected versus actual stock received
 controls over dispatches and goods outwards ,including authorization of dispatch and
physical check to ensure the correct type and number of stock items is released
 Stock held in a secure site
 Regular stock valuations and reconciliation's to accounting records
 Stock takes, including physical checks on level and type of stock
 Identification and physical tracking of raw materials, items in production and finished
goods.

2. Physical counts
From the audit point of view, the stock records substantiated by physical counts are most
important. Physical counts for the various stock categories may be taken at various intervals:
 At close to the year end (periodical)
 On a continuous basis over the whole year (continuous)
 Some combination of the above.
2.1. Client's procedures at stocktaking
 The two methods of stocktaking are continuous and periodical. Note that the periodical
stock take need not be exactly at the year-end provided that the client's internal control
procedures over stock are satisfactory. In fact it is common practice to take stock some
time before the year-end. Then to update for movements between the stocktaking date
and the year end. This procedure is especially useful where the accounts are being
produced to a tight deadline.
2.2 . Continuous stocktaking
 Where a suitable record of stock is maintained, it is often backed up by a programme of
continuous stocktaking as part of general stock control procedures. this programme
should ensure the following outcomes.
 Adequate records are kept up to date.
 the records are amended as a result of physical inspection, and there are appropriate
reports and investigation procedures for discrepancies.
 Two persons carry out each check, and there is a rotation of pairing of the checkers.
There are several advantages of continuous stock checking:
 No disruption caused by a periodical stock take
 More accurate and regular stocktaking, earlier identification of errors moving stocks, etc
 Increased discipline over storekeepers caused by the surprise elements of random checks
 Providing the above conditions are met, the auditing guideline allows auditors to rely on
the continuous stocktaking procedures, rather than a full year-end count.

2.4. Periodical stocktaking

This is necessary in most cases, i.e. where continuous stocktaking is not carried out. it can
also be undertaken to back up a continuous stocktaking system.
It will usually be undertaken on or around the financial year end. If undertaken around the
financial year end, the time gap between the physical count and financial year end should be
kept to a minimum, so as to ensure the accuracy of the records which are necessary to
adjust the year end figures.
Whether continuous or periodical stocktaking occurs, the practice is the same that is the
auditor must ensure that the stock is properly counted, identified and recorded.
2.4 Organization of stocktaking
Firstly the permanent organization of the stores should be considered, particularly
ensuring the following points:
 Goods are kept in bins and on racks, with complete descriptions of each item by bib
cards etc.
 Goods are protected against deterioration and misappropriation (restriction of access to
stores).
 Goods held for third parties, and slow-moving, obsolete stock, etc. are identifies and
separated.
 There is an adequate plan of the area to be covered, which should be tidy.
Secondly, comprehensive instructions should be laid down for the undertaking of the stocktaking
detailing.
 The procedure to be followed by each center, dividing each center into areas for
stocktaking purposes.
 The appointment of competent supervisors (both technically and managerially) for each
area, with teams (pairs) of technically competent counters under them. One person for
each team should be responsible for counting. unless their work is independently
checked.it is rare in practice to find anyone checking stock other than those responsible
for stock on aday-to-day basis. Auditors needed to be aware of the possibility of
misappropriation of assets combined with falsification of the related records.
 The mark to be applied to stock to indicate that it has been counted e.g chalk mark
docket etc.
 A standardised pre-numbered form for recording the stock count. the issue and return of
which should be controlled so that all stock counted and areas are accounted for, and
that proper accounting records are kept.
 Movement of stock during the stocktake should be halted or closely controlled
 Comparison as soon as practicable after the stocktake with the continous stock records
so that any discrepancies may be investigated and adjusted.
3. The auditor and the stocktake
3..1 Auditor's attendance at stockaking
The overall purpose of the audiror's attendance is to assess the effectiveness of the client's
stocktaking procedures. Attendance at stocktaking is primarily a test of controls,not a
substantive procedure it is not the auditor's responsibility to count stock, but the client The
auditor will perform test counts but these tiny samples are not intended to be representative
of the populations they are drawn from . They are tests of controls by re-performance. There
are three aspects of the auditor's duties covering the times before , during and after the
stoktaking.

