Approach to the audit of financial

statements
 Summary of the audit process
Objectives of the audit of financial statements

Outline Steps to develop audit objectives

Cycle approach to segment the audit
Management assertions
Audit objectives
Audit evidence
Audit tests
 Audit
process
 Audit
process
 Audit
Process
 Audit
process
Objectives of audit of financial statements
 Steps to
develop audit
objectives
Cycle approach to segment the audit
Audit is segmented by combining closely related types of transactions and account balances.
 • Claimed or expressed representations by management about
Management classes of transactions and related accounts and disclosures in the
financial statements
assertions
Audit objectives
How audit objectives are
met?

• Auditors obtain sufficient

appropriate evidence to
support audit objectives
• To do this, auditors follow an
audit process of four phases.
 Appropriateness
• Relevance
• Reliability
Sufficiency
(quantity,
sample size)

Audit
evidence
Persuasiveness
Combined effect
and cost
Types of
audit
evidence
 • Phase I: Auditors have audit strategy and plan, audit program for the
entire audit.
• Phase II:
• Obtain evidence in support of assessment of control risk

Audit
• Obtain evidence in support of the monetary correctness of
transactions

process
• Phase III:
• Obtain evidence in support of the fair presentation of account
balances and footnotes
• Phase IV:
• Accumulate additional evidence related to presentation &
disclosure, summarize results, issue report, perform other forms of
communication.
 Tests of details Risk
Audit tests of balances
(TDB)
assessment
procedures

Substantive
Tests of
analytical
controls
procedures
(TOC)
(SAP)

Substantive
tests of
transactions
(STOT)
Risk assessment
procedures
• To assess the risk of material misstatement
in the financial statements
• Usually perform in the planning stage
• Usually perform after obtaining
understanding of client business and
control environment
Tests of controls

• To evaluate whether controls are

working effectively
• Reduce substantive
procedures
• Obtain additional audit
evidence
Substantive tests

STO
SAP
T

TDB
Practice exercises
• 6-31
• 6-34
• 7-28
• 7-29
• 13-27
AUDIT SAMPLING

CHAPTER 15 & 17

Academic year 2021-2022

 1. Overview of sampling
2. Representative of samples

Outline 3. Audit Sampling method

4. Selection methods
5. Exception rate
6. Sampling for phase II vs phase III
1. Overview

• Auditors obtain sufficient

appropriate evidence to
support audit objectives
• To do this, auditors follow an
audit process of four phases.
What is SAMPLING?
 What is SAMPLING?

The selection and evaluation of less than 100 percent of the population of
audit relevance such that the auditor expects the items selected to be
representative of the population and, thus, likely to provide a reasonable
basis for conclusions about the population
 2. Representative of sample
POPULATION

1000 invoices 3%
30 unqualified

Reasonable
Highly representative Nonrepresentative
representative

3% 5% 0%

3 unqualified invoices 5 unqualified invoices 0 unqualified invoices

out of 100 samples out of 100 samples out of 100 samples
 Sampling Risk
Sampling risk Nonsampling risk

The risk that an auditor reaches an The risk that the auditor reaches an
incorrect conclusion because the sample incorrect conclusion for any reason not
is not representative of the population related to sampling risk:

• Auditor’s failure to recognize exceptions

• Inappropriate or ineffective audit procedures

Sample size Selection method Careful design of audit procedures, proper

instruction, supervision, and review
6. Samplings for phase II vs III
3. Sampling process
 5. Exception rate

The occurrence rate, or exception rate, is the ratio of the items

containing the specific attribute to the total number of population
items.

Exception rate of total

Exception rate of sample
population
 5. Exception rate

Following are types of exceptions in populations of accounting data:

1. Deviations from the client’s established controls

2. Monetary misstatements in populations of transaction data
3. Monetary misstatements in populations of account balance details
5. Exception rate
 Sampling Method
Popular Statistical

