8 Audit Procedures Evidence Gathering and Evaluation

Question 1

What does audit evidence need to be?

Answer 1

Sufficient, relevant and reliable, for the purposes of the audit opinion

Question 2

What are the 5 ESSENTIAL criteria audit evidence must support

Answer 2

To achieve this aim and be relevant to the audit objectives, there must be sufficient and reliable audit evidence about all of the following:
1. Existence (assets and liabilities at y/e) and occurrence (transactions throughout the year). Genuine or not?
2. Completeness (includes accuracy of recording and correct cut-off)
3. Rights and obligations (per conceptual framework definitions of assets and liabilities)
4. Valuation and/or measurement (in accordance with relevant IAS / FRS)
5. Presentation or disclosure (in accordance with relevant IAS / FRS and/or Companies Act)

Question 3

What is occurance

Answer 3

Transactions and events that have been recorded have occurred and pertain to the entity – i.e. they are genuine

Question 4

What is completeness

Answer 4

• All transactions and events that should have been recorded have been recorded
• “Completeness” includes:
  o Accuracy and reliability of data recording and processing throughout the year – amounts and other data relating to transactions and events have been classified and recorded appropriately so that y/e transaction totals and balances are not over/under recorded
  o Correct cut-off – transactions and events have been recorded in the correct accounting periods

Question 5

What is presentation and disclosure

Answer 5

Financial information is appropriately presented and described, and disclosures are clearly expressed in accordance with International Accounting Standards, the Companies Act, and LSX listing rules

Question 6

What is the correct cut off

Answer 6

• Sales and purchases recorded in the correct month
• Accidental cut of errors are fairly common, but management can apply deliberate cut-off ‘errors’ as a means of window-dressing. See topic 4 re Thomas Gerard legal case
• Easy place for management to apply fraudulent accounting as errors here are common and therefore if they are caught they can pass it off as just a mistake
• General rule sale is considered to be the point of dispatch

Question 7

What is existence

Answer 7

Assets, liabilities, and equity interests exist (they are genuine) (reliable)

Question 8

What is completeness

Answer 8

All assets, liabilities and equity interests that should have been recorded have been recorded, and y/e cut-off is correct for debtors, creditors and inventory (reliable)

Question 9

What is rights and obligations

Answer 9

The entity holds or controls the rights to assets, and liabilities are the obligations of the entity (they meet the ASB definitions of assets and liabilities) (reliable and relevant)

Question 10

What is valuation and measurement

Answer 10

Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts in accordance with International Accounting Standards, to show a ‘true and fair view.’ (reliable)

Question 11

What is presentation and disclosure

Answer 11

Financial information is appropriately presented and described, and disclosures are clearly expressed in accordance with International Accounting Standards, the Companies Act, and LSX listing rules. (understandable, relevant, consistent).

Question 12

What are internal controls

Answer 12

• Internal control is ‘all embracing’ and includes absolutely everything which is designed/intended to help an organization achieve any of the above objectives.
• All internal controls are ultimately the responsibility of the directors

Question 13

What are the objectives of internal controls

Answer 13

Internal controls within accounting systems typically have one or more of the following specific objectives:
* Ensuring complete and reliable data processing (accounting records)
* Ensuring proper authorization, and preventing unauthorized transactions
* Safeguarding assets
* Detecting/preventing/correcting errors
* Deterring fraud (by making fraud more difficult and/or increasing the chance of detection)
* Facilitating management supervision and review (includes internal checks and reconciliations, and internal audit)
* Maintaining an audit trail

Question 14

What are the limitations of internal controls

Answer 14

• All systems of internal control are designed, operated and supervised by human beings.
  o Some are more careful and honest
• Therefore, they will never be perfect. CR will never be zero
  o Therefore AR can never be zero

Question 15

Why is the segregation of responsibilities important when considering internal controls

Answer 15

• This is a very important feature of internal control, and auditors will always look for this. It involves the division of functional responsibilities between different people, together with regular ‘internal checks’ and/or reconciliation by different members of staff and/or supervisors.
• This can greatly reduce the risks of undetected errors, unauthorized transactions.

Question 16

How does strong internal controls make fraud harder

Answer 16

• Fraud would require collusion, in a well designed system
• Fraud by nature is devious and by nature carefully concealed
• If good segregation then need lots of people to come together to create a successful fraud

Question 17

How does strong internal controls reduce audit work

Answer 17

• Strong segregation will allow auditors to place more reliance on compliance testing and do less substantive testing
  o Lower control risk and reliable internal control and records
  o Also accidental errors are far more likely to be detected

Question 18

What are the 4 main functions of controls that need separating (CARR)

Answer 18

Custody
* Maintains safe custody of particular assets/money/data. Can only accept/release assets after authorization (see below). Should deliver information to the record keeping function (see below).
Authorisation
* Authorises activities and takes decisions (of transactions/events relating to those assets).
Recording
* Records all the activities/events taking place (complete and reliable accounting records).
Reconciliation
* Independently checks and reconciles assets against authorisations and accounting records.

