AUDITING and ASSSURANCE Concepts and Applications PDF
AUDITING and ASSSURANCE Concepts and Applications PDF
AUDITING and ASSSURANCE Concepts and Applications PDF
EDITION
AUDITING
AND
ASSURANCE
Concepts and Applications
• Based on PSQC, Framework, ISAs, PSAs,
PAPSs, PSREs, PSAEs, PSRSs
• With Illustrative Audit Working Papers
1
Contents
UNIT I OVERVIEW OF THE CORE CONCEPTS OF
FINANCIAL STATEMENTS AUDIT
Review Questions 20
2
UNIT II APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE I - RISK ASSESSMENT
3
The Detailed Audit Plan 53
Scope of the Audit Engagement 54
Reporting Objectives, Timing of the
Audit and Communications Required 55
Direction, Supervision and Review 56
Documentation 57
Communications with those Charged
with Governance and Management 57
Additional Considerations in Initial Audit
Engagements 58
Other Critical Matters in Engagement
Planning 58
Engagement Team Conference 67
Planning a Repeat Engagement 71
Special Consideration in the Audit of Small
Entities (PAPS 1005) 72
Review Questions 73
4
UNIT III APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE II - RISK RESPONSE:
TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF
TRANSACTIONS
5
Auditing the Revenue and Collection Cycle 153
Phase I - Risk Assessment 153
Phase II - Risk Response 157
Audit of Sales Transactions 158
Evaluation and Obtaining Evidence
About Internal Control Operating
Effectiveness in the Revenue Cycle 160
Tests of Controls Over Sales and
Receivables 161
Illustrative Audit Program for Tests
of Controls: Sales Transactions 164
Substantive Tests of Sales
Transactions 168
6
Chapter 7 AUDIT OF EXPENDITURE (OR
ACQUISITION AND PAYMENT (CYCLE) 197
7
Chapter 8 AUDIT OF THE EXPENDITURE CYCLE,
CONTINUED ... 237
8
Chapter 9 AUDIT OF THE INVESTING CYCLE 275
9
Auditing the Financing Cycle 306
Phase I - Risk Assessment 306
Phase II - Risk Response 311
Obtaining Evidence About Internal
Control Operating Effectiveness for
Debt Obligations and Stockholders'
Equity Transactions 311
Obtaining Substantive Evidence in
Auditing Debt Obligations and
Shareholders' Equity Transactions 312
Substantive Tests of Details:
Debt Obligations Transactions 312
Substantive Tests of Details:
Shareholders' Equity Transactions 313
10
Chapter 12 AUDIT OF TRADE RECEIVABLES,
ALLOWANCE FOR DOUBTFUL
ACCOUNTS AN SALES 355
11
Chapter 14 AUDIT OF INVESTMENTS 431
12
Chapter 17 AUDIT OF PREPAID EXPENSES,
DEFERRED CHARGES AND OTHER
CURRENT LIABILITIES 517
13
Chapter 19 AUDIT OF OWNER(S)' EQUITY
ACCOUNTS 561
14
UNIT V APPLICATION OF THE RISK-BASED AUDIT
PROCESS
PHASE III - REPORTING
15
Chapter 22 FORMING AN OPINION AND
REPORTING ON FINANCIAL
STATEMENTS 649
16
Description of Auditor's Responsibility When the
Auditor Expresses a Qualified of Adverse
Opinion 680
Description of Auditor's Responsibility When the
Auditor Disclaims an Opinion 680
Communication with Those Charged with
Governance 681
Illustrative Audit Reports with Modified Opinion 681
17
UNIT I
OVERVIEW OF THE CORE
CONCEPTS OF FINANCIAL
STATEMENTS AUDIT
Chapter
1 Core Concepts of a Risk-Based
Approach to Conducting a
Quality Audit
18
Chapter
CORE CONCEPTS
RISK-BASED
APPROACH TO
CONDUCTING A
QUALITY AUDIT
1. Understand the core concepts of a Financial Statement Audit including the following:
Nature of an independent Financial Statement Audit
The overall objectives of the Independent Auditor and the conduct of an audit in
accordance with Philippine Standards on Auditing.
Ethical Requirements Relating to an Audit of Financial Statements.
Conduct of an Audit of Financial Statements.
Scope of an Audit of Financial Audit.
Professional Skepticism.
Reasonable Assurance.
Audit risk and Materiality.
Responsibility for the Financial Statements
19
CHAPTER 1
Auditing is a systematic process by which a competent, independent person objectively obtains and
evaluates evidence regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating the results to
interested users.
The Philippine Standard on Auditing (PSA) establishes the independent auditor's overall responsibilities
when conducting an audit of financial statements. Specifically, it sets out the overall objectives of the
independent auditor, and explains the nature and scope of an audit designed to enable the independent
auditor to meet those objectives. It also explains the scope, authority and structure of the PSAs, and includes
requirements establishing the general responsibilities of the independent auditor applicable in all audits,
including the obligation to comply with the PSAs.
OBJECTIVES OF AN AUDIT
In conducting an audit of financial statements, the overall objectives of the auditor are:
(a) To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud. or error, them by enabling the auditor to express an
opinion on whether the financial statements are prepared, in all material respects, in accordance
with an applicable financial reporting framework; and
(b) To report on the financial statements, and communicate as required by the PSAs, in
accordance with the auditor's findings.
20
The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements.
This is achieved by the expression of an opinion by the auditor on whether the financial statements are
prepared in all material respects, in accordance with an applicable financial reporting framework. In the
case of most general-purpose frameworks, that opinion is on whether the financial statement are presented
fairly, in accordance with PSAs and relevant ethical requirement enables the auditor to form that opinion.
An audit of financial statements is an assurance engagement, as defined in the Philippine Framework for
Assurance Engagements. The Framework defines and describes the elements and objectives of an
assurance engagement. The PSAs apply the Framework in the context of an audit of financial statements
and contain the basic principles and essential procedures, together with related guidance, to be applied in
such an audit.
The auditor should comply with relevant ethical requirements relating to audit engagements.
As discussed in PSA220, "Quality Control for an Audits of Financial Statements,” ethical requirements
relating to audits of financial statements ordinarily comprise Parts A and B of the Code of Ethics for
Professional Accountants in the Philippines (Ethics Code)' effective April 6, 2018 adopted and
promulgated by the Board of Accountancy. PSA 220 (Revised) identifies the fundamental principles of
professional ethics established by Parts A and B of the Ethics Code and sets out the engagement partner's
responsibilities with respect to ethical requirements.
PSA 220 recognizes that the engagement team is entitled to rely on a firm's systems in meeting its
responsibilities with respect to quality control procedures applicable to the individual audit engagement (for
example, in relation to capabilities and competence of personnel through their recruitment and formal
training; independence through the accumulation and communication of relevant independence information;
maintenance of client relationship through acceptance and continuance system. ; and adherence to
regulatory and legal requirements through the monitoring process), unless information provided by the firm
or other parties suggest otherwise. Accordingly, Philippine Standard on Quality Control (PSQC) 1,
“Quality Control for Firms that Perform Audits and
21
Reviews of Financial Statements, and Other Assurance and Related Services Engagements”, requires the
firm to establish policies and procedures designed to provide it with reasonable assurance that the firm and
its personnel comply with relevant ethical requirements.
The auditor should conduct an audit in accordance with Philippine Standards on Auditing.
PSAs contain basic principles and essential procedures together with related guidance in the form of
explanatory and other material, including appendices. The basic principles and essential procedures are to
be understood and applied in the context of explanatory and other materials that provide guidance for their
application. The text of a whole Standard is considered in order to understand and apply the basic principles
and essential procedures.
In conducting an audit in accordance with PSAs, the auditor is also aware of and considers Philippine
Auditing Practice Statements (PAPSs) applicable to the audit engagement. PAPSs provide interpretative
guidance and practical assistance to auditors in implementing PSAs. An auditor who does not apply the
guidance included in a relevant PAPS needs to be prepared to explain how the basic principles and essential
procedures in the Standard addressed by the PAPS have been complied with.
The auditor may also conduct the audit in accordance with both ISAs and PSAs. However, there are
currently no fundamental differences between the IAASB pronouncements and corresponding
requirements issued by the AASC and no such differences are expected in the future.
The term "scope of an audit" refers to the audit procedures deemed necessary in the circumstances to
achieve the objective of the audit. In determining the audit procedures to be performed in conducting an
audit in accordance with Philippine Standards on Auditing, the auditor to the auditor should comply with
each of the Philippine Standards on Auditing relevant to the audit.
2 As stated in the Preface to the Philippine Standards on Quality Control, Auditing, Review, and Other Assurance and Related Services, it is the
stated policy of the AASC to make the International Standards and Practice Statements issued by the IAASB the applicable standards and practice
statements in the Philippines. To implement such policy, the AASC makes Philippine specific those paragraphs or sections in International
Standards and Practice Statements that are addressed in broad terms to the international community as a whole to make them clearly applicable the
Philippine, or provides additional information certain paragraphs or sections, whenever necessary to facilitate and clearly establish their application
in the Philippines.
