CHAPTER TWO

AUDIT OF CASH AND MARKETABLE

SECURITIES
 2.1 INTRODUCING THE NATURE AND TYPES OF CASH

Cash, the most liquid of assets, is the standard medium of exchange

and the basis for measuring and accounting for all other items.
 Companies generally classify cash as a current asset.

 Cash consists of coin, currency, money orders, certified checks,

cashier’s checks, personal checks, ordinary checks, selling checks,

negotiable checks, bank drafts, etc.
CONTINUE
 Cash is the only account included in every business transactions and cycles. Cash

is important because of its susceptibility to theft and it can also be significantly

misstated. The relationship between cash in the bank and the other transaction cycles
serves a dual function:

(1) it shows the importance of audit tests of various transaction cycles on the audit of
cash and

(2) it aids in further understanding of the integration of the different transaction cycles.
CONTINUE
Cash typically has a small account balance, but auditors devote a
large proportion of total audit hours because:

– Liabilities, revenues, expenses and most other assets flow through

cash.
– It is the most liquid asset; so greater temptation for misappropriation.

– It is a high risk account.

 2.1.1TYPES OF CASH ACCOUNTS
Cash normally includes general, payroll, petty cash and less frequently saving
accounts.

1. The General cash account: General accounts are checking accounts similar in
nature to those maintained by individuals. The general cash account is the focal point
of cash for most organizations because virtually all cash receipts and disbursements
flow through this account. Cash sales, collections of receivables, and investment of
additional capital typically increase the account; business expenditures decrease it.
CONTINUE

2. Imprest payroll Accounts: many companies establish a separate imprest payroll account to improve

internal control over payroll disbursements. When payroll is paid, a check from the general account is

drawn to deposit funds into the payroll account.

3. Imprest Petty cash: An imprest petty cash fund is not a bank account, but it is sufficiently similar to

cash in the bank to merit inclusion. A petty cash account is often something as simple as a preset

amount of cash set aside in a cash box for incidental expenses. It is used for small cash acquisitions that

can be paid more conveniently and quickly by cash than by check, or for the convenience of

employees in cashing personal or payroll check. Petty cash fund is replenished as necessary
CONTINUE
 A fixed balance is maintained in the imprest account, and the authorized personnel uses these

funds for disbursements at their own discretion as long as the payments are consistent with

company policy.

4. Branch Bank Account: For a company operating in multiple locations, it is often desirable to

have a separate bank balance at each location. Branch bank accounts are useful for building banking

relations in local communities and permitting the centralization of operations at the branch level. In

some companies, the deposits and disbursements for each branch are made to a separate bank

account, and the excess cash is periodically transferred electronically to the main office general

bank account.
2.1.2 THE AUDITORS’ OBJECTIVES IN AUDIT OF CASH

The overall objective of the audit of cash is to determine that cash is fairly presented in conformity with

GAAP. The auditors’ objectives in the audit of cash are to:

1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks,

related to cash.

2. Obtain an understanding of internal control over cash transactions.

3. Determine the existence of recorded cash and the client’s ownership (right) of cash.

4. Establish the completeness of recorded cash.

5. Establish the clerical accuracy of cash schedules.

6. Determine that the statement presentation and disclosure of cash are appropriate.
 2.2 Internal control over Cash transactions, Receipts and
Disbursements

Internal control consists of all of the related methods and measures

adopted within a business to:
a.Safeguard assets from employee theft, robbery, and unauthorized use; and

b.Enhance the accuracy and reliability of its accounting records by

reducing the risk of errors (unintentional mistakes) and irregularities
(intentional mistakes and misrepresentations) in the accounting process.
 2.2.1 General Principles of Internal Controls over Cash

To safeguard assets and enhance the accuracy and reliability of its

accounting records, a company follows internal control principles. The
following six internal control principles apply to most companies:
Principle1: Establishment of Responsibility

An essential characteristic of internal control is the assignment of

responsibility to specific individuals.
a. Control is most effective when only one person is responsible for a given task.
Establishing responsibility includes the authorization and approval of
transactions
PRINCIPLE 2: SEGREGATION OF DUTIES

Segregation of duties is indispensable in a system of internal control. The

rationale for segregation of duties is that the work of one employee should,
without a duplication of effort, provide a reliable basis for evaluating the work
of another employee. There are two common applications of this principle:

a. The responsibility for related activities should be assigned to different

individuals. When one individual is responsible for all of the related
activities, the potential for errors and irregularities is increased.
CONTINUE
 The responsibility for record keeping for an asset should be

separate from the physical custody of an asset. The custodian of the

asset is not likely to convert the assets to personal use if one employee
maintains the record of the asset that should be on hand and a
different employee has physical custody of the asset.
 PRINCIPLE 3: DOCUMENTATION PROCEDURES

Documents provide evidence that transactions and events

have occurred.
 Documents should be pre-numbered and all documents
should be accounted for.
 Source documents for accounting entries should be
promptly forwarded to the accounting department to help
ensure timely recording of the transaction and event.
 PRINCIPLE 4: PHYSICAL, MECHANICAL, AND ELECTRONIC CONTROLS

Physical controls relate primarily to the safeguarding of assets. Mechanical and

electronic controls safeguard assets and enhance the accuracy and reliability of
the accounting records. Use of physical, mechanical, and electronic controls is
essential.
Examples of these controls include:
a. Safes, vaults, and safety deposit boxes for cash and business papers.
b. Locked warehouses and storage cabinets for inventory and records.
c. Computer facilities with pass key access or fingerprint or eyeball scans.
PRINCIPLE 5: INDEPENDENT INTERNAL VERIFICATION

Independent internal verification involves the review, comparison, and reconciliation of

data prepared by employees.

a. Verification should be made periodically or on a surprise basis.

b. Verification should be done by an employee independent of the personnel responsible

for the information.

c. Discrepancies and exceptions should be reported to a management level that can take

appropriate corrective action.

d. In large companies, independent internal verification is often assigned to internal auditors.

 PRINCIPLE 6: OTHER CONTROLS

a. Bonding of employees who handle cash.

b.Rotating employees' duties and requiring employees to take
vacations.
 2.2.2 APPLICATIONS OF INTERNAL CONTROL TO CASH RECEIPTS

Cash receipts may result from sales of goods and services on cash; collections from
customers on account; the receipt of interest, rents, and dividends; investments by
owners; bank loans and sale of bonds; and proceeds from the sale of non-current
assets.
The following internal control principles explained earlier apply to cash receipts
transactions:

1. Establishment of responsibility- Only designated personnel (cashiers) is authorized to

handle cash receipts.

2. Segregation of duties- Separate cash receipt from recordkeeping. Different

individuals receive cash, record cash receipts, and hold the cash.
CONTINUE

3. Documentation procedures- Use remittance advice (mail receipts), cash

register tapes, and deposit slips.

4. Physical, mechanical, and electronic controls- Store cash in safes and

bank vaults; limit access to storage areas; and use cash registers.
CONTINUE
5. Independent internal verification- Do not permit any one employee to handle a
transaction from beginning to end. For example, supervisors count cash receipts daily;
treasurer compares total receipts to bank deposits daily.
6. Other controls.
 Bond personnel who handle cash.
 Require vacations and rotation of employees.
 Deposit all cash receipts in bank daily.


