Auditing Pri and Pra II Cha All Stu

AUDITING PRINCIPLE AND PRACTICE II
CHAPTER ONE
1. TESTING AND AUDIT SAMPLING
1.1 Rationale for and Methods of Audit Sampling
Audit sampling refers to the process of using auditing procedures to test less than 100 percent of
various items in a company‟s account balance such that each unit may have an equal opportunity
of being selected. Thus audit sampling can be defined as the process of selecting a subset of a
population of items for the purpose of making inferences to whole population. In auditing,
sampling procedures are used because it is not practical to examine every single item in a
population.
 Audit sampling is used to conduct tests of controls and substantive tests.
 Audit sampling helps auditors on doing their audit work at a given period of time.
 Audit sampling helps to detect error and any material misstatements.
 Whenever auditors select a sample from a population, the objective is to obtain a
representative one
 A representative sample is one in which the characteristics in the sample of audit
interest are approximately the same as those of the population
 A sample result can be non representative due to non sampling error or sampling
error. The risk of these two types of errors occurring is called non sampling risk and
sampling risk, respectively.
 Non sampling risk is the risk that audit tests do not uncover existing exceptions in the
sample
The two causes of non sampling risk are:
I. The auditor‟s failure to recognize exception because of exhaustion, boredom, or
lack of understanding of what to look for.
II. Inappropriate or ineffective audit procedures.
 Sampling risk is the risk that an auditor reaches an incorrect conclusion because the
sample is not representative of the population.
 Sampling risk is an inherent part of sampling that result from testing less than the
entire population.
Instructor Alelign Asrat (MSc AcFn) 1

Auditors have two ways to control sampling risk:
I. Adjust sample size.
II. Use an appropriate method of selecting sample items from the population.
 Increasing sample size reduces sampling risk, and vice versa.
 At one extreme, a sample of all the items of a population has a zero sampling risk.
 At the other extreme, a sample of one or two items has an extremely high
sampling risk.
Audit Sample Selection Methods
Audit sampling methods can be divided into two broad categories: statistical sampling and non-
statistical sampling.
A. Statistical (Probabilistic) Sampling Method
 Through the application of mathematical rules,
 It allows the quantification (measurement) of sampling risk in planning the sample
and evaluating the results.
 Every population item has equal chance of being selected
Statistical (Probabilistic) Sample selection methods include the following techniques.
I. Simple Random Selection
II. Systematic Sampling Selection
III. Stratified Sampling
IV. Probabilistic Proportion to Sample Size
V. Cluster Sampling
I. Simple Random Selection
 every sample unit should have the same probability of being selected as every other
sample unit in the population
 Suppose an auditor decides to select 100 sample from a total of 12,000 cash
disbursement transactions for the year.
 Every transaction will be listed on a separate paper by assigning a number then the
auditor can pick 100 sample randomly from the list.
II. Systematic Sampling Selection
 First, the auditor determines the population and sample size to be taken for evaluation
 Then, the auditor picks the sample systematically from the population

 Divides the number of sampling units within a population into the sample size to
generate a sampling interval.
 The auditor selects the items for the sample based on the size of the interval.
 The first item in sample is selected at random.
 Suppose 1000 pre-numbered sales invoices and 100 sample; the auditor can
calculate an interval to pick the sample item as follows:
Interval
 The auditor then select one invoice randomly from 1 to 10; assumes the numbers
selected is 5, and then the remaining numbers are easily determined by adding the
interval 10 on this number
 Therefore, the sample selected are sales invoices with numbers 5, 15, 25, 35, 45, 55,
65, 75, 85, 95,... 985, 995.
III. Stratified Sampling
 Stratification is the process of dividing members of the population into
homogeneous subgroups before sampling.
 The strata should be mutually exclusive: every element in the population must be
assigned to only one stratum
 The strata should also be collectively exhaustive: no population element can be
excluded.
 Then random or systematic sampling is applied within each stratum.
 This often improves the representativeness of the sample by reducing sampling error
 Example :- Account Receivable Stratification
 Strata 1 Account Receivable greater than br. 5,000 total with total population 220
 Strata 2 Account Receivable between br. 1,000- br. 5,000 total with total
population 1,210
 Strata 3 Account Receivable less than br. 1,000 total with total population 850
 Strata 4 Account Receivable all credit balance total with total population 140
 10% sample size = 242
IV. Probabilistic Proportion to Sample Size

 The representative samples are usually selected based on the proportionate size of
the amount on each sampling unit.
V. Cluster Sampling
 The population that is being sampled is divided into groups called clusters
 The subgroup is heterogeneous as possible to matching the population
 A random sample then taken from within one or more selected clusters
B. Non-Statistical (Non-Probabilistic) Sampling Method
 Auditor does not quantify sampling risk
 Sample items are selected by professional judgment of the auditor
 Conclusions are reached about populations on judgmental basis.
Non-Statistical (Non-Probabilistic) sample selection methods include the following
I. Direct Sampling Method
II. Block Sampling Method
III. Haphazard Sampling Method
I. Direct Sampling Method
 Auditors deliberately select each item in the sample based on their own judgmental
criteria instead of using random selection.
 Is the use of professional judgment in selecting sample items for test of transaction
 When sample size is small, a random sample is often unlikely to provide a
representative sample
II. Block Sampling Method
 This method of sampling involves selecting a block (blocks) of contiguous items from
within a population. Hence several items are selected in sequence forming „„blocks‟‟ of
items.
 For example, assume the block sample will be a sequence of 100 sales transactions
from the sales journal for the third week of March. Auditors can select the total sample of
100 by taking 5 blocks of 20 items, 10 blocks of 10 items, 50 blocks of 2 items or 1 block
of 100 items.
III. Haphazard Sampling Method
 This method assumes selection of sample without regard to size, source, or
distinguishing characteristics.