Question 19

What are the components of internal controls

Answer 19

• Control environment
• Entity’s risk assessment processes
• Information systems
• Control activities
• Monitoring of controls

Question 20

What is the control environment

Answer 20

• This is important and pervasive.
• It sets the overall tone for the entire organisation and influences the consciousness of its people.
  o Leadership comes from to top directors must set a good example for all lower members of staff
• It is the foundation for all other components of the internal control structure.
• It Includes corporate governance (based on the UK C.G. Code, see Gray & Manson Chapter 5), integrity, ethical values and management attitudes to internal controls
  o UK companies either have to comply with the corporate governance code of explain why not. It is not law so cant force companies

Question 21

What are the elements of the control environment

Answer 21

• Communication and enforcement of integrity and ethical values
• Commitment to competence
• Management’s philosophy and operating style
• Organizational structure
• Assignment/delegation of authority and responsibility
• Human resource policies and practices
  o If any of the above are unsatisfactory, it is likely that ‘inherent risk’ and ‘control risk’ will BOTH be higher

Question 22

What should a risk assessment cover

Answer 22

• This involves detailed analysis by the PLC of its strategic, operational and market risks.
• Some of these may be highly unpredictable
• Public companies should consider the possibilities of various business risks crystallizing and the significance of the consequent financial impacts on the business. These are part of ‘inherent risk’, because they can have very serious impacts on profitability and asset values, and even ‘going concern’. Therefore, they impact the financial statements.
• When this has been done, suitable internal controls should be introduced to monitor and reduce risks to acceptable levels, to the extent that this is possible.

Question 23

How can information systems support the 5 criteria

Answer 23

• Relevant and timely information about internal activities and external factors are essential if a company is to be successful. We live in the ‘information age’.
• Successful managers need timely, relevant and reliable information e.g. ‘management accounts’.

Question 24

What is an accounting system

Answer 24

• It comprises all of the methods and records established to identify, assemble, analyse, classify, record and report transactions and accounting events, and maintain accountability for all assets and liabilities.
• It must also provide a complete audit trail for ALL transactions.

Question 25

What is communication

Answer 25

Communication involves a clear organisation structure with good understanding of individual roles and responsibilities with respect to all functions and internal controls over internal and external reporting i.e. financial reporting and management accounting

Question 26

What are control activities

Answer 26

These are the policies and procedures designed to ensure that management directives are carried out and that necessary actions are taken to address problems and risks as these arise.

Question 27

What are examples of control activities

Answer 27

• Authorisation by designated staff only (and controls to prevent unauthorised actions)
• Performance reviews
• Physical controls
• Segregation of duties between custody, authorisation, recording, and reconciliation
• General controls and application controls over information processing

Question 28

What are general controls

Answer 28

• General controls are controls over the environment in which information processing operates.
• They should ensure that applications are trouble free and prevent, detect or correct events that management do not intend to happen. They include:
  o Systems development and maintenance controls
  o Organizational controls, e.g. organisation chart, supervision, segregation of duties, proper authorisation of transactions, recording and safe custody, computer security.

Question 29

What are application controls

Answer 29

• Application controls are designed to ensure individual applications/processes run smoothly. They include:
  o Documentation and records
  o Independent checks

Question 30

What are monitoring controls

Answer 30

• This are any activities or procedures designed to assess the performance of controls and their adequacy and relevance over time, such that internal control failures and/or weaknesses are identified, reported to management, and resolved.
• The majority of large organisations have an internal audit department.
  o Note: internal audit is a part of the internal control structure. The objectives of internal audit fall within the overall definition of internal control.

Question 31

What are external audits on monitoring controls

Answer 31

• When external auditors identify internal control weaknesses, usually they will inform the client’s management.
• The notification is normally in the form of a ‘letter of weakness’ or ‘management letter’ which is provided to the client when the audit has been completed.
• Generally, this will include recommendations for improving internal control.
  o This is a useful ‘service’ but is NOT part of the external auditor’s duties (lecture topic 1).
  o Is benefit to both client as can improve controls and to auditor as strengthens internal controls so reduces control risk next year

Question 32

What are the limitations on internal controls

Answer 32

• ‘Overarching limitation’ all systems of IC are designed, operated and supervised by human beings.
  o Therefore, they will never be perfect. CR will never be zero!
  o However, ICs can be highly effective, and those control risks related to Information systems and Control activities can be very low.
• Internal controls may potentially be over-ridden by management.
  o For example, if the Board of Directors want to ‘window-dress’ the accounts, they are only prevented by code of corporate governance
  o The most effective check on ‘board level’ behaviour is sound and ethical corporate governance, in compliance with the UK C.G. Code.
   As would have independent audit directors overseas activities