3. 2 Before the stocktaking

The auditors should carry out the following procedures.
 . Review prior year's working papers familarise themselves with the nature , volume and
location of stocks, consider the
controlling and recording procedures over stock.
 Identify problem areas in relation to the system of internal control and decide whether
reliance can be placed on internal audirors.
 If stock held by third parties is material, or the third party is insufficiently independent
or reliable, then arrange a stocktake attendance at the third party's premises; otherwise,
arrange third party confirmation.
 If the nature of the stocks is sp3cialised then arrange expert help or review the client's
own arrangements.
 Examine the client's stocktaking instructions ; if found to be inadequate, the matter
should be discussed with the client with a view to improving them prior to the stocktake.

AUDIT AND INTERNAL REVIEW

Audirors should perform analytical procedures on stock as part of the planning process;
these will consists of consideration of the ageing of stock , stock turnover rates etc.

During the stocktaking

The main task is to ensure that the client"s staff are carrying out their duties effectively. The
auditor should perform the following steps :
 make two-way test counts from factory floor to stock sheets, and from stock sheets
to factory floor
 make notes of items counted damaged stock, instances where the stocktaking
procedures are not being followed
 examine and test control over the stock sheets. The client should keep a stock sheet
register
 examine cut-off procedures (see below)
 pay particular attention to goods held on behalf of third parties ( for example, goods
on sonsignment)
 reach a conclusion as to whether or not the stocktaking wassatisfactory, and hence
provides reliable evidence supporting the final stock figure.
Junior auditors often feel uncomfortable when required to reach a conclusion on the
adequacy of the performance of stocktaking procedures fearing that they may have
"missed something .. They often forget that attendance at stocktaking is only part of the
audit of stock and that there are many other audit procedures that will be used to
support the final opinion.

If the auditors in attendance at the stocktake do not feel that the procedures are being
carried out adequately. they must bring this to managment"s attention immediately and
seek to rectify the position as it may not be possible to obtain the relevant evideance at
a later date.

After the stocktaking

The auditor should check the cut-off details obtained at the stocktake to the ledgers to
ensure they ar accounted for in the correct period, review the final stock sheets and
follow up test counts to the final statements of stock. This is not always easy where the
audit trail is poor . We may have counted 15 red washing-up bowls at the stocktake and
there may be 150 in the final statement of stock, but do they include ours ? We would
obviously be even more concerned if the final statement of stock showed none of the
 iitems we counted. The auditor should also ensure that any continous stock records
have been adjusted or reconciled to the physical count and all differences investigated.
Cut-off

The auditor should examine the link between purchases records and stocks and between
sales records and stocks, to ensure that there is complete accord between stock and the
financial records of purchases and sales ,debtors and creditors. These are known as "cut
- off procedures. Also note that the same term may encompass the recording of cash in
the correct accounting period.
Tests the auditor would carry out to ensure correct cut-off include the following :

during stocktake attendance note the serial numbers of the last sales invoice, despatch
note and goods received note generated before the stocktake.

THE AUDIT OF STOCKS

 after the stocktake ,check the year-end despatch notes to sales invoices and the sales day
book and vice versa to ensure that despatches and the related invoice both fall before the
year end
 similarly for purchases, ensure year-end goods receipts notes and related purchase
invoices are correctly treated in the current period
 take a sample of goods received and goods despatched just after th year end and ensure
that the related stock was not included in the count in the case of goods received, and
that it was included, in the case of goods despatched