 When the auditor uses this method of sampling, he does so without following a
structured technique
1.2 Audit Sampling for Tests of Controls
1.3 Audit Sampling for Substantive Tests
Tests of controls are used to determine the client‟s internal control systems comply with the
stated policies, plans, laws and regulations. Auditors evaluate the design of controls and
determine if the controls are in operation. They must also obtain evidence whether the controls
are operating effectively.
Tests of controls are established to detect material error and whether the controls are operating
effectively throughout the period being audited. Normally tests of control provide information as
to the rate of error in terms of control failure rather than to enable direct extrapolation in terms of
monetary errors in the financial statements
Substantive tests are conducted to provide audit evidence to the completeness, accuracy and
validity of the information contained in the financial statements.
Substantive tests are designed to detect material misstatements that may exist in the financial
statements. Hence the sampling techniques should be designed in such a way that auditors are
able to estimate the amount of misstatement in a particular account balance. Based on the sample
results therefore auditors are able to conclude whether there is high risk of material misstatement
in the account balance
Audit Sampling Steps
Audit sampling is applied to tests of control and substantive tests of transactions through a set of
14 well defined steps
These steps are divided into three sections (phases) given below.
A. Plan the sample
B. Select the sample and perform the tests
C. Evaluate the results
A. Plan the Samples
1. State the objective 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 (TER)
7. Specify acceptable risk of assessing control risk too low
8. Estimate the population exception rate
9. Determine the initial sample size
B. Select the Sample and Perform the Audit Procedures
10. Select the sample
11. Perform the Audit procedures
C. Evaluate the Results
12. Generalize from the Sample to the Population
13. Analyze Exceptions:
14. Decide the Acceptability of the Population
A. Plan the Sample
1. State the Objectives of the Audit Test
The overall objectives of tests of controls and substantive tests of transactions:
 Test the operating effectiveness of controls
 Determine whether the transactions contain monetary misstatements
2. Decide Whether Audit Sampling Applies
Audit sampling applies whenever the auditor plans to reach conclusions about a population based
on a sample.
 The auditor should examine the audit program and select those audit procedures
where audit sampling applies.
 Audit sampling does not apply for some procedures in a given audit program.
3. Define Attributes and Exception Conditions.
When audit sampling is used, auditors must carefully define the characteristics (attributes) being
tested and the exception conditions. Exception or Misstatement: a difference that affects the
correctness of the overall account balance.
Example: ''Credit is approved'' is an attribute for tests of billing function of ABC Trading and
''Lack of initials indicating credit approval'' is the related exception condition.
4. Define the Population.

Audit population refers to all items constituting an account balance or class of transactions
defined by auditor‟s characteristic of interest. The population is those items about which the
auditor wishes to generalize.
Auditors can define the population to include any items they want, but when they select the
sample, it must be selected from the entire population as it has been defined.
5. Define the Sampling Unit.
Sampling units are the individual auditable elements as defined by the auditor. Auditor needs
assurance that the list accurately represents the population. The sampling unit is the physical unit
that corresponds to the random numbers the auditor generates. It is often helpful to think of the
sampling unit as the starting point for doing the audit tests.
For the sales and collection cycle, the sampling unit is typically a sales invoice or shipping
document number. For example, if the auditor wants to test the occurrence of sales, the
appropriate sampling unit is sales invoices recorded in the sales journal.
6. Specify the Tolerable Exception Rate (TER).
Exception rate that the auditor will permit in the population and still be willing to conclude the
control is operating effectively and/or the amount of monetary misstatements in the transactions
established during planning is acceptable (tolerable materiality).
 TER is the result of auditor judgment and is affected by materiality.
 More controls operating for an audit objective result in higher TER.
 High TER => Low sample size; Low TER =>High sample size
7. Specify Acceptable Risk of Assessing Control Risk Too Low (ARACR).
The risk that the auditor is willing to take of accepting a control as effective or a rate of monetary
misstatements as tolerable, when the true population exception rate is greater than TER.
 ARACR is a measure of sampling risk.
 The lower the assessed CR => The lower the ARACR => The fewer tests of detailed
balances.
8. Estimate the Population Exception rate (EPER).
Estimated population exception or error rate is exception rate that the auditor expects to find in
the population before testing begins.
 EPER is a judgmental estimate based on knowledge of client.
 Low EPER => Low sample size.

 As EPER approaches TER, more precision is needed and larger sample size is needed.
9. Determine the Initial Sample Size.
Initial sample size refers to sample size decided after considering the above factors in planning.
II. Select the Sample and Perform the Tests
10. Select the Sample.
After auditors determine the initial sample size for the audit sampling application, they must
choose the items in the population to include in the sample. Auditors can choose the sample
using any of the probabilistic or non-probabilistic methods as discussed above.
11. Perform the Audit Procedures.
The auditor performs the audit procedures by examining each item in the sample to determine
whether it is consistent with the definition of the attribute and by maintaining a record of all the
exceptions found.
III. Evaluate the Results
12. Generalize from the Sample to the Population.
13. Analyze Exceptions.
14. Decide the Acceptability of the Population

CHAPTER TWO
2. AUDIT OF THE SALES AND COLLECTION CYCLE
2.1 Overview of the Cycle

The overall objective in the audit of the sales and collection cycle is to evaluate whether the
account balances affected by the cycle are fairly presented in accordance with accounting
standards. The figure below shows typical accounts included in the sales and collection cycle
using “T” accounts. The nature of the accounts may vary, of course, depending on the industry
and client involved. There are differences in the nature and account titles for a service industry, a
retail company, and an insurance company, but the key concepts remain the same. To provide a
frame of reference for understanding the material in this chapter, let‟s assume we‟re dealing with
a wholesale merchandising company. The figure shows the way accounting information flows
through the various accounts in the sales and collection cycle. This figure shows that there are
five classes of transactions in the sales and collection cycle:
1. Sales (cash and sales on account)
2. Cash receipts
3. Sales returns and allowances
4. Write-off of uncollectible accounts
5. Estimate of bad debt expense

Figure- Accounts in the Sales and Collection Cycle
As shown in the above figure, with the exception of cash sales, every transaction and amount is
ultimately included in one of two balance sheet accounts, accounts receivable or allowance for
uncollectible accounts. For simplicity, we assume that the same internal controls exist for both
cash and credit sales.
The sales and collection cycle involves the decisions and processes necessary for the transfer of
the ownership of goods and services to customers after they are made available for sale. It begins
with a request by a customer and ends with the conversion of material or service into an account
receivable, and ultimately into cash.
There are eight business functions for the sales and collection cycle. They are
 Processing customer orders
 Granting credit
 Shipping goods
 Billing customers and recording sales
 Processing and recording cash receipts
 Processing and recording sales returns and allowances
 Writing off uncollectible accounts receivable
 Providing for bad debts