 2.2.3 APPLICATIONS OF INTERNAL CONTROL TO CASH DISBURSEMENTS

1. Cash is disbursed to pay expenses and liabilities or to purchase assets.

a. Internal control over cash disbursements is more effective when

payments are made by check, rather than by cash, except for incidental
amounts that are paid out of petty cash.

b.Cash payments are generally made only after specific control procedures
have been followed.

c. The paid check provides proof of payment.

CONTINUE
 The principles of internal control applicable to cash disbursements include

 Establishment of responsibility - Only designated personnel (treasurer) are authorized to sign checks.
Make all disbursements by check or electronic fund transfer, with the exception of small expenditures
from petty cash.
 Segregation of duties - Different individuals approve and make payments; check signors do not record
disbursements.
 Documentation procedures - Use pre-numbered checks and account for them in sequence; each check
must have approved invoice.
CONTINUE
 Physical, mechanical, and electronic controls - Store blank checks in safes
with limited access; print check amounts by machine with indelible
(permanent) ink.
 Independent internal verification - Compare checks to invoices; reconcile
bank statement monthly. Have monthly bank reconciliation prepared by
employees not responsible for the issuance of checks or custody of cash.
The completed reconciliation should be reviewed promptly by an
appropriate official
 Other controls - Stamp invoices PAID.
CONTINUE
2. Methods of disbursing and/or safeguarding Cash:
a. Electronic Funds Transfer (EFT) System: A new approach
developed to transfer funds among parties without the use of paper
(deposit tickets, checks, etc.). The approach, called electronic
funds transfers (EFT), uses wire, telephone, telegraph, or
computer to transfer cash from one location to another.
b. Petty Cash Fund - A cash fund used to pay relatively small
amounts.
CONTINUE
c. Use of a Bank. First it contributes significantly to good internal control over
cash by creating a separate set of records (bank and books). Second the asset
account Cash maintained by the company is the “flip-side” of the bank’s
liability account for that company. It should be possible to reconcile these
accounts at any time. Each month the company receives a bank statement
showing its bank transactions and balances.

d. Minimize the amount of cash that must be kept on hand

 2.3 GUIDELINES FOR INTERNAL CONTROL OVER CASH

Auditors need to determine whether following general guidelines for

internal control over cash have been followed by the client.
1. Do not permit any one employee to handle a transaction from start to
finish.
2. Separate cash handling from recordkeeping.
3. Centralize receiving of cash to the extent practical.
4. Record cash receipts on a timely basis.
5. Encourage customers to obtain receipts and observe cash register totals.
CONTINUE
6.Deposit cash receipts daily.

7. Make all disbursements by check or electronic funds transfer (EFT), with the exception of small
expenditures from petty cash.

8. Have monthly bank reconciliations prepared by employees not responsible for the issuance of checks or
custody of cash. The completed reconciliation should be reviewed promptly by an appropriate official.

9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts.
2.4 INTERNAL CONTROL WEAKNESSES

 Weak internal control procedures lead to or create opportunity for

fraud and/or defalcation. Thus it is important that the auditor

should investigate client's internal control procedures to see if
defalcation techniques are practiced. Some of the defalcation
techniques are discussed as follows.
 1. WITHHOLDING OF CASH RECEIPTS (SKIMMING)

Proceeds from cash sales are withheld at point of sales recording and
receiving of cash. Skimming means to take cash before recording it.
For example, a cash register clerk can fail to register sales, or under-
register amounts, pocketing full or partial amounts, if the customer
does not wait for the receipt and changes or check amounts charged,
registered and paid. The clerk could record an amount less than
received or record no sales at all to pocket the amount.
 2. LAPPING:

 Cash collected on account from credit customers can be withheld and

entry postponed for the collection of receivables. This is usually

practiced as temporary borrowing, but in the long run may lead to
cover up by more elaborate means. Lapping is basically a way to
conceal an unauthorized loan taken from the company.
CONTINUE
 For example, a clerk takes money paid by Mr. Assefa, which he intends to pay

back eventually. The next day, when Mr. Berhanu's payment arrives, he posts it
to Mr. Assefa's account. The next day, Ms. Konjit's money comes in, and the
clerk posts it to Mr. Berhanu's account, and so on. Sometimes the employee
manages to repay the loan, otherwise he may try to write off the amounts as bad
debts.
 Of course, this is possible if the cashier-accountant receives cash and keeps

accounts receivables records at the same time.

CONTINUE
 Lapping can be prevented by good control, such as segregating

receiving and recording duties, or by compulsory vacations for the

receipts clerk. The clerk cannot continue to cover his theft if he isn't
there, and the new clerk will hopefully post the accounts correctly.
 3. SALES DISCOUNT

Cash can be abstracted from sales discount not taken by customers. That
is, when customers pay full amount, only amounts net of discount are
recorded to customers and difference pocketed by recording it to discount.
4. Writing-off Bad Debts: Accounts receivable could be written-off as bad debts
when actually customers' remittance is pocketed. This is used to hide cash
shortage that may be apparent by repeated overlapping.

5. Fictitious Accounts Receivable: Goods could be taken for private use or

stolen by charging fictitious customers and writing-off as bad debts later on.
 6. CHECK KITING
Assume that an enterprise has two bank accounts say in Bank A and
Bank B. The enterprise writes a check to withdraw an amount from Bank
A account balance and deposit into the account in Bank B. The amount
deposited in Bank B is immediately reflected. But because of lag of time
for clearance (float) it is not reflected as deduction (withdrawal) from
Bank A account soon enough. Consequently, the cash position (current
ratio) of the organization is temporarily improved or overstated. Kiting is
practiced to cover up cash shortages, which an auditor might uncover.
CONTINUE
A) Kiting to cover Theft
Account clerk Mr. Atalay "borrows" incoming cash receipt (skimming) of
1,000 Birr. However, he needs to post amounts to individual customer accounts
in the A/R subsidiary ledger. Otherwise, they will complain and his theft will be
discovered. So he makes a journal entry as follows.
Cash in Bank - Dashen 1,000
Accounts Receivable 1,000
CONTINUE
7.Window-Dressing: Cash shortage or cash position can be improved by
holding the cashbook open beyond closing date to include subsequent
receipts. This may be encouraged by management to improve current
period sales.

8. Cash Disbursements: Cash from petty cash could be misused for

personal or other unauthorized expenses by producing false voucher
expenses, or voucher charges, or overstating vouchers submitted for
reimbursements or changing dates of previous vouchers.
CONTINUE
9. Checks Payable to Self: Checks could be prepared for amounts made payable to
self, forging signatures and destroying returned checks or over footing cash
disbursements.

10. Checks Payable to Others: Checks are prepared in payment of forged

endorsements or fictitious or previously used invoices, or over-invoiced vendors'
invoices, or padding payrolls.
 It should be noted that all of the above defalcations are performed only in absence

of proper segregation of duties or when there is collusion among employees.

 2.5 AUDIT PROGRAM FOR CASH

 Audit program is a detailed listing of the specific audit procedures to be performed in the

course of audit engagement. The following audit program indicates the general pattern of

work performed by the auditors in the verification of cash.

Perform Substantive test of cash transactions and balances

 Substantive tests are designed to detect material misstatement if they exist in the

financial statements. The amount of substantive testing done by the auditor is greatly

influenced by their assessment of the likelihood that misstatement exists. The auditor

undertakes the following activities in relation to the substantive test of cash

transactions and balances.

CONTINUE
1. Obtain analysis of cash balances and reconcile to the general ledger.