22
The auditor should not represent compliance with Philippine Standards on Auditing unless the auditor has
complied fully with all of the Philippine Standards on Auditing relevant to the audit. The auditor may, in
exceptional circumstances, judge it necessary to depart from a basic principle or an essential procedure that
is relevant in the circumstances of the audit, in order to achieve the objective of the audit. In such a case, the
auditor is not precluded from representing compliance with PSAs, provided the departure is appropriately
documented as required by PSA 230 (Clarified), "Audit Documentation."
PROFESSIONAL SKEPTICISM
The auditor should plan and perform an audit with an attitude of professional skepticism recognizing that
circumstances may exist that cause the financial statements to be materially misstated.
An attitude of professional skepticism means the auditor makes a critical assessment, with a questioning
mind, of the validity of audit evidence obtained and is alert to audit evidence that contradicts or brings into
question the reliability of documents and responses to inquiries and other information obtained from
management and those charged with governance. For example, an attitude of professional skepticism is
necessary throughout the audit process for the auditor to reduce the risk of overlooking unusual
circumstances, of over generalizing when drawing conclusions from audit observations, and of using faulty
assumptions in determining the nature, timing and extent of the audit procedures and evaluating the results
thereof. When making inquiries and performing other audit procedures, the auditor is not satisfied with
less-than persuasive audit evidence based on a belief that management and those charged with governance
are honest and have integrity. Accordingly, representations from management are not a substitute for
obtaining sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base
the auditor's opinion.
REASONABLE ASSURANCE
An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial
statements taken as a whole are free from material misstatement, whether due to fraud or error. Reasonable
assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to
conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable
assurance relates to the whole audit process.
23
An auditor cannot obtain absolute assurance because there are inherent limitations in an audit that affect the
auditor's ability to detect material misstatements. These limitations result from factors such as the
following:
The use of testing.
The inherent limitations of internal control (for example, the possibility of management override
or collusion).
The fact that most audit evidence is persuasive rather than conclusive.
Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in particular
regarding:
a) The gathering of audit evidence, for example, in deciding the nature, timing and extent of audit
procedure; and
b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the
reasonableness of the estimates made by management in preparing the financial statements.
Further, other limitations may affect the persuasiveness of evidence available to draw conclusions on
particular assertions (for example, transactions between related parties). In these cases, certain PSAs
identify specified audit procedures which will, because of the nature of the particular assertions, provide
sufficient appropriate audit evidence in the absence of:
a) Unusual circumstances which increase the risk of material misstatement beyond that which would
ordinarily be expected; or
b) Any indication that a material misstatement has occurred.
Accordingly, because of the factors described above, an audit is not a guarantee that the financial statements
are free from material misstatement, because absolute assurance is not attainable. Further, an audit opinion
does not assure the future viability of the entity nor the efficiency or effectiveness with which management
as conducted the affairs of the entity.
24
AUDIT RISK AND MATERIALITY
The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the financial
statements give a true and fair view or are presented fairly, in all material respects, in accordance with the
applicable financial reporting framework. The concept of reasonable assurance acknowledges that there is a
risk the audit opinion is inappropriate. The risk that the auditor expresses an inappropriate audit opinion
when the financial statements are materially misstated is known as "audit risk".
The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is
consistent with the objective of an audit. The auditor reduces audit risk by designing and performing audit
procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on
which to base an audit opinion. Reasonable assurance is obtained when the auditor has reduced audit risk to
an acceptably low level.
While the auditor is responsible for forming and expressing an opinion on the financial statements, the
responsibility for the preparation and presentation of the financial statements in accordance with the
applicable financial reporting framework is that of the management of the entity, with oversight from those
charged with governance. The audit of the financial statements does not relieve management or those
charged with governance of their responsibilities.
25
THE RISK-BASED AUDIT PROCESS
Introduction
Risk-based audit approach is an audit approach that begins with an assessment of the types and likelihood
of misstatements in account balance and then adjusts the amount and type of audit work, to the likelihood of
material misstatements occurring in account balances.
In risk-based audit, the audit team views all activities in the organization first in terms of risks to strategies
and objectives, and then in terms of management's plans and processes to mitigate the risk. The auditors
obtain an understanding of the client's objectives. The risks are identified and the auditors determine how
management plans to mitigate the risk and whether those plans are in place and operating effectively.
Account-based audit is an approach wherein the auditor obtains an understanding of control and assesses
control risk for particular types of errors and frauds in specific accounts and cycle.
26
Phase II. I Risk Response
a. Designing overall responses and further audit procedures to develop appropriate responses to the
assessed risk of material misstatement.
b. Implementing responses to assessed risk of material misstatement misstatement to reduce audit
risk to an acceptably low level.
a. Evaluating the audit evidence obtained to determine what additional audit work (if any) is
required.
b. Forming an opinion based on audit findings and preparing the auditor's report.
* An "event" is simply a business or fraud risk factor that, if it actually occurred, would adversely affect the
entity's ability to achieve its objective of preparing financial statements that do not contain material
misstatements resulting from error and fraud. This would also include risks resulting from the absence of
internal control to mitigate the potential for material misstatements in the financial statements.
Figure 1-2 shows the schematic risk-based audit process in accordance with the guidelines provided by the
International Federation of Accountants.
27
Figure 1-2: Risk-Based Audit Process*
* Adapted from “Guide to using International Standards of Auditing in the Audits of Small and Medium Sized
Entities” Volumes I and II, Core Concepts / Practical Application – Fourth Edition”. Copyright © November 2018 by
IFAC, All rights reserved. Used with permission of IFAC.
28
Figure 1-3 presents the Relevant Philippine Standard On Auditing (PSAS) To Be Used In The Risk Based
Audit Process
Figure 1-3Relevant Philippine Standard On Auditing (PSAS) To Be Used In The Risk Based Audit
Process
Client Acceptance and PSA 210, Agreeing the Terms of Audit Engagements
Continuance
Considering Fraud PSA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of
Financial Statements
Planning an Audit PSA 300, Planning an Audit of Financial Statements
Assessing Risk of Material PSA 315, Identifying and Assessing the Risk of Material Misstatement
Misstatement though Understanding the Entity and its Environment (Newly Revised
Standard effective for audits of financial statement for periods ending on
or after December 15, 2013)
29
Communicating with those Charged PSA 260, Communication with Those Charged with Governance
with Governance about the Audit
Plan
PHASE II - RISK RESPONSE
Testing Controls for the Financial PSA 330, The Auditor's to Assessed Risks
Statement Audit
Audit Sampling for Tests of Controls PSA 530 Audit Sampling
Testing Controls in an Integrated
Audit
Obtaining Evidence PSA 250. Consideration of Laws and Regulations in an Audit of
about Compliances with Laws and Financial Statements
Regulations
Substantive Audit Procedures PSA 330. The Auditor's Responses to Assessed Risks
PSA 500 Audit Evidence
Audit Evidence regarding the PSA 501, Audit Evidence Specific Considerations for Selected
a. Valuation of investments items
in securities and
derivative instruments;
b. Existence and condition of
inventory
c. Completeness of litigation,
claims, and assessments
involving the entity; and
d. Presentation and disclosure
of segment information,
in accordance with
the applicable
financial reporting
framework
30
Analytical Procedures as a PSA 520. Analytical Procedures
Substantive Test
Using an Auditor's Specialist/Expert PSA 620 Using the work of an Auditor's Expert
Evaluating the implications of PSA 250. Consideration of Laws and Regulation in an Audit of
Noncompliance with Laws and Financial Statements
Regulations
Evaluating Financial Statement PSA 450 Evaluation of Misstatements Identified during the Audit
Misstatements
Subsequent Events PSA 560. Subsequent Events
Disclosures about Related Parties PSA 550. Related Parties
Going Concern PSA 570. Going Concern
Management Representations PSA 580. Written Representations
Omitted Procedures PSA 250. Communication with those Charged with Governance
Communicating with those Charged PSA 700, Forming an Opinion and Reporting on Financial
with Governance Statements
Supervision
Engagement Quality Review
Audit Opinions
Audit Opinion Modifications PSA 705, Modifications to the Opinion in the Independent
Auditor's Report
Matter Paragraphs in the Audit PSA 706, Emphasis of Matter Paragraphs and Other Matter
Report Paragraphs in the Independent Auditor's Report
Special Considerations PSA 800. Special Considerations - Audits of Financial Statements
Prepared in Accordance with Special Purpose Frameworks
PSA 805, Special Considerations - Audits of Single Financial
Statements and Specific Elements, Accounts or items of a
Financial Statement
31
UNDERSTANDING THE AUDIT RISK MODEL
Nature of Risk
Risk is a concept used to express uncertainty about events and/or their outcomes that could have a material
effect on the organization.
The four critical components of risk that are relevant to conducting the audit are:
1. Audit Risk. The risk that an auditor may give an unqualified opinion on financial statements that
are materially misstated.