They occur in every business in the recording of the five classes of transactions in the sales and
collection cycle. The first four processes are for recording sales, while every other class of
transactions includes only one business function.
In this chapter, the eight businesses functions and describe typical documents and records for
each function are explained. Before auditors can assess control risk and design tests of controls
and substantive tests of transactions, they need to understand the business function.
A. Processing Customer Orders
A customer‟s request for goods initiates the entire cycle. Legally, it is an offer to buy goods
under specified terms. The receipt of a customer order often results in the immediate creation of
a sales order.
Customer Order A customer order is a request for merchandise by a customer. It may be
received by telephone, letter, a printed form that has been sent to prospective and existing
customers, through sales people, electronic submission of the customer order through the
Internet, or other network linkage between the supplier and the customer.
Sales Order A sales order is a document for communicating the description, quantity, and
related information for goods ordered by a customer. This is often used to indicate credit
approval and authorization for shipment.
B. Granting Credit
Before goods are shipped, a properly authorized person must approve credit to the customer for
sales on account. Weak practices in credit approval often result in excessive bad debts and
accounts receivable that may be uncollectible. An indication of credit approval on the sales order
often serves as the approval to ship the goods. In some companies, the computer automatically
approves a credit sale based on preapproved credit limits maintained in a customer master file.
The computer allows the sale to proceed only when the proposed sales order total plus the
existing customer balance is less than the credit limit in the master file
C. Shipping Goods
This critical function is the first point in the cycle at which the company gives up assets. Most
companies recognize sales when goods are shipped. A shipping document is prepared at the time
of shipment, which can be done automatically by a computer, based on sales order information.
The shipping document, which is often a multi copy bill of lading, is essential to the proper

billing of shipments to customers. Companies that maintain perpetual inventory records also
update them based on shipping records.
D. Billing Customers and Recording Sales
Because billing customers is the means by which the customer is informed of the amount due for
the goods, it must be done correctly and on a timely basis. The most important aspects of billing
are:
 All shipments made have been billed (completeness)
 No shipment has been billed more than once (occurrence)
 Each one is billed for the proper amount (accuracy)
Billing the proper amount is dependent on charging the customer for the quantity shipped at the
authorized price, which includes consideration for freight charges, insurance, and terms of
payments.
E. Processing and Recording Cash Receipts
The four sales transaction functions are necessary for getting the goods into the hands of
customers, correctly billing them, and reflecting the information in the accounting records. The
remaining four functions involve the collection and recording of cash, sales returns and
allowances, write-off of uncollectible accounts, and providing for bad debt expense.
Processing and recording cash receipts includes receiving, depositing, and recording cash. Cash
includes currency, checks, and electronic funds transfers. The most important concern is the
possibility of theft. Theft can occur before receipts are entered in the records or later. It is
important that all cash receipts are deposited in the bank at the proper amount on a timely basis
and recorded in the cash receipts transaction file. This file is used to prepare the cash receipts
journal and update the accounts receivable and general ledger master files
F. Processing and Recording Sales Returns and Allowances
When a customer is dissatisfied with the goods, the seller often accepts the return of the goods or
grants a reduction in the charges. The company prepares a receiving report for returned goods
and returns them to storage. Returns and allowances are recorded in the sales returns and
allowances transaction file, as well as the accounts receivable master file. Credit memos are
issued for returns and allowances to aid in maintaining control and to facilitate record keeping.

G. Writing Off Uncollectible Accounts Receivable
Regardless of the diligence of credit departments, some customers do not pay their bills. After
concluding that an amount cannot be collected, the company must write it off. Typically, this
occurs after a customer files for bankruptcy or the account is turned over to a collection agency.
Proper accounting requires an adjustment for these uncollectible accounts.
H. Providing for Bad Debts
Because companies cannot expect to collect on 100% of their sales, accounting principles require
them to record bad debt expense for the amount they do not expect to collect. Most companies
record this transaction at the end of each month or quarter.
2.2 Key Internal Control
Key control activities for sales are discussed below.
Adequate Separation of Duties
Proper separation of duties helps prevent various types of misstatements due to both errors and
fraud. To prevent fraud, management should deny cash access to anyone responsible for entering
sales and cash receipts transaction information into the computer. The credit-granting function
should be separated from the sales function, because credit checks are intended to offset the
natural tendency of sales personnel to optimize volume even at the expense of high bad debt
write-offs. Personnel responsible for doing internal comparisons should be independent of those
entering the original data. For example, comparison of batch control totals with summary reports
and comparison of accounts receivable master file totals with the general ledger balance should
be done by someone independent of those who input sales and cash receipt transactions.
Proper Authorization
The auditor is concerned about authorization at three key points:
1. Credit must be properly authorized before a sale takes place.
2. Goods should be shipped only after proper authorization.
3. Prices, including basic terms, freight, and discounts, must be authorized.
The first two controls are meant to prevent the loss of company assets by shipping to fictitious
customers or those who will fail to pay for the goods. Price authorization is meant to ensure that
the sale is billed at the price set by company policy. Authorization may be done for each
individual transaction or general authorization may be given for specific classes of transactions.
General authorizations are often done automatically by computer.

Adequate Documents and Records
Because each company has a unique system of originating, processing, and recording
transactions, auditors may find it difficult to evaluate whether each client‟s procedures are
designed for maximum control. Never-theless, adequate record-keeping procedures must exist
before most of the transaction related audit objectives can be met. Some companies, for
example, automatically prepare a multi-copy pre-numbered sales invoice at the time a customer
order is received. Copies of this document are used to approve credit, authorize shipment, record
the number of units shipped, and bill customers. This system greatly reduces the chance of the
failure to bill a customer if all invoices are accounted for periodically, but controls have to exist
to ensure the sale isn‟t recorded until shipment occurs. Under a system in which the sales invoice
is prepared only after a shipment has been made, the likelihood of failure to bill a customer is
high unless some compensating control exists. In many organizations, all sales documents are
electronic and no paper documents are prepared.
Pre-numbered Documents
Pre-numbering is meant to prevent both the failure to bill or record sales and the occurrence of
duplicate billings and recordings. Of course, it does not do much good to have pre-numbered
documents unless they are properly accounted for. To use this control effectively, a billing clerk
will file a copy of all shipping documents in sequential order after each shipment is billed, while
someone else will periodically account for all numbers and investigate the reason for any missing
documents
Monthly Statements
Sending monthly statements is a useful control because it encourages customers to respond if the
balance is incorrectly stated. These statements should be controlled by persons who have no
responsibility for handling cash or recording sales or accounts receivable to avoid the intentional
failure to send the statements. For maximum effectiveness, all disagreements about the account
balance should be directed to a designated person who has no responsibility for handling cash or
recording sales or accounts receivable.
Internal Verification Procedures
Computer programs or independent personnel should check that the processing and recording of
sales transactions fulfill each of the six transaction-related audit objectives. Examples include