2. Send standard confirmation forms to financial institutions to verify amounts on deposit.

3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and consider need to
reconcile bank activity for additional month.

4. Obtain a cut-off bank statement containing transactions of at least seven business days subsequent to
balance sheet date.
5. Count cash list on hand.
6. Verify the client’s cutoff of cash receipts and cash disbursements.

7. Analyze bank transfers for the last week of audit year and first week of following year to disclose
kitting.
8. Investigate any checks representing large or unusual payments to related parties.
9. Evaluate proper balance sheet presentation and disclosure of cash.
 2.6 AUDIT OF MARKETABLE SECURITIES
Definition of Marketable Securities

Companies often invest excess cash accumulated during certain parts of the operating
cycle that will be needed in the reasonably near future in short-term, highly liquid cash
equivalents. These may include time deposits, certificates of deposit, and money market
funds.

 Marketable securities (Short-term investments) are financial investments which are

convertible into cash within one year or one operating cycle. They are listed at their
current market value. Marketable securities are shown on the balance sheet as “Short-
term Investments”.
E.g. Commercial paper, marketable equity securities, and marketable debt securities
 CONTINUE
 Cash equivalents, which can be highly material, are included in the financial statements as a part of the cash account

only if they are short-term investments that are readily convertible to known amounts of cash, and there is

insignificant risk of a change of value from interest rate changes.

Nature of Marketable Securities

Companies group investments in debt and equity securities into three separate portfolios for valuation and

reporting purposes as:

• Held-to-maturity,

• Trading, and

• Available-for-sale securities.


 POTENTIAL MISSTATEMENTS OF MARKETABLE
SECURITIES

o Misstatement of recorded value of Securities

o Unauthorized Security transactions

o Incomplete recording of Securities

Inadequate disclosure of the nature of Security activities

 CONTROLS OVER MARKETABLE SECURITIES

 Establishment of formal security policies

 Review and approval of security activities by the security committee of the board of
directors

 Separation of duties among employees

- Authorizing purchases and sales
- Having custody of the securities

- Maintaining records

 Detailed records of all securities owned

 Registration in the name of the company

 Periodic physical inspection of securities

 Determination of accounting for complex securities by competent personnel

 OBJECTIVES FOR THE AUDIT OF MARKETABLE SECURITIES

 To consider the inherent risks, including fraud risks.

 To consider internal control over marketable securities.

 To determine the existence of recorded marketable securities and that the client has

rights to the securities.

 To establish the completeness of recorded marketable securities.

 To determine that the valuation of marketable securities is in accordance with GAAP.

 To establish the clerical accuracy of schedules of securities.

 To determine that the presentation and disclosure of marketable securities are

appropriate.
 SUBSTANTIVE AUDIT PROCEDURES: MARKETABLE SECURITIES

• Client prepares schedule of marketable securities activity including

– Marketable securities held at year-end

– Audit period transactions - purchases and disposals

• The schedule is footed to determine mathematical accuracy

• Auditor verifies cost or sales price by examining broker's advices

• Auditor recalculates gains/losses on disposal of securities

CONTINUE
• Existence of securities owned at year-end is verified by physically
examining securities held by the client, or confirmation with client's
broker for securities held by the broker
• Current market values are verified by referring to market sources
• Auditor asks management about any changes in the expected holding
period, and any restrictions on securities
• End of Chapter Notes!
 CHAPTER 3
AUDIT OF RECEIVABLES AND SALES
 INTRODUCTION

 The overall objective of the audit of accounts receivable and sales is to

determine if they are fairly presented in the context of the financial statements
as a whole. The sales account is closely tied to accounts receivable; therefore,
evidence supporting accounts receivable tends to support sales. For example,
having determined that an account receivable is valid, the auditor has thereby
supported the validity of the sale. Analytical procedures can often be used to
test the sales account. An unusual relationship detected in the audit of
receivables and inventory may reflect a problem for the reported sales figure as
well.
 3.1 INTERNAL CONTROL OVER RECEIVABLES/SALES

 The auditor, in evaluating the internal control system, is concerned to determine

the extent to which the common characteristics of control are present within the
system. Because the specific placement of responsibility, compliance and
qualified personnel characteristics all apply in the same way to all subsystems,
we shall concentrate our attention on the others as they relate specifically to the
revenue system
CONTINUE
The internal controls with regard to accounts receivable include the following:

a) Appropriate segregation of responsibilities

1. Persons handling cash receipts do not have access to the accounts receivable
records.
2. The billing function should be separated from the handling of cash receipts.

3. Any special discount concessions to customers should be approved by a

responsible supervisor.

4. The credit function should be separated from the handling of cash receipts
and the record keeping function.
CONTINUE
5. The A/R ledger clerk recording sales and cash collections should be someone other
than the general bookkeeper.

6. Persons having the authority to originate non-cash credits to receivables should

not have access to cash.
b) Documentation approvals and records

1. Sales invoices should be sequentially numbered and procedures should be established to

account for the use of the invoice forms.

2. Credit memos should also be sequentially numbered and controlled in the same
manner as are sales invoices.
CONTINUE
3. Sequentially numbered remittance advice forms should be prepared
when cash is received by the company. Formal procedures should be
established for carrying out the billing function.
4. A/R records should indicate both control account and a subsidiary ledger.

5. Formal procedures should be established for authorizing and approving

the acceptance of notes receivable
CONTINUE
c. Safeguarding Assets and records
1. All cash receipts should be deposited intact daily.
2. Appropriately protected storage facilities for undeposited cash receipts.

3. The accounts receivable records should be stored in a safe or vault designed

to protect those records from damage or alteration when they are not being
used.

INTERNAL CONTROL COMPONENTS (INTERNAL CONTROL OVER
A/R AND REVENUE)

1. Control Environment
– Important because of risk of intentional misstatement of revenue
– Independence of audit committee
– Management establishes tone at the top
– Commitment to competence
– Management’s philosophy and operating style
– Human resource policies and practices

CONTINUE
2.Risk Assessment
– Risk of misstatement of revenue
3. Control Activities
– Division of duties
• Prepare sales order
• Approve credit
• Issue merchandise from stock
• Shipment
• Billing
• Invoice verification
• Maintenance of control accounts
• Maintenance of customers’ ledgers
• Approval ofsales returns and allowances
• Authorization ofwrite-offs of uncollectible accounts
REVENUE CYCLE AND RELEVANT CONTROL

 The account data in the revenue system include sales or other trade

revenues, sales returns and allowances, sales discounts, the allowance for
doubtful accounts, bad debts expense, receivables and cash receipts from
cash sales and collection accounts. Because of the perceived inclination of
management to overstate assets, the auditor is most concerned with
verifying that the receivables element of the system and the offsetting
credits to sales are not overstated.
 REVENUE CYCLE---DOCUMENTS

• Customer purchase order

• Sales order
• Bill of lading
• Invoice
• Control listing
• Credit memo
REVENUE CYCLE CONTROLS
The revenue cycle controls include:
• Segregation of duties--sales and collections
• Matching of sales invoices and shipping documents
• Clerical accuracy checks on invoices
• Credit approval for sales transactions
• Mailing of monthly statements
• Reconciliation of bank accounts
• Use of control listing of cash receipts
• Use of budgets and analysis of variances
• Control over shipping and billing documents
• Use of authorized credit memoranda
• Use of chart of accounts and review of account coding
OBJECTIVES FOR THE AUDIT OF RECEIVABLES AND REVENUE

The auditors strive for attaining following objectives for the audit of
receivables and revenues.
1.Use the understanding of the client and its environment to consider

inherent risk, including fraud risks, related to receivables and revenues.

