Auditing II Edited

Auditing II
Chapter-One: Audit of cash and marketable securities

1.1. Sources and nature of cash - Cash normally includes general cash accounts,
payroll accounts, petty cash fund, saving accounts, marketable securities and other
cash equivalents such as money market funds, certificate deposit, saving certificates
and other similar types of deposits. Receipt and payment of cash is a significant part
of an independent financial statement audit. This is because these receipts and
payments affect almost all accounts relating to the income and expenditure and a
number of asset and liability accounts. On other hand, the liquid nature of cash
increases the risk of undetected fraud. The auditor has to recognize this factor in
developing appropriate audit program accordingly.
1.2. Auditors’ objectives of auditing cash
The auditor’s objectives in the audit of cash are to

1. Consider the internal control over cash transactions
2. Substantiate the existence of the recorded cash
3. Establish the completeness of the recorded cash
4. Determine that the client has the rights to the recorded cash
5. Establish the clerical accuracy of the cash schedules
6. Determine that the presentation and disclosure of cash, including restricted funds
(such as compensating balances and band sinking funds) are appropriate
In auditing the cash transactions, the auditor has to be extremely careful with the
possibility of the overstatements of the cash payments and understatements of the cash
receipts. The auditor has to verify the ending balance of cash thoroughly as there is a
possibility of including fictitious checks in the cash on hand at the year-end. The possible
irregularities of the cash transactions are
a. Receipt of cash without proper recording
b. Payment may not have made with actual withdrawal
c. Duplicate payments
d. Overpayments or payments to fictitious persons
e. Payments for the personal expenditures of officers and related parties
1.3. Internal control over cash transactions
Most of the functions of the cash handling are the responsibility of the finance
department and these functions include handling and depositing of cash receipts, signing
of checks, investing idle cash and maintaining custody of cash, marketable securities and
other liquid assets. In achieving a good internal control over cash transactions are the
following
 Do not permit any one employee to handle a transaction from beginning to
end
 Separate cash handling from record keeping
 Centralize receiving of cash to the extent possible
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Auditing II
 Record cash transactions on a timely basis
 Encourage customers to obtain receipts and observe cash register totals
 Deposit cash receipts daily
 Make all disbursements by check or electronic fund transfer with the
exception of small expenditures from petty cash
 An appropriate official should review the completed reconciliations promptly.
 Forecast expected cash receipts and disbursements and investigate variances
from forecasted amounts
Internal control over cash receipts

1. Cash sales: Control over cash sales is important when two or more employees
participate in each transaction with the customer. Some organizations use a
centrally located cashier who receives cash from the customer along with a sales
ticket prepared by another employee. If the ticket or the sales checks are serially
numbered and all numbers accounted for, this separation of responsibility for the
transaction is an effective means of preventing fraud. In many establishments, the
nature of business is such that one employee must make over the counter sales,
deliver the merchandise, receive cash and record the transaction. In this situation
dishonesty may be discouraged by proper use of cash registers or electronic point
of sale systems. The protective features of the cash registers include
a. Visual display of the amount of the sale is in full view of the customer
b. A printed receipt, which the customer is urged to take with the
merchandise
c. Accumulation of a locked in total of the day’s sales
2. Electronic Point-of –Sale (POS) System: In many establishments, various type

of electronic cash registers, including on-line computer terminals are being used.
With these registers, an electronic scanner is used to read the sales price and other
data from specially prepared product tags. The sales person need only pass the tag
over the scanner for the register to record the sale at the product’s price. Thus the
risk of a salesperson recording sales at erroneous prices is substantially reduced.
Besides providing strong control over cash sales, electronic registers often may be
programmed to perform numerous other control functions such as verification of
the status of the customers, update the accounts receivable and perpetual
inventory records, provide special printouts accumulating sales data by product
line, salesperson, department and type of sale etc.
3. Collection from credit customers: For most of the establishments, a major part
of sales are made on credit and collection from these credit customers is a tedious
task. Most of the collections are received through mail. This poses a major threat
if one employee is allowed to receive, deposit, and record the credits to the
customer’s accounts. Hence a proper internal control system should be established
leaving no room for misappropriation.
4. Lockbox Control over Cash Receipts: Business receiving a large volume of
cash through the mail often uses a lockbox system to strengthen the internal
control and hasten the depositing of cash receipts. The lockbox is actually a post
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office box controlled by the company’s bank. The bank picks up mail at the post
office box several times a day, credits the company’s checking accounts for cash
received and send the remittance advices to the company. The internal control
system of the company is strengthened by the fact that the bank has no access to
the company’s accounting records.
Internal control over the cash disbursements

The cash disbursements of the company should be made by check, electronic fund
transfer and for minor items petty cash should be used.
1. Payment by check: the principal advantage of requiring disbursement by check is
obtaining evidence or receipt from the payee in the form of an endorsement on the
check. The other advantages of using check for payment are
a. The centralization of disbursement authority in the hands of a few designated
officials who is authorized to sign the check
b. A permanent record of payments
c. Reduction in the amount of cash kept on hand
In order to have a proper control of payments,
 The checks should be serially pre-numbered and all the numbers in
the series should be accounted for.
 Unissued prenumbered checks should be adequately safeguarded
against theft or misuse.
 Voided checks should be defaced to eliminate any possibility of
further use and filed in the regular sequence of paid checks.
 A computer or a check-protecting machine should print the amount
on the check.
 The check should be crossed before issue.
 The authorized official should sign the check only after reviewing
the supporting documents and put some identification to prevent
them from being produced a second time.
 The check should reach the official for signature after completing all
formalities except signature
 The check should not be returned to the accounting department who
prepares them after signature
 If a check signing machine is used, a key should be required to
retrieve the signed checks and facsimile signature plate should be
removed from the machine when the machine is not in use
 Frequent bank reconciliation statements should be prepared to have
adequate internal control over cash. The reconciliation should be
prepared by a employee who do not have a role in the cash
transactions.
2. Electronic fund transfer: Electronic funds transfer system is that process fund
related transactions for customers as an alternative to paying by checks. The funds are
electronically transferred between companies’ bank accounts. This is done through
electronic data interchange, which allows the interchange of data from one company’s
computer to another. These systems have the advantage over paying by check by
reducing the paper work, processing costs and delays. But the disadvantage is that it
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requires an extensive set of computer network controls relating to the system access
and data entry. It also requires backup controls for situations in which a system
breakdown occurs.
3. Internal control for petty cash: internal control over payments from an imprest
petty cash fund is achieved at the time the fund is replenished to its fixed balance
rather than at the time of making the payments. The documents supporting each
payment will be reviewed for completeness and authenticity when the custodian of
the petty cash funds requests for replenishment of the fund. The petty cash payments
may not be material for the financial statement and hence the auditor may test one or
more replenishment transactions by examining petty cash vouchers.
1.4. Audit program for cash

The most appropriate procedures for a particular audit will be guided by the nature of the
internal controls in force and by other circumstances of the engagement. The following is
the audit program for the verification of cash transactions
A. Consider the internal control for cash transactions
1. Obtain an understanding of the internal control structure for cash
The auditors may prepare a written description or flow chart about a control in force
based on the questions held with the owners and employees; and through observations.
For cash - Are all persons receiving cash?

Receipts -Does the employee assigned to the opening of
incoming mail prepare a list of all checks and
money received?
Among the - Are each day’s receipt deposited intact and
questions that without delay by an employee other than
might be asked accounts receivable bookkeeper?
by auditors include - Other related questions
For cash- - Are all disbursement (except from petty cash)

disbursements by pre-numbered checks?
-Are all voided checks are preserved and filed?
-Are all checks are signed by selected
executives or not?
-Whether checks are mailed directly to the
Payees after being signed
-Questions about internal control over
- Disbursements for payroll, dividends, as
well as bank reconciliation and other
related
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After auditors have verified their understanding of the cash receipts and disbursements
cycles, they will observe whether there is appropriate segregation of duties and inquirers
as to who perform various functions throughout the year.
They also inspect various documents and reconciliations that are important to the
client’s internal control over cash receipts disbursements. After auditors have obtained an
understanding of the controls relating to cash, they will consider the types of
misstatements that may occur.
2. Assess control risk and design additional tests of controls for cash
3. Perform additional tests of controls for those controls which the auditors plan to
consider supporting their planned assessed levels of control risk such as:
a. Test the accounting records and reconciliations by performance
b. Compare the details of a sample of cash receipts listings to the cash receipts
journal, account receivable postings and authenticated deposit slips
c. Compare the details of a sample of recorded disbursements in the cash
payments journal to accounts payable postings, purchase orders, receiving
reports, invoices and paid checks.
4. Reassess control risk and modify substantive tests for cash
B. Perform substantive tests of cash transactions and balances
The objective of major substantive testing procedures of cash transactions and

balances are given in the following table.
Substantive tests Primary audit objective

to be addressed
5.Obtain analyses of cash balances
and reconcile them to the general ledger Clerical accuracy
6. Send standard confirmation forms to financial
institutions to verify amounts on deposit.
7. Obtain or prepare reconciliations of bank
(financial institutions) accounts as of the balances Existence and right
sheet date and consider needs to reconcile bank
activity for additional months.
8. Obtain a cut-off bank statements containing
transactions of at least seven days
subsequent to balances sheet date.
9. Count and list cash on hand
10. Verify the client’s cut-off of cash receipts
and cash disbursements Existence and right
11. Analyze bank transfer for last week of Completeness
audit year and first week of the following year.
12. Investigate any check representing large or
unusual payments to related parties Presentation and disclosure
13. Evaluate proper financial statements
presentation and disclosure of cash.
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The factor of materiality applies to audit work on cash as well as to other aspects of the
audit. Even if the cash balance shown in the financial statements is relatively small, the
auditor may have to devote a larger proportion of the total audit hours to cash
transactions. This is due to the amount of flow of cash into and out of the business during
the year is often great than for any other account. Several reasons exist to explain the
auditors’ traditional emphasis on cash transactions. Liabilities, revenue, expenses and
most other assets flow though the cash account i.e. most of these items either arise or
result in cash transactions. The examination of cash transactions assists the auditors in the
substantiation of many other items in the financial statements.
Another reason contributing to extensive auditing of cash is that cash is the most liquid of
all assets and offers the greatest temptation for theft, embezzlement and
misappropriation. For liquid assets, the inherent risk is very high and auditors tend to
respond to high-risk situations with more intensive investigation. If the fraud in cash
transactions is material, then only the detection of fraud is relevant to the overall fairness
of the financial statements of the client. The auditor can avoid wasting audit time on
matters that are not material to the financial statements and that may better be pursued by
client personnel.
 Since cash generally has a high degree of inherent risk, more audit time is
devoted to the audit of the account than is indicated by its dollar amounts.
 Internal control over cash receipts should provide assurance that all cash
received is recorded promptly and accurately. Control over sales is strongest
when two or more employees participate in each transaction, or when a cash
register or an electronic point of sale system controls collections.
 When a cash receipt consists of checks received through the mail, the receipts
should be listed and controlled by personnel who do not maintain cash or
accounts receivables records. The control listing should be reconciled to the
entries in the cash receipts journal and deposit records from the financial
institutions.
 Internal control over cash disbursements is best achieved when all payments
are made by check or well- controlled electronic fund transfers, except for
payments of minor items from petty cash funds.
 Separation of the functions of presentation of the payments from that of
signing checks tends to prevent errors and fraud in cash disbursements.
1.5 Audit of Marketable securities
From the viewpoints of the auditors, the most important group of investments consists of
bonds and shares as they are found more frequently and usually are of greater value than
other kinds of investment holding. Commercial paper, mortgage deeds, surrender value of
the insurance policies are other type of investments. For the business organization, the
idle cash has to be utilized for some profitable purposes. Management may also choose to
maintain some investments in marketable securities on a semi permanent basis. The
length of time such investments are held may be determined by current security yields
and by the company’s income tax position, as well as by its cash requirements.
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1.5.1. The Auditors’ objectives in Examination of marketable securities
The auditors’ objectives in the examination of marketable securities are to:

1. Consider internal control over marketable securities.
2. Determine the existence of recorded marketable securities and that the client has
rights to the securities.
3. Establish the completeness of recorded marketable securities.
4. Determine that the valuation of marketable securities is in accordance with the
cost market, or equity method of accounting, as appropriate.
5. Establish the clerical accuracy of schedules of marketable securities.
6. Determine that the presentation and disclosure of marketable securities, including
current/non current classifications are appropriate.
In conjunction with their audit of marketable securities, the auditors will also verify the
related accounts of interest income and dividends, accrued interest revenue, and grains
and losses on the sale of securities.
The liquid nature of marketable securities makes the potential for irregularities high.
Auditors must coordinate their cash and marketable securities audit procedures to detect
any possible irregularities involving unauthorized substation between the accounts. The
overall audit approach is one of assessing control risk for securities, inspecting
certificates, confirming securities held by third parties such as banks, and determining the
appropriate valuation of the securities.
1.5.2. Internal Control for Marketable Securities:
The major elements of adequate internal control over marketable securities include the
following:
1. Separation of duties between the executive authorizing purchases and sales of
securities, the custodian of the securities, and the person maintaining the record of
investments.
2. Complete detailed records of all securities owned and the related revenue from
interest and dividends.
3. Registration of securities in the name of the company.
4. Periodic physical inspection of securities by an internal auditor or an official
having responsibilities for the authorization, custody or record keeping of
investments.
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1.5.3. Audit Program for Securities
The following are the procedures typically performed by auditors to achieve the
objectives:
A. Consider internal control for securities

1) Obtain an understanding of internal control for securities.
2) Assess control risk and design additional tests of controls for securities.
3) Perform additional tests of controls for those controls the auditors plan to
consider to support their planned assessed levels of control risk such as:
a) Trace several transactions for purchases and sales of securities through
the accounting systems.
b) Inspect reports by internal auditors on their periodic inspection of
securities.
c) Inspect monthly reports on securities owned, purchased, and sold and
amounts of revenue earned and budgeted.
4) Reassess control risk and modify substantive tests for securities.
B. Perform substantive tests of securities transactions and year-end balances.