accounting for the numerical sequence of pre-numbered documents, checking the accuracy of
document preparation, and reviewing reports for unusual or incorrect items
2.3 Tests of Controls & Substantive Tests of Transactions
For Sales
Transaction Test of Control Substantive Test of Transaction
Related Audit
Objective
Occurrence - Examine customer order for evidence of - Account for a sequence of sales
(Recorded sales are credit approval invoices
for shipments - Examine sales invoice for supporting - Review sales journal and master
actually made to non bill of lading and customer order file for unusual transactions and
fictitious customers) - Examine file of batch totals for initials amounts
of data control clerk - Trace sales journal entries to
- Observe whether monthly statements supporting documents, including
are sent duplicate sales invoice, bill of
lading, sales order, and customer
order
Completeness - Account for a sequence of shipping - Trace selected shipping
(Existing sales documents documents to the sales journal to be
transactions are - Examine file of batch totals for initials sure that each one is included
recorded) of data control clerk
Accuracy - Examine sales invoice for supporting - Trace entries in sales journal to
(Recorded sales are documents sales invoices
for the amount of - Examine file of batch totals for initials - Re-compute prices and extensions
goods shipped and of data control clerk on sales invoices
are correctly billed - Examine the approved price list for - Trace details on sales invoices to
and recorded) accuracy and proper authorization . shipping documents
- Observe whether monthly statements . sales order
are sent . customer order
Posting and - Examine evidence that accounts - Trace selected sales invoices from
summarization receivable master file is reconciled to the the sales journal to the accounts
(Sales transactions general ledger receivable master file and test for
are correctly - Examine evidence that accounts amount, date, and invoice number
included in the receivable master file is reconciled to the - Use audit software to foot and
accounts receivable general ledger cross-foot the sales journal and
master file and are - Observe whether monthly statements trace totals to the general ledger
correctly are sent
summarized)
Classification - Examine document package for internal - Examine duplicate sales invoice
(Sales transactions verification for proper account classification
are correctly
classified)
Timing (Cut off) - Account for a sequence of shipping - Compare date of recording of sale
(Sales are recorded documents in sales journal with duplicate sales
on the correct dates) invoice and bill of lading

Auditors use the same methodology for designing tests of controls and substantive tests of
transactions for cash receipts as they use for sales. Cash receipts tests of controls and substantive
tests of transactions audit procedures are developed around the same framework used for sales,
but of course the specific objectives are applied to cash receipts. (We will learn separately Audit
of Cash in Chapter 7)
2.4 Tests of Details of Balances
Tests of details of balances for balance sheet accounts in sales and collection cycle: accounts
receivable and the allowance for uncollectible accounts required discussion. But test of details of
balanced for Account receivable is discussed below.
In tests of details of balances for accounts receivable, auditors must satisfy each of the eight
balance-related audit objectives. These eight general objectives are the same for all accounts.
Specifically applied to accounts receivable, they are called accounts receivable balance-related
audit objectives and are as follows:
1. 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. (Detail tie-in)
2. Recorded accounts receivable exist. (Existence)
3. Existing accounts receivable are included. (Completeness)
4. Accounts receivable are accurate. (Accuracy)
5. Accounts receivable are correctly classified. (Classification)
6. Cutoff for accounts receivable is correct. (Cutoff)
7. Accounts receivable is stated at realizable value. (Realizable value)
8. The client has rights to accounts receivable. (Rights)
Detail discussions for each balance-related audit objectives of Account Receivable are presented
below.
I. Accounts receivable in the aged trial balance agree with related master files amounts,
and the total is correctly added and agrees with the general ledger (detail tie-in)
Most tests of accounts receivable and the allowance for uncollectible accounts are based on the
aged trial balance. An aged trial balance lists the balances in the accounts receivable master file
at the balance sheet date, including individual customer balances outstanding and a breakdown of
each balance by the time passed between the date of sale and the balance sheet date.

II. Recorded account receivable exist (existence)
Confirmation of customers‟ balances is the most important test of details of balances for
determining the existence of recorded accounts receivable. When customers do not respond to
confirmations, auditors also examine supporting documents to verify the shipment of goods and
evidence of subsequent cash receipts to determine whether the accounts were collected.
III. Existing accounts receivable are included (completeness)
It is difficult for auditors to test for account balances omitted from the aged trial balance except
by relying on the self-balancing nature of the accounts receivable master file. For example, if the
client accidentally excluded an account receivable from the trial balance, the only likely way it
will be discovered is for the auditor to foot the accounts receivable trial balance and reconcile the
balance with the control account in the general ledger.
IV. Accounts receivable are accurate (accuracy)
Confirmation of accounts selected from the trial balance is the most common test of details of
balances for the accuracy of accounts receivable. When customers do not respond to
confirmation requests, auditors examine supporting documents in the same way as described for
the existence objective. Auditors perform tests of the debits and credits to individual customers‟
balances by examining supporting documentation for shipments and cash receipts.
V. Cutoff for accounts receivable is correct (cut off)
Cutoff misstatements exist when current period transactions are recorded in the subsequent
period or vice versa. The objective of cutoff tests, regardless of the type of transaction, is to
verify whether transactions near the end of the accounting period are recorded in the proper
period. The cutoff objective is one of the most important in the cycle because misstatements in
cutoff can significantly affect current period income. For example, the intentional or
unintentional inclusion of several large, subsequent period sales in the current period—or the
exclusion of several current period sales returns and allowances—can materially overstate net
earnings