2.Obtain an understanding of internal control over receivables and revenues.

3.Assess the risks of material misstatement and design tests of controls and

substantive procedures that:

CONTINUE
a. Substantiate the existence of receivables and the occurrence of revenue

transactions.

b. Establish the completeness of receivables and revenue transactions.

c. Verify the cutoff of revenue transactions.

d. Determine that the client has rights to recorded receivables.

e. Establish the proper valuation of receivables and the accuracy of revenue

transactions.

f. Determine that the presentation and disclosure of receivables and revenue are

appropriate.
 ACCOUNTS RECEIVABLE BALANCE-RELATED AUDIT OBJECTIVES

accounts receivable balance-related audit objectives and are as follows:

1Accounts receivable in the aged trial balance agree with related master file amounts, and the
total is correctly added and agrees with the general ledger. (Test of Valuation and Accuracy)
2. Recorded accounts receivable exist. (Existence)
3. Existing accounts receivable are included. (Completeness)
4. Accounts receivable are stated at realizable value. (Valuation)
5.Accounts receivable are accurate. (Accuracy)
6. Accounts receivable are correctly classified. (Classification)
7. Cut-off for accounts receivable is correct. (Cut-off)
8. The client has rights to accounts receivable. (Rights)
AUDIT PROGRAM FOR RECEIVABLE/SALES (RECEIVABLES AUDIT STEPS)

(I) Internal Control considerations- Tests of Controls

Perform following tests of controls.

A) Examine significant aspects of a sample of sales transactions.

B) Compare a sample of shipping documents to related sales invoices.

C) Review the use and authorization of credit memoranda.

D) Reconcile selected cash register tapes and sales tickets with sales journals.

E) Test IT application controls.

F) Examine evidence of review and approval of revenue estimates.

 II) SUBSTANTIVE AUDIT PROCEDURES FOR RECEIVABLE/SALES

Perform following major Substantive procedures for receivables and revenue.

1. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable and
reconcile to ledgers.
2. Obtain analyses of notes receivable and related interest.

3. Inspect notes on hand and confirm those with holders.

4. Confirm receivables with debtors.

5. Review the year-end cutoff of sales transactions.

6. Perform analytical procedures for accounts receivable, notes receivable, and revenue.

7. Review significant year-end sales contracts for unusual terms.

8. Test the valuation of notes receivable, computation of interest income, interest receivable, and amortization
of discount or premium.
CONTINUE
9. Evaluate the propriety of the client’s accounting methods for receivables and revenue.

10. Evaluate accounting estimates related to revenue.

11. Determine the adequacy of the client’s allowance for uncollectible accounts.

12. Ascertain whether any receivables have been pledged.

13. Investigate any transactions with or receivables from related parties.

14. Evaluate the business purpose of significant and unusual sales transactions.

15. Evaluate financial statement presentation and disclosures of receivables and revenue.
 CHAPTER 4
AUDIT OF INVENTORIES AND COST
OF GOODS SOLD
 4.1 MEANING OF INVENTORIES AND THE SIGNIFICANCE OF AUDIT OF
INVENTORIES

Inventories are goods held for resale in the ordinary course of business or goods that will be used or

consumed in the production of goods to be sold. They are mainly divided into two major categories:
Inventories of merchandising businesses

Inventories of manufacturing businesses

Source of Inventories
Inventories include:
Goods on hand ready for sale.
Goods in the process of production.
Goods to be consumed directly or indirectly in production such as raw materials,
purchased parts, and supplies.
 SPECIAL SIGNIFICANCE OF AUDIT OF INVENTORIES

The audit of inventory is quite complex and time-consuming part for the following
reasons:

1. Inventory is generally a major item on the balance sheet, and it is often the largest
item making up the accounts included in the working capital. I.e., inventories often
represent the largest current asset of a company.
2. The inventory may be in different locations, which makes physical counting
difficult. I.e., determining the quantities of inventories may require specialized
techniques.
3. The diversity of items in inventory creates another difficulty for auditors.
CONTINUE
4. The valuation of inventory is also difficult due to such factors as obsolescence and
the need to allocated manufacturing costs to inventories. I.e., the valuation of goods on
hand and in process often presents complex and difficult issues.

5. There are several acceptable inventory valuation methods, but any given client must
apply a method consistently from year to year.

6. Misstatements of inventories directly affect cost of goods sold and, therefore, net
income.

7. Management fraud has often involved the fraudulent overstatement of inventories.

 RISKS OF MATERIAL MISSTATEMENTS

i. Inventories constitute a large asset and are very susceptible to major errors and fraud.

ii. The accounting profession allows numerous alternative methods for valuation of
inventories, and different methods may be used for various classes of inventories.

iii.The determination of inventory value directly affects the cost of goods sold and has a
major impact on net income for the year.

iv.The determination of inventory quality, condition, and value is inherently a more

complex and difficult task than is the case with most other elements of financial
position.
 4.2 FUNCTIONS MAKING UP THE INVENTORY AND
WAREHOUSING CYCLE
 Inventory takes many different forms, depending on the nature of the business. For

retail or wholesale businesses, the largest account in the financial statements is

often merchandise inventory available for sale.

 To study the inventory and warehousing cycle, we will use an example of a

manufacturing company, whose inventory may include raw materials, purchased

parts and supplies for use in production, goods in the process of being
manufactured, and finished goods available for sale. Still, most of the principles
discussed apply to other types of businesses as well.
CONTINUE
The inventory and warehousing cycle can be thought of as comprising two separate
but closely related systems, one involving the physical flow of goods and the other the
related costs. Six functions make up the inventory and warehousing cycle. Each of
these is discussed next.
1. Process Purchase Orders
2. Receive Raw Materials
3. Store Raw Materials
4. Process the Goods
5. Store Finished Goods
6. Ship Finished Goods

1. PROCESS PURCHASE ORDERS

 The inventory and warehousing cycle begins with the acquisition of raw materials

for production. Adequate controls over purchasing must be maintained whether

inventory purchases are raw materials for a manufacturer or finished goods for a
retailer. Purchase requisitions are forms used to request the purchasing department
to order inventory. These requisitions may be initiated by stockroom personnel as
raw materials are needed, by automated computer software when raw materials
reach a predetermined level, by orders placed for the materials required to produce
a customer order, or by orders initiated on the basis of a periodic raw materials
count.
 2. RECEIVE RAW MATERIALS

 Receipt of the ordered materials, which is also part of the acquisition and

payment cycle, involves the inspection of material received for quantity and
quality. The receiving department prepares a receiving report that becomes a part
of the documentation before payment is made. After inspection, the material is
sent to the storeroom and copies of the receiving documents, or electronic
notifications of the receipt of goods, are typically sent to purchasing, the
storeroom, and accounts payable. Control and accountability are necessary for all
transfers.
 3. STORE RAW MATERIALS