5. Obtain or prepare analyses of the securities investment account and
related revenue accounts and reconcile to the general ledger.
6. Inspect securities on hand.
7. Obtain confirmation of securities held by others.
8. Vouch selected purchases and sales of securities during the year.
9. Verify the client’s cutoff of securities transactions.
10. Perform analytical procedures.
11. Make independent computations of revenue from securities
12. Determine the market values of securities at date of balance sheet.
13. Evaluate the method of accounting for securities.
14. Evaluate financial statement presentation and disclosure of securities.
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Chapter-two:
Audit of Accounts receivables and sales
2.1. Sources and nature of accounts receivables
Receivables-included not only claim against customers arising from the sale of goods or
services, but also a variety of miscellaneous claims such as loans to officers or employee,
loans to subsidiaries, claims against various other firms, claims for tax refunds, and
advances given to suppliers
In the financial statements of most of the companies, accounts receivables and notes
receivables are relatively large in amounts and auditors need to have more concern about
the audit of these items during the course of audit. Auditors need to have a special
attention to the presentation and disclosure of the loans to the officers, directors and
subsidiary companies, as these related party transactions may benefit only the borrower
rather than the lending company.
2.2. Auditors’ Objectives in auditing account receivables and sales
The auditor’s objectives in the audit of accounts receivables and sales are:
1. Consider the internal control over accounts receivables and sales transactions
2. Substantiate the existence of the accounts receivables and occurrence of sales
transactions
3. Establish the completeness of the accounts receivables and sales
4. Determine that the client has the rights to the recorded receivables
5. Establish the clerical accuracy of the records and supporting schedules of accounts
receivables and sales
6. Determine the valuation of receivables and sales is at appropriate net realizable value
7. Determine that the presentation and disclosure of receivables and revenues are
adequate including the separation of receivables into appropriate categories,
adequate reporting of any receivables pledged, and collateral, and
disclosure of related-party sales and receivables
2.3. Internal control over sales transactions and receivables
2.3.1. Internal control over sales transactions

If the internal control over credit sales is ineffective, it may cause business much
because the major revenue for the organization arises from sales only. Hence the
auditor has to study and evaluate the internal control relating to the sales. This helps
the auditor in determining the nature, timing and extent of his substantive procedures.
Before studying and evaluating the internal control relating sales the auditor should
have sufficient understanding about the business of the client. This will help the
auditor in assessing the extent to which the sales transactions of the client’s business
will affect the misstatement. If the internal control procedures are not satisfactory, the
auditor can apply additional tests or modify the procedures according to the
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circumstances. The internal control relating to sales can be studied and evaluated by
dividing the sales cycle into the following four segments
1. Processing orders and dispatching goods
(a) Does the company maintain a standard price list and if sales are done at a lower
price whether proper authorization is received.
(b) Does the system allows for rebates and discount and if so is it with proper
authorization.
(c) What are the procedures for related party transactions?
(d) Are the sales invoices are prenumbered?
(e) What are the procedures for fixing credit limits for the customers?
(f) Is a copy of the sales invoice is sent to the dispatch department and the
accounting department?
(g) Is the dispatch documents prenumbered?
(h) Is the copy of the dispatch documents sent to the customer and to the accounting
department?
(i) Does the customer or his agent obtain an acknowledgement for the receipt of
goods?
(j) Whether dispatch documents are prepared at the time of dispatch of
merchandise
(k) Whether the dispatch documents are prenumbered
2. Billing of customers and recoding of sales

(a) Whether the sales invoices are prepared on receipt of dispatched documents.
(b) Whether the sales invoice contain all the relevant details including name of the
customer, the quantity, price, freight, insurance, tax, etc.,
(c) Whether the sales invoices are properly checked and authorized before dispatch.
(d) Whether the original invoice is sent directly to the customer.
(e) Whether the accounting entries are made on a timely basis.
(f) Whether the dispatch documents the railway receipt or the transporter’s receipts
or the bill of lading is attached with the sales invoice.
(g) Whether the sales invoice is prenumbered?
3. Processing and recoding of receipts
(This has already been discussed in chapter – 1 Audit of Cash Transactions.)
4. Follow up on sales
(a) After sales service
1) What is the nature of after sales service?
2) Whether the company maintains adequate records of after sales service?
3) Whether the service engineers required filling up any form after the service
or visiting along with the signature of the customers?
4) Whether the service engineers authorized to collect cash and issue receipts
provisionally.
5) Whether the periodic comparison of cost of parts replaced free of charge
with the budgeted figures.
(b) Sales Returns
1) Whether the goods returned are accepted with proper authority
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2) Whether inward return note is prepared or not
3) Whether inward return note are prenumbered
4) Whether returned goods are sent to the store immediately
5) Whether credit note is prepared on the basis of inward return note.
6) Whether credit note is prenumbered
7) Whether the sales commission paid with respect to the goods returned are
recovered
8) Whether the reason for return are analyzed.
2.3.2. Substantive procedures for sales transactions
A. Tests of individual transactions

1. Examine the sales summary regarding name, date, amount, quantity,
discount, calculation etc.
2. Select sample of invoices and check in detail- audit in depth for approval
of granting credit, price, discount, dispatch of goods, entry in the
inventory records, entries in the customer accounts etc
3. Examine the numerical sequence of the sales order, outward challan etc
4. Examine the arithmetical accuracy of the sales book
5. Examine the entries in the sales return book
6. Examine the copies of the credit note
7. Examine the numerical sequence
8. Check the year end or the cut off transactions
9. Examine the payment made by the customers
10. Examine whether GAAP is followed in recognition of revenue
B. Analytical procedures
1. Compare the sales figures of different months or quarters of the current
year and enquire into any unusual fluctuations
2. Prepare a statement showing the quantities of the beginning inventory plus
purchases made and minus the sales made during the year and the result
will give the ending inventory. If there is any negative figure will disclose
the manipulations if any
3. Compare the budgeted sales with the actual sales for the current year
4. Compare the current year’s total sales as well as sales of different months
or quarters with the corresponding figures of the previous year.
5. Compare the ratio of value of sales of each major product of the total sales
for the current year with the corresponding figures for the previous years
6. Compare the gross profit ratio for the current year with the corresponding
gross profit ratio of the previous years and with the industry average
C. Examination of presentation and disclosure
The auditor has to verify whether the sales have been properly classified and
disclosed under appropriate heads in the financial statements in accordance with
the generally accepted accounting principles
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2.3.3. Internal control over accounts receivables
The auditor has to verify the internal control system regarding the accounts receivable
and examine
1. Whether the basis for determining the credit limit is satisfactory
2. Whether the credit limit is reviewed periodically
3. Whether the credit limit is approved by an appropriate official
4. Whether the processing orders, dispatch of goods, billing, receiving and
recording of realizations and follow up of sales are effective
5. Whether the accounts receivables are remaining unpaid beyond normal
period and if remaining whether suitable actions has been taken or not
6. Whether a statement of account is sent to all accounts receivables
periodically
7. Whether confirmations of balances are made
8. Whether adjustments such as discounts, sales returns etc are approved by
an authorized officer
9. Whether the uncollectible expenses are properly written off
10. Whether the general ledger is in agreement with the subsidiary ledgers
2.3.4. Substantive tests for accounts receivables

The auditor has to apply the following substantive tests for accounts receivables
1. Examination of individual accounts
2. Examination of realization from customers
3. Identification of bad debts
4. Confirmation of accounts
5. Examination of presentation and disclosure
2.4. Audit program for receivables and sales transactions

The most appropriate procedures for a particular audit will be guided by the nature of the
internal controls in force and by other circumstances of the engagement. The following
are the audit program for the verification of receivables and sales transactions.
A. Consider the internal control for receivables and sales transactions
1. Obtain an understanding of internal control over receivables and sales transactions.

To do so, auditors may prepare a written description or flow chart and complete
internal control questionnaire for revenues and receivables. Some of the questions that
might be asked include:
 Are orders from customers initiated and reviewed by sales department?
 Are sales invoices pre-numbered and all numbers accounted for?
 Are all sales approved by the credit department before shipment?
 Are estimates of revenues performed by competent personnel using appropriate
method?
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 Are all policies and procedures indicated in the flow-chart being used in the
operation?
As auditors confirm their understanding of the revenues cycle, they will observe:
 Whether there is appropriate segregation of duties
 Review revenue budget and follow up on the variance
 Perform a work through of the cycle; inspect various documents such as bills of
lading, sales invoice, and customers statements
After auditors have obtained an understanding of the controls relating to receivables and
sales, they will consider the types of misstatements of the accounts that may occur.
2. Asses control risk and design additional tests of controls for receivables and sales.
Based on the understanding of the client’s internal controls over receivables, the
auditors develop their planned level of assessed control risk for the various
financial statements assertions. If auditors need to obtain additional evidences
about operating effectiveness of the client’s controls, they may design additional
tests of controls.
3. Perform additional tests of controls for those controls which the auditors plan to
consider to support their planned assessed level of control risk, such as:
a) Examine significant aspects of a sample of sales transactions by applying procedures
such as:
 Compare customers purchase orders to the client’s sales order and then to
duplicate copy of the sales invoice. The description and quantity should be
the same on the three documents.
 See whether there is consistent pricing and sales discount policies
 Investigate the controls for sales to related parties (Effective control over
inter-company or inter-branch transfers of merchandise often requires the same
kind of formal billings, shipping and collection functions as for sales to
outsiders.
b) Compare a sample of shipping documents to related sales invoices
To assure that all shipments are billed, the auditors may obtain a sample of shipping
documents may obtain a sample of shipping documents issued during the year and
compare these to sales invoice.
c) Review the uses and authorization of credit memorandum
- See whether all returns and allowances should be supported by credit memorandum.
-Review whether there is proper authorization of credit memorandum is practiced.
d) Reconcile selected cash register tapes and sales tickets with sales journals. For cash
sales auditors may compare selected daily totals in the sales journals with cash register
readings or tapes.
e) Test computer application controls if any. If the client company has established
effective computer application controls for sales transactions, the auditors might decide to
test these controls directly instead of testing a sample of sales transactions
4. Reassess control risk and modify substantive tests for receivables and sales
transactions.
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When auditors have completed the procedures described in the preceding sections,
they should reassess the extent of control risk for each financial statements assertion
regarding receivables and revenues.
B. Perform substantive tests of receivables and sales transactions
The objective of major substantive testing procedures of Account receivables
and revenue balances are given in the following table.

to be addressed
5.Obtain an aged trial balance of trade accounts
receivables and analyses of other accounts receivable
and reconcile to ledgers which helps to:
- Confirm the existence of the balances
- To check adequacy of estimate of credit-losses
(doubtful expenses)
- To test footing, cross footing and aging
- To check balances of current and past due accounts Clerical accuracy
- For other related purposes.
6. Obtain analyses of notes receivables and related
interests. The analyses of notes receivables
supporting the general ledger control accounts may
be prepared with regard to information such as name
of the maker, date of issuance, maturity date, amounts
interest rate etc
7. Inspect notes on hand and confirm those with
holders
-Make confirmation with client debtor for notes Existence, occurrence and
receivables that is with holders. Ownership right.
-For discounted notes receivable make
confirmation with the maker as to the naming
of the maker, balance of the notes, the interest
rate, due date and so on.
8. Confirm receivables with debtors through direct Existence, occurrence, and
communication with the debtors. Right; valuation.
9. Review the year end cut-off sales transactions Existence, occurrence
(year end sales and collections) right and completeness
10. Perform analytical procedures for A/R, N/R, other

Receivables and revenues. In this case, several ratios
and relation ships can be computed to indicate the Existence, occurrence
overall reasonableness of the amounts of receivables, and right completeness
revenues e.g. Gross profit rate, the ratios of sales of
last month or weak to total sales for the quarter or
year and so, units shipped in relation to revenues and
production records, the ratio of uncollectible accounts
expenses to credit sales and others.
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11. Review significant year end contracts for unusual
terms e.g. relaxed terms of sales near year end to boost
level of sales which may affect collectability,test unusual
pricing, billings, delivery, returns, exchange, and others
Substantive testing Primary audit objectives
12. Verify the interest earned on notes and Existence, occurrence, right,
accrued receivables by computing such as completeness
accrued interest receivable at the beginning of
of the year, interest earned during the year,
interest collected during the year, and interest
accrued at the end of the year.
13.Evaluate the propriety/ appropriateness/

of client’s accounting for transactions e.g. check
the appropriateness of sales and receivables
related transactions, recognition Valuation
or revenues ( point of sale, installments,
percentage of completions) ,timing of customer
billings and other related matters.
14.Evaluate accounting estimates related to
receivables and revenues e.g. estimate of
sales returns, percentages of completion,
allowance for uncollectability, etc.
15.Determine adequacy of allowance for
Uncollectablity accounts-for fair presentation
the receivables should be presented in the
balance sheet at net realizable values
16. Ascertain the existence of pledged

receivables-if there is pledged receivables
it should be adequately disclosed Presentation and disclosure.
17. Investigate receivables from related parties
such as officers, stockholders, affiliates,
branches, divisions, etc as to their
legitimacy.
18. Evaluate financial statements presentation
and disclosure ie appropriate presentation of
A/R, N/R, interest receivables, loan receivables
and disclosure in accordance with GAAP
those pledged or collate red receivables
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Chapter-Three: Audit of inventories and cost of goods sold

3.1. Sources and Nature of Inventories
The interrelation ship of inventories and cost of goods sold makes it logical for the
two topics to be considered together.
Inventories – The term inventories is used in this chapter to include (1) goods on
hand ready for sale, either the merchandize of a trading concern or the finished goods
of a manufacturing; (2) goods in the process of production; and (3) goods to be
consumed directly or indirectly in production: raw materials, purchased parts, and
supplies.
Inventories have received much attention in both the accounting and auditing
literature, as well as in the discussions among professional accountants due to the
following reasons.
1. Inventories often constitutes a large current assets of an enterprise and very
susceptible to major errors and fraud.
2. The accounting profession sanctions numerous alternatives methods for valuation
of inventories, and different methods may be used for various classes of
inventories.
3. The determination of inventor value directly affects the cost of goods sold and
has a major impact on net income for the year.
4. The determination of inventory quality, condition, and value is inherently a more
difficult task that is the case with most other elements of financial positions.
Many items, such as precious gems, sophisticated electronic parts, and
construction in progress presents significant problems of identification and
valuation.
3.2. Auditors’ objectives in auditing inventories and cost of goods sold
The auditors’ objectives in the audit of inventories and cost of goods sold are to:
1. Consider internal control over inventories and cost of goods sold.