2. Engagement Risk. The economic risk that a CPA Firm is exposed to simply because it is
associated with a particular client including loss of reputation, inability of the client to pay the
auditor, or financial loss because management is not honest and inhibits the audit process.
Engagement risk is controlled by careful selection and retention of client.
3. Financial Reporting Risk. Those risks that relate directly to the recording of transactions and the
presentation of financial data in an organization's financial statements.
4. Business Risk. Those risks that affect the operations and potential outcomes of organizational
activities.
The following considerations are important in integrating the concepts of materiality and risk in the conduct
of a risk-based audit:
1. Risky areas of a business must be identified by the auditors to determine which account balances
are more prone to material misstatements, how the misstatements might occur and how a client
might be able to cover them up.
2. Auditors need to develop approaches and methodologies to allocate overall assessments of
materiality to individual account balances because some account balances may be more important
to users.
3. Audits involve testing or sampling and thus cannot provide absolute (100%) assurance that the
financial statements are free of material misstatements without inordinately driving up the cost of
audits.
4. Not all clients are worth accepting. Since audits rely on testing and to some extent on the integrity
of management, there are some clients that an audit firm should not accept because the
engagement risk is too high.
5. Competition for clients among audit firms is high. Clients choose auditors based on a number of
factors including fees, service, industry knowledge, personal rapport and ability to assist the
client.
32
6. Auditors should understand society's expectations of financial reporting to reduce audit risk to an
acceptably low level and therefore minimize lawsuits that the users may possibly bring forth.
Although audit risk is a concept, it is often illustrated using quantitative examples. For instance, the
relationship between engagement risk and audit risk may presented as follows:
Engagement Risk
Audit Risk High Moderate Low
Do not accept client Set Very Low (1%) Set within professional standard but
can be higher companies with higher
engagement risk (5%)
Setting audit risk at 1% is equivalent to performing a statistical test using 99% confidence level.
Audit risk set at 1% implies that the auditor is willing to take a 1% chance of issuing an
unqualified opinion on materially misstated financial statements.
Audit risk set at 5%, implies that the auditor is willing to take a 5% chance of issuing an
unqualified opinion on materially misstated financial statements.
High levels of audit risk are appropriate for client with lower levels of engagement risk.
Based on the assessment of engagement risk, the auditor sets the desired audit risk. Audit risk oftentimes
illustrated using numeric or quantitative examples. In fact many audit firms use the measures associated
with statistical sampling to set audit risk, e.g., setting audit risk at a 1% level for high-risk clients and 5% for
lower-risk clients. Other auditing firms use a broader description of audit risk as high, moderate or low and
adjust the nature of their audit procedures accordingly.
The following general observations are considered to have influenced the implementation of the audit risk
model:
The better the company's internal controls, the lower the likelihood of material misstatement.
Unusual or complex transactions are more likely to be erroneously recorded than am recurring or
routine transactions.
The amount and persuasiveness of audit evidence gathered should vary inversely with audit risk;
i.e., lower audit risk requires gathering more persuasive evidence.
33
COMPONENTS OF AUDIT-RISK MODEL
These general premises have been incorporated into an audit risk (AR) model with three components:
inherent risk (IR), Control Risk (CR), and Detection Risk (DR) as follows:
AR = IR x CR x DR
where
Inherent risk (IR) is the initial susceptibility of a transaction or accounting adjustment to be recorded in
error, or for the transaction not to be recorded in the absence of internal controls.
Control risk (CR) is the risk that the client's internal control system will fail to prevent or detect a
misstatement.
Detection risk (DR) is the risk that the audit procedures will fail to detect a material misstatement.
Stated differently, audit risk is the risk that the auditor may give an unqualified opinion on materially
misstated financial statements. It is influenced by: (IR) the likelihood that a transaction, estimate, or
adjustment might be recorded incorrectly; (CR) the likelihood that the client's internal control processes
would fail to prevent or detect the misstatement and (DR) the likelihood that, if a misstatement occurred,
the auditor's procedures would fail to detect the misstatement.
The audit risk model may also be illustrated using a quantitative approach with probability assessments
applied to each of the model's component.
XYZ Mining Corporation, an audit client of Aquino and Marcos CPAs ., has many complex transactions
and weak internal control. The auditors assess both inherent risk and control risk at their maximum. This
implies that the client does not have effective control (CR) and there is a high risk that the transaction would
be recorded incorrectly (IR).
The auditors believe that engagement risk is high and have set audit risk at the 0.01 level. This means that
the auditors do not want to take much of a risk that the misstatement goes undetected in the financial
statements.
.
34
The effect on the extent of audit procedures and thus, detection risk is as follows:
AR = IR x CR x DR
𝐴𝑅
𝐷𝑅 =
(𝐼𝑅 𝑥 𝐶𝑅)
.
𝐷𝑅 = or 0.01 or 1%
( . . )
In this particular case, detection risk and audit risk are the same because the auditor cannot rely on internal
control to prevent or detect misstatements.
"Poor controls and a high likelihood of misstatement would lead to extended audit work to maintain
audit risk at an acceptable level."
Zoren Trading Corporation is an audit client of Cayetano and Loren CPAs. Zoren has simple transactions,
well-trained accounting personnel effective control and no incentive to misstate the financial statements.
The auditor's previous audit experience with the client; an understanding of the client's internal controls and
the results of preliminary testing this year indicate a low risk of material misstatement existing in the
accounting records. The auditor assesses inherent risk as low as 50% and control risk of 20%.
.
𝐷𝑅 = or 0.50 or 50%
(. . )
35
The auditor could therefore design test of the accounting records with a lower detection risk, in this
situation 50%, because only minimal substantive test of account balances are needed to provide
collaborating evidence on the expectations that the accounts are not materially misstated. The auditor,
however would have had to test whether the controls are operating effectively in order to support a control
risk assessment below 100%.
The following general observations on an audit client influence the implementation of the audit risk model:
1. High-risk activities
This includes operations or events where a material misstatement could easily occur. For example,
an inventory of high-value diamonds or gold bars held by a jeweler, or a new / complex
accounting system being introduced.
Identified significant related party transactions outside the entity's normal course of business are
to be treated as giving rise to significant risks. This includes infrequent and large transactions.
For example:
Routine non-complex transactions that are subject to systematic processing are less likely to give
rise to significant risks.
36
Where management intervention is required to specify the accounting treatment to be used.
The risk of not detecting a material misstatement resulting from fraud (which is intentional and
deliberately concealed) is higher than the risk of not detecting one resulting from error.
In evaluating whether significant risk could result from the identified fraud risk factors and the
possible scenarios and schemes identified in team discussions, consider the following:
Skillfulness of the potential perpetrator;
Relative size of individual amount manipulated;
Level of authority of management or employee to:
directly or indirectly manipulate accounting records, and override control procedures;
Significant fraud risks may be identified at any stage in the audit as a result of new information
being obtained.
Audit risk is a concept that drives the auditor's thinking about planning the audit and then executing an audit.
The illustrations are designed to provide guidance, but should not be applied rotely to any audit client.
CPA firms in determining their approach to implementing the audit risk model should consider the
following limitations:
a) Inherent risk is difficult to formally assess. Some transactions because of their complexity are
more susceptible to error but it is quite difficult to assess that level of risk independent of the
client's accounting system.
b) The model treats each risk component as separate and independent when in fact the components
are not independent. It is also quite difficult to separate a client's material controls and inherent
risk.
c) Audit risk is judgmentally determined.
d) Audit technology is not so fully developed that each component of the model can be accurately
assessed. Auditing is based on testing and precise estimates of the model's components are not
possible. Auditors can, however, make subjective assessments and use the audit risk model as
guide.
37
REVIEW QUESTIONS
Questions
3. Discuss the role of risk in the audit process and how its existence is communicated to the user in
the audit report.
4. Prior to naming Cruz and Company as its auditors, Del Pelayo of Verbatim, Inc, met with Gracie
Cruz and inquired about the auditors who would work on Verbatim audit. Pelayo wants Cruz to
assign only persons who graduated only in his alma mater.
5. Describe the conditions under which an auditor is associated with financial statements.
6. What factors should an auditor consider in determining whether financial statements are
presented fairly in conformity with applicable financial reporting standards?
7. Why must the auditor refrain from explaining why she or he is independent?
10. Describe the relationship between detection risk and evidence accumulation.
11. Below are an auditor's planned audit risk and assessment of inherent risk
Situation Planned Audit Risk Assessed Inherent Risk Assessed Control Risk
1 1% 20% 20%
2 1 100 50
3 4 20 20
4 5 100 50
5 5 100 100
38
Required:
a. Determine the detection risk that can be allowed for each situation.
b. Rank the five situations, based on the amount of audit evidence that will be needed. You may
assume that all other factors that may affect audit evidence accumulation are the same.