 Once received, materials are normally stored in a storeroom. When another

department needs materials for production, personnel submit a properly

approved materials requisition, work order, or similar document or electronic
notice that indicates the type and quantity of materials needed. This requisition
document is used to update the perpetual inventory master files and record
transfers from raw materials to work in process accounts. These updates occur
automatically in organizations with integrated inventory management and
accounting software systems.
 4. PROCESS THE GOODS
 Processing inventory varies greatly from company to company. Companies

determine the finished goods items and quantities they will produce based on
specific orders from customers, sales forecasts, predetermined finished goods
inventory levels, and economical production runs. A separate production
control department is often responsible for determining the type and
quantities to produce.
CONTINUE
 An adequate cost accounting system is an important part of the processing of

goods function for all manufacturing companies. The system shows the
relative profitability of the products for management planning and control and
values inventories for preparing financial statements. Two primary types of
cost systems exist: job cost systems and process cost systems, but there are
many variations and combinations of these systems.
CONTINUE
 Cost accounting records consist of master files, spreadsheets, and reports that

accumulate material, labour, and overhead costs by job or process as those costs
are incurred. When jobs or products are completed, the related costs are
transferred from work-in-process to finished goods based on production
department reports.
 5. STORE FINISHED GOODS

 When finished goods are completed, they are placed in the stockroom to await

shipment. In companies with good internal controls, finished goods are kept
under physical control in a separate, limited-access area. The control of finished
goods is often considered part of the sales and collection cycle.
 6. SHIP FINISHED GOODS

 Shipping completed goods is part of the sales and collection cycle. The actual

shipment of goods to customers in exchange for cash or other assets, such as

accounts receivable, creates the exchange of assets necessary for meeting
revenue recognition criteria. For most sales transactions, the actual shipment
becomes the trigger for recognizing the related accounts receivable and sales in
the accounting system. Thus, shipments of finished goods must be authorized by
a properly approved shipping document.
4.3 AUDIT OBJECTIVES FOR INVENTORIES/COST OF SALES

1. Use the understanding of the client and its environment to consider inherent risks, including fraud

risks, related to inventories and cost of goods sold.

2. Obtain an understanding of internal control over inventories and cost of goods sold.

3. Assess the risks of material misstatement and design tests of controls and substantive procedures that:

a. Substantiate the existence of inventories and the occurrence of transactions affecting cost of

goods sold.

b. Establish the completeness of recorded inventories.

c. Verify the cutoff of transactions affecting cost of goods sold.

CONTINUE
a. Determine that the client has rights to the recorded inventories.

b.Establish the proper valuation of inventories and the accuracy of

transactions affecting cost of goods sold.
c. Determine that the presentation and disclosure of information about
inventories and cost of goods sold are appropriate, including disclosure of
the classification of inventories, accounting methods used, and inventories
pledged as collateral for debt.
 4.4 AUDIT PROGRAM FOR INVENTORIES/COST OF SALES

 The auditor needs to design an appropriate audit program for

inventories/cost of sales as follows.

 Internal Control Consideration- Tests of Controls (Verification of Transaction

validity)

 The primary objective of an auditor is to verify effectiveness of internal of the client to

enhance efficient and effective utilization of inventory. The auditor depends primarily on the
reliability of the system of internal control in judging whether inventory, cost of sales and
cash disbursement transactions have been appropriately recorded, classified and
accumulated in the accounting records.
CONTINUE
During the preliminary study and evaluation of the system of internal controls, the
reliability of the system can be evaluated in general by verifying the extent to which it
included the desirable internal control characteristics. If selected controls are found to be
weak, related substantive tests over inventory and related accounts should be expanded.
Internal Control over inventory includes

 Documentation of authorization and approval procedures

 Appropriate separation of responsibilities

 Safeguarding assets and records: Inventory Balances

 A. DOCUMENTATION OF AUTHORIZATION AND
APPROVAL PROCEDURES
The more important procedures for inventory and cost of sales require that:

1. A properly approved purchase requisition be originated as the first document in support of materials

acquisition.

2. Purchase orders, originated in response to properly approved purchase requisitions, be sequentially

numbered and a procedure be established to account for the use of each of the purchase order forms.

3. Debit memos, issued in connection with purchase returns and allowances, be sequentially numbered and

controlled in the same manner as are purchase orders.

4. Sequentially numbered vouchers be prepared and properly approved in support of all cash disbursements.

When a check is issued against a properly approved voucher, the voucher should be cancelled by being

stamped “paid” and should be initialed by the person signing the check in payment of it.
CONTINUE
1. A voucher register be maintained to record all approved vouchers.

2. Properly controlled, sequentially numbered receiving report forms be used to

acknowledge receipt of goods from vendors.

3. Job order cost sheets or cost of production reports be used to account for goods in
the process of being manufactured.
4. Subsidiary perpetual inventory records be maintained for raw materials and
finished goods.
5. Bills of material or raw material requisitions be used to account for materials
issued into production.
6. Properly controlled, sequentially numbered paychecks be used to pay all employees.
 B. APPROPRIATE SEPARATION OF RESPONSIBILITIES

The appropriate separation of responsibilities should be checked by making inquiries, observing procedures, and examining

policy and procedures manuals. This requires that many functions be assigned to different employees to protect resources

and provide reliable financial data, as follows:

1. Persons preparing and approving the vouchers for payment should have no other responsibilities relating to cash payments.

2. The person authorized to sign checks should have no responsibilities relating to the preparation of vouchers and should

have no access to cash receipts or the cash records.

3. The authority to borrow should be separated from the cash handling transactions.

4. The stores ledger clerk should not have access to the store room or to the handling of inventory items.

5. The various authorization and approval functions associated with payments of accounts should be divided among a

number of different persons.

6. Persons having a responsibility for the purchase of goods or services should have no access to cash.
 C. SAFEGUARDING ASSETS AND RECORDS: INVENTORY
BALANCES

All assets and records associated with the cost of sales system should be
appropriately protected from physical loss or alteration. This requires that:
1.All payments be made by use of pre-numbered checks.

2.The inventory storage areas should be fitted to the goods stored in them.

3.Inventory records should be stored so as to protect them from damage or

alteration.
 (II) SUBSTANTIVE AUDIT PROCEDURES FOR
INVENTORIES/COST OF SALES

Perform following Substantive procedures for inventories/cost of goods sold.

1. Obtain listings of inventory and reconcile to ledgers.

2. Evaluate the client’s planning of physical inventory.

3. Observe the taking of physical inventory and make test counts.

4. Review the year-end cutoff of purchases and sales transactions.

5. Obtain a copy of the completed physical inventory, test its clerical accuracy,
and trace test counts.
CONTINUE
6. Evaluate the bases and methods of inventory pricing.
7. Test the pricing of inventories.

8. Perform analytical procedures.

9. Determine whether any inventories have been pledged and review

purchase and sales commitments.
10. Evaluate financial statement presentation of inventories and cost of
goods sold, including the adequacy of disclosure.

 Summary of Major Substantive Tests of Inventories
Substantive Test Preliminary Audit Objectives

Clerical Accuracy
Obtain listings of inventory and reconcile to
ledgers
Evaluate the client’s planning of physical Existence and rights
inventory Completeness
Valuation
Observe the taking of the physical inventory
Review the year end cut-off of purchase and Existence and rights
sales transactions Completeness Clerical accuracy
Obtain a copy of the completed physical
inventory and test its accuracy
Evaluate the bases and methods of inventory Valuation
pricing
 4.5 VERIFICATION OF INVENTORIES
1. Verification of Existence: Inventory Balance

Auditors must observe the client taking a physical inventory count to determine
whether recorded inventory actually exists at the balance sheet date and is
correctly counted by the client. Physical examination is an essential type of
evidence used to verify the existence and count of inventory
 When inventories exist and are material to the financial statements taken as a

whole the auditor must generally be present to observe and to take some test
counts when the client physically counts the inventory.
CONTINUE
 Observation of inventory ordinarily begins with an inspection of the client’s

physical inventory instructions. To making this inspection, the auditor should be

alert for weaknesses that could allow particular elements of the inventory to be
counted twice or possibly be omitted during the inventory taking process.
CONTINUE
These procedures must be performed as soon as possible after the balance sheet date and
include the following:
1. Review of client inventory instructions.
2. Inquiry of the client as to how counts were made.