2. Determine the existence of inventories and the occurrence of transactions affecting
cost of goods sold
3. Establish the completeness of inventories
4. Establish that the client has right to the recorded inventories
5. Establish the clerical accuracy of records and supporting schedules for inventories
and cost of goods sold.
6. Determine that the valuation of inventories and cost of goods sold is arrived at by
appropriate methods.
7. Determine that the presentation and disclosure of inventories and cost of goods sold
is adequate, including disclosure and classification of inventories, accounting
methods and any inventories pledged as collateral for loans.
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Auditing II
In conjunction with auditing of inventories and cost of goods sold, the auditors will
also obtain evidences about the related purchase, sales, purchase returns, and sales
returns accounts.
3.3. Internal controls over inventories and cost of goods sold
The study and evaluation of accounting system and internal controls relating to
inventories helps the auditor in determining the nature, timing, and extent of substantive
procedures to be carried out during the course of audit. The following are the general
aspects of internal control relating to inventories.
 Segregation and rotation of duties: -
 Are the duties relating to the inventories such as purchasing, billing,
and accounting etc., are properly segregated?
 Are the duties of various persons relating to inventories rotated
periodically?
 Authorization of purchases, receipts and other related issues
 Are the goods are purchased with proper authorities?
 Is there a proper system of receipt of goods?
 Are the procedures for issue of inventories from the stores is clearly
laid down?
 Other related issues
 Maintenance of records and documents – Auditors may see important

aspects of transactions related to inventories and cost of goods sold with
respect to issues such as:
 Whether there is any proper documentation of receipts of merchandize from

suppliers.
 Whether there is any proper documentation for issues inventories.
 Whether there is any proper documentation for transfer of inventories from
one department to another.
 The king of inventory record system followed.
 Whether there is any system for determining the cost of work in progress
and finished goods.
 Whether the overhead absorption rates properly determined.
 Whether actual cost is compared with standard or budgeted costs and the
variance is properly analyzed and adjusted.
 Whether proper records have been maintained for waste, scrap etc.
 Whether proper records have been maintained in respect of inventories
belonging to the organization but existing with the third parties such as
warehouses, consignees, customers etc.
 Whether proper records are maintained in respect of merchandise exists with
the company belong to third parties.
 Whether adequate cut of procedures are followed.
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Auditing II
 Accountability for, and safeguarding of, inventories -Auditors may see
important aspects of transactions related to inventories and cost of goods sold
with this regard such as:
 Whether the goods are stored properly to protect against damage,
deterioration in quality etc.
 Whether the access to the place where the materials are stored is restricted.
 Whether the materials have been insured against fire, theft etc.
 Whether the insurance cover is adequate and reviewed periodically.
 Whether the insurance premium is paid up to the date.
 Whether the insurance cover notes or the policy notes are kept in proper
custody.
 What is the system for stock taking, continuous, annual, or both.
 Whether physical verification sheets are made after checking physically.
 Whether any variation exists with the physical verification and as per
inventory records and if there is any differences, the cause for the variation
has been investigated and necessary action has been taken.
 Substantive procedures -The auditor carries the substantive procedures in

relation to inventories on the basis of his evaluation of the effectiveness of
internal controls. The various substantive procedures may be as follows:
A. Examination of Records and Documents: The records maintained by different

enterprises vary considerably. Some organizations maintain detailed records
under perpetual inventory system, while others maintain the basic records relating
to purchases and sales and also statements of periodic stocktaking. The records
relating to the inventories are relevant to the auditor for determining the fairness
of the financial statements of the organization. The auditor’s examination of the
records relating to the inventories depends upon the nature of records maintained
by the organization under audit. The auditor has to examine the records
maintained by the client in order to determine the correctness of the figures of the
ending inventories and consequently, of the cost of the goods sold or
manufactured. However, in preparing the financial statements, the ending
inventories are generally valued on the basis of the physical verification rather
than on the basis of stock records. The auditor obtains the necessary evidence in
support of inventories primarily form review or observation of physical
verification and from examination of records relating to the sales and purchases.
The examination of the inventory records provides only corroborative evidence to
the auditor.
B. Review/ observation of physical verification: The physical verification is the
duty of the management; it is necessary for the auditor to satisfy himself that the
physical verification was carried out properly. Hence the auditor review the
procedures followed by the management, the follow up action on the
discrepancies found during the physical verification etc. Normally, the auditor/s/
may reviews the following points
1. Whether clear instructions have been given to the physical verification
team
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Auditing II
2. Whether the person in charge of the physical verification is clearly
specified
3. Whether the members of the team is independent of the stores personnel
4. Whether the auditor or his staff has been permitted to observe the physical
verification
5. Whether proper procedures have been laid down for the physical
verification
6. Whether the movement of inventories are restricted during the physical
verification
7. Whether any specific form for the recording of physical verification for
uniformity
8. Whether there is any provision for follow up action if there is
discrepancies
9. Whether adjustments have been made for the damaged, obsolete, and
defective inventories
10. Whether cut of transactions are examined properly
C. Examination of valuation and disclosure
1. Examine the relevant records such as, inventory records, physical
verification forms, invoices, costing records etc.
2. Test /check/ the application of inventory valuation methods
3. Examine the treatment of overheads in determining cost of inventories
4. Examine the evidences in support of the assessment of the net realizable
value
5. Examine the disclosure of the inventories in the financial statements
D. Analytical procedures
1. Quantitative reconciliation of inventories i.e. reconciliation of quantities
with the beginning inventories and purchases with the quantities sold or
produced and ending inventories
2. Comparison of the value of the inventories of the current year with that of
the previous year
3. Comparison of the ratio of various items to the total items with the ratios
of the previous year
4. Comparison of the gross profit ratio of the current year with that of the
previous years
5. Comparison of the inventory turn over ratios of the current year with the
ratio of the previous year
6. Comparison of the per unit value of the current year with that of the
previous year
E. Confirmation from third parties
When the inventories of the organization is held by other parties such as consignees,
agent etc examine whether a confirmation is obtained for holding the inventories and
if the inventories are held by a third party without any legitimate business reason, the
auditor should carry out further enquiries. The auditor should directly receive the
confirmation letter. When the inventories belonging to the outsiders are held by the
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Auditing II
organization the auditor should seek a confirmation from the parties about the
inventories held on their behalf
F. Management representation letter
The auditor should obtain a management representation letter from the management
stating that the inventories are valued by appropriate methods, all the inventories are
included, no inventory belonging to outside party are included, proper adjustments
have been made for the damaged, obsolete, and/or defective materials.
3.4. Audit Program For inventories and cost of goods sold

The following are the procedures typically performed by auditors to achieve the
objectives:
A. Consider internal control over inventories and cost of goods sold (test of control)
(1). Obtain an understanding of internal control over inventories and cost of goods sold.
Consideration of the internal control may involve activities such as filling out of a
questionnaire, writing or description memorandum, the preparation of flowcharts,
depicting organizational structure and the flow of material documents.
The understanding of internal control enables auditors to be familiar with
procedures for:
- Purchasing - controlling productions
- Receiving - Cost accounting systems
- Storing - Perpetual inventory systems
- Issuing goods - Other related matters
Questions that may be asked by auditors in consideration of control over inventory and
cost of goods sold may include (for perpetual inventory systems)
 Are perpetual inventory records made for each class of inventory?
 Are perpetual inventory records verified by physical inventories at least once
each year?
 Do the procedures for physical inventory include the use of prenumbered tags
with all tags numbers accounted for?
 Are differences between perpetual inventory records and physical count
investigated before the perpetual records are adjusted?
 Is a separate purchasing department responsible for the purchase of a material
supplies and equipment?
 Does a separate receiving departments process all incoming shipments?
 Are all materials supplies held in the custody of a stores department and issued
only upon receipt of properly approved requisitions?
Auditors also determine whether the policies and procedures indicated in the description
(flaw chart ) are used in operation, through inquires of entity personnel, inspection of
documents, and observation as to whether there is appropriate segregation of duties and
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Auditing II
varies documents such as purchase requisites purchase orders, materials requisitions ,
time ticked, shipping advices etc. After obtaining understanding of the controls relating to
inventories and cost of goods sold, auditors will consider the types of misstatements that
may occurs.
(2). Assess control risk and design additional tests of controls for inventories and cots of
goods sold
Based upon their understanding, auditors determine the planned assessed level of control
risk for various financial statement assertions. To support the assessments of control risk,
the auditors may need to obtain additional evidences of the operating effectiveness of the
client’s controls by designing additional tests of controls
(3). Perform additional tests of controls for those controls which auditors plan to
consider to support their planned assessed levels of control risk i.e.
(a) Examine significant aspects of a sample of purchase transactions such as:

 select a sample of purchase transactions
 Examine the purchase acquisitions or other authorizations for each purchase
transactions in the sample
 Examine related vendors invoices, receiving reports and paid checks for
each purchase orders in the supplies
 Inspects vender’s invoices for approval of prices, freight, credits terms and
accounts distributions and recomputed extensions and footings.
 Compare quantities and prices in the invoices, purchase orders and receiving
reports
 Trace postings from vouchers register to general ledgers and to any
applicable subsidiary ledgers.
(b) Test the accounting systems such as cost accounting systems for direct materials,
direct labors, manufacturing overhead costs ie as to whether the systems
accumulates actual or standard cost according to process, job, or other costing
systems.
(4) Reassess control risk for the financial statements assertions about inventories and cost
of goods sold and modify substantive tests based on information about weakness
and strength of the control systems.
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Auditing II
B. Perform substantive tests of inventories and cost of goods sold transaction and
balance
The objective of major substantive testing procedures of inventories and cost of

goods sold balances are given in the following table.

to be addressed
5.Obtain listing of inventory and reconcile to ledgers
i.e. schedules of listing of inventories is reconciled Clerical accuracy
to general ledger control accounts and appropriate
subsidiary ledgers.
6. Evaluate the client’s planning of physical inventory

Effective and efficient inventory planning requires
careful advance planning. In planning inventory count
client should consider factors such as
- Selecting the best date or dates Existence and right
- Suspending productions in certain departments Completeness
- Segregating obsolete and defective goods Valuations
- Establish control over the counting process
- Achieve proper cut off sales and purchased
Transactions
- Approving for services of engineers or other
Specialists to determine quantities, qualities,
Certain goods materials
7. Observe the tacking of physical inventory and make
test counts- as part of the process of observing
the physical inventory, the auditors may see the
possibilities in including absolute and damaged
inventories, infrequent sales, see records of the final
receipts and sales, make test count of selected
inventory items
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Auditing II
8. Review the year end cut- cut off of purchase

and sales transactions-an accurate cut off
purchase is one of the most important Existence
factors in verifying the existence and Ownership right
completeness of the year end-inventory i.e. Completeness
see whether all purchase and sale of inventory Clerical accuracy
made during the period under consideration is
is included and non from subsequent period
in included in the period under consideration.
9. Obtain a copy of the completed physical
Inventory and test its accuracy ie test clerical
Accuracy of extensions and footings, and that of
reconciliation of inventory count to inventory
recorded
10. Evaluate the bases and methods of
inventory pricing i.e. verify whether the
basis and methods for inventory pricing
and costing are in accordance with GAAP
Investigation of inventory valuations may
involve questions such as
- What methods of pricing does the client use?
- Is the methods of pricing the same as that Valuations
that used in prior periods?
- Has the method selected by the client
been applied consistently and accurately in
in practice?
- Other related questions.
11. Test the pricing of inventories i.e. test the
the pricing method applied to raw materials,
purchased parts, supplies, WIP-inventories
finished goods and other inventory items
12. Perform analytical procedures on items such as:
-Gross profit rate over the periods Existence and ownership right
-Inventory turnover(CGS/Average inventory) Completeness
-Volume of purchase from period to period Valuations
-Others
13. Determine whether any inventories have been Valuation
Pledged and review commitments presentations and disclosure
14. Evaluate financial statements presentations
and disclosure i.e. see whether there is adequate
disclosure of inventory methods, classifications Presentation and disclosure
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Auditing II
change in allowance for inventory, terms of
inventory purchase, commitments, pledged of
inventory et
Chapter-Four:
Audit of property, plant, and Equipment and the related
depreciation
4.1. Overview of property, plant and equipment
The term property, plant and equipment (fixed assets) include all tangible assets with
a service life of more than one year that are used in the operation of the business and
are not acquired for the purpose of resale. Three major subgroups of such assets are
generally recognized.
1) Land, such as property used in the operation of the business, has the significant
characteristics of not being subject to depreciation.
2) Building machinery, equipment and land improvements, such as fences and
parking lots, have limited service lives and are subject to depreciation.
3) Natural resources (wasting assets), such as oil wells, coal mines, and tracts of
timber, are subject to depletion as the natural resources are extracted or removed.
Fixed asset constitute a significant proportion of the total assets of many organizations
particularly those engaged in manufacturing activities. Audit of fixed asset is, therefore
generally considered to be an important part of an independent financial audit. Though
the number of transactions involving fixed assets is smaller in number, the amount
involved in these transactions will be very high. Hence the auditor has to give more
attention while auditing the transactions relating to fixed asset.
4.2. Auditors’ objectives in auditing property, plant and equipment
The auditor’s objectives in the audit of fixed assets are
1. Consider internal control over property, plant and equipments.