Monetary Unit
Attribute Sampling Variables sampling
Sampling

For TOC, STOT For TODB For TODB

Sampling Method
Statistical Nonstatistical

• Calculate sampling risk (SR) • Not calculate SR

• Probabilistic method • Nonprobabilistic &

Probabilistic method

• Accept/ reject the population • Accept/ reject the population

Mathematical rule Professional judgement

 4. Selection Method
Probabilistic Nonprobabilistic
sample selection sample selection

1. Simple random 1. Haphazard

2. Systematic 2. Block sample
3. Probability proportional to size
& Stratified sample

Mathematical rule Professional judgement

 Selection Method
Probabilistic
sample selection

1. Simple random
2. Systematic
 Selection Method
Probabilistic
sample selection
3. Probability proportional to size (PPS)
& Stratified sample

PPS
• Take a sample in which the probability of selecting any individual population item is proportional to
its recorded amount.
• It is evaluated using nonstatistical sampling or monetary unit statistical sampling (MUS)

Stratified sample
• Divide the population into subpopulations and take larger samples from the subpopulations with
larger sizes.
• It is evaluated using nonstatistical sampling or variables statistical sampling.
3. Sampling process

14 Detailed Steps
14 steps of
sampling
process

TOC & STOT

14 steps of Sampling method

sampling
process Statistic sampling: Nonstatistic
Attribute Sampling sampling

Same 14 steps for both approaches

TOC & STOT The main differences:

The calculation of initial sample sizes / estimated upper

exception rates are developed from statistical
probability distributions using tables or audit software
I. Planning
1. State the objectives of the audit test.
2. Decide whether audit sampling
applies.
3. Define attributes and exception
conditions.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.
II. Select Sample and Perform Test
III. Evaluate the Results
1. Objectives of TOC &STOT:
• Test the operating effectiveness of control
• Determine whether the transactions contain monetary
misstatements
2. The auditor should examine the audit program and
select those audit procedures where audit sampling
applies.
Illustration
Observe whether the duties of the accounts receivable
clerk are separate from handling cash (TOC)
=> Not apply audit sampling
Select a sample of shipping documents and trace each to
related duplicate sales invoices (TOC)
=> Apply audit sampling
I. Planning

1. State the objectives of the audit test.

2. Decide whether audit sampling
applies.
3. Define attributes and exception
conditions.
4. Define the population. When audit sampling is used, auditors must carefully
5. Define the sampling unit. define the characteristics (attributes) being tested and
6. Specify the tolerable exception rate. the exception conditions.
7. Specify acceptable risk of
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning
1. State the objectives of the audit test.
2. Decide whether audit sampling
applies.
3. Define attributes and exception
conditions.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.
II. Select Sample and Perform Test
III. Evaluate the Results
Population
• The population is those items about which the
auditor wishes to generalize.
• Sample must be selected from the entire
population as it has been defined.
• Auditor may generalize only about that population
that has been sampled.
• Completeness and detail tie-in of population should
be tested before a sample is selected
Sampling unit
• The sampling unit is the physical unit that
corresponds to the random numbers the auditor
generates.
Ex: invoice, shipping doc., customer order, pay slip
I. Planning
Tolerable exception rate TER represents the highest
1. State the objectives of the audit test. exception rate the auditor will permit in the control
2. Decide whether audit sampling being tested and still be willing to conclude the control
applies.
3. Define attributes and exception is operating effectively (and/or the rate of monetary
conditions. misstatements in the transactions is acceptable).
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of High reliance on control (important) – lower TER
overreliance. lower TER – larger sample size
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning

1. State the objectives of the audit test.

1. State the objectives of the audit test. Risk of overreliance (ROA): The risk that the auditor
2. Decide whether audit sampling concludes that controls are more effective than they
applies. actually are.
3. Define attributes and exception
conditions.
⇒ impacts the effectiveness of the audit
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of Risk of underreliance: The risk that the auditor will
overreliance. erroneously conclude that the controls are less
8. Estimate the population deviation or effective than they actually are.
exception rate. ⇒ affects the efficiency of the audit
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning

1. State the objectives of the audit test.

1. State the objectives of the audit test. ROA represent auditor measure of Sampling Risk
2. Decide whether audit sampling
applies.
3. Define attributes and exception Attribute sampling:
conditions. Quantify
4. Define the population. (5%, 10%...)
5. Define the sampling unit.
6. Specify the tolerable exception rate. Nonstatistical sampling:
7. Specify acceptable risk of High, Medium, Low
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning

1. State the objectives of the audit test.

1. State the objectives of the audit test.
2. Decide whether audit sampling
applies.
3. Define attributes and exception
conditions.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.
II. Select Sample and Perform Test
Estimated population exception rate (EPER):
Exception rate that the auditor expects to find in
the population before testing begins
• use the preceding year’s audit results to
estimate EPER.
• If prior- year results are not available, or if they
are considered unreliable, a small preliminary
sample of the current year’s population can be
tested.