Question 33

What is the audit ‘context’ for sales and debtors

Answer 33

• Sales generate profit and debtors are an asset.
• Therefore, it is extremely unlikely that the directors of a PLC would deliberately understate sales or debtors!
  o However as sales is the largest, or the company would be loss making, it is the most material
• If they are ‘window-dressing’, they might overstate sales or debtors or both. Therefore, in this context the main ‘audit risk’ is that of overstatement.
• There are a number of different ways in which sales and debtors can potentially be overstated, e.g. deliberate cut-off errors (see L8.1), recording of non-existent sales and/or debtors, understatement of sales returns transactions, understatement of bad and/or doubtful debts.
• However, these are not the only matter to be considered. All sections of the audit require evidence about all five assertion categories

Question 34

How can you find a bad debt

Answer 34

• When the customer cannot be traced or is potentially insolvent
• Or when it would cost more to chase the debt than it is worth
  o Good credit control would prevent this
  o Therefore, looking at bad debts will allow you to understand the quality of the credit controls

Question 35

How can information about bad debts relate to existence or occurrence

Answer 35

Transaction class audit objective
* Recorded sales and cash receipts represent goods shipped / services provided / cash received during the period. (sales are real and not made up)
* Recorded sales adjustments represent discounts, returns and bad debts during the period.
Account balance audit objectives
* Debtors represent amounts owed by customers at the y/e date

Question 36

How can information about bad debts relate to completeness

Answer 36

Transaction class audit objective
* All sales, cash receipts, and sales adjustments transactions that occurred during the period have been recorded.
Account balance audit objectives
* Debtors include all claims on customers at the y/e date.

Question 37

How can information about bad debts relate to rights and obligations

Answer 37

Transaction class audit objective
* The PLC has rights to the debtor balances and cash resulting from the revenue cycle transactions.
Account balance audit objectives
* Debtors represent legal claims of the PLC on customers at the y/e date.

Question 38

How can information about bad debts relate to valuation or measurement

Answer 38

Transaction class audit objective
* All sales and cash receipts and sales adjustments are correctly journalised (classified), summarised and posted. Testing controls are working correctly
Account balance audit objectives
* Total accounts receivable in the draft f.s. agrees with the computer output and draft trial balance.
* The provision for doubtful debts is based on a reasonable estimate of the net realisable value of debtors.

Question 39

How can information about bad debts relate to presentation or disclosure

Answer 39

Transaction class audit objective
* The details of sales, cash receipts and sales adjustment transactions are consistent with their classification and presentation in the income statement.
Account balance audit objectives
* Debtors are correctly identified and classified in the statement of financial position.

Question 40

What is the difference between vouching and tracing

Answer 40

• These can be used in both compliance and substantive testing
• Difference is all about the direction of the test

Question 41

What is vouching

Answer 41

• Starting with a particular debtor balance and trace that back to when the sale was made to the customer and before that when they placed the order
• If you trace a sale back to the source and it does not exist then it suggests that the debtor doesn’t exist and therefore is overstated
• This could be due to an error or something deliberate

Question 42

What is tracing

Answer 42

• This is when you start at the customer sales order, through the consolidation and look at the outputs
• Called a “walk through test”
• Making sure the audit trail exists
• If you are not able to follow this through then you cannot say that the system is operating correctly
• Also a good test for understatement to make sure that all sales are actually tracked and added to the system
  o This is very unlikely for sales but could be the case for purchases

Question 43

Potential causes of misstatements and preventative internal controls

Answer 43

Functions that could include misstatement
* Accepting customer orders
* Approving credit
* Filling sales orders (if a manufacturer)
* Shipping
* Invoicing customers
* Recording sales and debtors
* Credit control

Question 44

What are the potential systematic errors and necessary internal controls for accepting customer orders

Answer 44

Potential systematic errors
* Unknown customers, incorrect product, incorrect quantity / description/ pricing etc (can lead to customer disputes, loss of business, bad debts)
Necessary internal controls
* Approval by supervisor in sales office.
* Our sales order document matched against the customer order.
* Independent checks on pricings and orders details

Question 45

What are the potential systematic errors and necessary internal controls for approving credit

Answer 45

Potential systematic errors
* Poor credit control, causing frequent bad debts
o Which would require a large provision for doubtful debts
Necessary internal controls
* Approval by credit controller, who sets credit limit for every customer.
* (Can sometimes upset customers if declined – but preferable to bad debts!)

Question 46

What are the potential systematic errors and necessary internal controls for filling sales orders

Answer 46

Potential systematic errors
* Incorrect product or quantity or quality is manufactured (causes wastage, extra work, upset customers etc.)
o INTERFACE inventory cycle
Necessary internal controls
* Production always based on copy of approved sales order, (sent to factory)

Question 47

What are the potential systematic errors and necessary internal controls for shipping

Answer 47

Potential systematic errors
* Goods shipped may differ from goods ordered (causes wastage, extra work, upset customers, possible bad debts or loss of business etc.)
o INTERFACE inventory cycle
Necessary internal controls
* All despatch notes raised from copy of approved sales order.
* Warehouse staff check goods against this.
* Customer complaints investigated and followed up by supervisors

Question 48

What are the potential systematic errors and necessary internal controls for invoicing customers

Answer 48

Potential systematic errors
* Billings for fictitious transactions or duplicate billings
* Some shipments not billed
* Invoices have incorrect price or quantity
Necessary internal controls
* All invoices matched to despatch note or other record of despatches