12. Last year you were assigned to minor parts of the audit of the sales and collections cycle for
Patrick Corporation. This year you have been assigned significant responsibility in the audit of the
sales and collections cycle. You recall that last year, the credit manager, Josie Tan, treated you as
if you were one of the clerks. In fact, you had to call her "Ms. Tan" when you went to ask her
several questions. This year, she has become very friendly. Josie, as she now wants you to call her,
has just invited you to join her for dinner at a very exclusive private club in town. You were called
away before you could give Josie a reply, but she did indicate to you that last year she took your
predecessor to such a dinner.
13. The fairness of financial statements and the adequacy of internal controls are judged only by
reference to pre-established criteria. What serves as the criteria to judge the fairness of financial
statements and the adequacy "of internal controls? Explain why "reference to criteria" is
important to the audit function and the results communicated by the audit function.
14. How does complexity affect (1) the demand for auditing services and (2) the performance of
auditing services?
15. Who is the most important user of an auditor's report on a company's financial statements:
company management, the company's shareholders, or the company's creditors? Briefly explain
your rationale and indicate how auditors should resolve potential conflicts in the needs of the
three parties.
16. How does an audit enhance the quality of financial statements and management's reports on
internal control? Does an audit ensure a fair presentation of a company's financial statements or
that internal control systems are free of material deficiencies? Explain.
17. In what ways does the practice of internal auditing differ from the practice of public accounting?
To whom is the internal auditing function responsible?
39
18. Maria Cruz & Co, CPAs, is planning its audit procedures for its tests of the valuation of
inventories of Eastern Manufacturing Co. The auditors on the engagement have assessed inherent
risk and control risk for valuation of inventories at 100 percent and 50 percent, respectively.
Required:
a. Calculate the appropriate level of detection risk for the audit of this assertion, given that the
auditors wish to restrict audit risk for the assertion to 3 percent.
b. Calculate the appropriate level of detection risk for the audit of this assertion, given that the
auditors wish to restrict audit risk for the assertion to 5 percent.
19. State whether each of the following statements is correct or incorrect concerning audit risk and its
components - inherent risk, control risk, and detection risk.
a. The risk of material misstatement is composed of the three components of audit risk.
b. Inherent risk is the possibility of material misstatement before considering the client's
internal control.
c. Less control risk means in increase in the risk of material misstatement.
d. Detection risk does not exist when no audit is performed.
e. Rather than restrict detection risk through the performance of more substantive procedures,
auditors assess it.
f. Absent any other changes, an increase in the risk of material misstatement results in an
increase in audit risk.
g. Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately
modify their opinion on financial statements that are materially inherent risk or immaterially
misstated.
h. Both inherent risk and control risk exist independently of the audit of financial statements.
20. In applying a top-down, risk-based approach to an audit, should the auditor start with the ending
account balances or does the auditor start with the significant processes that lead to material
account balances? Is one approach preferred over the other? Explain.
40
41
UNIT II
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE I - RISK ASSESSMENT
Chapter
2 Phase I - Risk Assessment:
Preliminary Engagement
Activities
42
Chapter
PHASE I -
RISK ASSESSMENT:
PRELIMINARY
ENGAGEMENT
ACTIVITIES
43
CHAPTER 2
PHASE I - RISKASSESSMENT:
PRELIMINARY ENGAGEMENT ACTIVITIES
Introduction
One of the most important decisions that an audit firm can make is determining what engagements to accept
or which client relationships to retain. A poor decision can lead to unbillable time, unpaid fees additional
stress on partners and staff, potential lawsuits and worst of all, loss of reputation.
Even though obtaining and retaining clients is not easy in a competitive profession such as public
accounting, a CPA firm must use care in deciding which clients are acceptable. The firm's legal and
professional responsibilities are such that clients who lack integrity or argue constantly about the proper
conduct of the audit and fees can cause more problems than they are worth. Some CPA firms now refuse
clients in certain high-risk industries, such as savings and loans, health, and casualty insurance companies,
and may even discontinue auditing existing clients in those industries.
Before accepting a new client, most CPA firms investigate the company to determine its acceptability. To
extent possible, the prospective client's standing in the business community, financial stability, and
relations with its previous CPA firm should be evaluated. For example, many CPA firms use considerable
caution in accepting new clients in newly formed, rapidly growing businesses. Many of these businesses
fail financially and expose the CPA firm to significant potential liability.
For prospective clients that have previously been audited by another CPA firm, the new (successor) auditor
should endeavor to communicate with the predecessor auditor. The purpose of the requirement is to help the
successor auditor evaluate whether to accept the engagement. The communication may, for example,
inform the successor auditor that the client lacks integrity or that there have been disputes over accounting
principles, audit procedures, or fees.
44
Even when a prospective client has been audited by another CPA firm, other investigation are often made.
Sources of information include local attorneys, other CPAs, banks and other businesses. In some cases, the
auditor professional investigator to obtain information about the reputation and background of the members
of management. More extensive investigation is appropriate when there has been no previous auditor will
not provide the desired information, or if any indication of problems arises from the communication.
Many practitioners take advantage of the Internet as a search tools to learn more about the potential new
client and its key operations, by studying available client web sites and by using search engines for other
sites that discuss the potential client.
Continuing Clients
Many CPA firms evaluate existing clients annually to determine whether there are reasons for not
continuing to do the audit, previous conflicts over such things as the appropriate scope of the audit, the type
of opinion to issue, or fees may cause the auditor to discontinue association. The auditor may also
determine that the client lacks integrity and therefore should no longer be a client. If the client files a lawsuit
against a CPA firm or vice versa, the firm cannot do the audit. Similarly, if there are unpaid fees for services
performed more than 1 year previously, the CPA firm cannot do the current year audit. To do an audit in
either of these circumstances violates the Code of Ethics for Professional Conduct rules on independence.
Even if none of the previously discussed conditions exists, the CPA firm may decide not to continue doing
audits for a client because of excessive risk. For example, a CPA firm might decide that there is
considerable risk of regulatory conflict between a governmental agency and a client, which could result in
financial failure of the client and ultimately lawsuits against the CPA firm. Even if the engagement is
profitable, the risk may exceed the short-term benefits of doing the audit.
Investigation of new clients and reevaluation of existing ones is an essential part of deciding acceptable
audit risk. Assume a potential client in a reasonably risky industry, where management has a reputation of
integrity, but is also known to take aggressive financial risks. If the CPA firm decides that acceptable audit
risk is extremely low, it may choose not to accept the engagement. If the CPA firm concludes that
acceptable audit risk is low but the client is still acceptable, it is
45
likely to affect the fee proposed to the client. Audits with a low acceptance audit risk will normally result in
higher audit cost, which should be reflected in higher audit fees.
A. The firm shall implement policies and procedures for the acceptance and continuance of client
relationships and specific engagements, designed to provide the firm with reasonable assurance that it
will only undertake or continue relationship s and engagements where the firm:
a) Is competent to perform the engagement and has the capabilities, including time and resources to
do so;
b) Can comply with relevant ethical requirements; and
c) Has considered the integrity of the client, and does not have information that would lead it to
conclude that the client lacks integrity.
The auditor shall be satisfied that appropriate procedures regarding the acceptance and continuance of
client relationships and audit engagements have been followed, and shall determine that the
conclusions reached in this regard are appropriate.
B. If the auditor obtains information that would have caused the firm to decline the audit engagement has
that information been available earlier, the engagement partner shall communicate that information
promptly to the firm, so that the firm and the engagement partner can take the necessary action.
C. The auditor shall undertake the following activities prior to starting an initial audit:
a) Performing procedures regarding the acceptance of the client relationship and the specific audit
engagement; and
b) Communicating with the predecessor auditor, where there has been a change of auditors, in
compliance with relevant ethical requirements.
46
D. Strict client acceptance / continuance guidelines should be established to screen out the following:
Clients that are in financial and/or organizational difficulty - For example, clients that could go
bankrupt or clients with poor internal accounting controls and sloppy records
Clients that constitute a disproportionate percentage of the firm's total practice - Clients may
attempt to influence the auditor into allowing unacceptable accounting practices or issuing
inappropriate opinions.
Disreputable clients - External audit firms cannot afford to have their good reputation tarnished
by serving a disreputable client or by associating with a clear that has disreputable management.
Clients that offer an unreasonably low free for the auditor's services - In response, the auditor
may attempt to cut corners imprudently or lose money on the engagement. Conversely, auditors
may bid for audits at unreasonably low prices.
Determine the nature of the engagement and whether it can be undertaken in accordance with the firm's
policy. Then address the following questions, and document the findings and conclusions.
1. What are the values ("tone at the top") and future goals of the entity?
2. How competent are the entity's senior management and staff?
3. Has the firm conducted an Internet search and had discussions with firm personnel and other third
parties (such as bankers) to identify any reasons why the firm should not accept the engagement?
4. Are there difficult or time-consuming issues to address (accounting policies, estimates,
compliance with legislation, etc.)?
5. What changes have taken place this period that will impact the engagement (business trends and
initiatives, personnel changes, financial reporting, IT systems, purchase / sale of assets,
regulations, etc.)?