VI. Accounts receivable are properly classified (classification)
Normally, auditors can evaluate the classification of accounts receivable relatively easily, by
reviewing the aged trial balance for material receivables from affiliates, officers, directors, or
other related parties. Auditors should verify that notes receivable or accounts that should be
classified as noncurrent assets are separated from regular accounts, and significant credit
balances in accounts receivable are reclassified as accounts payable.
VII. Accounts receivable are stated at realizable value (realizable value)
Accounting standards require that companies state accounts receivable at the amount that will
ultimately be collected. The realizable value of accounts receivable equals gross accounts
receivable less the allowance for uncollectible accounts. To calculate the allowance, the client
estimates the total amount of accounts receivable that it expects to be uncollectible
VIII. The client has right to accounts receivable (rights)
The client‟s rights to accounts receivable ordinarily cause no audit problems because the
receivables usually belong to the client. In some cases, however, a portion of the receivables may
have been pledged as collateral, assigned to someone else, or sold at discount
Accounts receivable presentation and disclosure are proper (presentation)
Tests of the presentation and disclosure-related audit objectives are generally done as part of the
completion phase of the audit. When testing sales and accounts receivable, the auditor must
understand and evaluate the appropriateness of the client‟s revenue recognition policy to
determine whether it is properly disclosed in the financial statements. The auditor must also
decide whether the client has properly combined amounts and disclosed related party information
in the statements.

CHAPTER THREE
3. AUDIT OF PAYROLL AND PERSONEL CYCLE
The payroll and personnel cycle involves the employment and payment of all employees. The
overall objective in the audit of the payroll and personnel cycle is to evaluate whether the
account balances affected by the cycle are fairly stated in accordance with applicable accounting
standards. Typical accounts in the payroll and personnel cycle are shown in Figure below. “T”
accounts are used to illustrate the way in which accounting information flows through the
various accounts in the payroll and personnel cycle. In most systems, the accrued wages and
salaries account is used only at the end of an accounting period. Throughout the period, expenses
are charged when the employees are actually paid rather than when the labor costs are incurred.
Accruals for labor are recorded by adjusting entries at the end of the period for any earned but
unpaid labor costs.
Accounts in the Payroll and Personnel Cycle
There is only one class of transactions for payroll. Because the receipt of services from
employees and the payment for those services through payroll usually occur within a short time
period.

The payroll and personnel cycle begins with hiring employees and ends with paying them for the
services they performed. Within in this payroll and personnel cycle there are four business
functions. They are
 Human resources and employment
 Timekeeping and payroll preparation
 Payment of payroll
 Preparation of payroll tax returns and payment of taxes
A. Human Resources and Employment
The human resources department provides an independent source for interviewing and hiring
qualified personnel. The department is also an independent source of records for the internal
verification of wage information, including additions and deletions from the payroll and changes
in wages and deductions.
B. Timekeeping and Payroll Preparation
Timekeeping and payroll preparation are important in the audit of payroll because they directly
affect payroll expense for each period. Adequate controls are necessary to prevent misstatements
in the following four activities:
 Prepare time records by employees
 Summarize and calculate gross pay, deductions, and net pay
 Payment of payroll
 Prepare payroll records
C. Payment of Payroll
The approval and distribution of payroll must be carefully controlled to prevent theft. To
increase control, payroll disbursements are generally processed separately from other
disbursements.
D. Preparation of Payroll Tax Returns and Payment of Taxes
Government laws require the timely preparation and submission of payroll tax returns. To
prevent misstatements and potential liability for taxes and penalties, a competent individual must
independently verify the output.
Key control activities the payroll and personnel cycle are discussed below
Adequate Separation of Duties

Separation of duties is important in the payroll and personnel cycle, especially to prevent over
payments and payments to nonexistent employees. The payroll function should be kept
independent of the human resources department, which controls key payroll activities, such as
adding and deleting employees. Payroll processing should also be separate from the issuance of
payroll disbursements.
Proper Authorization
As already noted, only the human resources department should be authorized to add and delete
employees from the payroll or change pay rates and deductions. The number of hours worked by
each employee, especially overtime, should be authorized by the employee‟s supervisor.
Adequate Documents and Records
The appropriate documents and records depend on the nature of the payroll system. Time records
are necessary for hourly employees but not for salaried employees. For employees compensated
based on piece rate or other incentive systems, different records are required.
Physical Control over Assets and Records
Access to unsigned payroll checks should be restricted. Checks should be signed by a
responsible employee, and payroll should be distributed by someone independent of the payroll
and timekeeping functions. Any unclaimed checks should be returned for redeposit. If checks are
signed by a signature machine, access to the machine should be restricted. Similarly, when
payment occurs through direct deposit, access to systems used to authorize payments should be
restricted.
Independent Checks on Performance
Payroll computations should be independently verified, including comparison of batch totals to
summary reports. A member of management or other responsible employee should review the
payroll output for any obvious misstatements or unusual amounts.

Transaction Related Test of Control Substantive Test of Transaction
Audit Objective
Occurrence - Examine time records for - Review the payroll journal,
(Recorded payroll indication of approvals. general ledger, and payroll earnings
payments are for work - Examine time records records for large or unusual
actually performed by - Review human resource amounts.
existing employees) - Examine human resource file
- Examine payroll records for
indication of approval.
Completeness - Account for a sequence of - Reconcile the disbursements in
(Existing payroll payroll checks. the payroll journal with the
transactions are recorded) - Discuss with employees and disbursements on the payroll bank
observe reconciliation. statement
- Prove the bank reconciliation.
Accuracy - Examine indication of internal - Recompute hours worked from
(are recorded transactions verification. time records
are for the amount of time - Examine payroll records for - Compare pay rates with union
actually worked and are at indication of authorization contract, approval by board of
the proper pay rates; - Examine authorizations in human directors, or other source.
withholdings are correctly resource file. - Recompute gross pay.
calculated) - Check withholdings
- Recompute net pay.
Posting and - Examine indication of internal - Test clerical accuracy by footing
summarization verification. the payroll journal and tracing
(Payroll transactions are - Examine initialed summary total postings to the general ledger and
correctly included in the reports indicating that comparisons the payroll master file.
payroll master file and are have been made.
correctly summarized)
Classification - Review chart of accounts. - Compare classification with chart
(Payroll transactions are - Examine indication of internal of accounts or procedures manual.
correctly classified ) verification - Review time record for employee
department and job ticket for job
assignment and trace through to
labor distribution
Timing (Cut off) - Examine procedures manual and - Compare date of recorded
(Payroll transactions are observe when recording takes payment in the payroll journal with
recorded on the correct place. date on cancelled check or direct
dates) - Examine indication of internal deposit and time record.
verification - Compare date on check with date
the check cleared the bank
3.4 Tests of Details of Balances
 The eight general objectives of test of details of balance are the same for all accounts.
 Tests of details of balances for payroll liability accounts is the same as that followed in
Chapter 3 for accounts receivable.
CHAPTER FOUR
4. AUDIT OF ACQUISITION AND PAYMENT CYCLE
The objective in the audit of the acquisition and payment cycle is to evaluate whether the
accounts affected by the acquisitions of goods and services and the cash disbursements for those
acquisitions are fairly presented in accordance with accounting standards. Figure below shows
the way accounting information flows through the various accounts in the acquisition and
payment cycle.
Accounts in the Acquisition and payment Cycle
There are three classes of transactions included in the cycle:

1. Acquisitions of goods and services
2. Cash disbursements
3. Purchase returns and allowances and purchase discounts
There are four business functions that occur in every business in recording the three classes of
transactions in the acquisition and payment cycle. The first three functions are for recording the
acquisition of goods and services on account, and the fourth function is for recording cash
disbursements for payments to vendors.

 Processing Purchase Orders
 Receiving Goods and Services
 Recognizing the Liability
 Processing and Recording Cash Disbursements
A. Processing Purchase Orders
The request for goods or services by the client‟s personnel is the starting point for the cycle. The
exact form of the request and the required approval depend on the nature of the goods and
services and company policy
B. Receiving Goods and Services
The receipt by the company of goods or services from the vendor is a critical point in the cycle
because it is when most companies first recognize the acquisition and related liability on their
records. When goods are received, adequate control requires examination for description,
quantity, timely arrival, and condition.
C. Recognizing the Liability
The proper recognition of the liability for the receipt of goods and services requires prompt and
accurate recording. The initial recording affects the financial statements and the actual cash
disbursement; therefore, companies must take care to include all acquisition transactions, only
acquisitions that occurred, and at the correct amounts.
D. Processing and Recording Cash Disbursements
The payment for goods and services represents a significant activity for all entities. This activity
directly reduces balances in liability accounts, particularly accounts payable.
Key internal control in the acquisition and payment cycle are similar to other transaction cycles,
as discussed in earlier chapters. These are authorization of purchases, separation of the custody
of the received goods from other functions, timely recording and independent review of
transactions, and authorization of payments to vendors.
Tests of controls and substantive tests of transactions for the acquisition and payment cycle are
divided into two broad areas:
1. Tests of acquisitions, which concern three of the four business functions discussed earlier in
this chapter: processing purchase orders, receiving goods and services, and recognizing the
liability

2. Tests of payments, which concern the fourth function, processing and recording cash
disbursements.
Tests of Controls, and Substantive Tests of Transactions for Acquisitions is discussed a table
below
Transaction Related Audit
Objective Test of Control Substantive Test of
Transaction
Occurrence - Examine documents in voucher - Review the acquisitions
(Recorded acquisitions are package for existence. journal (purchase journal),
for goods and services - Examine indication of approval. general ledger, and accounts
received, consistent with the - Examine indication of internal payable master file for large or
best interests of the client) verification unusual amounts
- Examine vendor master file
for unusual vendors.
- Examine fixed assets
acquired.
- Examine inventory acquired.
Completeness - Account for a sequence of purchase - Trace from a file of receiving
(Existing acquisition orders. reports to the acquisitions
transactions are recorded) - Account for a sequence of receiving journal
reports. - Trace from a file of vendors‟
- Account for a sequence of vouchers. invoices to the acquisitions
journal.
Accuracy - Examine indication of internal - Compare recorded
(Recorded acquisition verification transactions in the acquisitions
transactions are accurate) - Examine indication of approval. journal with the vendor‟s
invoice, receiving report, and
other supporting
documentation
Posting and summarization - Examine indication of internal - Test clerical accuracy by
(Acquisition transactions are verification footing the journals and tracing
correctly included in the - Examine initials on general ledger postings to general ledger and
accounts payable and accounts indicating comparison. accounts payable and
inventory master files and are inventory master files
correctly files and are
correctly)
Classification - Examine procedures manual and - Compare classification with
(Acquisition transactions are chart of accounts. chart of accounts by referring
correctly classified) to vendors‟ invoices.
Timing (Cut off) - Examine procedures manual and - Compare dates of receiving
(Acquisition transactions are observe whether unrecorded vendors‟ reports and vendors‟ invoices
recorded on the correct dates) invoices exist. with dates in the acquisitions
journal
Tests of Controls, and Substantive Tests of Transactions for payment(Cash Disbursements)-
reading assignment—ch -7

4.4 Tests of Details of Balances of Accounts Payable
Because all acquisition and payment cycle transactions typically flow through accounts payable,
this account is critical to any audit of the acquisition and payment cycle. Accounts payable are
unpaid obligations for goods and services received in the ordinary course of business. Accounts
payable includes obligations for the acquisition of raw materials, equipment, utilities, repairs,
and many other types of goods and services that were received before the end of the year. Most
accounts payable can also be identified by the existence of vendors‟ invoices for the obligation.
The same balance-related audit objectives applied to verifying accounts receivable are used for
account payable with minor modifications.
A. Accounts payable in the accounts payable list agree with related master file, and the total is
correctly added and agrees with the general ledger (detail tie-in).
B. Accounts payable in the accounts payable list exist (existence)
C. Existing accounts payable are included in the accounts payable list (completeness).
D. Accounts payable in the accounts payable list are accurate (accuracy).
E. Accounts payable in the accounts payable list are correctly classified (classification).
F. Transactions in the acquisition and payment cycle are recorded in the proper period (cutoff).
G. The company has an obligation to pay the liabilities included in accounts payable
(obligations).
4.5 Tests of Details of Property, Plant and Equipment
Property, plant, and equipment are assets that have expected lives of more than one year, are
used in the business, and are not acquired for resale. The intent to use the assets as part of the
operation of the client‟s business and their expected lives of more than one year are the
significant characteristics that distinguish these assets from inventory, prepaid expenses, and
investments.
Classifications of Property, Plant, and Equipment Accounts
 Land and land improvements
 Buildings and building improvements
 Equipment Furniture and fixtures
 Autos and trucks
 Leasehold improvements
 Construction-in-process for property, plant, and equipment