2. Determine the existence of recorded property, plant and equipment.
3. Establish the completeness of recorded property, plant and equipment.
4. Establish that the client has ownership rights to the recorded property, plant and
equipments
5. Establish the clerical accuracy of schedules of property, plant, and equipment.
6. Determine that the valuation or allocation of the cost of property, plant, and
equipment is in accordance with generally accepted accounting principles.
7. Determine that the presentation and disclosures of property, plant, and
equipment, including disclosure of depreciation methods is appropriate.
In conjunction with the audit of property, plant, and equipment, the auditors also obtain
evidence about the related accounts of depreciation expenses, accumulated depreciation,
and repair and maintenance expenses.
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Auditing II
4.3. Internal controls relating to fixed assets
The auditor studies and evaluates the accounting system and the effectiveness of internal
control relating to fixed assets. The auditor’s study and evaluation of internal control
relating to fixed assets covers the following aspects:
1. Segregation and rotation of duties.
2. Authorization of acquisition, transfer and disposal of fixed assets
3. Maintenance and record of documents.
4. Accountability for and safeguarding of fixed assets.
5. Independent checks.
1. Segregation and rotation of duties: The auditor has to see whether there is proper
segregation of various duties relating to fixed assets such as
 Authorization of acquisition and disposals
 Execution of transactions relating to execution and disposals.
 Recording of transactions
 Physical custody of items.
The auditor also has to see whether the duties of various persons relating to fixed assets
are rotated periodically or not.
2. Authorization of acquisition, transfer and disposal of fixed assets:

a) The auditor has to check the internal control relating to capital budgeting. i.e.,
whether the proposal for capital expenditure has been received in time in the
proper format, approved by the top management and whether it is properly
communicated to the various departments after the approval.
b) Whether a written authorization from a senior level of the management is
included in the budget.
c) Whether the organization have laid down proper procedures for acquisition of
fixed assets i.e. for inviting quotations, selection of suppliers, approval of
prices, payment terms, safeguard for timely delivery etc.
d) Whether the purchases are made on the basis of competitive bids. And whether
there is requirement for documenting the reasons for making purchases other
than at lowest price.
e) Whether the control over receipt of fixed assets are effective ie., whether the
technical specifications of the assets received are verified with the purchase
orders before accepting and if rejected whether the debit notes are raised
promptly.
f) Whether periodic comparisons of the actual expenditures of the fixed assets are
compared with the capital expenditure budget and whether approval from the
competent authority is received if there is a deviation form the budget.
g) Whether there any system of getting prior approval from the competent
authority in case of transfer of fixed assets from one department to another?
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Auditing II
h) Whether adequate controls exist for disposal of fixed assets i.e. with proper
authorization, invitation of quotations, approval of prices, proper documentation
etc
3. Maintenance of records and documents
a) The auditor has to check whether the company maintains proper records of
fixed assets including those items, which are fully depreciated.
b) Whether the organization maintains the record of assets given on lease or
used by the organization but owned by others.
c) Whether a register containing title deeds of the assets are maintained
properly.
d) Whether the title deeds or registration documents are kept in safe custody
and verified periodically.
e) Whether the organization maintained a detail record of projects which are in
progress.
f) Whether the expenditures incurred are properly allocated between capital
and revenue.
4. Accountability for and safeguarding of fixed assets
a) Whether there is any system for identification of fixed assets.

b) Whether adequate safeguards are made to protect the fixed assets from fire,
theft accessibility to unauthorized persons, and use of locks burglar alarms
etc.
c) Whether the fixed assets are properly insured and the auditor has to check
regarding the adequacy of the cover the time period, etc.
d) Whether the fixed assets are physically verified on a periodic basis including
those assets lying with third parties.
e) Whether follow up action has been taken for the discrepancies between the
record books and physical verifications.
f) Whether there is any system for identifying and reporting damaged, obsolete
and idle fixed assets.
5. Independent checks:
The auditor has to see whether there is any internal audit for fixed assets and
determining the coverage and effectiveness of the internal audit. The auditor has to
examine the scope of the work of the internal auditors and their reports.
Substantive procedures for fixed assets
The auditor determines the nature timing and extent of substantive procedures
relating to fixed assets after evaluating the effectiveness of internal controls. The
procedures normally followed are the following
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Auditing II
(A). Examination of records and documents.
1. Verify the opening balances from the previous years' financial statements or
ledger accounts.
2. Verify the additions made during the year from the approval of appropriate
authority copies of purchase orders, invoices receiving reports,
acknowledgement form the supplier and bank statement.
3. Verify the assets constructed during the year by examining work order
records, statement of allocation and apportionments of costs, certificate of
work performed, contractors bills, invoices of suppliers of materials, bank
statement etc.
4. Verify the major repairs and maintenance to ensure no revenue expenditure
related to the capital assets is included.
5. Verify the disposal or retirement of fixed assets by examining the approval of
appropriate authority, quotations invited from buyers, contract with the buyer,
copy of the sale bills, evidence of physical deliveries etc.
6. Examine whether the book values and accumulated depreciation of the fixed
assets disposed or discarded are properly adjusted accounting the resulting
gains or losses properly.
7. Verify the minutes of the board of directors, agreements, and correspondence
with lawyers to identify any charges or encumbrances on the fixed assets.
8. Verify the arithmetical accuracy of the fixed asset records.
9. Verify whether the value shown in the financial statement is after charging
adequate depreciation.
10. Examine the evidence of ownership of fixed assets.
(B). Review or observation of a second verification
Though the physical verification is the duty of the management, the auditor can review or
observe the verification by examining the documents relating to the physical verification.
The procedures followed are:

1. Review the instructions issued to the staff entrusted with the responsibility of
physical verification and judges the appropriateness and adequacy of the
instructions.
2. Assess the competence of the personnel conducting the physical verification.
3. Examine the frequency of the verification and verify whether it is reasonable
in the circumstances of the case.
4. When direct physical verification is not possible examine any indirect
evidence of the existence of the fixed assets.
5. Tests check the fixed asset record with the physical verification records.
6. Examine the appropriate follow up action taken for the discrepancies revealed
by physical verification with the fixed asset records.
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Auditing II
7. Examine whether appropriate adjustments have been made in the fixed asset
records and financial accounts for obsolescence, damage, or other losses
reveled by the physical verification.
(C). Examination of Valuation and disclosure
1. Examine whether the fixed assets have been valued according to the generally
accepted accounting principles.
2. Examine whether adequate depreciation have been provided.
3. Examine whether the fixed assets have been revalued in a systematic/
scientific/ appraisal basis considering the future life and the possibility of
obsolescence.
4. Examine the basis on which the consideration has been approportionated to
various assets when several assets have been purchased for a consolidated
price.
5. Examine the relevant documents such as title deeds agreements etc in order to
ascertain the extent of the shares of the organization when the organization
owns assets jointly with others.
(D). Analytical Procedures: -The analytical procedures employed by the auditors in the
audit of fixed assets are the following:
1. Compare the additions or disposals of fixed assets made during the year with
the budgeted figures.
2. Compare the ratio of depreciation for the current year to the average book
value of the fixed assets with the corresponding figures of the previous year.
3. Compare the amount of repairs and maintenance of the current year with the
figures of the previous year.
4. Compare the ratio of actual capacity utilization with the installed capacity of
the current year with the figures of the previous year.
(E). Obtaining Management Representation

The auditor has to obtain an appropriate representation form the management concerning
the fixed assets stating that the fixed assets shown in the balance sheet are arrived at after
considering all capital expenditures on additions, eliminating the cost and accumulated
depreciation relating to the items discarded, destroyed and disposed off and adequate
depreciation has been provided for during the current year.
4.4. Audit program for auditing fixed assets
The following procedures are typical of the work required in many engagements for the
verification of property, plant and equipments.
A) Consider internal control over property, plant and equipment
1. Obtain an understanding of internal control over property, plant and equipment
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Auditing II
Auditors may use written description, flow chart or internal control questionnaire to
describe the nature of client’s internal control structure. After preparing description of
internal control, the auditors will determine whether the controls as described to them
have been placed in operation, whether there is appropriate segregation of duties and
considered the misstatements that may occur.
2. Assess control risk and design additional tests of control for the assertions
about property, plant, and equipment.
Based on an understanding of the client’s internal control over property, plant and
equipment, the auditors develop their planned assessed level of control risk for the
various financial statement assertion assertions and obtain additional evidences of the
operating effectiveness of the client’s controls by designating additional tests of control.
3. Perform additional tests of controls for those controls that the auditors plant to
consider to support their planned assessed levels of control risk.
As auditors obtain an understanding of the client’s internal control; certain tests of
control are performed.
E.g. select a sample of purchase of plant and equipment to test the control related to
authorization, receipts and proper recording of the transactions.
4. Reassess control risk for each of the major financial statements assertions about
property, plant, and equipments based on the results of tests of controls and, if necessary,
modify substantive tests.
The final step in the auditor’s consideration of internal control involves a reassessment of
control risk based on the results of the tests of control. On the basis of the reassessed
level of control risk auditor modify their planned program of substantive testing
procedures for property, plant, and equipment assertions.
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Auditing II
B. Perform substantive tests of property, plant and equipments and related

depreciation transactions and balances
The objective of major substantive testing procedures of property, plant and

equipment balances are given in the following table.

to be addressed
5. Obtain a summary analysis of changes in property
owned and reconcile to ledgers
-The summary analysis shows the beginning balances
of property, plant, and equipment, additions to Clerical accuracy
and/or retirement from property, plant, and
equipments and ending balances of property plant
and equipments.
Auditors reconcile subsidiary ledgers with the
Controlling accounts
6. Vouch additions to property, plant and equipment

during year – The vouching process utilizes a
working paper analysis of the general ledger
controlling accounts and includes the tracing of
entries through the journal to original documents
such as contracts, construction work orders, invoices
canceled checks authorization by appropriate
individuals - Existence and right
7. Make physical inspection of major acquisitions - valuation or allocation
-The auditors usually make a physical inspection of
major units of plant and equipment acquired during
the year under audit by comparing the physical
assets with underlying records.
-Helps to maintain good working knowledge of the
Client’s operations and also in interpreting the
accounting entries for both additions and retirements.
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Auditing II

8. Analyze repair and maintenance expenses accounts
-The auditors principal objective in in analyzing
repair and maintenance expense accounts is to
discover items that should have capitalized Valuation and allocation
-To determine that there is proper repair and maintenance
charges, the auditors will trace the ledger expenditures
to written authorizations for the transactions.
9.Investigate the status of property, plant and equipment
- Auditors investigate plant assets currently in use, plant
assets not currently in use but expected to be used in - Valuation and allocation
the future operation (depreciate at normal rate); and -Presentation and disclosure
plant assets dismantled, found to be unsuitable for future
operating use(should be written down their net realizable
value and should not be classified as plant assets.
10. Test the client’s provision for depreciations

- Review and test management’s process of
developing the estimate
- Review subsequent events or transactions bearing
on the estimates -Valuation and allocation
-Independently develop an estimate of the amounts
to compare to management’s estimates
11.Investigate potential impairments of property, plant,
and equipments
-When ever events or changes in circumstances indicate
that the carrying amount of long lived assets may not
be recoverable ie if the sum of the expected future cash
flows from the assets is less than its carrying amounts,
an impairments loss is recognized.
12. Investigate retirement of property, plant and equipment
during the year
-The principal purpose of this procedures is to determine
Whether any property has been replaced, sold, dismantled -Existence and right
Or abandoned without such actions being reflected in the
Accounting records.
13. Examine evidence of legal ownership
- To determine that plant assets are property of the client,
the auditors look for such evidences as a deeds, title,
insurance policy, property tax bills, receipts, for payments
to mortgages and fire insurance policies.
14. Review rental revenues-rental revenues from land,
building, equipments, machinery, and so on should be
reviewed and the party responsible to pay cost of
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Auditing II
electricity, water, telephone should be reconciled against
with provisions of utility expenses.

15.Examine lease agreements on property, plant
and equipments i.e. lease to and/ or form other party.
the auditors should carefully examine lease agreements
to determine whether the accounting for assets involved
in proper (in accordance with the requirements of GAAP)
eg Capitalization of assets leased by the client company. - Existence and right
16.Perform analytical procedures for property, plant, and -Completeness
equipments - Valuation or allocation
- Auditors may use trends and ratios to judge the
reasonableness of recorded amounts for plant
and equipments
e.g. – Cost of plant assets/ annual out put in dollar or
other units
-Monthly repair and maintenance expense to yearly
amounts
- Compare acquisition and retirements of current year to
prior years.
17. Evaluate financial statements presentation and

disclosure for property, plant and equipment and Presentation and disclosure
for related revenues and expenses.
-The balance sheet or accompanying notes should
disclose balances of major classes of depreciable
assets, accumulated depreciation, method(s) for
computing depreciation, base of valuation, property
pledged and property not in current use.
4.5 Auditors perspective towards depreciation
Depreciation is the decrease in the value of the asset due to wear and tear, obsolescence,
lapse of time etc. Fixed assets are to be disclosed in the balance sheet at their cost or at
the revalued amount less depreciation
Determining the annual depreciation expense involves two rather arbitrary decisions by
the client company: first, an estimate of the useful economic lives of various groups of
assets, and second, a choice among several depreciation methods, each of which would
lead to a different answers. The wide range of possible amounts for annual depreciation
expense because of these decisions by the client suggests that the auditors should
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maintain a perspective of looking for assurance of overall reasonableness. Specifically,
overall tests of the year/s depreciation expense are of special importance.
Accordingly, the auditor has to examine whether adequate depreciation has been
provided in the books in respect of all depreciable assets according to the provisions of
the relevant statutes.
While auditing depreciation, the auditor has to examine the following points in respect of
depreciation
1. Whether adequate depreciation has been provided during the current year.
2. Whether the depreciation has been calculated by appropriate methods.
3. Whether appropriate method has been selected after considering the useful life of
the asset and salvage value.
4. Whether the method of calculating depreciation has been consistent over the
years.
5. Whether any change in the method has been properly disclosed in the financial
statements.
6. Whether accumulated depreciation in respect of discarded or disposed assets have
been adjusted in the accumulated depreciation amount.
7. Whether depreciation has been provided properly on the assets added or disposed
of during the current year.
8. Whether depreciation has been provided on revalued assets
9. Whether the depreciation has been properly disclosed in the financial statements.
4.5.1 The auditors’ objectives in auditing depreciation
When evaluating the reasonableness of depreciation (with accounting estimate), auditors