INTERNAL AUDIT AND STOCK AUDITS

The internal auditor will also undertake audits of stock and the external auditor may be able to
rely on the work undertaken by internal audit What work is undertaken will be dependent on the
organisation and the nature of the risk exposure. The internal auditor will approach a stock audit
in the same way as any other auditor as explained in previous chapters. In particular , the internal
auditor will perform the following steps:
  Conduct detailed planning,including evaluation of background information.previous
audits (whether internal or external) , company policy and procedures relating to stock,
management information and performance measures and overall objectives.
 Identify risks associated with stock and asses impact and probablity of risks for the
organisation concerned.
 Review controls in place against those expected. Are the controls appropriate, and are
they operating effectively and in a timely manner ? Key controls alrelady identified and
commented on in detail are the operation of procedures and stocktaking
 Test key controls:
- review evidence if sticktakes being undertaken on a regular basis (see above for testing
procedures on stocktakes)
- confirm accuracy of data input to other systems
- sample of disposals to confirm evidence of authorisation of transactions. desposals
with in policy and the best price being obtained
- check accuracy of management information relied upon for decision making
- records of liaison with other departments to confirm awareness of changing needs for
stock.
 The internal auditor will be able to formulate a report based on conclusions
from the testing including an overall evaluation of the level of risk exposure.
Findings are discussed with management and an action plan formulated for any
issues identified.

You are an intrnal auditor for Harvey Supplies and have been asked to undertake a
stock audit. Stock is akey asset of Harvey Supplies and the last audit was carried
out by the external auditors. Outline your approach to the audit.
Feedback to this activity is at the
end of the chapter

Stock valuation procedures

As pointed out above , attendance at the stocktake cannot prove that stock is correctly
valued. Suggested valuation tests are set out below . Do not attempt to learn these. take them
as illustrative and try and consider why the various tests are appropriate .
Raw materials and consumables
 Ascertain what elements of cost are included e.g carriage in, duties etc.
 Ascertain the method of valuing stock issues.
 If standard costs are used. enquire into basis of standards, how these compare
with actual costs and how variances are treated.
 Test check cost prices used with purchase invoices received in the month(s)
prior to stocktaking .
 Test check quantities withstock records or bin cards with a particular aim of
finding items which have been in stock for. say, more than six months. Discuss
these items with a responsible official in order to find out when they might be
used; if it is unlikely that they will be used, try to ascertain a reasonable net
realisable value
Work in progress
 Ascertain what elements of cost are included. If overheads are included,
ascertain the basis on which they are included and review this basis with
the available costing and financial information.
 Ascertain how the various stages of process are measured and if estimates
are made, on what basis they ar e made, on what basis they are made.
 Ensure that any materials costs exclude any abnormal wastage factors.
 Ensure that any addition for overheads includes only normal expenses
based on normal production capacity and that any costs arising from under-
utilisation of production faciilities excessive waste or exceptional
circumstances are not carried forward in the stock valuation.
 Enquire into any old, obsolete or damaged items and ensure that these are
valued at a reasonable estimated net realisable value. check this with
previous or subsequent sales of similar items.
Finished goods and goods for resale
  Enqire into what costs are included, and how these have been established Ensure that
the overhead addition is based on normal costs and is reasonable in relation to the
information disclosed by the draft accounts.
 Test check prices on stock lists with officials sales list, bearing in mind any trade
discounts which are normally garanted off the list prices. Ensure that stocks are valued
at net realizable value if this is less than cost . For any such items , also check back and
see if the relevant partly processed stocks and raw materials have also been written
down.
 Follow up any items which stock records show are more than, say six months in stock.
Enquire into reasons for this and ascertain possible realisable value of such items.
 Follow up any stocks which at the time of observance of physical stocktaking were
noted as being damaged or obsolete.
 Discuss with sales manager any possible policy of selling off certain lines at less than
usual selling prices, e.g 'loss leaders' due to competition, substitute products
 on the market etc.
 Follow up valuation of all ' seconds' items and ensure that they are valued at a
reasonable estimated net realisable value if less than cost.
SSAP 9: Problem areas
problem areas
Appendix 1 of SSAP 9 contains general guidance on certain practical matters which may cause
difficulty in particular businesses. These are explained briefly below .
Allocation of overheads
Overheads are expenses incurred in the manufacture of goods and include items like factory rates
and lighting and heating

Production overheads should normally be added to the cost of goods being produced based on
the normal activity level of the company. An estimate of overheads to be incurred at this level of
activity will be produced. and allocated to the goods produced based on this activity level. If the
company produces less output than expected, then the 'unused' overheads will be written off to
the profit and loss account and nor included in the stock figure.
Activity levels in excess of budget may require a reapportionment of overheads. This will ensure
that too much overhead cost is not included in stock.