Because of the importance of current period acquisitions in the audit of equipment, auditors use
seven of the eight balance-related audit objectives as a frame of reference for tests of details of
balances: existence, completeness, accuracy, classification, cutoff, detail tie-in, and rights and
obligations.
A. Current year acquisitions in the acquisitions schedule agree with related master file amounts,
and the total agrees with the general ledger (detail tie-in)
B. Current year acquisitions as listed exist (existence).
C. Existing acquisitions are recorded (completeness).
D. Current year acquisitions as listed are accurate (accuracy).
E. Current year acquisitions as listed are correctly classified (classification).
F. Current year acquisitions are recorded in the correct period (cutoff).
G. The client has rights to current year acquisitions (rights).
4.6 Tests of Details of Other Accounts

CHAPTER FIVE
5. AUDIT OF INVENTORY AND WAREHOUSE CYCLE
5.1 Nature of Inventory
 Inventories are major items on the balance sheet, i.e. in total assets, especially in the
current asset section.
 Inventories play also a very significant and important role in preparation of income
statement and determination of net income or loss.
 Misstatements of inventories directly affect cost of goods sold and, therefore, indirectly
affect net income
 Determining the quantities of inventories may require specialized techniques
 There are different type of inventory based on the type of business
 Management fraud has often involved the fraudulent overstatement of inventories
 The inventory and warehousing cycle is unique because of its close relationships to other
transaction cycles.
 The inventory and warehousing cycle begins with the acquisition of raw materials for
production
 The inventory and warehousing cycle ends with the sale of goods in the sales and
collection cycle
 The audit of inventory, especially tests of the year-end inventory balance, is often the
most complex and time consuming part of the audit.
Six functions make up the inventory and warehousing cycle. They are Process purchase orders,
receive raw materials, store raw materials, process the goods, store finished goods, ships finished
goods.
5.2 Control Activities and Tests of Controls
 Purchase or other commitment should be initiated only by authorized personnel, preferably
on the basis of competitive bid.
 Purchase orders for good and materials are placed as needed and for optimum quantity
 Follow up should be made on purchase orders if delivery has not been made by the
scheduled delivery date
 Incoming shipment should be accepted only if the receiving department has authorization
in the form of a copy of purchase order.

 Quantity and quality of goods received should be as specified before payment is authorized
 Terms, prices, and clerical accuracy of vendors invoice should be correct before payment
is authorized
 Refund or credit should be received for all purchase returned and allowance
 The need to reorder signaled as soon as the amount of inventory on hand reaches a
minimum safety balance
 Inventory quantity should be adequately protected against losses from theft, spoilage,
unauthorized withdrawal by employee.
 There should be full accountability for both units and birr for inventory quantity received,
on hand and issued or sold.
 Difference between book and physical inventories are ascertained, differences adjusted and
the amount of overage or shortage should be properly accounted for.
 Proper authorization exists for inventory quantity removed from stock
 All transactions pertaining to the issue or sales of inventories quantity should be accounted
for and entered in the controlling record.
 Inventory issues should be valued according to an acceptable method and the costs should
be accounted for in a manner that provides adequate information for management
including variance from standard
5.3 Auditing Cost Accounting
5.4 Observing Physical Inventory
The auditor‟s observation of inventory is generally accepted auditing procedure. However, the
auditor is not required to observe all inventories, but only inventory that is material. Internal
auditors may also observe physical inventory. The primary reason for observing the clients
physical inventory is to establish the validity or existence of the inventory. The observation of
the physical inventory also provides evidence on the ownership and valuation audit objectives.
Prior to the physical count of the inventory, the auditor should be familiar with the inventory
location, the major items in inventory and the client‟s instructions for counting inventory. During
observation of physical inventory, the auditor should do the following.

 Ensure that no production is scheduled or if production is scheduled, ensure that proper
control are established for movement between departments in order to prevent double
counting.
 Ensure that there is no movement of goods during the inventory count. If movement is
necessary, the auditor and client personnel must ensure that the goods are not double
counted and that all goods are counted.
 Make sure that the clients count teams are following the inventory count instruction, the
auditor notify the client’s representation in charge of the area.
 Ensure that inventory tags are issued sequentially to individual departments for many
inventory counts; the goods are marked with multi copy inventory tags. The count teams
record the type and quantity of inventory on each tag, and one copy of each tag is then
used to compile the inventory, such as detailed inventory listing on handheld computers,
the auditor should obtain copies of the listing or files prior to the start of the inventory
count.
 Perform test counts and record a sample of counts in the working papers. This
information will be used to test the accuracy and completeness of the client’s inventory
compilation.
 Obtain tag control information for testing the client’s inventory compilation. Tag control
information includes documentation of the numerical sequence of all inventory tags and
accounting for all used and unused inventory tags. If inventory listings are used by the
clients, copies of listing will accomplish the objectives of documenting the entire
inventory count.
 Obtain cutoff information, including the numbers of the last shipping and receiving
document issued on the date of the physical inventory count.
 Observe the condition of the inventory for items that may be obsolete, slow moving or
carried in excess quantity.

 Inquiry about goods held on consignment for others or held on a bill and hold basis, such
items should not be included in the clients inventory. The auditor must also inquire about
goods held on consignment for the client. These goods should be included in the
inventory count. If these audit procedures are followed, the auditor has reasonable
assurance that a proper inventory count has been taken
5.5 Tests of Pricing and Compilation