use one or more of the following three basic approaches.
1). Review and test management’s process of developing the estimates
2). Review subsequent events or transactions that might have bearing on the estimate to
management’s estimate
3). Independently develop an estimate of the amounts to compare to managements
estimate.
4.5.2 Audit program-Depreciation expense and accumulated depreciation
The following outlines of substantive tests to be performed by the auditors in reviewing

depreciation are stated in sufficient detail to be largely self-explanatory.
1) Review the depreciation policies set forth in company manuals or other management
directives. Determine whether the methods in use are designed to allocate costs of
plant and equipment assets systematically over their service lives.
a) Inquire whether any extra working shifts or other conditions of accelerated
production are present that might warrant adjustment of normal depreciation
rates.
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Auditing II
b) Discuss with executives the possible need for recognition of obsolescence
resulting from technology or economic developments.
2) Obtain or prepare a summary analysis of accumulated depreciation for the major

property classification as shown by general ledger accounts, listing beginning
balances, provisions for depreciation during the year, retirements, and ending
balances.
a) Compare beginning balances with the audited amounts in last year/s working
papers.
b) Determine that the totals accumulated depreciation recorded in the plant and
equipment subsidiary records agree with the applicable general ledger controlling
accounts.
3). Test the provisions for depreciations
(a). Compare rates used in prior years and investigate any variance.
(b). Test computations of depreciations for provisions for a representatives
number of units and trace to individuals records in the property ledger. Be
alert for excessive depreciation on fully depreciated assets.
(c). Compare credits to accumulated depreciation accounts the year’s depreciation
provisions with debits entries in related depreciation expenses accounts.
4). Test deductions from accumulated depreciation for assets retired.
(a) Trace deductions to the working paper analyzing retirements of assets during
the year.
(b) Test the accuracy of accumulated depreciation to date of retirements.
5). Perform analytical procedures for depreciation
(a) Compute the ratio of depreciation expenses to total cost of plant and compare
with prior years.
(b). Compare the percentage relationships between accumulated depreciation and
related property accounts with that prevailing in prior years. Discuss significant
variations from normal depreciation program with appropriate members of
managements.
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Auditing II
Chapter-Five: Audit of Purchase, Accounts payable, and other

liabilities
5.1: Sources of purchase-Audit of purchases is a significant part of independent

financial audit because the purchases constitute the largest item of expense in the income
summary of an organization. Purchase transaction might be resulted from different
sources such as purchase of materials, merchandise, fixed assets of various types etc
5.2: Auditors objectives in auditing purchases
The auditor’s objectives in the audit of purchases are:

1. Consider the internal control over purchases
2. Determine the existence of purchases
3. Establish the completeness of the
4. Determine that the client has the rights to the recorded purchases
5. Establish the clerical accuracy of the records and supporting schedules of
purchases
6. Determine the valuation of purchases
7. Determine that the presentation and disclosure of inventories and cost of goods
sold is adequate including disclosure of classification of inventories, accounting
methods and any inventories pledged as collateral for loans.
5.3: Audit program for Purchase- The audit program for purchase transactions also
deal with two types of procedures
(A) Procedures applied to internal control of the company over different purchase
transactions and
(B) Substantive testing procedures applied to a sample of purchase transactions and
account balances.
5.3.1: Consideration of internal control over purchases
The auditor studies and evaluates the accounting systems and internal controls relating to
purchases. It helps the auditor to determine the nature, extent, and timing of the
substantive procedures. The auditor seeks to obtain an understanding the flow of
transactions while analyzing the internal control system and the accounting of purchases.
verification of purchase transactions
A) Consider internal control over purchases

1. Obtain an understanding of internal control over purchases
Auditors may use written description, flow chart or internal control questionnaire to
describe the nature of client’s internal control structure. After preparing description of
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Auditing II
internal control, the auditors will determine whether the controls as described to them
have been placed in operation, whether there is appropriate segregation of duties and
considered the misstatements that may occur.
2. Assess control risk and design additional tests of control for the assertions
about purchase transactions.
Based on an understanding of the client’s internal control over purchase, the auditors
develop their planned assessed level of control risk for the various financial statement
assertion and obtain additional evidences of the operating effectiveness of the client’s
controls by designating additional tests of control.
3. Perform additional tests of controls for those controls that the auditors plant to
As auditors obtain an understanding of the client’s internal control; certain tests of
control are performed.
E.g. select a sample of purchase transactions to test the control related to authorization,
proper recording, etc of the transactions.
purchase transactions based on the results of tests of controls and, if necessary, modify
substantive tests.
The internal control relating to purchases can be studied and evaluated by segregating the
purchase cycle into four segments. They are:
a) Processing of purchase orders.
b) Receiving of goods.
c) Recognizing the liability of purchase.
d) Processing and recording of payments.
A) Processing of Purchasing Orders:
The auditor has to examine the internal control related to processing, purchase orders and
should understands
 Whether the purchases are centralized or decentralized.
 Whether the purchase procedure provide for the preparation of the return purchase
requisition
 Whether the purchase requisition are prepared in a standard format
 Whether the standard format requires furnishing of sufficient details about
quantity required, technical specification, delivery schedule etc.
 Whether the authorities regarding sanctioning of purchases have been clearly laid
down with proper authority.
 Whether a list of approved suppliers maintained for each major item
 Whether purchases are made from approved suppliers
 Whether tenders and quotations are invited from suppliers
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 Whether any long term purchase contracts have been entered into with suppliers
and if so, whether the provision in the contract is clear and unambiguous.
 Whether any undue advantage is given to any supplier
 Whether any special authorization required in case of lowest quotation accepted.
 Whether there is any system for approving the prices and other terms and
conditions in case of purchases, which are not made on quotations.
 Whether any purchases are made from organizations in which the related parties
are interested.
 Whether the purchase orders are prenumbered and kept in the proper custody.
 Whether the purchase orders are made in detail and precise
 Whether the copy of the purchase order required to be signed by the supplier
significant his acceptance of the terms of the order.
 Whether a copy of the purchase order is forwarded to the receiving and inspection
department and to the accounting department.
 Whether any periodic review has been done on the purchase order, which
remained, unexecuted beyond the due dates.
B) Receiving goods:
 Whether all the goods are received only in the receiving department and if not
whether there is any procedure for obtaining conformations about the quantity and
quality of the goods received
 Whether goods received note is prepared when the materials are received.
 Whether the goods received note are prenumbered
 Whether there is any procedure for verifying the quantities and the quality of the
materials at the time of receipt
 Whether there is any procedure for verifying the specifications given in the
purchase order with that of the materials received.
 Whether any system exist for the receiving department to reject the material if
there is any variation in the goods received with that of the purchase order.
 Whether there is any procedure for the receiving department to inform the
accounts department, purchase department, and stores with regard to the receipt of
materials
 Whether the materials received are promptly sent to the stores.
C) Recognizing the liability for purchase:
 Whether the supplier’s invoices received by the accounting department and

matched with the purchase order, good received note and advance payment
records.
 Whether the invoices are checked thoroughly to ensure the terms and conditions
of the purchase order have been complied with.
 Whether the invoices are checked for arithmetical accuracy
 Whether invoices are entered promptly in the purchase book
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 Whether proper debit notes are prepared for any variations in quantity and quality
of the materials received with those specified in the purchase order.
 Whether the debit notes are prenumbered
 Whether the debit notes are issued with proper authority
 Whether the debit notes are entered in the proper books.
 Whether duplicate invoices are accepted when original invoices are accepted with
proper authority
 Whether the advances are made only as per the terms of the purchase order and
with proper authority.
 Whether all advances are reviewed periodically and properly followed up
 Whether there is any periodic reconciliation of goods paid for and goods received
as per stores record.
D) Processing and recording of Payments:
The internal control procedures for processing and recording of payments have being
already seen while discussing audit of cash and marketable securities.
E) Overall controls
1. Whether there is any proper segregation of duties in relation to the activities

involved in purchase.
2. Whether there is any system for the rotation of duties of personnel involved in
the purchase transaction.
3. Whether there is a proper procedures for cut off transactions
4. Whether there is any proper procedure for returning the purchases.
5. Whether there is any internal audit in respect of the purchase cycle.
6. Whether there is any system for sending periodic statement of accounts to the
suppliers.
(B) Substantive testing procedures applied to a sample of purchase

transactions and account balances.
The auditor determines the nature, the timing, and the extent of substantive procedures
relating to purchases on the basis of the auditors’ assessment of the inherent risk of
misstatement of purchases in the financial statements and his evaluation of the internal
control system. The procedures may involve
(a) Tests of individual transactions and purchase.

(b) Analytical procedures
(c) Presentation and disclosures.
A) Tests of individual transactions and purchase:

The auditor has to
 Examine the entries in the purchase book with reference to the invoices and
supporting documents such as goods received note, inspection reports, etc.
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 Examine a sample of invoices selected at random and conduct an in-depth audit.
 Examine the numerical sequence of purchase orders and goods received note and
determine whether all the members are duly accounted.
 Examine the Arithmetical accuracy of the purchase records and check the totals,
balances, and their carry forwards.
 Examine the entries in the purchase return book and examine Arithmetical
accuracy
 Examine whether proper adjustments have been done for the debit notes.
 Examine whether the debit notes are issued with proper authority.
 Examine the debit notes issued at the year-end, which appear unusual.
 Examine the numerical sequence of the debit notes and see whether all debit notes
are duly accounted.
 Examine the sales invoice of goods directly delivered to the third parties.
 Examine the cutoff transactions relating to purchases and purchase returns.
 Examine the response of the suppliers to the periodic statement of accounts sent
by the client.
 Obtain the conformation of balance form the suppliers.
B) Analytical Procedures:
The following are the analytical procurers adopted by the auditors in respect of
purchases.
 Compare the purchase figures of different periods of the current year and enquire
into the unusual fluctuations.
 Prepare a reconciliation statement for the quantities of purchases.
 Compare the budgeted purchases with the actual purchases.
 Compare current years purchase figures with those of the previous years.
 Compare the ratios of value of each item to the total purchases for the current year
with the figures of the previous year.
 Compare the gross profit ratio for the current year with the ratio of the previous
year and with the industry average.
The auditor examines the result of the application of the analytical procedure to identify
any unusual fluctuations or variations and satisfy himself to form an opinion.
C) Examination of presentation and disclosure: The auditor has to examine the

presentation and disclosure of purchases with the financial statements in accordance
with the generally accepted accounting principles. He has to also examine whether
the purchases have been properly classified and disclosed under the appropriate
account heads. The presentation and disclosure should also be in accordance with the
provisions of the various statutes if any exist in the country.
D) Imports: The auditor has to apply the following substantive procedure if the
purchases are made out of imports.
 Examine whether the imports have been made in accordance with the relevant
legal provisions.
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 Examine the documents such as bill of lading import clearance certificate receipt
for the payment of customs duty
 Examine the evidence of the approval of the concerned authorities for the
remittance of foreign currency.
 Examine the transactions of imports are properly recorded in the books and the
amount has been properly converted into local currency.
Forward Contracts:
A forward contract for purchase is an agreement to purchase certain items at a future
date at an agreed price. The objective of forward contract for purchase from the
viewpoint of the buyer is to cover himself against possible increase in price in future. The
auditor has to pay a special attention to the forward contract for purchases. The auditor
should examine these forward contracts for purchases carefully as they represent a future
liability for the enterprise. If the prices fall in future, the organization may tend to incur a
loss and, hence the auditor has to examine whether proper provision has been made in the
financial statements. If the professional body of accountants had issued any guidelines in
respect of such transactions or if any statute contains any provisions in respect of these
transactions, the auditor has to examine whether these provisions or guidelines are strictly
complied with.
5-5: Audit of accounts payables, payrolls and other liabilities
5-5-1: Audit Of Accounts payable-The term accounts payable often referred to as

vouchers payable for a voucher system) is used to describe short-term obligations arising
from the purchase of goods and services in the ordinary course of business. Typical
transactions creating accounts payable include the acquisition on credit of merchandise
raw materials, plant assets, and office supplies. Other sources of accounts payables
include the receipt of services, such as legal and accounting services advertising, repair
and utilities.
Invoices and statements from suppliers usually evidence accounts payable arising from
the purchase of goods or services and most other liabilities.
The auditors’ approach to auditing accounts payables and other related liabilities
The auditors’ objectives in the audit of accounts payables are to:
1. Consider internal control over accounts payables and other liabilities
2. Determine the existence of recorded accounts payable and other liabilities
3. Establish the completeness of recorded accounts payables and other liabilities.
4. Determine that the valuation of accounts payable is in accordance with generally
accepted accounting principles
5. Establish the clerical accuracy of schedules of accounts payables
6. Determine that the presentation and disclosure of accounts payable are
appropriate.
Audit program for accounts payables
verification of accounts payables.
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Auditing II
A. Consider internal control over accounts payables.
1. Obtain an understanding of internal control over accounts payables

2. Assess control risk for each the major financial assertions about accounts
payables, and design additional tests of controls.
3. Perform additional tests of control for those controls that the auditors plan to
(a) Verify a sample of posting to the accounts payables accounts.
(b) Vouch to supporting documents a sample of postings in selected accounts of
the account payable subsidiary ledger.
(c) Test computer applications controls if any.
accounts payables based on the results of the tests of controls and modify
substantive tests.
B. Perform substantive tests of accounts payables transactions and balances with

their primary audit objectives.
5. Obtain or prepare trial balances of accounts payables as of the balance sheet data and
reconcile with the general ledger (To test clerical accuracy)
6. Vouch balances payable to selected creditors by inspection of supporting documents
(To test existence; obligation and valuations)
7. Reconcile liabilities with monthly statements To test completeness,

from creditors -existence and obligation
8. Confirm accounts payables by direct correspondence -Valuation
with venders
9. Perform analytical procedures for accounts
payables and related accounts
10. Search for unrecorded accounts payables ( To test completeness)
11. Perform procedures to identify accounts payables to related parties To test