III. Evaluate the Results

I. Planning
Four factors determine the initial sample size:
1. State the objectives of the audit test.
1. State the objectives of the audit test. population size, TER, ARO, and EPER.
2. Decide whether audit sampling
applies.
Attribute sampling:
3. Define attributes and exception using audit software/ table
conditions.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate. Nonstatistical sampling:
using professional judgment
7. Specify acceptable risk of
overreliance.
8. Estimate the population deviation or
exception rate.
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning

II. Select Sample and Perform Test

10. Select the sample

11. Perform the audit procedures
III. Evaluate the Results
12. Generalize from the sample to the
population.
Attribute sampling:
probabilistic method
Nonstatistical sampling:
Both probabilistic and non probabilistic method

13. Analyze the misstatements.

14. Decide the acceptability of the

population.
I. Planning

II. Select Sample and Perform Test

10. Select the sample Examining each item in the sample to determine
11. Perform the audit procedures
whether it is consistent with the definition of the
III. Evaluate the Results attribute and by maintaining a record of all the
exceptions found.
12. Generalize from the sample to the
population.
Study further in next lectures!
13. Analyze the misstatements.

14. Decide the acceptability of the

population.
I. Planning

II. Select Sample and Perform Test Calculate the sample exception rate (SER):
actual number of exceptions divided by the actual
10. Select the sample sample size.
11. Perform the audit procedures

III. Evaluate the Results Attribute sampling:

CUER at specific ARO
Using table/ audit software
12. Generalize from the sample to the
population.

13. Analyze the misstatements.

Nonstatistical sampling:
Allowance for sampling risk:
14. Decide the acceptability of the (TER – SER)
population. Must be large enough
I. Planning

II. Select Sample and Perform Test

• Analyze individual exceptions to determine
10. Select the sample the breakdown in the internal controls that
11. Perform the audit procedures allowed them to happen
- carelessness of employees
III. Evaluate the Results - misunderstood instructions
- intentional failure to perform procedures
12. Generalize from the sample to the - others
population.
• The nature of an exception and its causes
13. Analyze the misstatements. have a significant effect on the qualitative
evaluation of the system.
14. Decide the acceptability of the
population.
I. Planning

II. Select Sample and Perform Test Attribute sampling:

CUER < or = TER
10. Select the sample Population accepted
11. Perform the audit procedures
CEUR > TER
III. Evaluate the Results Population rejected
12. Generalize from the sample to the Nonstatistical sampling:
population.
SER < or = EPER
13. Analyze the misstatements. Population
Actions when accepted is rejected
the population
• Revise TER or ARO
14. Decide the acceptability of the • SERSize
Expand the Sample > EPER
population. • Population
Revise Assessed Controlrejected
Risk
• Communicate with the Audit Committee or
Management
14 steps of
sampling
process

TDB
14 steps of
sampling
process

TDB
 Sampling Method
Popular Statistical

Monetary Unit
Attribute Sampling Variables sampling
Sampling

For TOC, STOT For TODB For TODB

 Monetary Unit Sampling

MUS is an innovation in statistical sampling methodology

that was developed specifically for use by auditors.
 MUS and Nonstatistical Sampling

Differences Between MUS and Nonstatistical Sampling

• The Definition of the Sampling Unit Is an Individual Dollar

• The Population Size Is the Recorded Dollar Population
• Sample Size Is Determined Using a Formula
• Sample Selection Is Done Using PPS
• The Auditor Generalizes from the Sample to the Population Using MUS Techniques
Variables method

Difference estimation

Ratio estimation

Mean-per-unit estimation

I. Planning
1. State the objectives of the audit test.
2. Decide whether audit sampling
applies.
3. Define a misstatement.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable misstatement.
7. Specify acceptable risk of incorrect
acceptance.
8. Estimate misstatement in population
9. Determine the initial sample size.
II. Select Sample and Perform Test
III. Evaluate the Results
In tests of details of balances, the population is
defined as the items making up the recorded
dollar population.
The sampling unit is almost always the items
making up the account balance.
Tolerable misstatement may be the same
amount as performance materiality or may be
lower if the population from which the sample is
selected is smaller than the account balance.
Illustration:
The recorded population of accounts receivable in consists of 40
accounts totaling $207,295.
Population
TOC &STOT
40 items
TBD
$207,295
Sampling unit Sale invoice $1
I. Planning