The overheads to be included in stock should be only those relating to production (the factory
rates etc.) Some companies will try to include all overheads in their stock figures . This happens
because their accounting system cannot isolate the production overheads from the non-
productive. Where this type of absorption costing is used, an estimate should be made of the non-
productive overheads. These will then be excluded from the stock valuation . This estimate is
unlikely to be accurate, but as good a 'guess' as possible should be made.
Choice of costing method
There are many different ways of including overheads into the cost of stock. Each company must
make its own decision about which method to use. The method must give a close approximation
to the actual cost of overheads incurred in making the stock. If should contains as few matters
of judgement as possible

Net realisable value

stocks should be valuee at the lower of cost and net realisable value.

Net realisable value is the actual or estimated selling price less all further costs to completion and
all costs to be incurred in marketing selling and distribution.

It is not always easy to find a figure for net realisable value. Some estimat4s must be reached
based on sales of stock after the year end. or from other evidence such as price lists. This
estimate should be made for each individual stock line.

post balance sheet events may influence the net realizable value calculation .Low selling prices
after the year end may result in net realizable value being less than cost.

Where net realizable value is found to be less than cost the individual stock lines affected should
be revalued at the (flower) net realizable value. The only exception to this rule is for raw
materials and components to be used in manufacture. These items may have their net realizable
value being less than cost. No reduction in value is needed if it can be shown that the product
made from these items can still be sold at a profit.
Here are some of the circumstances in which net realizable value may be less than cost:
 increased costs of manufacture
 reduced selling prices of products
 deterioration of stocks (particularly food stuffs)
 obsolescence of products (perhaps due to technological changes)
 deliberate selling at loss (supermarket ' loss leaders')
 buying and production errors.
AUDITING SAMPLING

As business entities have evolved in size and complexity, auditors increasingly have had to
rely upon sampling procedures as the only practical means of obtaining for sufficient, competent
evidential matter as the basis for audit reports. This reliance upon sampling procedures is one of
the basic reasons that audit reports are regarded as expressions of opinion, rather than absolute
certificates of the fairness of financial statements.
It is neither practicable nor necessary for the auditor to check all the transactions in a
client’s accounting records or to verify or confirm all individual items comprising the assets,
liabilities, revenues, equities, and expenses. The auditor will examine only a representative
sample of such transactions and will form his/her opinion on the reliability of the accounting
records as a basis for the correctness of the financial statements under audit opinion from the
results of such tests.
 Auditors frequently use sampling, usually in combinations with other auditing procedures,
in examining account balances or classes of transactions. Audit sampling is the application of an
audit procedure to less than 100% of the items within an account balance or class of transactions
for the purpose of evaluating some characteristic of the balance or class. According to SAS # 39,
Audit Sampling, three conditions must be met to constitute audit sampling. First, less than 100%
of the population must be examined. Second, the sample results must be projected as population
characteristic. Third, the projected sample results must be compared to an existing client-
determined account balance to determine whether to accept or reject the client’s balance, or the
projected sample results must be used to assess control risk. For example, in determining
whether inventory quantities are appropriately recorded, an auditor may complete an internal
control structure questionnaire on inventory and also may select some items for independent
count. Completing the questionnaire is a nonsampling procedure, whereas making independent
counts is a sampling procedure if the auditor projects the sample findings to evaluate the
accuracy of the client’s inventory count.
The aim of sampling as related to auditing, whether statistical or nonstatistical, may be stated
as to draw conclusions about a large group of data, e.g., all the entries in the purchase of day
book or all the items in stock from an examination of a sample. The underlying assumption is
that the sample will allow the auditors to make accurate inferences about the population. Basic to
audit sampling is sampling risk- the risk that the auditors’ conclusions based on a sample might
be different from the conclusion they would reach if they examined every item in the entire
population. In other words, it is the risk that there will be sampling error, that is, that the
projected sample results and the true condition will differ. For example, an auditor selecting a
sample of sales invoices processed during 1997 may project that a maximum of 6% of the total
sales invoices were not properly stamped with “credit approval.” If the auditor were to examine
all credit sales for 1997, he or she might find that the true deviation rate (unstamped credit
approvals) is actually 9%. The difference between the projected sample rate of 5% and the true
deviation rate is the sampling error.