6. Is there a high level of public scrutiny and media interest?
47
7. Is the entity in good financial health and does it have the ability to pay the firm's professional
fees?
8. Will the entity provide help to firm in obtaining information and preparing schedule, analysis of
balances, providing data files, etc.?
9. For new engagements, has the firm communicated with the predecessor auditor to determine if
there are any reasons for not accepting the engagement?
II. Does the firm have the competence, resources, and time required?
An external audit firm should not undertake an engagement that it is not qualified to handle. Doing so is
especially important for smaller, growing firms that may be tempted to agree to conduct an audit for
which they are not qualified or not large enough to perform. Statistics show that firms covered by a
professional liability insurance plan that are most susceptible to litigation are those with staffs of eleven
to twenty-five auditors. They appear to become overzealous, leading to low audit quality and exposure
to subsequent litigation.
48
III. Is the firm / staff independent and free from conflict?
1. Can the firm and the engagement team comply with ethical and independence requirements?
2. Where conflicts of interest, lack of independence, or other threats have been identified:
Has appropriate action been taken to eliminate those threats or reduce them to an acceptable
level by applying safeguards, or
Have steps been taken to withdraw from the engagement?
3. If the entity being audited is a component of a larger group, the group engagement team may
request certain work to be performed on the financial information of the component. In such cases,
the group engagement would first obtain an understanding of the following:
Whether the component auditor understands and will comply with the ethical (including
independence) requirements that are relevant to the group audit,
The component auditor's professional competence,
Whether the group engagement team will be able to be involved in the work of the
component auditor to the extent necessary to obtain sufficient appropriate audit evidence,
and
Whether the component auditor operates in regulatory environment that actively oversees
auditors.
1. Is there any reason (or recent event) that casts doubt on the integrity of the principal owners,
senior management, and those charged with government of the entity? Consider the entity's
operations, including business practices, the business' reputation, and history of any ethical or
regulatory infringements.
2. Are there any indications that the entity might be involved in money laundering or other criminal
activities?
3. What is the identity and business reputation of related parties?
4. .Does management have a poor attitude toward internal control and an aggressive attitude toward
interpretation of accounting standards? Consider corporate culture, organizational structure, risk
tolerance, complexity of transactions, etc.
49
To ensure that the information obtained from the entity is accurate, consider what third-party information
could be obtained to validate key aspects of the risk assessment. This simple step could avert problems later
on. Examples include information from sources such as previous financial statements income tax returns
credit reports and possibly (after receiving permission from the prospective client) discussion with key
advisors such as bankers etc.
Before contracting third parties and collecting information on a prospective client, take steps to ensure that
all partners and staff partners and staff are aware of:
The firm's policies to protect confidential information maintained on clients;
Requirements of any privacy legislation; and
Requirements of the applicable code of ethics.
Figure 2-1 shows a sample questionnaire that could be used in assessing client acceptance / continuance.
Figure 2-1 Illustrative Questionnaire That Could Be Used in Assessing Client Acceptance /
Continuance (Partial)
50
Does the firm have the capacity in time, competencies, and resources to
complete the engagement in accordance with professional and firm
standards?
Are there any issues identified in previous audits and other engagements
for this entity that need to be addressed?
Are there any new circumstances that increase our engagement risk?
Can the client continue to pay our fees?
Conclusion:
Overall assessment of engagement risk ______ (Low, Moderate or High)
We should __________ client.
Chris Garcia
Santos & Associates, CPAs
*accept/decline
*continue with / discontinue with
In order to establish whether the preconditions for an audit are present, the auditor shall:
a) Determine whether the financial reporting framework to be applied in the preparation of the financial
statements is acceptable; and
b) Obtain the agreement of management that it acknowledges and understand its responsibility:
i. For the preparation of the financial statements in accordance with the practicable financial
reporting framework, including where relevant their presentation;
ii. .For such internal control as management determines is necessary to enable the presentation of
financial statements that are free from material misstatement, whether due to fraud or error; and
51
iii. To provide the auditor with:
Access to all information of which management is aware that is relevant to the preparation of
the financial statements such as records, documentation and other matter;
Additional information that the auditor may request from management for the purpose of the
audit; and
Unrestricted access to persons within the entity from whom the auditor determines is
necessary to obtain audit evidence.
Where management does not acknowledge its responsibilities or agree to provide the written
representations, the auditor will not be able to obtain sufficient appropriate audit evidence.in such
circumstances, or where the financial reporting framework is not acceptable, the auditor is required by PSA
to decline the engagement unless required by law or regulation.
Likewise, the auditor should determine whether management or those charged with governance imposes
any type of limitation on the scope of the audit. This could include unrealistic deadlines, not accepting
certain firm's staff to perform the work, and denial of access to a facility, key personnel, or relevant
documents. If such a limitation would result in a disclaimer of opinion, the firm would decline the
engagement, unless the firm is required by law or regulation to proceed with the engagement.
Engagement Letter
A clear understanding of the terms of the engagement should exist between the client and the CPA firm.
PSA requires that auditors must document their understanding’s objectives, the responsibilities of the
working papers including the engagement’s limitations. This is typically done with an engagementletter.
The engagement letter is an agreement between the CPA firm and the client for the conduct of the audit
and related services.
The engagement letter states the scope of the work to be done on the audit so that system there should be no
doubt in the mind of the client, external auditor, or the court as to the expectations agreed to by the external
auditor and the client.
52
The agreed terms of the audit engagement shall be recorded in an audit engagement letter or other suitable
form of written agreement and shall include:
a) The objective accounting framework, and the form of auditor's report resulting from scope of the
audit of the financial statements;
b) Identification of the applicable financial reporting framework for the preparation of the financial
statements;
c) Reference to the expected form and content of any reports to be issued by the auditor and a
statement that there may be circumstances in which a report may differ from its expected form and
content;
d) .The responsibilities of the auditor;
e) .The responsibilities of management; and
f) .Arrangements on how the audit will be conducted, involvement of other auditors and experts, if
any, dispute resolution, obligation and the basis on the computation of fees and billing.
The client should confirm the terms of the engagement by acknowledging receipt of the engagement letter.
If the terms of the audit engagement are changed, the auditor and management shall agree on and record the
new terms of the engagement in an engagement letter or other suitable form of written agreement.
If the auditor is unable to agree to a change of the terms of the audit engagement and is not permitted by
management to continue the original audit engagement, the auditor shall:
a) .Withdraw from the audit engagement where withdrawal is possible under applicable laws or
regulations; and
b) Determine w ether there is any obligation, either contractual or otherwise, to report the
circumstances to other parties, such as those charged with governance, owners or regulators.
53
Figure 2-2: Illustrative Engagement Letter
You have requested that we audit the financial statements of ABC, Inc. which comprise the statementof
financial position as at December 31, 20X8, and the income statement, statement of changes in equity
and cash-flow statement for the year ended, and a summary of significant accounting policies and other
explanatory information. We are pleased to confirm our acceptance and our understanding of this audit
engagement by means of this letter. Our audit will be conducted with the objective of our expressing an
opinion on the financial statements.
Our Responsibilities
We will conduct our audit in accordance with Philippine Standards on Auditing. Those standards require
that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free from material misstatement. An audit involves
performing procedures to obtain audit evidence about the amounts and disclosures in the financial
statements. The procedures selected depend on the auditor's judgment, including the assessment of the
risks of material misstatement of the financial statements, whether due to fraud or error. An audit also
includes evaluating the appropriateness of accounting policies used and the reasonableness of
accounting estimates made by management, as well as evaluating the overall presentation of the
financial statements.
Because of the inherent limitations of an audit, together with the inherent limitations of internal control,
there is an unavoidable risk that some material misstatements may not be detected, even though the audit
is properly planned and performed in accordance with PSAS.
In making our risk assessments, we consider internal control relevant to the entity's preparation of the
financial statements in order to design audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the entity's internal control. However,
we will communicate to you in writing any significant deficiencies in internal control relevant to the
audit of the financial statements that we have identified during the audit.
Unless unanticipated difficulties are encountered, our report will be substantially in the following form:
[Form and content of the auditor's report has not been reproduced.]
The form and content of our report may need to be amended in the light of our audit findings.
54
Management's Responsibility
Our audit will be conducted on the basis that management and those charged with governance
acknowledge and understand that they have responsibility:
a) For the preparation and fair presentation of the financial statements in accordance with Philippine
Financial Reporting Standards;
b) For such internal control as management determines is necessary to enable the preparation of
financial statements that are free from m misstatement, whether due to fraud or error; and
c) To provide us with:
i. Access to all information of which you are aware that is relevant to the preparation of the
financial statements such as records, documentation and other matters;
ii. Additional information that we may request from you for the purpose of the audit, and
iii. Unrestricted access to persons within the company from whom we determine it necessary to
obtain audit evidence.
As part of our audit process, we will request from management and, where appropriate those charged
with governance written confirmation concerning representations made to us in connection with the
audit.