3. Inspection of physical inventory records, noting that the proper procedures were performed and

adjustment were made where necessary.

4. Test counting of selected items, tracing the movement of inventories back through the perpetual

records by use of issue slips and receiving reports, and then reconciling the resultant
calculations with amounts shown on the perpetual records as of the balance sheet date.
 VERIFICATION OF VALUATION: INVENTORY BALANCE

 The verification of inventory valuation generally begins when the auditor

investigates the valuation method used by the client. The auditor must then
determine whether that method produces, within the limits of materiality, a
valuation that is in accordance either with one of the generally accepted cost-
flow assumptions or with the lower of cost or market valuation procedures.
CONTINUE
Specifically, the investigation of inventory valuation (pricing) often will emphasize
the following questions:
i. What method of pricing (costing) does the client use? Inventories should be priced in
accordance either with one of the generally accepted cost-flow assumptions (FIFO,
LIFO, and Weighted Average) or with the lower of cost or market valuation (LCM)
procedures.
ii. Is the method of pricing the same as that used in prior years?

iii.Has the method selected by the client been applied consistently and accurately in
practice?
 3. VERIFICATION OF OWNERSHIP OF INVENTORY: INVENTORY BALANCE

 The verification of ownership requires the auditor to inspect, on test basis, the

documents underlying to the acquisition of individual inventory items including

purchase orders, receiving reports and vender invoices. With respect to
consigned goods, the auditor should inquire about them and secure an inventory
representation letter stating that such goods have been excluded from the
inventory accounts. He or she can then examine the final inventory listing to
verify that such goods have, in fact, been excluded from inventories.
 4. VERIFICATION OF CUT OFF (PERIODICITY):
INVENTORY BALANCE
 Cut off errors occur near the beginning or end of the audit period when entries involving

the acquisition or disposal of merchandise are included as transactions in the wrong

period. In verifying proper cutoff the auditor must inspect the underlying documents
relating to both purchases and sales made near the end of the period under audit and
during the first few days of the succeeding period. This procedure is performed to
determine that the transaction has been recorded in the proper period and that he client
held legal title to the goods as of the balance sheet date. Ordinarily, merchandise
acquisitions should be recorded at the date the title to the goods passes to the purchaser,
i.e., the FOB shipping point.
 5. VERIFICATION OF STATEMENT PRESENTATION
 The verification of statement presentation primarily involves seeing that the

disclosure requirement relating to inventory has been met. The auditor must inquire
of the client as to whether any part of the inventory has been pledged as security
against creditor claims. If so, the auditor must ascertain that the amount of the
pledged inventory has been appropriately disclosed in the balance sheet. It is also
necessary for the financial statement to disclose the method used in valuing the
inventory. Furthermore, in case of manufacturing firm, appropriate distinction
should be made between inventories of raw materials, work in process and finished
goods.
 CHAPTER 5
AUDIT OF PROPERTY, PLANT AND
EQUIPMENT
 INTRODUCTION

Property, plant and equipment are tangible assets with a service life of more than one
year that are used in the operation of the business and are not acquired for the purpose
of resale. The primary accounting record for property, plant, and equipment accounts is
generally a fixed asset master file.
Property, plant and equipment are also known as plant assets, fixed assets or tangible
assets. Three major subgroups of property, plant and equipment are:
 Land
 Buildings, machinery, equipment and land improvements
 Natural resources
 5.2 COMPARISON OF AUDIT OF FIXED ASSETS WITH
AUDIT OF CURRENT ASSETS
 In many companies (especially in industrial firms), the investment in

plant, property and equipment amounts to 50 percent or more of the

total assets. However, the audit required to verify these properties is
usually a much smaller proportion of the total audit time spent on the
engagement. Auditors verify equipment differently from current asset
accounts for three reasons
 1.There are usually fewer current period acquisitions of

equipment (little change in property and equipment account

from year to year), especially in manufacturing firms. The
equipment is likely to be kept and maintained in the
accounting records for several years.
For example, the Land account often remains unchanged for a long
span of years.
 The durable nature of building and equipment also tend to hold
accounting activity to a minimum for these accounts. In contrast,
such current assets as accounts receivable and inventory may have
a complete turnover several times a year.
2. The amount of any given acquisitions is often material.
 A typical unit of property and equipment has a high dollar value,
and few transactions may lie behind a large balance sheet
amounts.
 3. Year-end Cut-off transaction in fixed assets is less.
For current assets the year end cut-off is a critical issue. However, it is
almost non-existent for plant assets. An error in the cut-off of a $50,000
purchases or sales transaction may cause a $50,000 error in year –end pre-
tax income. For plant assets, on the other hand, a year end cut-off error in
recording an acquisition or retirement ordinarily will not affect net income
for the year.
 5.3 OBJECTIVES FOR THE AUDIT OF PROPERTY, PLANT AND EQUIPMENT

1. To use the understanding of the client and its environment to consider inherent
risk, including fraud risks, related to property, plant, and equipment.

2. To obtain an understanding of internal control over property, plant, and equipment.

3. To assess the risks of material misstatement and design tests of controls and
substantive procedures that:
a. Substantiate the existence of property, plant, and equipment.

b. Establish the completeness of recorded property, plant, and equipment.

a. Verify the cutoff of transactions affecting property, plant, and equipment.

b. Determine that the client has rights to recorded property, plant, and equipment.

c. Establish the proper valuation or allocation of property, plant, and equipment

and the accuracy of transactions affecting property, plant, and equipment.

d. Determine that the presentation and disclosure of property, plant, and

equipment are appropriate
5.4 INTERNAL CONTROL OVER FIXED ASSETS

Importance of fixed assets audit arises from the following facts:

a. The amount of capital investment in fixed assets represents a large portion of

total assets (especially in industrial companies).

b. Maintenance and depreciation of these assets are major expense in the income
statements.

 Therefore, the total expenditure for these assets and related expenses make

strong internal control essential to the preparation of reliable financial

statements.
  Errors in measurement of income may be material if the distinction between capital and
revenue expenditure is not maintained consistently.
 The losses that arise from uncontrolled method of acquisition, and retiring fixed assets are
often greater than losses from fraud of cash handling.
Common Internal controls: Companies need to apply the following internal control over
fixed assets.
a. Acquisition and retirement of fixed assets must be based on plan/budget.
b. There must be proper recording of acquisition and disposal of fixed assets.

c. Maintain a subsidiary ledger for each unit of fixed asset (e.g. separate ledger for equipment,
another for machinery, furniture, etc).
a. Acquisition and disposals of fixed assets must be approved by concerned higher

management.

b. Any variance between authorized expenditure and actual costs must be disclosed,

reported and analysis for the cause for the variance must be investigated.

c. There must be company policy that distinguishes between capital expenditure and

revenue expenditure.

d. Receipt of purchased fixed asset should be made with proper inspection and goods

receiving report must be issued to suppliers.

a. Periodic physical inventory must be undertaken in order to
ascertain existence, location and condition of all fixed assets.

b.There must be a system of retirement procedure stating reasons

for retirement and bearing appropriate approval.