CHAPTER SIX
6. AUDIT OF THE CAPITAL AND REPAYMENT CYCLE
Four characteristics of the capital acquisition and repayment cycle influence the audit of capital
acquisition and repayment related accounts:
1. Relatively few transactions affect the account balances, but each transaction is often highly
material.
2. The exclusion or misstatement of a single transaction can be material.
3. A legal relationship exists between the client entity and the holder of the stock, bond, or
similar ownership document.
4. A direct relationship exists between the interest and dividends accounts and debt and equity.
The accounts in a company‟s capital acquisition and repayment cycle depend on the type of
business the company operates and how its operations are financed.
As with other cycles, cash is an important account in the cycle because both the acquisition and
repayment of capital affect the cash account. The unique characteristics of the capital acquisition
and repayment cycle affect how auditors verify the accounts in the cycle. This cycle often
includes these accounts:
 Notes payable
 Cash in the bank  Interest expense
 Contracts payable  Accrued interest
 Capital stock—common  Retained earnings
 Mortgages payable  Dividends payable
 Capital stock—preferred  Treasury stock
 Bonds payable  Proprietorship—capital
 Paid-in capital in excess of account
par  Dividends declared
 Partnership—capital account
 Proper Authorization of Transactions
 Proper Record Keeping and Segregation of Duties
 Independent Registrar and Stock Transfer Agent
6.3 Auditing Long-Term Debt

6.4 Auditing Capital Stock
Auditors have four main concerns in auditing capital stock and paid-in capital in excess of par:
1. Existing capital stock transactions are recorded (completeness transaction-related
objective).
2. Recorded capital stock transactions occurred and are accurately recorded (occurrence
and accuracy transaction-related objectives).
3. Capital stock is accurately recorded (accuracy balance-related objectives).
4. Capital stock is properly presented and disclosed (all four presentation and disclosure
objectives).
The first two concerns involve tests of controls and substantive tests of transactions, and the last
two involve tests of details of balances and related disclosures
6.5 Auditing Dividends
The emphasis in the audit of dividends is on dividend transactions rather than on the ending
balance. The exception is when there are dividends payable.
All six transaction-related audit objectives for transactions are relevant for dividends. But
typically, dividends are audited on a 100 percent basis. The most important objectives, including
those concerning dividends payable, are:
1. Recorded dividends occurred (occurrence).
2. Existing dividends are recorded (completeness).
3. Dividends are accurately recorded (accuracy).
4. Dividends are paid to stockholders that exist (occurrence).
5. Dividends payable are recorded (completeness).
6. Dividends payable are accurately recorded (accuracy).
6.6 Auditing Retained Earning
For most companies, the only transactions involving retained earnings are net earnings for the
year and dividends declared. Other changes in retained earnings may include corrections of
prior-period earnings, prior-period adjustments charged or credited directly to retained earnings,
and the setting up or elimination of appropriations of retained earnings.
To begin the audit of retained earnings, auditors first analyze retained earnings for the entire
year. The audit schedule showing the analysis, which is usually a part of the permanent file,
includes a description of every transaction affecting the account.
To accomplish the audit of the credit to retained earnings for net income for the year (or the debit
for a loss) auditors simply trace the entry in retained earnings to the net earnings figure on the
income statement. This procedure must, of course, take place fairly late in the audit after all
adjusting entries affecting net earnings have been completed

CHAPTER SEVEN
7. AUDIT OF CASH BALANCES
7.1 Cash in the Bank and Transaction Cycles
In the audit of cash, auditors must distinguish between verifying the client‟s reconciliation of the
balance on the bank statement to the balance in the general ledger, and verifying whether
recorded cash in the general ledger correctly reflects all cash transactions that took place during
the year. It is relatively easy to verify the client‟s reconciliation of the balance in the bank
account to the general ledger, but a significant part of the total audit of a company involves
verifying whether cash transactions are correctly recorded. For example, each of the following
misstatements ultimately results in the improper payment of or the failure to receive cash, but
none will normally be discovered as a part of the audit of the bank reconciliation:
 Failure to bill a customer
 An embezzlement of cash by intercepting cash receipts from customers before they are
recorded, with the account charged off as a bad debt
 Duplicate payment of a vendor‟s invoice
 Improper payments of officers‟ personal expenditures
 Payment for raw materials that were not received
 Payment to an employee for more hours than he or she worked
 Payment of interest to a related party for an amount in excess of the going rate

If these misstatements are to be uncovered in the audit, their discovery must occur through tests
of controls and substantive tests of transactions, which we discussed in preceding chapters. The
first two misstatements can be discovered as part of the audit of the sales and collection cycle
(Chapter 2), the next three in the audit of the acquisition and payment cycle (Chapter 4), and the
last two in the tests of the payroll and personnel cycle (Chapter 3) and the capital acquisition and
repayment cycle (Chapter 6), respectively.
7.2 Audit of the General Cash Account
The general cash account is the focal point of cash for most organizations because virtually all
cash receipts and disbursements flow through this account. For example, the disbursements for
the acquisition and payment cycle are normally paid from this account, while the receipts of cash
in the sales and collection cycle are deposited in the account.
7.3 Audit of Imprest Bank Account and Petty Cash
Petty cash is a unique account. Although it is often immaterial in amount, many auditors verify
petty cash primarily because of the potential for embezzlement and the client‟s expectation that
auditors will examine the account, even when the amount is immaterial.
The most important internal control for petty cash is the use of an imprest fund that is the
responsibility of one individual. In addition, petty cash funds should not be mingled with other
receipts, and the fund should be kept separate from all other activities. There should also be
limits on the amount of any expenditure from petty cash, as well as on the total amount of the
fund. The types of expenditures that can be made from petty cash transactions should be well
defined by company policy.
When a disbursement is made from petty cash, adequate internal controls require a responsible
official‟s approval on a prenumbered petty cash form. The total of the actual cash and checks in
the fund, plus the total unreimbursed petty cash forms that represent expenditures, should equal
the total amount of the petty cash fund stated in the general ledger.
When the petty cash balance runs low, a check payable to the petty cash custodian should be
written on the general cash account for the reimbursement of petty cash. The check should be for
the exact amount of the prenumbered vouchers that are submitted as evidence of actual
expenditures. These vouchers should be verified by the accounts payable clerk and cancelled to
prevent their reuse.

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AUDITING PRINCIPLE AND PRACTICE II

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IV. Probabilistic Proportion to Sample Size

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2.1 Overview of the Cycle

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III. Existing accounts receivable are included (completeness)

IV. Accounts receivable are accurate (accuracy)

V. Cutoff for accounts receivable is correct (cut off)

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VII. Accounts receivable are stated at realizable value (realizable value)

VIII. The client has right to accounts receivable (rights)

Accounts receivable presentation and disclosure are proper (presentation)

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There are three classes of transactions included in the cycle:

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5.5 Tests of Pricing and Compilation

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