We look forward to full cooperation from your staff during our audit.
Fees
Our fees which are based on the time required by individuals assigned to the engagement will be
Php100,000 plus out-of-pocket expenses and will be billed as work progresses. Individual hourly rates
vary according to the degree of responsibility involved and the experience and skill required.
This letter will be effective for future periods unless it is terminated, amended, or superseded.
Please sign and return the attached copy of this letter to indicate that it is accordance with your
understanding of the arrangements for our audit of the financial statements.
55
REVIEW QUESTIONS AND EXERCISES
Questions
2. List the four types of information the auditor should obtain or review as a part of gaining
background information for the audit, and provide one specific example of how the information
will be useful in conducting an audit.
4. What information should a CPA firm seek in its investigation of a prospective client?
5. Discuss what is meant by the phrase "shopping for accounting principles." What mechanisms
have served to prevent this practice by management?
6. Many CPA firms are taking a business risk approach to audits. Define what is meant by business
risk. Provide an example of a business risk that could result in a risk of material misstatement of
the financial statements.
8. "An audit plan is desirable when new staff members are assigned to an engagement, but an
experienced auditor should be able to conduct an audit without reference to it." Do you agree?
Discuss.
9. What is an engagement letter? Why is its use recommended prior to the rendering of professional
services by CPAs?
56
Exercises
Exercise 1
Martinez, CPA, is approached by a prospective audit client who wants to engage Martinez
to perform an audit for the current year. In prior years, this prospective client was
audited by another CPA.
Identify the specific procedures that Morgan should follow in deciding whether to accept
this client.
Exercise 2
Mary Dizon has been asked to accept an engagement to audit a small financial institution.
Dizon has not previously audited a financial institution.
a. Describe the types of knowledge about the prospective client and its environment that
Dizon should obtain to plan the engagement.
b. Explain how Dizon may obtain this knowledge.
c. Discuss how this knowledge of the client and its environment will help Dizon in
planning and performing an audit in accordance with generally accepted auditing
standards.
Exercise 3
You are invited by John Berlin, the president of Cherry Corporation, to discuss with him
the possibility of your conducting an audit of the company. The corporation is a small,
closely held manufacturing organization that appears to be expanding. No previous audit
has been performed by independent certified public accountants. Your discussions with
Berlin include an analysis of the recent monthly financial statements, inspection of the
accounting records, and discussion of policies with the chief accountant. You also are
taken on guided tour of the plant by the president. He then makes the following statement:
Before making definite arrangements for an audit, I would like to know about how long it
will take and about how much will it cost. I want quality work and expect to pay a fair price,
but because this is our first experience with independent auditors, I would like a full
explanation as to how the cost of the audit is determined. Will you please send me a
memorandum covering these points?
57
Chapter
PHASE I -
RISK ASSESSMENT:
PLANNING THE AUDIT AND
DEVELOPMENT OF OVERALL
AUDIT STRATEGY
58
CHAPTER 3
PHASE I - RISK ASESSMENT:
PLANNINGTHEAUDIT AND
DEVELOPMENT OF OVERALL AUDIT
STRATEGY
PLANNING THE AUDIT
Audit planning involves the establishment of the overall audit strategy for the engagement and developing
an audit plan, in order to reduce audit risk to an acceptably low level. Planning involves the engagement
partner and other key members of the engagement team to benefit from their experience and insight andto
enhance the effectiveness and efficiency of the planning process.
The nature and extent of planning activities will vary according to the size and complexity of the entity, the
auditor's previous experience with the entity, and changes in circumstances that occur during the audit
engagement.
Planning is a continuous and iterative process that often begins shortly after or in connection with the
completion of the previous audit and continues until the completion of the current audit engagement.
However, in planning an audit, the auditor considers the timing of certain planning activities and audit
procedures that need to be completed prior to the performance of further audit procedures. For example, the
auditor plans the discussion among engagement team members, the analytical procedures to be applied as
risk assessment procedures, the obtaining of a general understanding of the legal and regulatory framework
applicable to the entity and how the entity is complying with that framework, the determination of
materiality, the involvement of experts and the performance of other risk assessment procedures prior to
identifying and assessing the risks of material misstatement and performing further audit procedures at the
assertion level for classes of transactions, account balances, and disclosures that are responsive to those
risks.
59
Benefits of Audit Planning
Audit planning generally involves the determination of the expected nature, timing and extent of the
audit .Among the benefits derived from audit from audit planning are the following:
a) It helps ensure that appropriate attention is devoted to important areas of
the audit
b) It aids in identifying potential problems and resolving them on a timely basis.
c) It helps ensure that the audit is properly organized, managed and performed in an effective and
efficient manner.
d) It assists in the proper assignment and review of the work of the engagement team members.
e) It helps coordinate the work to be done by auditors of components and other partiesinvolved such
as experts, specialists, etc.
Assuring that the audit is conducted in a quality manner is paramount to fulfilling the users' expectations
about the approach and methodology used by the auditor. And one of the drivers of audit quality is the
auditor's thorough understanding and effective application of the concept of materiality in conducting the
audit.
Materiality provides a quantitative threshold or cut-off point, rather than being a primary qualitative
characteristic, which information must have if it is to useful. The auditor establishes materiality level based
on his professional judgment so as to detect quantitatively material misstatements. Information is material
if its omission or misstatement could influence the economic decisions of users taken on the basis of the
financial statements.
When establishing overall audit strategy, the auditor shall determine materiality for the financial statements
as a whole. If, in the specific circumstances of the entity, there is one or more particular classes of
transactions, account balances of disclosures for which material misstatements of lesser amounts that the
materiality for the financial statements as a whole could be reasonably expected to influence the economic
decisions of users taken on the basis of the financial misstatements, the auditor shall also determine the
materiality level(s) to be applied to those particular classes of transactions, account balances or disclosures.
60
PSA 320,"Materiality in Planning and Performing an Audit" establishes standards and deals with the
auditor's responsibility to apply the concept of materiality in planning and performing an audit of financial
statements
To reiterate the importance of the concept of materiality to audit, the definition of materiality in accordance
with the FRSC's "Framework for the Preparation and Presentation of Financial Statements" follows:
"Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements. Materiality depends on the size of the item or
error judged in the particular circumstances of its omission or misstatement. Thus, materiality
provides a threshold or cut-off point rather than being a primary qualitative characteristic which
information must have if it is to be useful."
This definition emphasizes the importance of materiality to reasonable users who rely on the statements to
make decisions. Auditors, therefore, must have knowledge of the likely uses of their client's statements and
the decisions that are being made.
The auditor's determination of materiality is a matter of professional judgment and is affected by the
auditor's perception of the financial information needs of users of the financial statements. In this context, it
is reasonable for the auditor to assume that users:
a) Have a reasonable knowledge of business and economic activities and accounting and a
willingness to study the information in the financial statements with renewable diligence;
b) Understand that financial statements at prepared mud and audited to levels of materiality;
c) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates,
judgment and the consideration of future events; and
d) Make reasonable economic decisions on the basis of the information in the financial statements.
61
Levels of Materiality
The auditor considers materiality at both the overall financial statement level and in relation to individual
account balances, classes of transactions and disclosures. Materiality may be influenced by considerations
such as legal and regulatory requirements and considerations relating to individual financial statement
account balances and relationships. This process may result in different materiality levels depending on the
aspect of the financial statements being considered.
1. Overall materiality
Materiality for the financial statements as a whole (overall materiality) is based on the auditor's
professional judgment as to the highest amount of misstatement(s) that could be included in the
financial statements without affecting the economic decisions taken by a financial statement user.
If the amount of unconnected misstatements, either individually or in the aggregate, is higher than
the overall materiality established for the engagement, it would mean that the financial statements
are materially misstated.
Overall materiality is based on the common financial information needs of the various users as a
group. Consequently, the possible effect of misstatements on specific individual users, whose
needs may vary widely, is not considered.
2. Specific materiality
In some cases, there may be a need to identify misstatements of lesser amounts than overall materiality
that would affect the economic decisions of financial statement users. This could relate to sensitive
areas such as particular note disclosures (i.e., management remuneration or industry-specific data),
compliance with legislation or certain terms in a contract, or transactions upon which bonuses are
based. It could also relate to the nature of a potential misstatement.
62
Performance Materiality
Performance materiality is used by the auditor to reduce the risk to an appropriate low level that the
accumulation of uncorrected and unidentified misstatements exceeds materiality for the financial
statements as a whole (overall materiality), or materiality levels established for particular classes of
transactions, account balances, or disclosures (specific materiality).
Performance materiality is set at a lower amount (or amounts) than overall specific materiality. The
objective is to perform more audit work than would be required by the overall or a specific materiality to:
Ensure that misstatements less than overall or specific materiality are detected, so as to appropriately
reduce the probability that the aggregate of uncorrected errors and undetected misstatements exceed
materiality for the financial statements as a whole; and thus
Provide a margin or buffer for possible undetected misstatements. This buffer is between detected but
uncorrected misstatements in the aggregate and the overall or specific materiality.