5.5 AUDIT PROGRAM FOR PROPERTY, PLANT AND EQUIPMENT AND RELATED ACCOUNTS
 The auditor's program for plant asses audit includes the following.
 Obtain an understanding of client’s internal control
 Preliminary review
 System documentation
 Transaction walk-through
 Determine whether controls are potentially reliable in assessing control risk below
maximum
 Physically inspect sampled fixed assets
 Review adequacy insurance coverage
 Inquire about the nature of training to a select sample of personnel (Inquiry)
 Observe property management actions in process (Observation)

 Reviewdocumentation showing completion of the training (Inspection of

documentation)
(II) SUBSTANTIVE AUDIT PROCEDURES FOR PROPERTY, PLANT, AND
EQUIPMENT

1. Obtain a summary analysis of changes in property owned and reconcile to

ledgers.
2. Vouch additions to property, plant, and equipment during the year.
3. Make a physical inspection of major acquisitions of plant and equipment.
4. Analyze repair and maintenance expense accounts.
5. Investigate the status of property, plant, and equipment not in current use.
6. Test the client’s provision for depreciation.
7. Investigate potential impairments of property, plant, and equipment.
8. Investigate retirements of property, plant, and equipment during the year.
9. Examine evidence of legal ownership of property, plant, and equipment.
10. Review rental revenue from land, buildings, and equipment owned
by the client but leased to others.

11. Examine lease agreements on property, plant, and equipment

leased to and from others.
12. Perform analytical procedures for property, plant, and equipment.

13. Evaluate financial statement presentation and disclosures for

plant assets and for related revenue and expenses.
 (III) AUDIT OF PLANT ASSET RELATED ACCOUNTS

1. Analyze Repairs and Maintenance Expense Accounts

Analyze repairs and maintenance expense accounts to:

a. Discover items that should have been capitalized

b.Use company policy to determine consistency in application

c. Analyze monthly amounts for significant variations from:

i. Month to month

ii.Between corresponding months of two years


2. Auditors’ Approach for Depreciation

The auditor should audit depreciation because it is an estimate that needs

due consideration.

Client makes

– Estimate of useful economic life

– Choice of several depreciation methods

 Audit approach for estimate

– Review and test management’s process of developing the estimate

– Review subsequent events or transactions bearing on the estimate

– Independently develop an estimate of the amount to compare to

management’s estimate
3. Audit Program – Depreciation
o Review the depreciation policies set forth in company manuals or other

management directives. Determine whether the methods in use are designed to

allocate costs of plant and equipment assets systematically over their service
lives.
o Obtain or prepare a summary analysis of accumulated depreciation for the

major property classifications as shown by the general ledger control

accounts,
listing beginning balances, provisions for depreciation during the year, retirements,
and ending balances.

o Test the provisions for depreciation.

o Test deductions from accumulated depreciation for assets retired.

o Perform analytical procedures for depreciation.

o Overall test

 5.6 TESTS IN THE AUDIT OF FIXED ASSETS

Although the approach to verifying equipment differs from that used for current assets, several
other asset accounts are verified in much the same manner. These include patents, copyrights, and all
property, plant, and equipment accounts. In the audit of equipment and related accounts, it is helpful
to separate the tests into the following categories:

1. Perform analytical procedures

2. Verify current year acquisitions

3. Verify current year disposals

4. Verify the ending balance in the asset account

5. Verify depreciation expense

6. Verify the ending balance in accumulated depreciation

 Next, let’s examine the use of these categories of tests in the audit
of equipment, depreciation expense, accumulated depreciation,
and gain or loss on disposal accounts.
1. Perform Analytical Procedures

 This involves the comparison of relationship among financial and

non-financial data. This is used to assess whether account

balances or other data appear reasonable.
 Examples:
 Compare gross profit margin of this year with last year.
 Compare amount of payable of this year (month) with last year (month).

 Compare current year’s repair expense with previous year’s repair expense
and investigate the cause for any difference.
 The purpose of analytical procedure is to investigate the cause for any

unusual or unrealistic deviation (difference) among (between) data.

as in all audit areas, the type of analytical procedures depends on the nature of the
client’s operations. the following table illustrates analytical procedures often
performed for equipment.
Analytical Procedure Possible Misstatement
Compare depreciation expense divided by Misstatement in depreciation expense and
gross equipment cost with previous years. accumulated depreciation

Compare accumulated depreciation divided Misstatement in accumulated depreciation

by gross equipment cost with previous years.

Compare monthly or annual repairs and maintenance Expensing amounts that should be capitalized
expense, small tools expense,
and similar accounts with previous years.
 As you can see, most of the typical analytical procedures assess the

likelihood of material misstatements in depreciation expense and

accumulated depreciation.
 2. VERIFY CURRENT YEAR ACQUISITIONS

Companies must correctly record current year additions because the assets have
long-term effects on the financial statements. For example, failure to capitalize a
fixed asset (recording fixed asset cost as expenses) affects balance sheet and income
statement.

a. Understates assets in the balance sheet.

b. Overstates current period’s operating expenses and understates income of the

period. On the other hand, depreciation expenses of the subsequent years will
be understated thereby overstates income of the years.
 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, cut-off, detail tie-in,

and rights and obligations (Realizable value is discussed in connection with verifying

ending balances.) The balance-related audit objectives and common audit tests are shown

in the following table Existence, completeness, accuracy, classification, and rights are

usually the major objectives for this part of the audit.

 As in all other audit areas, the actual audit tests and sample size depend

heavily on tolerable misstatement, inherent risk, and assessed control

risk. Tolerable misstatement is important for verifying current year
additions because these transactions vary from immaterial amounts in
some years to a large number of significant acquisitions in others.
 BALANCE-RELATED AUDIT OBJECTIVES AND TESTS OF DETAILS OF BALANCES FOR EQUIPMENT
ADDITIONS
Balance Related Audit objective Common Tests of Details of Balances Procedures Comments

Current year acquisitions in the Foot the acquisitions schedule. Footing the acquisitions schedule and
acquisitions schedule agree with related tracing individual acquisitions should
master file amounts and the total agrees Trace the individual acquisitions to the master be limited unless controls are
with the general ledger (detail tie-in). file for amounts and descriptions. deficient.
All increases in the general ledger
Trace the total to the general ledger.
balance for the year should reconcile
to the schedule.
Current year acquisitions as listed exist Examine vendors’ invoices and receiving It is uncommon to physically examine
(existence). reports. assets acquired unless controls are
Physically examine assets. deficient or
amounts are material.
Existing acquisitions are recorded Examine vendors’ invoices of closely related This objective is one of the most
(completeness). accounts such as repairs and maintenance to important for equipment.
uncover items that should be
Balance Related Audit objective Common Tests of Details of Balances Procedures Comments

Current year acquisitions as listed Extent depends on inherent risk and

Examine vendors’ invoices.
are accurate effectiveness of internal
(accuracy). controls.
Current year acquisitions as listed are Examine vendors’ invoices in various equipment The objective is closely related to
correctly classified (classification). accounts to uncover items that should be office tests for completeness. It is done in
equipment, part of the buildings, classified as conjunction with that objective and
manufacturing or repairs. tests for accuracy.
Examine vendors’ invoices of closely related
accounts such as repairs to uncover items that
should be recorded as equipment.
Examine rent and lease expense for
capitalizable leases.
Current year acquisitions Review transactions near the balance sheet date for Usually done as part of
are recorded in the correct period (cutoff). correct period. accounts payable cut-off tests.