Question 49

What are ‘confirmations’ for substantive testing of y/e debtor balances

Answer 49

• During the ‘final’ audit, a ‘debtor circularisation’ is almost always used as a substantive test for the existence and rights and obligations and valuation of y/e debtor balances.
• Obtaining audit evidence in this way is known as a confirmation (see topic 5).
• It is primarily a test designed to detect over-statement

Question 50

How do you get a confirmation

Answer 50

• The auditor will select a sample of y/e debtors (typically about 50 or 60 customers) and will obtain a ‘covering letter’ from the directors requesting the debtor to reply directly to the auditor confirming the balance owed.
• The auditor then writes to each debtor, stating the balance owed according to the client’s records and asking them to confirm if this amount is correct, or to explain any disagreements.
• Typically about 60% to 65% actually reply to the audit firm

Question 51

What if the third party does not reply to the confirmation

Answer 51

For ‘non-respondents’ the auditor will look for ‘payments received after date’ i.e. during January and February, for a 31st December y/e.

Question 52

What if the third party does not reply to the confirmation and does not pay

Answer 52

• If the debtor has not replied and ‘after date’ payments have not been received, the auditor will attempt to VOUCH the debt back to the customer order and/or evidence of goods despatched or services supplied.
• See above notes on vouching which is when the start with a particular debtor balance and trace that back to when the sale was made to the customer and before that when they placed the order
• If you trace a sale back to the source and it does not exist then it suggests that the debtor doesn’t exist and therefore is overstated
• This could be due to an error or something deliberate
• The adequacy of the doubtful debts provision will also be reviewed, in the context of evidence of slow or unreliable payments within the sample

Question 53

What is the audit ‘context’ for purchases and creditors

Answer 53

• Purchases and expenses are costs against profit and creditors are a liability.
• Therefore, it is extremely unlikely that the directors of a PLC would deliberately overstate purchases or expenses or creditors!
• If they are ‘window-dressing’, they might understate purchases and/or expenses and/or creditors!
  o Therefore, in this context the main ‘audit risk’ is that of understatement.
• There are a number of different ways in which purchases and/or expenses and/or creditors can potentially be understated, e.g. deliberate cut-off errors (see topic 8 lecture 1), non-recording of purchases and/or expenses and/or creditor balances, overstatement of purchases returns transactions.
• However, these are not the only matter to be considered.
  o All sections of the audit require evidence about all five assertion categories

Question 54

How can information about purchases and creditors relate to existence or occurrence

Answer 54

Transaction class audit objective
* Recorded purchases represent goods, productive assets and services received during the period.
* Recorded cash payments represent payments made to suppliers and creditors during the period.
Account balance audit objectives
* Creditors represent amounts owed by the PLC at the y/e date.

Question 55

How can information about purchases and creditors relate to completeness

Answer 55

Transaction class audit objective
* All purchases and cash payments that occurred during the period have been recorded.
Account balance audit objectives
* Creditors include all amounts owed by the PLC to suppliers of goods and services at the y/e date.
* Accrued expenses and provisions have been identified

Question 56

How can information about purchases and creditors relate to right and obligations

Answer 56

Transaction class audit objective
* The PLC is obligated to pay the creditors resulting from the purchases transactions.
Account balance audit objectives
* Creditors are legal obligations of the PLC at the y/e date

Question 57

How can information about purchases and creditors relate to valuation or measurement

Answer 57

Transaction class audit objective
* All purchases and cash payments are correctly journalised (classified), summarised and posted.
Account balance audit objectives
* Total accounts payable in the draft f.s. agrees with the computer output and draft trial balance.
* Accrued expenses and provisions have been correctly calculated or fairly estimated.

Question 58

How can information about purchases and creditors relate to presentation or disclosure

Answer 58

Transaction class audit objective
* The details of purchases and cash payments transactions are consistent with their classification and presentation in the income statement.
Account balance audit objectives
* Creditors and accrued amounts are correctly identified and classified in the statement of financial position.

Question 59

Potential causes of mis-statements and preventative internal controls

Answer 59

• Requisitioning goods and services
• Ordering goods and services
• Receipt of goods
• Paying suppliers
• Recording purchases and creditors

Question 60

What are the potential systematic errors and necessary internal controls for requisitioning goods and services

Answer 60

Potential systematic errors
* Goods and services are ordered by persons who do not have the required authority.
* Expenditures may exceed budgets
Necessary internal controls
* Purchasing dept checks proper authorisation before raising a purchase order.
* Accounts office regularly reviews expenditures against budgets.