The margin provides some assurance for the auditor that undetected misstatements, along with all
uncorrected misstatements, will not likely accumulate to reach an amount that would cause the financial
statements to be materially misstated.
Performance materiality is set in relation to overall materiality or specific materiality. For example, a
specific performance materiality can be set at a lower amount than overall performance materiality for
testing repairs and maintenance expenses if there is a higher risk of assets not being capitalized. Specific
performance materiality may also be used to perform additional work in areas that may be sensitive due to
the nature of potential misstatements and their occurrence, rather than their monetary size.
For example, if overall materiality was set at P200,000 and the audit procedures were planned to detect all
errors in excess of P200,000, it is quite possible that an error of say P80,000 would go undetected. If three
such errors existed totaling to P240,000, the financial statements would be materially misstated. If
performance materiality was set at P120,000, it would be much more likely that at least one or all of the
P80,000 errors would be detected. Even if only one of the three errors is identified and corrected, the
remaining Pi60,000 misstatement would still be less than P200,000 and the financial statements as a whole
would not be materially misstated.
63
How to Determine Materiality
In establishing planning materiality or preliminary judgment about materiality, an auditor must also
consider any potential effect a misstatement might have which may be greater than the peso amount
involved. A misstatement which may not be material based on quantitative factors but that does not allow a
client to meet a condition in a contractual obligation or expectations of a financial statement user may be
considered material. In these instances, amount of planning materiality based on the users expectations of
income or alter those working on the engagement to the potential for these types of material misstatement.
Assets- 1% to 3%
Equity - 3% to 5%
64
Other Considerations
When accepting new audit engagement, 'inquire about the overall materiality used by the previous
auditor. If available, this would help in determining whether further audit procedures may be required
on the opening asset and liability balances.
Ensure that any experts employed by the entity (to assist the entity in preparing the financial statements)
or used by the audit team are instructed to use an appropriate materiality level in relation to the work
they perform.
When planning the audit, the auditor considers what would make the financial statements materially
misstated. The auditor's assessment of materiality, related to specific account balances and classes of
transactions, helps the auditor decide such questions as what items to examine and whether to use sampling
and analytical procedures. This enables the auditor to select audit procedures that, in combination, can be
expected to reduce audit risk to an acceptably low level.
There is an inverse relationship between materiality and the level of audit risk, that is, the higher the
materiality level, the lower the audit risk and vice versa. The auditor takes the inverse relationship between
materiality and audit risk into account when determining the nature, timing and extent of audit procedures
For example, if, after planning for specific audit procedures, the auditor determines that the acceptable
materiality level is lower, audit risk is increased.
a) reducing the assessed level of control risk, where this is possible. and supporting the reduced level by
carrying out extended or additional tests of control OR;
b) reducing detection risk by modifying the nature, timing and extent of planned substantive procedures.
65
Figure 3-1 shows an illustration of a memo on determining and using materiality.
Materiality Assessment
The main users of the financial statements are the bank and the shareholders. The materiality number
used in the last period was P80,000.
Using our professional judgment, we decided to base our materiality on 5% of the profit before tax.
Other bases for materiality, such as revenues, were also considered but it was felt that profit before tax
was the most meaningful amount in relation to the identified financial statement users.
For this period, the plan is to use P100,000 as the overall materiality. The concept of materiality and its
use in the audit has been discussed in general two terms with the client.
Using professional judgment, and the types of misstatements identified in previous audits, overall
performance materiality has been set at P75,000.
A specific materiality for the local sales taxes paid has been set at P10,000 as we are required to audit
and report on this amount to the local government.
66
Related accounts hall be determined based on the classification and aggregation on the face of
financial statements such as current assets, non-current assets, current liabilities, non-current
liabilities, equity items, revenues, cost of sales, cost of service, administrative expenses or
operating expenses, as the case may be.
The SEC requires the following regulated entities to be audited by independent auditors by the
Commission under the appropriate category:
Group A
1) Issuers of registered securities which have sold a class of securities pursuant to a registration
under Section 12 of the Securities Regulation Code (SRC) except those issuers of registered
timeshares, proprietary and non-proprietary membership certificates which are covered in
Group B.
2) Issuers with a class of securities listed for trading in an Exchange;
3) Public companies or those which have total assets of at least Fifty million pesos
(P50,000,000) or such other amount as the Commission shall prescribe, and having two
hundred [200]or more holders each holding at least One hundred (100) shares of a class of its
equity securities.
Group B
67
11) Special Purpose Corporations registered under the Securitization act of 2004 and its
implementing rules;
12) Such other corporations which may be required by law to be supervised by the Commission.
Group C
1) Financial Companies;
2) Lending Companies;
3) Transfer Agents;
4) Foundations and other non-stock non-profit organizations which solicit or received
donations or contributions or with fund balance aggregating to more than P10 million at any
given year; and
5) Large corporations or those with total assets of more than P350 million or total liabilities of
more than P250 million.
Group D
1) Companies not included above but are mandated by other regulatory agencies to have an
independent auditor accredited by the Commission. For Groups A and B, both the
independent auditor and auditing firms (if applicable) shall be accredited by the
Commission.
੦ For Group A and B, both the independent auditor and auditing firms [if applicable]
shall be accredited by the Commission.
੦ For Group C, the accreditation of the auditing firms shall be sufficient. However, an
individual independent auditor shall be accredited by the Commission as such.
੦ Accreditation under Group A shall be considered a general accreditation which shall
allow the independent auditor to also audit companies under Groups B, C and D.
Independent auditors with Group B accreditation can likewise audit companies under
Groups C and D. Accordingly, Group C accredited independent auditors are allowed
to audit Group D companies.
68
LEVELS OF AUDIT PLANNING
PSA 300 requires that the auditor establishes the overall strategy for the audit. This overall audit strategy
sets the scope, timing and direction of the audit and guides the development of the more detailed audit plan.
In developing the audit strategy, the auditor considers the results of the preliminary activities described in
the preceding section. The process of establishing the audit strategy involves
B. Ascertaining the reporting objectives of the engagement to plan the timing of the audit and the
nature of the communication required such as:
1. Deadlines for interim and final reporting, and
2. Key dates and organization of meetings with management and those charged with
governance to discuss the nature and extent of audit work.
3. Discussion with management regarding the expected communication on the status of audit
work throughout the engagement.
C. Considering the significant factors and experience that will determine the focus and direction of
the engagement teams efforts, such as:
1. Determination of appropriate materiality levels
2. Preliminary identification of areas where there may be higher risks of material
misstatement.
3. Preliminary identification of material components and account balances.
69
4. Evaluation whether the of auditor may plan to obtain evidence regarding the effectiveness
internal control, and
5. Identification of recent significant entity-specific, industry, financial reporting or other
relevant developments.
D. Determining whether there are significant business developments affecting the entity such as:
a. Significant industry development (e.g., changes in industry regulations and new reporting
requirements.)
b. Significant changes in information technology and business processes, key management,
acquisition, mergers.
c. Significant changes in the financial reporting framework such as changes in accounting
standards.
d. Significant changes in the legal environment.
a) The resources to deploy for specific audit areas, such as the use of appropriately experienced
team members for high risk areas or the involvement of experts on complex matters;
b) The amount of resources to allocate to specific audit areas, such as
1. The number of team members assigned to observe the inventory count at material
locations,
2. The extent of review of other auditors' work in the case of group audits, or
3. The audit budget in hours to allocate to high risk areas;
c) When these resources are deployed, such as whether at an interim audit stage or at key cut-off
dates; and
d) How much resources are managed, directed and supervised, such as when team briefing and
debriefing meetings are expected to be held, how engagement partner and manager reviews
are expected to take place (for example, on-site or off-site), and whether to complete
engagement quality control reviews.
e) Engagement budgeting including time allocation.
70
The Appendix of PSA 300 lists examples of matters the auditor may consider in establishing the
overall audit strategy for an engagement. Many of these matters will also influence the
auditor's detailed audit plan.
There sources to deploy for specific audit areas, such as the use of appropriately experienced team
members for high risk areas or the involvement of experts on complex matters.
The amount of resources to allocate to specific audit areas, such as the number of team members
assigned to observe the inventory count at material locations, the extent of review of other
auditors' work in the case of group audits, or the audit budget in hours to allocate to high risk
areas;
When these resources are to be deployed, such as whether at an interim audit stage or at key
cut-off dates; and
How such resources are managed, directed and supervised, such as when team briefing and
debriefing meetings are expected to be held, how engagement partner and manager reviews are
expected to take place [for example, on-site],and whether to complete engagement quality control
reviews.
71
Figure 3-2 presents an illustrative overall strategy memorandum.
Scope
The scope of the audit has not changed this period. Audit to comply with PSAs and the PFRS accounting
framework. There have been no change in PFRS that affect XYZ Company this year.
Entity Changes
Internet sales are also increasing and XYZ' IT capabilities will be stretched.