The client has rights to current year Examine vendors’ invoices. Ordinarily the main concern is whether
acquisitions (rights). equipment is owned or leased.
Purchase or lease contracts are examined
for equipment and property deeds,
abstracts, and tax bills are frequently
examined for land or major
buildings.
 3. VERIFY CURRENT YEAR DISPOSALS

 Transactions involving the disposal of equipment are often misstated when

company internal controls lack a formal method to inform management of the sale,
trade-in, abandonment, or theft of recorded machinery and equipment. If the client
fails to record disposals, the original cost of the equipment account will be
overstated indefinitely, and net book value will be overstated until the asset is fully
depreciated
 Formal methods of tracking disposals and provisions for proper authorization
of the sale or other disposal of equipment help reduce the risk of
misstatement. There should also be adequate internal verification of
recorded disposals to make sure that assets are correctly removed from the
accounting records.

The auditor’s main objectives in the verification of the sale, trade-in, or

abandonment of equipment are to gather sufficient appropriate evidence that
all disposals are recorded and at the correct amounts
 The starting point for verifying disposals is the client’s schedule of recorded
disposals. The schedule typically includes the date when the asset was disposed of,
name of the person or firm acquiring the asset, selling price, original cost,
acquisition date, and accumulated depreciation.

The nature and adequacy of the controls over disposals affect the extent of the search.
The following procedures are often used for verifying disposals:
• Review whether newly acquired assets replace existing assets.

• Analyze gains and losses on the disposal of assets and miscellaneous income for
receipts from the disposal of assets.
• Review plant modifications and changes in product line, changes in major
costly computer-related equipment, property taxes, or insurance coverage for
indications of deletions of equipment.
• Make inquiries of management and production personnel about the possibility
of the disposal of assets.
 4. VERIFY ENDING BALANCE OF ASSET ACCOUNT

Two of the auditor’s objectives when auditing the ending balance in the equipment accounts include

determining that:

1. All recorded equipment physically exists on the balance sheet date (existence)

2. All equipment owned is recorded (completeness)

When designing audit tests to meet these objectives, auditors first consider the nature of internal

controls over equipment or assess the control risk (Examine the effectiveness of internal control) and

following audit programs:

3. Typically, the first audit step concerns the detail tie-in objective-equipment, as listed in the master file,

agrees with the general ledger..

1. Based on the auditor’s assessment of control risk for the completeness objective, the auditor
may physically examine a sample of major equipment items and trace them to the master
file. If a physical inventory is taken, the auditor normally observes the count.

2. The auditor normally does not need to test the accuracy or classification of fixed assets
recorded in prior periods because, presumably, they were verified in previous audits at the
time they were acquired. But if there is an idle plant asset with material balance, the auditor
should evaluate whether they should be written down to net realizable value (realizable value
objective) or at least classified separately as “non- operating equipment.”
1. A major consideration in verifying disclosures related to fixed assets is the
possibility of legal encumbrance (impediment). Auditors may use several
methods to determine whether equipment is encumbered, including:

a. Read the terms of loan and credit agreements

b. Mail loan confirmation requests to banks and other lending institutions

c. Have discussions with the client or send letters to legal counsel

 The proper presentation and disclosure of equipment in the financial statements

must be evaluated carefully to make sure that accounting standards are followed.
Equipment should include the gross cost and should ordinarily be separated from
other fixed assets. Leased property should also be disclosed separately, and all
liens on property must be included in the footnotes. Auditors must perform
sufficient tests to verify that all presentation and disclosure objectives are met.
 5. VERIFY DEPRECIATION EXPENSE

 Depreciation expense is one of the few expense accounts not verified as part of

tests of controls and substantive tests of transactions. The recorded amounts are
determined by internal allocations rather than by exchange transactions with
outside parties. When depreciation expense is material, more tests of details of
depreciation expense are required than for an account that has already been
verified through tests of controls and substantive tests of transactions.
 The most important balance-related audit objective for depreciation expense
is accuracy. Auditors focus on determining whether the client followed a
consistent depreciation policy from period to period, and the client’s
calculations are correct. In determining the former, auditors must weigh
four considerations:
1. The useful life of current period acquisitions
2. The method of depreciation
3. The estimated salvage value
4. The policy of depreciating assets in the year of acquisition and disposition
 The client’s policies can be determined by discussions with appropriate

personnel and comparing their responses with information in the auditor’s

permanent files. In deciding on the reasonableness of the useful lives
assigned to newly acquired assets, the auditor must consider the physical
life of the asset, the expected life (taking in to account obsolescence or the
company’s normal policy of upgrading equipment), and established
company policies on trading in equipment.
 A useful method of auditing depreciation is an analytical procedures

test of reasonableness made by multiplying un-depreciated fixed assets

by the depreciation rate for the year. In making these calculations, the
auditor must make adjustments for current year additions and disposals,
assets with different lengths of life, and assets with different methods
of depreciation.
 Because accounting standards require footnote disclosures related to fixed asset

depreciation, including disclosure of depreciation methods and related useful lives

by asset class, auditors perform procedures to obtain evidence that the
presentation and disclosure-related audit objectives for depreciation are satisfied.
For example, auditors compare information obtained through audit tests of the
depreciation expense accounts to information disclosed in footnotes to ensure the
information presented is consistent with the actual method and assumptions used
to calculate and record depreciation.
 6. VERIFY ENDING BALANCE IN ACCUMULATED DEPRECIATION

 The debits to accumulated depreciation are normally tested as a part

of the audit of disposals of assets, while the credits are verified as a

part of depreciation expense. If the auditor traces selected transactions
to the accumulated depreciation records in the property master file as a
part of these tests, then little additional testing should be required for
the ending balance in accumulated depreciation.
 Two objectives are usually emphasized in the audit of the ending
balance in accumulated depreciation:

1.Accumulated depreciation as stated in the property master file

agrees with the general ledger. This objective can be satisfied by
test-footing the accumulated depreciation in the property master
file and tracing the total to the general ledger.
2.Accumulated depreciation in the master file is accurate.
 In some cases, the life of equipment may be significantly reduced

because of reductions in customer demands for products, unexpected

physical deterioration, a modification in operations, or other changes.
Because of these possibilities, auditors must evaluate the adequacy of the
allowances for accumulated depreciation each year to make sure that the
net book value does not exceed the realizable value of the assets.
 CHAPTER 6
AUDIT OF CURRENT LIABILITIES
& EQUITIES
PART ONE : AUDIT OF LIBILITITY
1. Meaning and Sources of Current liabilities

Current liabilities are liabilities or the obligations that a company reasonably expects to liquidate either
through the use of current assets or the creation of other current liabilities. This concept includes:
 Payables resulting from the acquisition of goods and services: accounts payable, wages payable,
taxes payable, and so on.
 Collections received in advance for the delivery of goods or performance of services, such as
unearned rent revenue or unearned subscriptions revenue.
 Other liabilities whose liquidation will take place within the operating cycle, such as the
portion of long-term bonds to be paid in the current period or short-term obligations arising
from purchase of equipment.