Question 61

What are the potential systematic errors and necessary internal controls for ordering goods and services

Answer 61

Potential systematic errors
* Purchase orders do not match requisitions for description / price / quantity / supplier.
Necessary internal controls
* All orders matched to requisitions (multi-part set).
* Independent checks on pricings and orders details

Question 62

What are the potential systematic errors and necessary internal controls for receipt of goods

Answer 62

Potential systematic errors
* Goods received may differ from goods ordered.
* Description / quality / quantity must agree.
o INTERFACE inventory cycle
Necessary internal controls
* Warehouse staff check this.
* A Goods received note (GRN) (multipart set) is raised only after goods have been checked against the purchase order copy.
* Incorrect goods are returned to the supplier and a ‘debit note’ is raised

Question 63

What are the potential systematic errors and necessary internal controls for paying suppliers

Answer 63

Potential systematic errors
* Payments made to fictitious suppliers, or where the correct goods or services have not been received.
* Creditors are paid twice.
o INTERFACE cash and bank cycle
Necessary internal controls
* Payments of supplier invoices are not made without an approved GRN (above) or proof of services received.
* Make sure invoices are not paid before goods are received and checked to make sure that they are sufficient quality
* The accounts office checks payment details against the GRN and purchase order.
* Paid supplier invoices are marked ‘PAID’ and filed with the paid order.
* Segregation of duties to reduce risks of errors/collusion.

Question 64

What are the potential systematic errors and necessary internal controls for recording purchases and creditors

Answer 64

Potential systematic errors
* Accounting records do not match actual purchases and/or cash payments and /or creditor balances.
* Y/E cut-off errors (easy way to window dress accounts, looks accidental but could have been done on person)
o INTERFACE inventory cycle
Necessary internal controls
* Segregation of responsibility.
* Details checked independently.
* Regular reconciliations.
* Checks for correct purchases cut-off at Y/E.

Question 65

Are ‘confirmations’ used for substantive testing of y/e creditor balances

Answer 65

• These are not generally used for credit balances, for the reasons shown below:
  o It is very unlikely that the management will deliberately overstate current liabilities
  o Normally, there will be reliable externally generated evidence to support all creditor balances (i.e. supplier invoices and statements plus reminders if our client is slow to pay them)
  o And they will be following us up
• Thus, creditor confirmations are unlikely to be used unless there are specific reasons (only rarely) such as the need for extensive substantive testing due to unreliable or absent internal controls for processing purchases and/or cash payments and recording creditor balances.

Question 66

What is the audit ‘context’ for inventory

Answer 66

• Inventory is an asset and also affects profit because ‘closing stock’ reduces cost of goods sold.
• Therefore, it is extremely unlikely that the directors of a PLC would deliberately understate inventory!
  o If they are ‘window-dressing’ they might overstate inventory.
  o Therefore, in this context the main ‘audit risk’ is that of overstatement.
• This only affects 25% of companies by value as most of the largest companies are serviced based
  o However, these are not the only matter to be considered. All sections of the audit require evidence about all five assertion categories

Question 67

What is the risk of inventory manipulation

Answer 67

• As there are many allowed ways to value and manage inventories it is a key area to be audited
• As there is a great deal of management discretion and is allowed by law
• This makes it a prime target to be manipulated
• Due to the above complexity the audit of inventory is only done by senior audit staff with a few years of experience

Question 68

How can inventory be manipulated

Answer 68

There are a number of different ways in which inventory can potentially be overstated, e.g. deliberate cut-off errors (see topic 8 lecture 1), stock-taking errors and/or recording of non-existent inventory, failure to comply with IAS 2 ‘Inventories’ e.g. over-valuation of inventory, inappropriate costings, failure to make provisions or write-offs for damaged, slow-moving or unsaleable inventory (i.e. where net realisable value is less than cost).

Question 69

How can information about inventory relate to existence or occurrence

Answer 69

Transaction class audit objective
* Recorded inventory and manufacturing transactions represent materials, labour and overheads transferred to production and the movement of completed production to finished goods during the period.
o INTERFACE purchases & expenses cycle.
Account balance audit objectives
* Inventories physically exist at the y/e date.
* Cost of goods sold represent the cost of goods despatched (sold) during the period.
o INTERFACE sales cycle.

Question 70

How can information about inventory relate to completeness

Answer 70

Transaction class audit objective
* All manufacturing transactions that occurred during the period have been recorded.
o INTERFACE purchases & expenses cycle.
Account balance audit objectives
* Inventories include all materials, products and supplies on hand at the y/e date.
* Cost of goods sold includes the effects of all despatches during the period.
o INTERFACE sales cycle

Question 71

How can information about inventory relate to rights and obligations

Answer 71

Transaction class audit objective
* The PLC has rights to inventories resulting from recorded purchases and manufacturing
Account balance audit objectives
* The PLC has legal title to the inventories held at the y/e date

Question 72

How can information about inventory relate to valuation or measurement

Answer 72

Transaction class audit objective
* Manufacturing transactions are correctly journalised (classified), summarised and posted.
* Costing and/or management accounting systems are appropriate, resulting in measurements (costings) which comply with IAS2 ‘Inventories’.
* Major cost variances are reported and investigated.
Account balance audit objectives
* Inventories are stated at the lower of cost or net realisable value, per IAS2.
* Cost of goods sold is based on consistent application of appropriate costing methods