Numerous situations exist in an audit when an auditor does not use audit sampling. For example,
sometimes an auditor may perform a 100% examination of an account or transaction balance
because he or she not willing to accept any sampling risk for the balance. Alternatively, the
auditor may select a transaction for purposes of following it through the client’s accounting
system (a walk-through) to gain an understanding of how transactions are processed. In those
situations, the auditor is not sampling. Likewise, an auditor may examine all large-amount
account balances, such as buildings, equipments, and properties. In such cases, the auditor has
not engaged in sampling but, in effect, has limited the population to material items and has
audited the entire population of material items.
Sampling risk is reduced by increasing the size of the sample. At the extreme, when the
entire population is examined there is no sampling risk. But, auditing large samples or the entire
population is costly. A key element in efficient sampling is to balance the sampling risk against
the cost of using large samples.
Auditors may also draw erroneous conclusions because of nonsampling errors- those due to
factors not directly caused by sampling. For example, the auditors may fail to apply appropriate
audit procedures, or they may fail to recognize errors in the documents or transactions that are
examined. The risk pertaining to nonsampling errors is referred to nonsampling risk.
Nonsampling risk can generally be reduced to low levels through effective planning and
supervision of audit engagements and implementation of appropriately designed quality control
procedures by the CPA firm.

If sampling risk is subtracted from audit risk, the balance or remainder is equal to nonsampling
risk. That is,
Audit Risk – Sampling Risk = Non-sampling Risk.
Statistical Vs. Non-Statistical Samplings
Audit sampling methods can be divided into two broad categories: statistical and non-statistical.
In all of the sampling methods, there are four steps:
i) planning the sample,
ii) selecting the sample,
iii) performing the sample, and
iv) Evaluating the results and drawings conclusions.
However, statistical sampling differs from non-statistical in that the former applies mathematical
models to quantify or measure sampling risk in planning the sample (step 1) and evaluating the
results (step 4).A sample is said to be nonstatistical (or judgments) when the auditors estimate
sampling risk by using professional judgment rather than using statistical techniques. This is not
to say that nonstatistical samples are carelessly selected samples. Indeed, both nonstatistical and
statistical audit samples should be selected in a way that they may be expected to allow the
auditor to draw valid inferences about the population. In addition, the misstatements found in
either a nonstatistical or a statistical sample should be used to estimate the total amount of
misstatement in the population (called the projected misstatement). However, nonstatistical
sampling provides no means of quantifying sampling risk. Thus, the auditors may find
themselves taking larger and more costly samples than are necessary, or unknowingly accepting
a higher than acceptable degree of sampling risk.

The use statistical sampling does not eliminate professional judgment from the sampling process.
It does, however, allow the auditors to measure and control sampling risk. Through statistical
sampling techniques, the auditors may specify in advance the sampling risk that want in their
sample results and then compute a sample size that controls sampling risk at the desired level.
Since statistical sampling techniques are based upon the laws of probability, the auditors are able
to control the extent of the sampling risk in relying upon sample results. Thus, statistical
sampling may assist auditors in (1) designing efficient samples, (2) measuring the efficiency of
the evidence obtained, and (3) objectively evaluating sample results. However, these advantages
are not obtained without additional costs of training the audit staff, designing sampling plans,
and selecting items for examination. For these reasons, nonstatistical samples are widely used by
auditors, especially for tests of relatively small populations. Both statistical and nonstatistical
sampling can provide auditors with sufficient competent evidential matter.