1. State the objectives of the audit test.

2. Decide whether audit sampling
applies. ARIA
3. Define a misstatement.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable misstatement.
7. Specify acceptable risk of incorrect
acceptance.
8. Estimate misstatement in population ARIR
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

I. Planning

1. State the objectives of the audit test.

2. Decide whether audit sampling
applies.
3. Define a misstatement. 1. Estimate an expected point estimate
4. Define the population. 2. Make an advance population standard
5. Define the sampling unit. deviation estimate – variability of the population.
6. Specify the tolerable misstatement.
7. Specify acceptable risk of incorrect
acceptance.
8. Estimate misstatement in population
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

 Determine the initial sample size by considering the
influence factors (using professional judgement)
I. Planning

1. State the objectives of the audit test.

2. Decide whether audit sampling
applies. Nonstatistical sampling:
3. Define a misstatement.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable misstatement.
7. Specify acceptable risk of incorrect
acceptance.
8. Estimate misstatement in population
9. Determine the initial sample size.

II. Select Sample and Perform Test

III. Evaluate the Results

 Statistical sampling:
I. Planning 2
SD*(ZA + ZR)N
n=
1. State the objectives of the audit test. (TM – E*)
2. Decide whether audit sampling
applies. where:
3. Define a misstatement.
4. Define the population.
5. Define the sampling unit. n = initial sample size
6. Specify the tolerable misstatement. SD* = advance estimate of the standard deviation
7. Specify acceptable risk of incorrect ZA = confidence coefficient for ARIA
acceptance. ZR = confidence coefficient for ARIR
8. Estimate misstatement in population
N = population size
9. Determine the initial sample size.
TM = tolerable misstatement for the population
II. Select Sample and Perform Test (materially)
E* = estimated point estimate of the population
III. Evaluate the Results misstatement
 Effect on Sample Size of
Changing Factors
Effect on initial
Type of change sample size
Increase acceptable risk of
assessing control risk too low Decrease
Increase tolerable risk rate Decrease
Increase estimated population
exception rate Increase
Increase population size Increase (minor)
I. Planning

II. Select Sample and Perform Test

10. Select the sample

11. Perform the audit procedures
III. Evaluate the Results
12. Generalize from the sample to the
population.
13. Analyze the misstatements.
1. Compute the point estimate of the total
misstatement
2. Compute an estimate of the population standard
deviation
3. Compute the precision interval
4. Compute the confidence limits

14. Decide the acceptability of the

population.
 Effect of Changing Each Factor
Effect on the computed
Type of change precision interval

Increase ARIA Decrease

Increase the point estimate
of the misstatements Increase
Increase the standard deviation Increase
Increase the sample size Decrease
I. Planning
II. Select Sample and Perform Test
10. Select the sample
11. Perform the audit procedures
III. Evaluate the Results
12. Generalize from the sample to the
population.
13. Analyze the misstatements.
14. Decide the acceptability of the
population.
If the misstatement in a population larger than
tolerable misstatement
⇒ Reject the population
1. Take no action until tests of other audit areas
are completed
2. Perform expanded audit tests in specific areas
3. Increase the sample size
4. Adjust the account balance
5. Request the client to correct the population
6. Refuse to give an unqualified opinion
 The end!
Exercise 15-29, 15-30, 17-25, 17-28
Reference: VSA530
Audit of the sales and collection
cycle: tests of controls and
substantive tests of transactions