Question 73

How can information about inventory relate to presentation or disclosure

Answer 73

Transaction class audit objective
* The details of manufacturing transactions support their presentation in the financial statements
Account balance audit objectives
* Inventories and cost of goods sold are properly identified and classified in the financial statements.
* Disclosures relating to the bases of valuation are appropriate

Question 74

Potential causes of mis-statements and preventative internal controls

Answer 74

• Functions that could include misstatement
  o Recording of raw materials
  o Costing & recording of work in process
   Only if manufacturing or processing
  o Recording of finished goods
  o Recording of cost of sales
  o Safe custody, protection of value and stock-taking

Question 75

What are the potential systematic errors and necessary internal controls for recording raw materials

Answer 75

Potential systematic errors
* Records of raw materials do not match purchase records e.g. incorrect product / quantity / description/ pricing etc., and/or incorrect purchases cut-off
o INTERFACE purchases cycle
Necessary internal controls
* Matching of all GRNs against purchase orders.
o Warehouse staff check quantity, specification and condition against the order.
* Segregation of responsibilities and independent checks/reconciliations by supervisors.
* Purchases cut-off controls at y/e with independent checks.

Question 76

What are the potential systematic errors and necessary internal controls for costing and recording work in progress

Answer 76

Potential systematic errors
* Any inappropriate costing system and/or estimates (re IAS2). Any poorly designed and/or unreliable costing system. Costings do not match inputs
o INTERFACE purchases cycle and payroll cycle.
* Systemic failures to report and/or investigate major cost variances from cost budgets.
Necessary internal controls
* Appropriate costs should be absorbed into the production process.
o Costs matched against inputs.
* Choice of costing methods vary enormously, depending on the type of activity, e.g. oil refinery vs car plant vs food processing
* Total absorbed costs must be recoverable, allowing for a reasonable profit margin within selling price.
o Cost cannot exceed NRV (IAS2).

Question 77

What are the potential systematic errors and necessary internal controls for recording finished goods

Answer 77

Potential systematic errors
* Systemic errors in transfers of quantities or costs from WIP to FG.
Necessary internal controls
* Recording systems are well designed and reliable, with segregation of responsibilities and independent checks.

Question 78

What are the potential systematic errors and necessary internal controls for recording cost of sales

Answer 78

Potential systematic errors
* Inventory records do not match sales records re quantities, pricings or timing.
* Incorrect sales cut-off
* INTERFACE sales cycle.
Necessary internal controls
* Sales orders are matched against warehouse despatch notes or other inventory records, with segregation of responsibilities and independent checks.

Question 79

What are the potential systematic errors and necessary internal controls for safe custody of stock and stock taking

Answer 79

Potential systematic errors
* Theft – particularly if inventory is high value or saleable.
* Physical or environmental or ‘time’ damage or obsolescence – particularly for food /delicate / perishable goods, or any ‘high tech’ goods.
* Differences between ‘book’ and ‘actual’ stock held.
* Poor recording or control of multiple sites.
Necessary internal controls
* Suitable and secure warehouse or other storage.
* Access is restricted to authorised staff only. Possible use of security staff or surveillance, etc.. Goods are not held beyond ‘saleable’ life.
* Periodic stock-taking at all locations, using clear procedures, independent checks and investigation of unexpected differences.

Question 80

What are stock taking procedures

Answer 80

• Regular stock-taking and reconciliations are a very important aspect of internal control for most companies holding inventory.
  o Stock-taking should be undertaken, where possible, at all locations where significant inventory is held.
• Client staff who are performing the counting or measurement should be properly supervised and given clear instructions and pre-printed documentation (stock-sheets) for recording their counts and observations.
  o There should be no stock-movements during stock-taking (therefore it is usually done on a Saturday or Sunday). Removable pre-numbered ‘stock-tags’ should be used, to prevent double counting and to make sure that nothing is missed.
• Details recorded on stock sheets should be correctly totalled, collated, and recorded on summary sheets and compared with perpetual inventory records (if any). (Comparing ‘book’ to ‘actual’).

Question 81

How do auditors check stock taking

Answer 81

• An auditor should attend and observe stock-taking at the main locations or a sample of locations, as near as possible to the Y/E date. They will perform a sample of counts, and will later compare these to the client’s records. They will also review the instructions, documentation etc., given to the stock-takers.
• The auditor should be alert to the possibility of inventory which is slow-moving, obsolete or not in saleable condition. This raises the possibility that NRV may be less than cost – ref IAS2.
  o Therefore, the auditor should, if possible, inspect the inventory as well as counting it.
• Subsequently, the auditor will examine a sample of completed stock-sheets, checking that these are correctly totalled and collated, the totals correctly recorded in the accounting records, and reviewing any significant differences and stock adjustments.

Question 82

What is the audit ‘context’ for fixed assets

Answer 82

• Fixed assets are often the highest value asset category in the SOFP, i.e. very material. Land and buildings are expensive! For industrial companies, plant and equipment (e.g. factory machinery) can also be expensive.
  o These are capitalised assets which (except for land) are normally subject to an annual depreciation charge.
  o Often very few transactions but high value (unless in construction)
• The purpose of depreciation is to MATCH the cost of long term assets against their estimated useful lives, allowing for any estimated residual values.
• Therefore, long term assets affect the income statement as well as the SOFP.
  o The purpose of depreciation is NOT to show a reduced net book value in the SOFP.
• Accumulated depreciation is a residual EFFECT of matching cost against useful life. It does NOT imply a particular valuation or revaluation of the asset.