12. Evaluate proper balances sheet presentation and disclosure of presentation
accounts payables and disclosure
NB. Other liabilities such as amounts withheld from employees’ pay, sales taxes payable,
unclaimed wages, customers’ deposits, accrued liabilities and the like should also be
considered by auditors. Thus, auditors also need to apply the necessary audit procedures
with these respects.
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Auditing II
5-5-2: Audit of payroll liabilities
The payroll in many companies is by far the largest operating cost and therefore, deserves
the close attention of the auditors. In the past, payroll frauds were common and often
substantial. Today, however, such frauds may be more difficult to conceal for several
reasons such as:
(1) Extensive subdivision of duties relating to payroll;

(2) Use of computer, with proper controls, for preparation of payrolls; and
(3) Necessity of filing frequent reports to the environment, listing employees’
earnings and tax will withholdings.
Audit program for payrolls- The audit program for payroll is also classified in to
two major sections: (A) Consideration of internal control and (B) Application of
substantive testing procedures
A) Internal control over payroll-The establishment of strong internal control over

payrolls is partially important for several reasons. Although payroll frauds are less
frequent, today, the possibilities of large scale payroll frauds still exists. Such frauds may
involve listing of fictitious persons on the payroll, overpaying employees, and
continuing employees on the payroll after their separation from the company.
A second reason for emphasizing internal control over payroll is that a great mass of
detailed information concerning hours worked and rates of pay must be processed quickly
and accurately if workers are to be paid promptly and without error. Maintaining good
employee relations demands that pay checks be ready on time and be free from errors.
Internal control here is therefore a means of securing accuracy and dependability in
accounting data as well as a means of preventing fraud.
Still another reason for emphasizing the importance of internal control over payrolls is
the existence of various payroll tax and income tax laws which require the certain payroll
records be maintained and that payroll data be reported to the employee and to
government agencies. Complete and accurate records of time worked are also necessary
if a company is to protect itself against lawsuits country’s labor law.
Methods of achieving internal control over payroll
Budgetary controls -of labor costs-to control payroll costs to avoid wastes and to obtain
the maximum production from the dollars expended for services of employees. As a
means of establishing control over payroll costs, many companies delegate to
departments heads and other supervisors responsibilities fro the control of costs in their
respective units of the business. The supervisors may be requested at the beginning of
each period/year/to submit for the budget an estimate of departmental labor costs for the
coming period against which actual labor costs will be compared and significant
departure if any will be investigated and the necessary corrective action could be taken.
Reports to government agencies-Another important internal control over payroll lies in
the necessity of preparing reports to government agencies, showing the earrings and tax
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Auditing II
deduction for all employees. This type of control is not concerned with holding labor
costs to a minimum but is an effective means of preventing and detecting payroll frauds.
Subdivision of duties-payroll activities include the function of employment, time
keeping, payroll preparation and record keeping, and the distribution of pay to
employees. For effective internal control each of these functions should be handled by a
separate department of the company. Combination of these functions in a single
department or under the authority of one person opens the door to payroll fraud.
Description of internal control for payroll-Typical of the questions to be answered by

the auditors for the completion of an internal control questionnaire, a systems flowchart,
or other record of payroll internal control are the following.
- Are employees paid by checks or direct deposit?
- Is a payroll bank account maintained on an important basis?
- Are the activities of timekeeping, payroll compilation, payroll check signing, and
paycheck distribution/cash payments/ performed by separate departments or
employees.
- Are all operations involved in the preparation of payrolls subject to independent
verifications before the paychecks are distributed?
- Are employees time reports approved by supervisors?
- Is the payroll bank account reconciled monthly by employees having no other payroll
duties?
B) Substantive testing procedures over payrolls
The following substantive procedures are representative of the works generally

completed to establish the propriety of payments for salaries, wages, bonuses and
commissions
(1) Perform substantive tests of over payrolls transactions for selected pay periods,
including the following specific procedures:
(a) Compare names and wages or salary rates to records maintained by the
personnel department
(b) Compare time shown on payroll to time cards and time reports approved
by supervisors.
(c) If payroll is based on piecework rates rather than hourly rates, reconcile
earnings with procedures records.
(d) Determine basis of deductions from payroll and compare with records o
deductions authorized by employees.
(e) Test extensions and footings of payroll
(f) Compare total of payroll with total of payroll checks issued.
(g) Compare total of payroll with total of labor cost summary prepared by cost
accounting department.
(h) If wages are paid in cash, compare receipts obtained from employees with
payroll records.
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Auditing II
(i) If wages are paid by check, compare paid checks with payroll and
compare endorsements to signatures on withholding tax exceptions
certificates.
(j) Observe the use of time clocks by employees reporting for work and
investigate time cards not used.
2.Perform analytical procedures to test the reasonableness of payroll expenses; for
example, developing an expectation about the amount of payroll expense by multiplying
the amount of one pay period by the number of pay periods in the year.
3. Investigate any extraordinary fluctuations in salaries, wages and commissions.
4. Obtain or prepare a summary of compensation of officers for the year and compare to
contracts, minutes of directors, meetings, or other authorizations.
5. Test commission earnings by examination of contracts and detailed supporting records.
6. Test pension obligations by reference to authorization pension plans and to supporting
documents.
In addition to the above procedures, the auditors may plan a surprise observation of
regular distributions of pay checks to employees. The auditors’ objective in observing the
distribution of checks or cash to employees on a regular payday is to determine that every
name on the company payroll is that of a bona fide employee presently on the job. These
audit payroll works are not sufficiently segregated by departments to afford good internal
control.
Objectives of major substantive tests of payrolls
Substantive Tests Primary Audit objectives
 Perform analytical procedures

 Investigate fluctuations in salaries, - Existence or occurrence
wages, and commissions completeness and valuation
 Obtain a summary of amounts of officers
compensations and trace to authorizations
 Test computations of compensations

under profit sharing or bonus plans - Valuations
 Test commissions earrings
 Test pension obligations
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Auditing II
Chapter six:
Audit of debt and Equity capital
Business corporations obtain substantial amounts of their financial resources by
incurring interest-bearing debt and by issuing capital stock. The acquisitions and
repayment of capital is sometimes referred to as the financing cycle. This transaction
cycle includes the sequence of procedures for authorizing, executing, and recording
transactions that involve bank loans, mortgages, bonds payables, and capital stock as well
as the payments of interests and dividends. In this sections, the auditor’ approach to both
debt and equity capital accounts shall be presented.
6-1: Audit of Interest bearing debt
Long term debt usually is substantial in amount and often extends over a longer time
period. Debenture, secured bond, and notes payable (sometimes secured by mortgages or
trust deeds) are the principal types of long-term debt. Debentures are backed only by the
general credit of the issuing corporation and not by liens on specific assets. Since in most
respects, debenture has the characteristics of other corporate bonds, we shall use the term
bonds to include both debentures and secured bonds payable.
The formal document creating bond indebtedness is called the indenture or trust
indenture. When creditors supply capital on a long-term basis, they often insist upon
placing certain restrictions on the borrowing company. For example, the indenture often
includes a restrictive covenant that prohibits the company from declaring dividends
unless the amount of working capital is maintained above a specific amount. The
acquisitions of plant and equipment, or the increasing of material salaries, may be
permitted only if the current ratio is maintained at a specified level and if net income
reaches a designed amount. Another device for protecting the long-term creditors is the
requirement of a sinking fund or redemption fund to be held by a trustee. If these
restrictions are violated, the indenture may provide that the entire debt is due on demand.
6.1.1:The auditors’ objectives in the audit of interest-bearing debt are to:

1. Consider internal control over interest-bearing debt
2. Determine the existence of recorded interest-bearing debt
3. Establish the completeness of recorded interest –bearing debt.
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Auditing II
4. Determine that the client has obligations to pay the recorded interest-bearing debt.
5. Establish the clerical accuracy of schedules of interest-bearing debt.
6. Determine that the valuation of interest-bearing debt is in accordance with
generally accepted accounting principles.
7. Determine that the presentation and disclosure of interest-bearing debt are
appropriate, including disclosures of the major provisions of loan agreements.
In conjunction with the audit of interest-bearing debt, the auditors will also obtain
evidence about interest expense, interest payables and bond discount and premium.
Many of the principles related to accounts payable also apply to audit of interest-bearing
debt. As in the case of accounts payable the understatement of debt is a major potential
audit problem. Related to disclosure of interest-bearing debt, the auditors must determine
whether the company has met requirements and restrictions imposed upon it by debt
agreements.
6.1.2: Audit program for interest-bearing debt- The audit program does not
provide for the usual distinction between tests of controls and substantive testing. This is
because; individual transactions will generally be examined for all large debt agreements.
To document the internal structure, the auditors will usually prepare a written description
as well as an internal control questionnaire. Questions included in a typical questionnaire
are the following.
- Are all amounts of new interest-bearing debt authorized by appropriate management?
- Is an independent trustee used for all bond issues?
- Does a company official monitor compliance with debt provisions?
- Other relevant questions
Because, transactions are few in number, but large in dollar amounts, the auditors are
generally able to substantiate the individual transactions. Therefore, testing of controls
occurs through what actually amounts to dual-purpose transactions testing.
The objective of major substantive testing procedures of interest bearing debt
transactions and balances are given in the following table.

to be addressed
1.Obtain analysis of interest-bearing debt and related
accounts Clerical accuracy
2. Examine copies of notes payable and supporting
documents Completeness
3. Confirm interest-bearing debt with payees or Existence and obligations
appropriate third parties
2. Vouch borrowing and repayments transactions to
supporting documents.
5. Perform analytical procedures to test the overall

reasonableness of interest-bearing debt and interest Completeness, Existence
expense. and valuations
6. Test the computation of interest expense, interest
payable, and authorization of discount and premium.
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Auditing II
7. Evaluate whether debt provisions have been met
8. Trace authority for issuance of debt to corporate
minutes.
9.Review notes payable paid or renewed after the
the balance sheet date.
10. Perform procedures to identify notes to related parties.
11. Send confirmation letters to financial institutions to
obtain information about financing arrangements.
12.Evaluate proper financial statement presentation and
and disclosure of interest-bearing debt and related
transactions.
6-2: Audit of Owners Equity Capital and Retained earning
Most of this section is concerned with the audit of stockholder’s equity accounts of
corporate clients; the audit of owners’ equity in partnerships and sole proprietorships is
discussed briefly near the end of the chapter.
Owners’ equity of corporate clients consists of capital stock accounts (preferred and
common) and retained earrings. Balances in the capital stock accounts change when the
corporation issues or repurchases stock. The accounts balances are not affected by
transfers of ownership of shares from one shareholder to another. Retained earnings are
normally increased by earnings and decreased by dividends payments. Additionally, a
few journal entries (e.g. prior period adjustments) may directly affect retained earnings.
Transactions in the owners’ equity accounts are generally few in number, but material in
amounts. No change may occur during the year in the capital stock accounts, and perhaps
only one or two entries will be made to the retained earnings accounts.
6.2.1: The auditors’ objectives of auditing owners’ equity
The auditors’ objectives in the audit of owners’ equity are to:

1. Consider internal control over owners’ equity
2. Determine the existence of recorded owners’ equity
3. Establish the completeness of recorded owners ‘equity.
4. Determine that the valuation of owners’ equity is in accordance with generally
5. Establish the clerical accuracy of schedules of owners’ equity
6. Determine that the presentation and disclosure of owners’ equity are
appropriate.
In conjunction with the audit of owners’ equity accounts, the auditor will also obtain
evidence about the related accounts of dividends payables and capital stock discounts and
premiums. Evidence is also gathered regarding the proper cutoff of cash receipts and
disbursements relating to the equity accounts.
Internal control over owner’s Equity- There are three principal elements of strong
internal control over capital stock and dividends. These are:
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Auditing II
1) The proper authorization of transactions by the board of directors and corporate
officers
2) The segregation of duties in handling these transactions ( preferably the use of
independent agents for stock registration and transfer and for dividend
payments)
3) The maintenance of adequate records
6-2.2: Audit program for capital stock

verification of capital stock.
1. Obtain an understanding of internal control over capital stock transactions
2. Examine articles of incorporation, bylaws, and minutes for provisions in relation
to capital stock. ( To determine existence, completeness, and obligations)
3. Obtain or prepare analyses of the capital stock accounts. ( To establish clerical
accuracy)
4. Accounts for all proceeds from stock issues. ( To establish existence,
completeness and obligations and valuation )
5. Confirm shares outstanding with the independent register and stock transfer
agent.( To establish existence, completeness and obligations )
6. For a corporation acting as its own stock register and transfer agent, reconcile the
stockholders records with the general ledger. ( To determine existence,
completeness, and obligation)
7. Determine compliance with stock option plans and with other restrictions and
preferences pertaining to capital stock.( To establish presentations and
disclosure)
Capital stock transactions are usually few in number; consequently, the auditors usually,
substantiate all transactions rather than obtaining evidences to reduce their assessment of
control risk. In additions to the proceeding steps, the auditors must, determine the
appropriate financial statements presentation of capital stock.
6-2.3: Audit of retained earning and dividends
The audit work of retained earnings and dividends includes two major steps. These are:
1) The review of retained earnings and any appropriation of retained earnings- the
auditors should review the changes in retained earning during the year.
Credits to retained earning accounts ordinarily represent amounts of net income