Lecture 3
Outline

❖ Accounts in sales & collection cycle

❖ Business functions, documents and records in the cycle
❖ Methodology for designing controls and tests: sales
❖ Audit test for sales returns & allowance
❖ Methodology for designing controls and tests: cash receipts
❖ Audit tests for writing off uncollectibles
 Accounts in
the sales and
collection
cycle
 Accounts Sales, Accounts receivable (credit sales),
Sales Cash in Bank (cash sales)
Business
transaction functions
Processing customer orders,
Granting credit
Shipping goods,
Billing customers and recording sales
Documents Customer order, Sales order, Shipping
and records document, Sales invoice, Sale transaction
file, Sales journal, Accounts receivable
master file and trial balance, Monthly
statements
 Accounts Cash in bank
Cash receipts
transaction Accounts receivable
Business Processing and recording
functions cash receipts
Documents Remittance advice
and records Prelisting of cash receipts
Cash receipts transaction file
Cash receipts journal or
listing
Sales returns
and allowances Accounts Sales returns and allowances
transaction Accounts receivable

Business Processing and recording sales

functions returns and allowances

Documents Credit note

and records Sales returns and allowances
journal
 Accounts Accounts receivable
Provision for Doubtful
Write-off of Debts
uncollectible Business Writing off uncollectible
accounts functions accounts receivable
transaction Documents Uncollectible account
and records authorisation form,
General journal
 Accounts Bad debt expense
Provision for
Bad debt Doubtful Debts
expense Business Providing for bad
transaction functions and doubtful debts
Documents General journal
and records
Methodology for
designing
controls
and substantive
tests of
transactions for
sales
Understanding internal control - sales

Study the client’s flowcharts,

prepare an internal control
questionnaire, and perform
walk-through tests of sales
 Framework for assessing control risk (6
transaction-related audit objectives)

Assess Identify key internal controls and

deficiencies
planned
control risk Associate controls and deficiencies
– sales with the objectives

Assess control risk for each objective

Example
 Assess planned control risk –
sales

Adequate Adequate
Proper Pre-numbered Internal Monthly
separation of document and
authorisation documents verification statement
duties records
 Occurrence Recorded sales are for shipments
actually made to existing customers

Completeness Existing sales transactions are

recorded
Transaction- Accuracy Recorded sales are for the amount
shipped
related audit and are correctly billed and recorded
objectives -
Sales Classification Sales transactions are properly
classified
Timing Sales are recorded on the correct
dates
Posting and Sales transactions are properly
summarisation recorded in the accounts receivable
master file and are correctly
summarised
Direction of tests for sales
 Transaction-related audit
objectives
Key internal controls
Summary of
methodology Test of controls
for sales Deficiencies

Substantive tests of transactions

 Objectives and
methodology are essentially
the same as sales
Sales
returns and
allowances Two differences

• Materiality
• Emphasis on occurrence
 Determine Determine key internal controls for each audit objective

TOC and
STOT for Design Design tests of control for each control used to support a
reduced control risk
cash
receipts
Design substantive tests of transactions to test for
Design monetary misstatements for
 Occurrence Recorded cash receipts
are for funds actually received

Transaction- Completeness Cash received is recorded in the cash

receipts journal
related audit
objectives – Accuracy Cash receipts are deposited and
recorded at the amounts received
Cash receipts
Classification Cash receipts transactions are
correctly classified
Timing Cash receipts are recorded on the
correct dates
Posting and summarisation Cash receipts are correctly included
in the accounts receivable master
file and are correctly summarized
 Audit procedures for discovery of fraud
Determine whether cash received was recorded

Prepare proof of cash receipts*

Test to discover lapping of accounts receivable*

* Only performed when fraud is suspected

 Occurrence transaction-related
Audit tests audit objective

for Proper authorization of the write-

uncollectible off of uncollectible accounts

accounts Verification of accounts written

off
Audit tests for sales & collection cycle
 The end!
Exercise 14 -24, 14-25, 14-26
Reference: C110
Completing the tests in the
sales and collection cycle:
accounts receivable
Lecture 4
Outline

❖Methodology for designing substantive tests – A/R

❖Design and perform analytical procedures
❖Design and perform test of details of balance for A/R
❖A/R confirmation
Methodolog
y for
designing
tests of
balances –
accounts
receivable
Accounts receivable balance-related audit
objectives
Existence Recorded accounts receivable exist
Completeness Existing accounts receivable are included
Accuracy Accounts receivable are accurate
Classification Accounts receivable are correctly classified
Detail tie in Accounts receivable in the aged trial balance agree with related
master file amounts, and the total is correctly added and agrees
with the general ledger
Cut off Cutoff for accounts receivable is correct
Realisable value Accounts receivable is stated at realizable value
Rights The client has rights to accounts receivable
 Identify significant
Obtain understanding of
business risks that
the client’s industry and
affect the financial
business
Phase I- statements