Question 83

How are fixed assets window dressed

Answer 83

• It is extremely unlikely that the directors of a PLC would deliberately understate or undervalue fixed assets.
• If they are ‘window-dressing’ they might overstate or overvalue them.
  o Therefore, the main ‘audit risk’ is that of overstatement and/or overvaluation.
• However, the directors could also window-dress by understating or underestimating depreciation, as a means of increasing reported profits. For many companies, depreciation is one of the largest ‘expenses’ in the income statement.
  o Prime spot for window dressing

Question 84

How can information about fixed assets relate to existence or occurrence

Answer 84

Transaction class audit objective
* Recorded fixed asset transactions represent transactions that occurred during the period.
* Usually there are relatively few transactions. See notes re purchases and sales transaction class objectives.
Account balance audit objectives
* Recorded property plant and equipment represent productive assets that are in use at the Y/E date.
* Need to make sure that exitance also meets the definition of an asset, brining in future value, if not doesn’t count

Question 85

How can information about fixed assets relate to completeness

Answer 85

Transaction class audit objective
* All fixed asset purchases and sales and related cash payments that occurred during the period have been recorded.
o See notes re purchases and sales transaction class objectives.
Account balance audit objectives
* Property plant and equipment asset balances include the effects of all applicable transactions in the period.

Question 86

How can information about fixed assets relate to rights and obligations

Answer 86

Transaction class audit objective
* The PLC has legal ownership of the fixed assets resulting from recorded purchases and/or the manufacture of ‘self-built’ assets.
* Leased assets are correctly identified as such, per IFRS 6.
Account balance audit objectives
* The PLC has legal ownership of all recorded property plant and equipment assets as at the Y/E date. Leased assets are correctly identified as such, per IFRS 6.
* Do they own it or just say that they do

Question 87

How can information about fixed assets relate to valuation or measurement

Answer 87

Transaction class audit objective
* Depreciation expenses have been calculated correctly, based on reasonable depreciation policies and estimates per IAS 16. Leased assets costs are correctly expensed as such, per IFRS 6.
o Any impairment losses have been recognised per IAS 36.
Account balance audit objectives
* Fixed assets are fairly valued based on historic costs, or revaluations by independent certified valuers per IAS 16.
* Accumulated depreciation has been calculated correctly, based on reasonable depreciation policies and estimates.
* Leased assets are correctly valued as such, per IFRS 6.
* Any impairments have been recognised per IAS 36.

Question 88

How can information about fixed assets relate to presentation or disclosure

Answer 88

Transaction class audit objective
* Disclosures are complete and adequate per IAS 16, IFRS 6, & IAS 36 in relation to the acquisition and/or disposal and/or leasing costs and depreciation of major classes of property, plant, equipment and leased assets.
Account balance audit objectives
* Disclosures are complete and adequate per IAS 16, IFRS 6, IAS 36 in relation to the cost, value, depreciation policies, useful lives &/or revaluation &/or impairment of major classes of property, plant, equipment & leased assets

Question 89

Can directors estimates be trusted

Answer 89

• All valuations are estimates and are normally always wrong
• Why directors get such subjectivity for estimations
• But equally allows them to manipulate the accounts
• Auditors just check that these estimations are reasonable
• And that impairment has taken place when it should have

Question 90

How can you physically inspect fixed assets

Answer 90

• Auditors will generally select a sample of fixed assets from the client’s records, and physically inspect these, noting any apparent lack of productive use and/or evidence of deterioration or obsolescence.
  o This work may require some technical expertise. For example, when observing factory assets the auditor can be accompanied by a factory foreman/supervisor, who can identify and comment on particular assets and answer the auditor’s questions.
• Auditors will, if in doubt, employ their own independent valuers to advise them concerning the valuation and/or productive use and/or impairment of major assets, if the effects could be material to the financial statements.
• Must check if you are getting future economic benefit. If it is sitting unused then not considered an asset

Question 91

What is the audit ‘context’ for ‘cash and bank.’

Answer 91

• Auditors use the term ‘cash and bank’ to cover all bank transactions and balances held as well as any ‘physical’ cash floats and transactions which are literally in cash. Physical cash is becoming ‘old-fashioned’ and may eventually die out! Almost all significant and/or high volume receipts and payments are processed electronically.
• As cash is an asset it is extremely unlikely that the directors of a PLC would deliberately understate it. Therefore, the main ‘audit risk’ is that of overstatement.
• As cash has an exact value, it is not subject to the accounting estimates and subjectivity which affect almost all other asset classes.
  o Therefore, the only way that cash can be deliberately falsified is by false accounting and/or non-disclosure of cash liabilities such as loans and overdrawn balances.
  o Very risky as not subjective to accounting policies
• If the directors are intent on ‘window-dressing’ the non-disclosure of ‘negative’ cash balances is the most obvious and likely method.
  o Therefore, auditors always use a bank confirmation letter (see slide 12), to discover any undisclosed loans, overdrafts or related commitments.