transferred from the income summary account.
Debit to Retained earnings accounts ordinarily includes entries for net losses,
cash and stock dividends, and for the creations or enlargement of appropriated
reserve.
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Auditing II
Appropriation of retained earnings requires specific authorization by the board of
directors. The only verification necessary for these entries is to ascertain that the
dates and amounts correspond to the actions of the board.
2) The review of dividend procedures for both cash and stock dividends- - in the
verification of cash dividends, the auditors usually, will perform the following
steps
a) Determine the dates and amounts of dividends authorized
b) Verify the amounts paid
c) Determine the amount of any preferred divided is arrears
d) Review the treatment of unclaimed dividend checks.
The auditors’ analysis of divided declarations may reveal the existence of cash dividends
declared but not paid. These dividends must be shown as liabilities in the balances sheet.
The auditors also may review the procedures for handling unclaimed dividends and
ascertain that these items are recognized as liabilities. The amount of any accumulated
divided in arrears on preferred stock should be computed. In the verification of dividend
there is additional responsibility of determining that the proper amounts have been
transferred from retained earnings to capital stock and paid-in-capital accounts for both
large and small stock dividends.
Presentations- the presentations of capital stock in the balance sheet include a complete
description of each issue. Information to be disclosed includes the title of each issue; par
or stated value; dividend rate, in any; dividend preference; conversion and call
provisions; number of shares authorized, issued and in treasure; dividends in arrears if
any ; and shares reserved for stock options or for conversions.
-Treasury stock preferably is shown in the stockholders’ equity section, at cost, as a
deduction from the combined total of paid-in capital and retained earnings.
- Changes in retained earning during the year may be shown in a separate statement or
combined with the income statement. One of the most significant points to consider in
determining the presentation of retained earnings in the balance sheet is the existence of
any restriction on the use of this retained income.
Disclosure-In evaluating client disclosure, the auditor must be aware that changes in
retained earning during the year may be shown in a separate statement or combined with
the income statement. A combined statement of income and retained earnings often is
presented. In this form of presentation, the amount of retained earnings at the beginning
of the year is added to the net income figure, dividends declared are subtracted from the
subtotal, and the final figure represents the new balances of retained earning.
Existence of any restriction on the use of retained that might be resulted form the
agreements with banks, bondholders, and other creditors commonly impose limitations
on the payment of dividends etc must be fully disclosed in the note to the financial
statements.
6.2.4: Audit of statements of cash flows
The statement of cash flows is prepared from other financial statements and from analysis
of increase and decrease in selected account balances. The amounts included in the
statements of cash flows are audited in conjunction with the audit of balance sheet and
income statements accounts. Thus, limited substantive testing is necessary. The auditors
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merely compare the amounts included in the statements of cash flows to other financial
statements balances and amounts included in the audit working papers.
Since receipts and payments must be classified in the statements of cash flows as to
whether they are from operating, investing or financing activities, the presentation and
disclosure audit objectives is especially important. The auditors must determine that the
concept of cash or cash and cash equivalents analyzed in the statements agrees with an
amount shown on the balances sheet. Finally, the auditors should ascertain that a
statement of cash flows is presented for early year for which an income statement is
presented
Chapter-Seven: Audit of Revenues and Expenses &

Completion of Audit engagements.
7.1: Audit of revenues and expenses
The doctrine of conservatism is a powerful force influencing decisions on revenues and

expenses. The concept remains important in large part due to the subjectivity involved
with many accounting estimates (as for expected future credit losses on receivables, lives
of assets, and the warranty liability for products sold). Conservatism in the valuation of
assets means that when two (or more) reasonable alternatives values are indicated, the
accountant will choose the lower amount. For valuation of liabilities, the higher amount
is chosen. Therefore, when applied to the income statement, the conservatism concept
results in a low or “conservative” income figure.
Most auditors have a considerable respect for the doctrine of conservatism. In part, this
attitude springs from the concept of legal liability to third parties. Financial statements
that understate financial positions and operating results almost never lead to legal actions
against the auditors involved. Nevertheless, auditors must recognize that overemphasis on
conservatism in financial reporting is a narrow and shortsighted approach to meeting the
needs of our society. To be of great value, financial statements should present fairly,
rather than understate, financial position and operating results.
Auditors obtain evidence about many income statement accounts concurrently with
related balance sheet accounts. Depreciation expenses, for example, are most
conveniently verified along with the plant and equipment accounts. Once the existence
and cost of depreciable assets are established, the verification of depreciation expenses is
merely an additional step. On the other hand, to verify depreciation expenses without first
establishing the nature and amount of assets owned and subject to depreciation would
obliviously be a cart-before-the horse approach. The same line of reasoning suggests that
the auditors’ work on inventories, especially in determining that inventory transactions
were accurately cut off at the end of the period, especially, is a major step toward the
verification of the income statement figures for sales and cost of goods sold.
The auditors’ examination of operations should, however, be much more than an

incidentally by-product of the examination of assets and liabilities. They use a
combination of cross-referencing, analytical procedures, and analysis of specific
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transactions to bring to light errors, omissions, and inconsistencies not disclosed in the
audit of balance sheet accounts.
Specifically, the auditors’ objectives for the audit of revenues and expenses are to:
1) Consider internal control over revenues and expenses
2) Determine the occurrence of recorded revenue and expense tractions
3) Establish the completeness of recorded revenue and expense tractions
4) Establish the clerical accuracy of schedules and revenue and expenses
5) Determine that the valuation of revenue and expenses and transactions in
accordance with generally accepted accounting principles
6) Determine that the presentation and disclosure of revenue and expenses
accounting are appropriate
7.1.1: Revenue- In this section (1) the relationship of revenue to various balances
sheet accounts and (2) the miscellaneous revenue account.
Relationship of revenue to balance sheet accounts-As pointed out previously, most

revenue accounts are verified by the auditors in conjunction with the audit of a related
assets or liabilities. The following list summarizes the revenue verified in this manner.
Balance sheet Item Revenue
Accounts receivables Sales
Note receivables Interest
Securities and other investments Interest, dividends, gains on sale,

Shares of invitee’s income
Property, plant and equipments Rent, gains on sale
Intangible assets Royalties
Miscellaneous Revenue- Miscellaneous revenues, by its very nature, is a mixture of

minor items, some nonrecurring and others likely to be received at irregular intervals. If
the client’s personnel receive a cash payment and are not sure of the source, it is likely
that it will be recorded as miscellaneous revenue. Because of the nature of items recorded
in the miscellaneous revenue account, the auditors will obtain an analysis of the account.
Among the items the auditors might find importantly included as miscellaneous revenue
are the following:
 Collections on previously written-of accounts or notes receivables

 Write-offs of old outstanding checks or unclaimed wages-in many states,
unclaimed properties revert to the state after statutory period; in such
circumstances, these write-offs should be credited to a liability accounts rather to
miscellaneous revenues.
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 Proceeds from sales of scrap- should be generally be applied to reduce cost of
goods sold, under by-product cost accounting principles.
 Rebates or refunds of insurance premiums-these refunds should be offset against
the related expenses or unexpired insurance.
 Proceeds from sale of plant assets –should be accounted for in the determination
of the gain or loss on the assets sold.
The auditor should propose adjusting journal entries to classify correctly any material
items of the types described above that have been included in miscellaneous revenues by
the client. Before conducting the audit work on revenue, the auditor should perform
analytical procedures and investigate unusual fluctuation. Material amounts of
unrecorded revenue, as well as significant misclassifications affecting revenue accounts,
may be discovered by these procedures.
7.1.2: Expenses – The auditors’ work relating to purchase and cost of goods sold was
covered in previous chapters. Hence, the concern of this section will be audit procedures
for other types of expenses.
Relationship of Expenses to Balance Sheet Accounts- The following relationships

between the balance sheet accounts and expenses accounts should be considered by
auditors in the audit of expenses.
Balance sheet Item Expenses( and costs)
Accounts and notes receivables Uncollectible accounts and notes expense
Inventories Purchases, cost of goods sold, and payroll
Property, plant and equipment Depreciation, repair and maintenance, and

depletion
Prepaid expenses and differed Various related expenses, such as rent,

Charges property, taxes, advertising, postages, and
and others
Intangible assets Amortization
Accrued liabilities Commissions, fees, bonuses, product

Warranty expenses, and others
Interest-bearing debt Interest
Substantive Testing Procedures for Selling, General, and Administrative Expenses-

for other expenses not verified in the audit of balance sheet accounts, the following
substantive tests are appropriate.
1) Perform analytical procedures related to the accounts
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a) Develop an expectation of the accounts balances- auditors develop an
expectation of the accounts balance by considering factors such as
budgeted levels, the prior-year audited balances, industry averages,
relationships among financial data, and relevant nonfinancial data.
b) Determine the amounts of difference from the expectation that can be

accepted without investigation-the auditors uses their estimate materiality
to arrive at which differences are to be investigated and which might be
expected to occur by chance. However, the extent of procedures for
analytical procedures must also be considered.
c) Compare the company’s accounts balances with the expected accounts

balance-Comparison of the revenue and expense accounts with expected
amounts may reveal significant differences that warrant investigations.
d) Investigate significant deviations from the expected accounts balances-the

starting point for investigating significant variations in expenses generally
is inquiry of management. The auditors substantiate management’s
expiations for significant variations by various means, including analyses
of accounts.
2) Obtain or prepare analysis of selected expenses accounts- the auditor may analyze
selected expense accounts such as advertising, research and development, legal
exposes and other professional fees, maintenance and repairs, and rents and
royalties.
3) Obtain or prepare analyses of critical expenses in income tax returns- income tax
return generally require schedules for officers’ salaries, directors’ fee, taxes,
travel and entertainment, contributions, and causality losses. In addition to these,
officers’ expenses account allowances are presented in the analysis of officer’s
salaries. Accordingly, the auditors should obtain or prepare analyses of any of
these expenses that were not analyzed when performing other audit steps.
7.2: Completing the audit engagements
The auditors’ opinion on the financial statements is based on all evidences gathered by
the auditors upon the last day of fieldwork, and any other information that comes to their
attention between that date and the issuance of the financial statements. To be effective,
certain audit procedures described in previous chapters can not be completed before the
end of the audit. Auditor, therefore, may apply audit procedures after the balances sheet
date in relation to many items such as the following.
i) Search for unrecorded liabilities
ii) Review the minutes of meetings
iii) Perform final analytical procedures
iv) Perform procedures to identify loss contingencies
v) Perform the review for subsequent events
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Auditing II
vi) Obtain the representation letter.
8-1: Search for unrecorded liabilities-Throughout the audit, the auditors must be alert
for any unrecorded payables. The search for unrecorded liabilities includes procedures
performed through the last day of field work such as reconciliation, confirmation
examining subsequent cash disbursements and analytical procedures which are perhaps
used to disclose unrecorded. These procedures are designed to detect liabilities that
existed at year-end but were omitted from the liabilities recoded in the client’s financial
statements. In addition to normal trade payables, that may be unrecorded, other examples
include unrecorded liabilities related to customer’s deposits recorded as credits to
accounts receivables, obligations for securities purchased but not settled at the balance
sheet date, and unbilled contractor or architect fees for a building under construction at
the audit date and unpaid attorney or insurance broker fees.
In addition to the prior audit steps, when searching for unrecorded accounts payable, the
auditors will examine transactions that were recorded following year-end. A comparison
of cash payments occurring after balance sheet date with the accounts payables trial
balances is generally the most affective means of disclosing unrecorded accounts
payable. All liabilities must eventually be paid and will, therefore, be reflected in the
account at least by the time they are paid. Regular monthly expenses, such as rent and
utilities are often posted to the ledger accounts directly from the cash disbursements
journal without any accounts payable or other liability having been set up. Therefore,
thee auditors will often examine all cash disbursements, over specific dollar amounts that
are made by the client during the subsequent periods.
The auditors should also consider sources of potential unrecorded payables such as the
following.
a) Un matched invoice and unbilled receiving report
b) Vouchers payables entered in the vouchers register subsequent to the balances sheet
date.
c) Invoices received by the client after the balances sheet date
d) Consignments in which the client acts as a consignee in which case the consignee
assumes liabilities for consigned merchandise when those goods have been sold to
third party.
When unrecorded liabilities are discovered by auditors, the next question is whether the
omissions are sufficiently material to warrant postings and adjusting.
8.2 Review the minutes of meetings-the auditor’s review the minutes of meeting of
stockholders and directors, including important subcommittees of directors such as the
audit committee and the investment committee.
The corporate minute’s book is an official record of the actions taken at meetings of
directors and stockholders. Typical of actions taken at meetings of stockholders is the
extension of authority to management to acquire or dispose of subsidiaries and to adopt
or modify pension or profit sharing plans for officers and employees. The stockholders
also customarily approve the selection of a firm of independent auditors. Representative
of the auditing firm attend the stockholders’ meetings for the purpose of assuring
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Auditing II
questions that may arise concerning internal control and the financial operation of the
business.
Minutes of directors’ meetings usually contain authorization fro important transactions
and contractual arrangements, such as the establishment of bank accounts, settings of
officers’ salaries, declaration of dividends, and formation of long-term agreements with
venders, customers, and lesser. In addition, the minutes may document discussions by the
board of pending litigation, investigation by regulatory agencies, or other loss
contingencies. Therefore, the auditors should read the minutes of meetings held through
the last day of field work. The review of the minutes of meetings includes meetings held
through the last day of field work. In completing the audit, the auditors must determine
that they have considered all minutes, including those for meetings subsequent to year-
end. They will also obtain representation from management that all minutes have been
made available.
8.3: Perform final Analytical procedures- Analytical procedures must be performed in

planning as well as for overall review purpose at the completion of the audit. Analytical
procedures involve evaluation of financial statements information by a study of relation
ships between among financial and non-financial data (SAS-56), “Analytical
procedures,” provide guidance and examples of applications of these procedures.
Essentially, the process of performing analytical procedures consists of steps:

(1) Develop an expectation of an account balances
(2) Determine the amount of differences from the expectations that can be accepted
without investigations
(3) Compare the company’s account balances with the expected account balances
(4) Investigate significant deviations from the expected account balances.
Techniques used in performing analytical procedures range in sophistication from
straight forward comparisons and ratios to complex models involving many relationships
and data from many previous years. Examples of analytical procedures includes
comparisons of revenues and expenses amounts for the current year to those of prior
periods, to industry averages, to budget levels, and to relevant non financial data, such as
units produced or hours of direct labor.
A more sophisticated analytical procedure might involve the development of an multiple
regression model to estimate the amount of sales for the year using economic and
industry.
In addition analytical procedures may involve computations of percentage relationships
of various items in the financial statements such as gross profit percentages. When the
relation ships turn out as expected, auditors are provided with evidence that the data
being reviewed are free from material error. On the data hand, unusual fluctuations in
these relationships may indicate serious problems in the financial statements and should
be investigated fully by the auditors.
Analytical procedures performed as a part of the overall review assist the auditors in
assessing the validity of the conclusions reached including the opinion to be issued. This
final review may identify areas that need to be examined further as well as provide a
consideration of the adequacy of data gathered in response to unusual or unexpected
relationships identified during the audit.
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Illustrative case
In performing analytical procedures for a marine supply store, the auditors noticed that
uncollected accounts expense, which normally had been running about 1 percent of net
sales for several years, had increased in the current year to 4 percent of net sales. This
significant variations caused the auditors to make a careful investigation of all accounts
written-off during the year and those presently past due-mostly of the uncollectible
accounts examined were found to be fictitious and thee cashier-bookkeeper then admitted
that he had created and the cashier-bookkeeper then admitted that he had created those
accounts to cover up his abstraction of cash receptions.
8-4: Perform procedures to identify loss contingencies-a loss contingency may be

defined as a possible loss, stemming from events that will be resolved as to existence and
amounts by some future events. Central to the concept of a contingent loss is the idea of
uncertainty both as to the amount of loss and whether, in fact, any loss has been incurred
i.e. its existence. This uncertainty is resolved when some future event occurs or fails to
occur.
Most loss contingencies may also appropriately be called contingent liabilities. Loss
contingencies, however, is broader term, encompassing the possible existence of
liabilities.
The audit problem with respect to loss contingencies is twofold. First, the auditors must
determine the existence of the loss contingencies. Because of the uncertainty factor, most
loss contingencies do not appear in the accounting records, and a systematic search is
required if the auditors are to have reasonable assurance that no important loss
contingencies have been over looked.
Second, the auditors must appraise the probability that a loss has been incurred and its
amount. This is mode difficult both by the uncertainty factor and also by the tendency of
the client management to maintain at least an out word appearance of optimisms.
In FASB statement No. 5, “ Accounting for contingencies”, the financial Accounting

standard board set forth the criteria for accounting for loss contingencies such losses
should be reflected in the accounting records when both of the following conditions are
met:
(1). Information available prior to the issuance of the financial stalemates indicates that it
is probable that a loss had been sustained before the balances sheet date, and
(2) The amounts of the loss can be reasonably estimated.
Recognition of the loss may involve either recognition of a liability or reduction of assets.
When a loss contingency has been accrued in the accounts, it is usually desirable to
explain the nature of the contingency in a desirable to explain the nature of the
contingency in a note to the financial statements and to disclose any exposure to loss in
excess of the amount accrued.
Loss contingencies that don not meet both of the above criteria should still be disclosed
in a not to the financial statements when there is at least a reasonable possibilities that a
loss has been incurred. This disclosure should describe the nature of the contingency and,
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Auditing II
if possible, provide an estimate loss. If the amount of loss cannot be reasonably
estimated, the disclosure should include either a range of loss or a statement that an
estimate cannot be made.
The procedures undertaken by the auditors to ascertain the existence of loss contingencies
and to assess the probability of loss vary with the nature of the contingent item.
Regardless of the procedures performed, it is important that they be extended to near the
last day of fieldwork, so that the auditors have the latest available information to evaluate
the financial statements presentation and disclosure of loss contingencies. Some of the
more frequent types of contingencies warranting financial statements disclosure includes
litigation, income tax disputes between client co. and tax authority, with respect to the
amount of income to be paid, accommodation endorsements and other guarantees of
indebtedness, accounts receivable sold or assigned with recourse, commitments to
purchase, sale and to undertake certain transaction for specified price, and so on.
The auditors procedures for loss contingencies-A summary of the auditors procedures
to detect and evaluate loss contingencies is described below.
(1) Review the minutes of directors meetings to the date of completion of fieldwork.
Important contracts, lawsuits, and dealings with subsidiaries are typical of matters
discussed in board meetings that may involve contingencies.
(2) Send a letter of inquiry to the client’s lawyers requirements
(a) A depreciation ( or evaluation of management’s description) of the nature of
pending and threatened litigation and of tax disputes.
(b) An evaluation of the likelihood of an unfavorable outcome in the matters
described
(c) An estimate of the probable loss or range, or a statement that an estimate
can not be made
(d) An evaluation of management’s description of any unasserted claims that, if
asserted, have a reasonable possibility of an adverse outcome.
(e) A statement of the amount of any legal fees.
(3) Send confirmation letters to financial institutions to request information on

contingent liabilities of the company.
(4) Review correspondence with financial institutions for evidence of accommodation
endorsements, guarantees of indebtedness, or sales or assignments of accounts
receivables.
(5) Review reports and correspondence from regulatory agencies to identify potential
assessments or fines.
(6) Obtain a representation letter from the client including that all liabilities known to
officers are recorded or disclosed.
8-5: Perform review of subsequent events-evidence not available at the close of the
period under audit often becomes available before the auditors finish their field work and
write their audit report. The auditors’ opinion on the fairness of the financial statements
may be changed considerably by these subsequent events. The term subsequent event
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Auditing II
refers to an event or transaction that occurs after the date of the balance sheet but prior to
the completion of the audit and issuance of the audit report. Subsequent events may be
classified into two broad categories.
(1) Those providing additional evidence about facts existing on or before the balance
sheet date, and
(2) Those involving facts coming into existence after the balances sheet date.
Type-1 subsequent events are event that provide additional evidence as to conditions
that existed at the balance sheet date and affects the estimates inherent in the process of
preparing financial statements. These types of subsequent events require that the financial
statements amounts be adjusted to reflect the changes in estimates resulting from the
additional evidences.
As an example, let us assume that a client’s accounts receivable at December-31 includes
one large account and numerous small ones. The large amounts due from the major
customer was regarded as a fully collectable at the year end, but during the course of the
audit engagement the customer entered bankruptcy. As a result of this information, the
auditors found it necessary to recommend an increase in the December-31 allowance for
uncollectible accounts. The bankruptcy of the customer shortly after the balance sheet
date indicates that the financial strength of the customer had probably deteriorated before
December-31, and the client was simply in error in believing the receivables to be fully
collectable at that date. Evidence becoming available after the balance sheet date through
the date of issuance of the auditors’ report should be used in making judgments about the
valuation of receivables.
Others examples of this first type of subsequent events include the following.
 Customers’ check included in the cash receipts of the last day of the year prove to
be uncollectible and are charged back to the client’s account by the bank. If the
checks were material in amounts, an adjustment of the December-31 cash balance
may be necessary to exclude the checks now known to be uncollectible.
 A new three year union contract signed two weeks after the balance sheet date
provides evidences that the clients has materially underestimated the total cost to
revenues is recognized by the percentage of completion method. The amount of
income (or loss) to be recognized using revised cost estimates.
 Litigation pending against the clients in settled shortly after the balance sheet
date, and the amount owned by the client is material. This litigation was to be
disclosed in notes to the financial statements, but no liability had been accrued
because at year end no reasonable estimate could be made of the amount of the
client’s loss. Now the competent evidence exists as to the dollar amount of the
loss, this loss contingency meets the criteria for accrual in the financial
statements, rather than mere note disclosures.
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Type-2 Subsequent events are events that involve conditions coming into existence after
the balance sheet date. These events do not require adjustments to dollar amounts shown
in the financial statements, but they should be disclosed if the financial statements other
wise would be misleading. To illustrate assume that shortly after the balance sheet date, a
client sustain an uninsured fire loss destroying most of its plant assets. The carrying value
of plant assets should not be reduced in the balances sheet because these assets were
infact at year end. However, any one analyzing the financial statements would be misled
if they were not advised that most of the plant assets are no longer in a useable condition.
It is generally agreed that the subsequent events involve business combination,

substantial causality losses, early retirements of bond payables, and other significant
changes in a company’s financial position or financial structures should be disclosed in
notes. Otherwise, the financial statements might be misleading rather than informative.
NB. In distinguishing between the two types of subsequent events and in deciding
whether particular subsequent events should result in adjustments to the financial
statements or notes disclosure, the auditors should carefully consider when the underlying
condition came into existence. E.g. Bankruptcy of client customer resulted from a steady
deterioration in financial position where the receivables were uncollectible at year end
and the allowance for doubtful accounts should be increased. On the other hand, if the
customer’s bankruptcy stemmed from casualty ( such as fire) according after year end
the conditions making the receivables uncollectible came into existence after the balance
sheet date and this subsequent event should be disclosed in a not to financial statements.
Audit procedures related to subsequent events- The period of time between the
balance sheet date and the last day of field work is called the subsequent period. During
this period, the auditors should determine that proper cut offs of cash receipts, and
disbursements and sales and purchase have been made, and should examine data to aid
the evaluation of assets and liabilities as of the balances sheet date. In addition, the
auditors should:
(1) Review the latest available interim financial statements and minutes of directors,
stockholders, and appropriate committee meetings.
(2) Inquire about matters dealt with at meetings for which minutes are not available.
(3) Inquire of appropriate clients’ officials as to loss contingencies, changes in capital
stock, debt, or working capital, changes in the current status of items estimated in
the financial statements under audit, or any unusual adjustments made subsequent
to the balance sheet date.
(4) Obtain a letter from the client’s lawyers describing as of the last day of field work
any pending litigation, unasserted claims, or other loss contingencies.
(5) Include in the representation letter a representation from the client concerning
subsequent events.
Generally, the auditors’ responsibility for performing procedures to gather evidences
as to subsequent events extends only through the last day of field work. However,
even after completing normal audit procedures, the auditors have the responsibilities
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Auditing II
to evaluate subsequent events that come to their attention. E.g. subsequent events that
become evident between the final field work day and audit report day.
8-6: Obtain Representation letters- At the conclusion of the letters summarizing the
most important oral representations made during the engagement. Many specific
items are included in this representation letter. For example, management usually
represents that all liabilities known to exist are reflected in the financial statements
most of the representation fall into the following broad categories.
1. All accounting records, financial data, and minutes of directors meetings have
been made available to the auditors of directors
2. The financial statements are complete and prepared in confirmation with generally
3. All items requiring disclosure (such as loss contingencies, illegal acts, and related
party transactions) have been properly disclosed.
SAS-19 “clients Representation” requires auditors to obtain a representation letter on
every engagements and provides suggestions as to its form and content. These letters
are dated as of the last day of field work and usually are signed by both client’s chief
executive official and chief financial officers.
NB. A client representation letter is a low grade of audit evidence and should never
be used as a substituted for performing other audit procedures. The financial
statement already constitutes written representations by the client; hence a
representation letter does little more than asset that the original representations were
correct.
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Auditing II

Chapter-One: Audit of cash and marketable securities

1.2. Auditors’ objectives of auditing cash

The auditor’s objectives in the audit of cash are to

1.3. Internal control over cash transactions

Internal control over cash receipts

2. Electronic Point-of –Sale (POS) System: In many establishments, various type

Internal control over the cash disbursements

1.4. Audit program for cash

A. Consider the internal control for cash transactions

1. Obtain an understanding of the internal control structure for cash

For cash - Are all persons receiving cash?

For cash- - Are all disbursement (except from petty cash)

B. Perform substantive tests of cash transactions and balances

The objective of major substantive testing procedures of cash transactions and

Substantive tests Primary audit objective

1.5 Audit of Marketable securities

1.5.1. The Auditors’ objectives in Examination of marketable securities

The auditors’ objectives in the examination of marketable securities are to:

1.5.2. Internal Control for Marketable Securities:

1.5.3. Audit Program for Securities

A. Consider internal control for securities

B. Perform substantive tests of securities transactions and year-end balances.

2.2. Auditors’ Objectives in auditing account receivables and sales

2.3. Internal control over sales transactions and receivables

2.3.1. Internal control over sales transactions

2. Billing of customers and recoding of sales

2.3.2. Substantive procedures for sales transactions

A. Tests of individual transactions

C. Examination of presentation and disclosure

2.3.3. Internal control over accounts receivables

2.3.4. Substantive tests for accounts receivables

2.4. Audit program for receivables and sales transactions

A. Consider the internal control for receivables and sales transactions

1. Obtain an understanding of internal control over receivables and sales transactions.

Substantive tests Primary audit objective

10. Perform analytical procedures for A/R, N/R, other

Substantive testing Primary audit objectives

13.Evaluate the propriety/ appropriateness/

16. Ascertain the existence of pledged

Chapter-Three: Audit of inventories and cost of goods sold

3.2. Auditors’ objectives in auditing inventories and cost of goods sold

1. Consider internal control over inventories and cost of goods sold.

 Maintenance of records and documents – Auditors may see important

 Whether there is any proper documentation of receipts of merchandize from

 Substantive procedures -The auditor carries the substantive procedures in

A. Examination of Records and Documents: The records maintained by different

E. Confirmation from third parties

F. Management representation letter

3.4. Audit Program For inventories and cost of goods sold

(a) Examine significant aspects of a sample of purchase transactions such as:

The objective of major substantive testing procedures of inventories and cost of

Substantive tests Primary audit objective

6. Evaluate the client’s planning of physical inventory

Substantive testing Primary audit objectives

8. Review the year end cut- cut off of purchase

4.2. Auditors’ objectives in auditing property, plant and equipment

The auditor’s objectives in the audit of fixed assets are

1. Consider internal control over property, plant and equipments.

4.3. Internal controls relating to fixed assets

2. Authorization of acquisition, transfer and disposal of fixed assets:

4. Accountability for and safeguarding of fixed assets