Identify
ROMM Perform preliminary
analytical procedures
Assess inherent risk for
for indication of
accounts, including A/R
material misstatements
in the A/R
 Decide preliminary judgement
about materiality for the entire
financial statements (in audit
Phase I – Set planning)

performance
materiality Allocate performance materiality
to significant balance sheet
accounts, including A/R
 Controls that
prevent or
detect
embezzlements

Phase I –
Assess
control risk
o t he l e
t e d t lectib Co
nt r
a l
l s rel unco ols
ove
o r s
o ntr ce fo ount r cut
C an cc off
w a
allo
 Relationship
between
transaction-
related and
balance-related
objectives
 Compare

Analytical • Gross margin percentage with previous years

• Sales by month over time
procedures for
• Sales returns and allowances as a percentage of
the sales and gross sales with previous years
collection
cycle
by product line
 Compar
e balances over a set
• Individual customer
amount
Analytical • Bad debt expense as a percentage of gross
procedures for sales
• Days that accounts receivable are
the sales and outstanding
collection cycle

with previous
years
 Compar
e
• Aging category as a percentage of
receivables
Analytical • Provision for doubtful debts as a
procedures for percentage of accounts receivable
the sales and • Write-off of uncollectible accounts
as a percentage of total accounts
collection cycle receivable

with previous
years
 Tests of details of A/R balance
Detail tie in A/R are correctly added and agree with the master file (S/L) and
general ledger
Existence Confirmation
Examine supporting documents and check to subsequent cash receipts
for non responses
Completeness Foot A/R trial balance and reconcile with G/L.
Substantive tests of transactions for shipments
Substantive analytical procedures
Accuracy Confirmation
Examine supporting documents for shipments and cash receipts
Classification Review aged trial balance for material receivables from affilliates,
officers, other related parties
Verify notes receivable, long term receivables, and credit balance A/R
 Tests of details of A/R balance
Cut off Sales cutoff test
Sales returns and allowances cutoff
Cash receipts cutoff
Reliasable value Review client’s credit policy and results of TOCs over credit approval
Examine unpaid A/R balance, review credit files, correspondence files,
inquire management
Verify the appropriateness of percentage of allowances
Recalculate bad debt expense
Rights Review the minutes, correspondence files, debt contracts
Discuss with the client
Confirm with banks
Presentation & Some tests are often done with tests to meet the balance-related audit
disclosure objectives
Review A/R for separate disclosures as required by accounting standards
 a direct written response from a
third party

Confirmation to satisfy the existence, accuracy,

and cutoff objectives.

auditing standards indicate that

auditors should use external
confirmations for accounts
receivable
Confirmations • Accounts receivable are immaterial
are commonly • The auditor considers confirmations
used in ineffective evidence because response
rates may be inadequate or unreliable
practice, • The combined level of inherent risk and
except where control risk is low and other substantive
evidence can be accumulated to provide
sufficient evidence
Type of confirmation

Positive
confirmation

Invoice
Blank confirmation form
confirmation

Negative
confirmation
Timing

The most reliable evidence

from confirmations is obtained
when they are sent as close to
the balance sheet date as
possible
 Tolerable error

Inherent risk

Sample size Control risk

Achieved detection risk from other substantive tests

Type of confirmation
 Audit focus is on
$ value (e.g. audit
overstatement of
material balances &
receivables, so
random sample of
stratification is
others.)
desirable:
Selection of
items for
testing Age of balance
When selecting a
sample of accounts
receivable for
(overdue balances confirmation, the
have higher risk of auditor should be
non-collection) careful to avoid being
influenced by the
client
Issues

▪ Maintaining control of the process

▪ Follow up of non-responses

▪ Analysis of differences

▪ Drawing suitable conclusions

 Maintaining • The auditor must maintain control of the
control of confirmations until they are returned from the
customer
the process

Issues
• When positive confirmations are used, auditing
standards require follow-up procedures for
Follow up confirmations not returned by the customer
• Alternative procedures
of non- • Subsequent cash receipts

responses • Duplicate sales invoices

• Shipping documents
• Correspondence with the client
 Subsequent cash receipts

• Examine remittance advices, entries in the cash receipts

records, or perhaps even subsequent credits in the accounts
receivable master file.