Question 92

What is the nature of cash transactions in businesses

Answer 92

• For most companies, the vast majority of ‘cash’ transactions relate to purchases, expense payments, and sales. In most audits, the interface between transactions in the sales and purchases systems and ‘cash’ is compliance tested within the sales and purchases sections of the audit. This interface is usually tested by tracing or vouching the transactions selected in the audit sample through to the payment received from the debtor or payment made to the creditor, i.e. to the cash receipts and cash payments records. (See slides in previous lectures which point out this interface). The person who is doing the ‘cash’ section of the audit will check the reconciliations between these cash receipts and cash payments records and the bank statements.
• If the person who is doing the ‘cash and bank’ section of the audit were also to examine and test the sales and/or purchases interface, this would be a duplication of effort. This is not usually done. Therefore, the following slide showing ‘Specific audit objectives for cash and bank balances’ relates only to the ‘account balance’ objectives, not ‘transaction class’ objectives

Question 93

How do you do a cash audit of a bank

Answer 93

• If the audit client happens to be a bank or other financial institution, then most of the audit work will relate to bank and financial transactions. Even if the client is not a bank or other financial institution, the cash cycle will still be the ‘central’ business cycle which links the other cycles together (see the diagram in Topic 8 lecture 3 slide 3).
• ‘Cash and bank’ can be the most ‘sensitive’ section of an audit, for obvious reasons. Cash is currency! It is a highly vulnerable asset. Almost any fraud needs to involve some kind of illicit cash or bank transaction, otherwise the fraudster does not gain any benefit! This a matter always to be borne in mind by the person performing the ‘cash and bank’ section of an audit.

Question 94

How does the segregation of responsibilities help cash audits

Answer 94

• In view of the above, the effective segregation of staff responsibilities (see lecture topic 8 lecture 1 slide 9) between the four key functions of safe custody, authorisation, recording and reconciliation are particularly important.
• This involves effective supervision and regular independent bank reconciliations. The auditor will pay attention to these points in evaluating the effectiveness of internal controls for cash and bank transactions.
• All fraud requires some transfer of money at some point so tight segregation on cash is key so that it would require a large conspiracy to be successful
• And so that errors and fraud can be detected

Question 95

How can information about cash relate to existence or occurrence

Answer 95

Account balance audit objectives
* Recorded cash balances exist at the Y/E date.

Question 96

How can information about cash relate to completeness

Answer 96

Account balance audit objectives
* Recorded cash balances include the effects of all applicable transactions in the period.
* Loans and overdrawn balances are not omitted.

Question 97

How can information about cash relate to rights and obligations

Answer 97

Account balance audit objectives
* The PLC has legal title to all cash balances shown at the Y/E date.

Question 98

How can information about cash relate to valuation and measurement

Answer 98

Account balance audit objectives
* Recorded cash balances are realisable at the amounts stated, and these agree with documents provided by the client’s bank (and lenders, if any).

Question 99

How can information about cash relate to presentation or disclosure

Answer 99

Account balance audit objectives
* Cash balances are properly identified and classified. Lines of credit, loans, loan guarantees and any other restrictions on cash balances are appropriately disclosed.

Question 99

How can ‘bank confirmation letters’ be used for substantive testing of y/e balances

Answer 99

• Auditors always send a bank confirmation letter to all banks with which the client has any accounts and/or loans or other legal contracts.
• At first sight, this might seem un-necessary. The auditor already has access to bank statements and other documents provided by the bank to the audit client. These are (almost certainly) highly reliable evidence, from an independent external source.
• However, it is possible that the directors could be window-dressing, for example by failing to disclose bank overdrafts, loans, loan guarantees or other legal agreements with the bank.
• Therefore the audit firm will obtain the client’s permission to write to the banks asking that they confirm all Y/E bank balances and provide full disclose directly to the audit firm concerning all arrangements between the bank and the audit client. If this permission is refused by the client’s directors, this would be a scope limitation of the audit

Question 100

How can auditors complete cash counts

Answer 100

• Some businesses need to hold physical cash, for a range of reasons – such as cash collected from retail customers, or to pay small bills and /or sundry expenses.
• For obvious reasons, there needs to be strong internal control and effective segregation of staff responsibilities (see lecture topic 8 lecture 1 slide 9) between the four key functions of safe custody, authorisation, recording and reconciliation.
• The ‘cashier’ usually has physically custody but cannot authorise or record any transactions.
• The cash will regularly be counted by an independent person and reconciled to the cash and banking records.

Question 101

What are the two most important steps in completing a cash count

Answer 101

1. The auditor should not pre-announce the cash count! This is done on a ‘surprise’ basis!
2. The auditor must ensure that the cashier is present at all times and observes the auditor counting the cash, and that the cashier immediately signs the document recording the results of the count!