Sample Selection
In auditing, a sample should be:
a. Random- a random sample is one where each item of the population has an equal (or
specified) chance of being selected. Statistical inferences may not be valid unless the sample is
random.
b. Representative- the sample should be representative of the differing items in the whole
population. For example, it should contain a similar proportion of high and low value items to
the population (e.g. all the accounts receivable).
c. Protective- protective, that is, of the auditor. More intensive auditing should occur on
high value items known to be high risk.
d. Unpredictable- client should not be able to know or guess which items will be examined.
There are several methods available to an auditor for selecting items. These include:
a. Haphazard: simply choosing items subjectively but avoiding bias. Bias might come
conversely by tendency to favour items in a particular location or in an acceptable file or
conversely in picking items because they appear unusual. This method is acceptable for non-
statistical sampling but is insufficiently rigorous for statistical sampling.
b. Simple random: all items in the population have (or are given) a number. Numbers are
selected by a means which gives every number an equal chance of being selected. This is done
using random number tables or computer or calculator generated random numbers.
c. Stratified: auditors often stratify a population before computing the required sample and
selecting the sample. Stratified means dividing the population into sub population (strata= layers)
and is useful when parts of the population have higher than normal risk (e.g. high value items,
oversea customers). Frequently, high value items form a small part of the population and are
100% checked and the remainders are sampled.
d. Cluster sampling: This is useful when data is maintained in clusters (= groups or
bunches) as salary records are kept in weeks or sales invoices in months. The idea is to select a
cluster randomly and then to examine all the items in the cluster chosen. The problem with this
method is that this sample may not be representative.
e. Random systematic: This method involves making a random start and then taking every
nth item thereafter. This is a commonly used method which saves the work of computing random
numbers. However, the sample may not be representative as the population may have some serial
properties.
f. Multi stage sampling: this sampling is appropriate when data is stored in two or more
levels. For example, inventory in retail chain of shops. This stage is to randomly select a sample
of shops and the second stage is to randomly select inventory items from the chosen shops.
g. Block sampling: simply choosing at random one block of items e.g. all June invoices.
This common sampling method has none of the detailed characteristics and is not recommended.
h. Value weighted selection: this method uses the currency unit value rather than the items
as the sampling population. It is now very popular and is described more fully later in the
chapter, under unit sampling.

Sample Size
There are several factors which must be considered when deciding upon the sample size. These
include:
a. Population size- surprisingly, in most instances this is not important and is only relevant
in very small population.
b. Level of Confidence- Even a 100% sample (for human consideration reasons) will not
give complete assurance. Auditors work to levels of confidence which can be expressed
precisely, for example 95%.
c. Precision- from a sample, it is not possible to say that I am 95% certain that, for example,
the error rate in a population of inventory calculations is x% but only that the error rate is x% + y
% where + is the precision interval. Clearly the level of confidence and the precision interval are
related, in that for a given sample size higher confidence can be expressed in a wider precision
interval and vice versa.
d. Risk- risk is a highly important concept in modern auditing and in high risk areas a large
sample will be desirable, because high confidence levels and narrow precision intervals are
required.
e. Materiality- this is really a subset of risk.
f. Subjective Factors- this is the most important and yet difficult area of consideration.
g. Expected error/deviation rate- the theory requires that the sample size required is a
function of the error/deviation rate. This is only known after the results have been evaluated.
Statistical Sampling Audit Uses
Statistical sampling plans can be used in all auditing situations when evidence about a population
is obtained by sampling. Some popular uses include:
Compliance Testing- the issue of sales credit notes is controlled by the requirements that all such
should be approved by a departmental manager and this approval evidenced by a signature. The
auditor would wish to confirm that this control was compiled with by sampling the sales credit
notes.
Substantive testing- in a client with very unreliable internal controls, the auditor may wish to
verify that all dispatches in year have resulted in invoices in that year. The correspondence
between dispatch note and invoice can be sampled.