Duplicate sales invoices

Alternative • These are useful in verifying the actual issuance of a sales
procedures invoice and the actual date of the billing

Shipping documents

• These are important in establishing whether the shipment

was actually made and as a test of cutoff

Correspondence with the client: covers disputed

and questionable receivables
Analysis of differences

Payment has already Goods have not been

been made received

The goods have been Clerical errors and

returned disputed accounts
 1 2 3
Drawing
conclusions Re-evaluate
internal control
Evaluate the
qualitative nature
of errors
Determine if
sufficient evidence
was obtained
 THE END!

Exercise:
16-25, 16-26 (16-27 optional)
Reference: D330, D331, D333
 Audit of the Acquisition and
Payment Cycle: Tests of Controls,
Substantive Tests of Transactions,
and Accounts Payable
Lecture 5
Outline

• Accounts and classes of transactions in acquisition and payment cycles

• Business functions, documents and records in the cycle
• Methodology for designing tests of control and substantive tests for
acquisitions
• Methodology for designing tests of balances for accounts payable
• Reliability of evidence
Classes of transactions in the Acquisition and Payment Cycle

1. ACQUISITIONS OF 2. CASH DISBURSEMENTS 3. PURCHASE RETURNS

GOODS AND SERVICES AND ALLOWANCES AND
PURCHASE DISCOUNTS
 Accounts in
the
Acquisition
and Payment
Cycle
Business
PROCESSING PURCHASE RECEIVING GOODS AND
ORDER SERVICES

Functions in
the Cycle

RECOGNISING THE PROCESSING AND

LIABILITY RECORDING CASH
DISBURSEMENTS
Related Documents and Reports
Methodolog
y for
Designing
Controls and
Substantive
Tests
TOC and STOT for acquisition and payment
cycle

Tests of acquisitions:
processing purchase Tests of payments:
orders, receiving processing and
goods and services, recording cash
and recognizing the disbursements
liability
Key internal controls

Authorization of purchases

Separation of Asset Custody from

Other Functions

Timely Recording and

Independent Review of
Transactions

Authorization of Payments
 Relate each of the internal controls to
transaction-related audit objectives

Design TOC &

STOT - Relate tests of controls to internal
controls

Acquisitions
Relate substantive tests of transactions
to transaction-related audit objectives
after considering controls and
deficiencies in the system
 Transaction-related audit objectives - acquisition

Occurrence Recorded Acquisitions Are for Goods and Services Received

Completeness Existing Acquisitions Are Recorded

Accuracy Acquisitions Are Accurately Recorded

Classification Acquisitions Are Correctly Classified

Timing Acquisition transactions are recorded on the correct dates

Posting and Acquisition transactions are properly recorded in the accounts

summarisation payable and inventory master file and are correctly summarized
Methodology for
Designing Tests
of Balances for
Accounts Payable
Analytical Procedures for the Acquisition and Payment Cycle
Design and
perform tests
of details of Two types of liability tests
balances for • Out-of-period liability tests
accounts • Cut-off test
payable
Out-of-liability tests

Examine underlying Examine underlying

Trace receiving reports
documentation for documentation for bills
issued before year-end to
subsequent cash not paid several weeks
related vendors’ invoices
disbursements after the year-end

Trace vendors’
statements that show a Send confirmations to
balance due to the vendors with which the
accounts payable trial client does business
balance
 Relationship of Cutoff to
Physical Observation of
Inventory

Cut-off test
Inventory in Transit
 Reliability of Evidence

A vendor's statement is a document made by the vendor but is in

the hands of the client

A confirmation is sent directly to the auditor by the vendor

 A vendor's statement includes
only total amounts of the
transaction
Reliability of
Evidence
A vendor’s invoice includes
units acquired, price, and other
data
 THE END!

Exercise:
18-21, 18-22, 18-25
Reference: C210, E230, E231, E233
Audit of acquisition and
payment cycle
Lecture 6
 Accounts associated with the acquisition
and payment cycle
Audit of property, plant and equipment
Outline
Audit of prepaid expenses

Audit of acrrued liabilities

Audit of income and expense accounts

Accounts associated with the acquisition and payment cycle
Audit of property, plant and equipment
Equipment and related accounts
 Perform Perform substantive analytical procedures

Verify Verify current year acquisitions

Audit of
Verify
equipment
Verify current year disposals

and related Verify Verify the ending balance in the asset account

accounts
Verify Verify depreciation expense

Verify Verify the ending balance in accumulated depreciation

Substantive analytical procedures
 Detail tie in:
• Foot the acquisition schedule.
Current
• Trace the individual acquisitions to the
acquisitions agree master file.
with the master • Trace the total to the general ledger
file.

Balance- Existence: Current • Examine vendors’ invoices and receiving

related audit acquisitions as
listed exist.
reports
• Physically examine assets
objectives
Completeness: • Examine vendors’ invoices of closely
Existing related accounts to uncover items that
acquisitions are should be manufacturing equipment.
recorded • Review lease and rental agreements
 Accuracy: Current
year acquisitions as • Examine vendors’ invoices
listed are accurate

Classification: Current • Examine vendors’ invoices in manufacturing equipment

Balance- year acquisitions as

listed are correctly
account.
• Examine vendors’ invoices of closely related accounts.

related audit classified. • Examine rent and lease expense for capitalizable leases

objectives Cutoff: Current year

acquisitions are • Review transactions near the balance sheet date for
recorded in the correct period
correct period

Rights: The client has

rights to current year • Examine vendors’ invoices
acquisitions
 Review Review whether newly acquired assets
replace existing assets

Analyze Analyze gains and losses on disposal

Verify
current year
disposals Review Review documents for indications of
deletion of equipment

Make inquiries about the possibility of the

Make disposal of assets
Verify ending All recorded equipment
balance of physically exists on the
asset balance sheet date (Existence)
accounts

All equipment owned is

recorded (Completeness)
 • The most important objective is
Verify accuracy.
depreciation • Consistent depreciation policy
• Correct calculations
expense
 Accumulated depreciation as
Verify ending stated in the property master file
agrees with the general ledger.
balance in
accumulated
depreciation Accumulated depreciation in the
master file is accurate.
Audit of prepaid expenses

Substantive analytical Some assets are

procedures are often significant and require
sufficient for prepaid complex judgement that
expenses, deferred need involvement of
charges, and intangibles specialist
 Controls over acquisition and
Prepaid recording of insurance
insurance – • Proper authorization is an important control
Internal
controls Insurance register

• auditor independently verifies terms and

amounts of insurance policies or contracts

Insurance expense
 Compare Compare total prepaid insurance and insurance expense with
previous years

Prepaid
insurance – Compute Compute the ratio of prepaid insurance to insurance expense and
compare it with previous years

Audit tests
Compare Compare the individual insurance policy coverage on the schedule of
insurance obtained with the preceding year’s schedule

Compare Compare the computed prepaid insurance balance for the current
year on a policy-by-policy basis with that of the preceding year.

Review Review the insurance coverage listed on the prepaid insurance

schedule with an appropriate client official or insurance broker
 Existence and completeness: Insurance policies in the
Prepaid prepaid insurance schedule exist and existing policies are
listed.
insurance – Rights: The client has rights to all insurance policies in the
Balance- prepaid insurance schedule

related Accuracy and detail tie-in: Prepaid amounts are accurate,

objectives and the total is correctly added and agrees with the general
ledger.
Classification: Insurance expense is properly classified.

Cutoff: Insurance transactions are recorded in the proper

period
 Completeness
Audit of
accrued
liabilities Accuracy: consistent treatment
of the accrual from year to year
Audit of income and expense accounts
 • Both tests of controls and
Tests of substantive tests of transactions
have the effect of simultaneously
Controls and verifying balance sheet and income
Substantive statement accounts

Test of
Transactions
 Repairs and maintenance
expense accounts

Expense
account Rent and lease expenses

analysis

Legal expense
 Several expense accounts result from the
Tests of allocation of accounting data rather than
Details of discrete transactions
Account
Balances – These include depreciation, depletion, and the
amortization of copyrights and catalog cost
Allocation

The allocation of manufacturing overhead

between inventory and cost of goods sold is an
example of a different type of allocation that
affects expenses
 The End!
Exercise:
19-20, 19-21, 19-22 (19-19 optional)
Reference: C510, D630, D730, D830, E530, E630