XYZ Company, is now selling to Momentus Merchandising. This company is renowned for squeezing
profit margins of suppliers in exchange for giving large orders. It also requires suppliers to maintain
additional inventories of some products for instant delivery as required.
Risk
Our assessment of risk at the financial level is low. Management is not particularly sophisticated but
there is a strong commitment to competence; it has introduced a code of ethics and, in general, has a
good attitude toward internal control.
Overall Strategy
1. Materiality for the financial statements as a whole will be increased from P80,000 to P100,000
this period to reflect the growth in sales and profitability during the last period. Performance
materiality (based on our assessment of audit risk) has been set at P75,000, except for certain
account balances.
2. Use the some senior staff as last period and perform the work at the same time.
3. Perform our risk assessment procedures at the end of August. There are no plans to change any
systems at present.
72
4. At our team planning meeting to be held on November 15,20X6 we need to:
d) Focus on identification of related party transactions that have been growing and
expanding our testing
5. Attend the period-end inventory counts. There are still no ongoing inventory control
Procedures.
6. Use David [who is knowledgeable about IT systems] to identify the risks of material
misstatement relating to the internet sales and whether any relevant internal controls exist to
mitigate such risks. He will al. Assess the general IT controls.
Once the audit strategy has been established, the auditor is able to start the development of a more
detailed audit plan to address the various matters identified in the audit strategy, taking into account the
need to achieve the audit objectives through the efficient use of the auditor's resources. Although the
auditor ordinarily establishes the audit strategy before developing the detailed audit plan, the two
planning activities are not necessarily discrete or sequential processes but are closely inter-related
since changes in one may result in consequential changes to the other. The auditor should develop an
audit plan for the audit in order to reduce audit risk to an acceptably low level.
The audit plan is more detailed than the audit strategy and includes the nature, timing and extent of
audit procedures to be performed by engagement team members in order to obtain sufficient
appropriate audit evidence to reduce audit risk to an acceptably low level. Documentation of the audit
plan also serves as a record of the proper planning and performance to the performance of the audit of
procedures that can be reviewed and approved prior further audit procedures.
73
Likewise, with the governance auditor should imposes determine any type of whether limitation
management on the scope or of these the charged audit. This could include:
A description of the nature, timing and extent of planned risk assessment procedures sufficient to
assess the risks of material misstatement, as determined under PSA 315, "Understanding the Entity and
Its Environment and Assessing the Risks of Material Misstatement";
A description of the nature, timing and extent of planned further audit procedures at the assertion level
for each material class of transactions, account balance, and disclosure, as determined under PSA
330, "The Auditor's Procedures in Response to Assessed Risks.? The plan for further audit procedures
reflects the auditor's decision whether to test the operating effectiveness of controls, and the nature,
timing and extent of planned substantive procedures; and
Such other audit procedures required to be carried out for the engagement in order to comply with
PSAs (for example, seeking direct communication with the entity's lawyers).
Planning for these audit procedures takes place over the course of the audit as the audit plan for the
engagement develops. For example, planning of the auditor's risk assessment procedures ordinarily occurs
early in the audit process. However, planning of the nature, timing and extent of specific further audit
procedures depends on the outcome of those risk assessment procedures. In addition, the auditor may begin
the execution of further audit procedures for some classes of transactions, account balances and disclosures
before completing the more detailed audit plan of all remaining further audit procedures.
The auditor may consider the following matters when establishing the scope of the audit engagement:
The financial reporting framework on which the financial information to be audited has been
prepared, including any need for reconciliations to another financial reporting framework,
Industry-specific reporting requirements such as reports mandated by industry regulators.
The expected audit coverage, including the number and locations of components to be included.
74
The nature of the business segments to be audited, including the need for specialized knowledge.
The reporting currency to be used, including any need for currency translation for the financial
information audited.
The need for a statutory audit of stand-alone financial statements in addition to an audit for
consolidation purposes.
The availability of the work of internal auditors and the extent of the auditor's potential reliance on
such work.
The entity's use of service organizations and how the auditor may obtain evidence concerning the
design or operation of controls performed by them.
The expected use of audit evidence obtained in prior audits, for example, audit evidence related to
risk assessment procedures and tests of controls. The effect of information technology on the
audit procedures, including the availability of data and the expected use of computer-assisted
audit techniques.
The coordination of the expected coverage and timing of the audit work with any reviews of
interim financial information and the effect on the audit of the information obtained during such
reviews.
The discussion of matters that may affect the audit with firm personnel responsible for
performing other services to the entity.
The availability of client personnel and data.
The auditor may consider the following matters when ascertaining the reporting objectives of the
engagement, the timing of the audit and the nature of communications required:
The entity's timetable for reporting, with such management as at interim and those final charged
stages.
The organization with management and those charged with governance to discuss the nature,
extent and timing of the audit work.
The discussion with management and those charged with governance regarding the expected type
and timing of reports to be issued and other communications, both written and oral including the
auditor’s report, management letters and communications to those charged with governance.
The expected nature and timing of communications among engagement team members, including
the nature and timing of team meeting and timing of the work performed.
75
Whether there are any other expected communications with third parties, including any statutory
or contractual reporting responsibilities arising from the audit.
The auditor should plan the nature, timing and extent of direction and supervision of engagement team
members and review of their work.
The nature, timing and extent of the direction and supervision of engagement team members and review of
their work vary depending on many factors, including the size and complexity of the entity, the area of audit,
the risks of material misstatement, and the capabilities and competence of personnel performing the audit
work. PSA 220 contains detailed guidance on the direction, supervision and review of audit work.
The auditor plans the nature, timing and extent of direction and supervision of engagement team members
based on the assessed risk of material misstatement. As the assessed risk of material misstatement increases,
for the area of audit risk, the auditor ordinarily increases the extent and timeliness of direction and
supervision of engagement team members and performs a more detailed review of their work. Similarly, the
auditor plans the nature, timing and extent of review of the engagement team's work based on the
capabilities and competence of the individual team members performing the audit work.
In audits of small entities, an audit may be carried out entirely by the audit engagement partner (who may be
a sole practitioner). In such situations, questions of direction and supervision of engagement team members
and review of their work do not arise as the audit engagement partner, having personally conducted all
aspects of the work, is aware of all material issues. The audit engagement partner (or sole practitioner)
nevertheless needs to be satisfied that the audit has been conducted in accordance with PSAs. Forming an
objective view on the appropriateness of the judgments made in the course of the audit can present practical
problems when the same individual also performed the entire audit. When particularly complex or unusual
issues are involved, and the audit is performed by a sole practitioner, it may be desirable to plan to consult
with other suitably-experienced auditors or the auditor's professional body.
76
Documentation
The auditor should document the overall audit strategy and the audit plan, including any significant changes
made during the audit engagement.
The auditor's documentation of the overall audit strategy records the key decisions considered necessary to
properly plan the audit and to communicate significant matters to the engagement team. For example, the
auditor may summarize the overall audit strategy in the form of a memorandum that contains key decisions
regarding the overall scope, timing and conduct of the audit.
The auditor's documentation of the audit plan is sufficient to demonstrate the planned nature, timing and
extent of risk assessment procedures, and further audit procedures at the assertion level for each material
class of transaction, account balance, and disclosure in response to the assessed risks. The auditor may use
standard audit programs or audit completion checklists. However, when such standard programs or
checklists are used, the auditor appropriately tailors them to reflect the particular engagement
circumstances.
The form and extent of documentation depend on such matters as the size and complexity of the entity,
materiality, and the extent of other documentation and the circumstances of the specific audit engagement.
The auditor may discuss elements of planning with those charged with governance and the entity's
management. These discussions may be a part of overall communications required to be made to those
charged with governance of the entity or may be made to improve the effectiveness and efficiency of the
audit. Discussions with those charged with governance ordinarily include the overall audit strategy and
timing of the audit, including any limitations thereon, or my additional requirements. Discussions with
management often occur to facilitate the conduct and management of the audit engagement [for example, to
coordinate some of the planned audit procedures with the work of the entity’s personnel]. Although these
discussions often occur, the overall audit strategy and the audit plan remain the auditor’s responsibility.
77
Additional Considerations in Initial Audit Engagements
For initial audits, additional matters the auditor may consider in developing the overall audit strategy and
audit plan include the following:
Unless prohibited by law or regulation, arrangements to be made with the previous auditor, liar
example, to review the previous auditor's working papers.
Any major issues (including the application of accounting principles or of auditing and reporting
standards) discussed with management in connection with the initial selection as auditors, the
communication of these matters to those charged with governance and how these matters affect
the overall audit strategy and audit plan.
The planned audit procedures to obtain sufficient appropriate audit evidence regarding opening
balances (see PSA 510, "Initial Audit Engagements - Opening Balances?).
The assignment of firm personnel with appropriate levels of capabilities and competence to
respond to anticipated significant risks.
Other Procedures required by the firm's system of quality control for initial audit engagements
(for example, the firm's system of quality control may require the involvement of another partner
or senior individual to review the overall audit strategy prior to commencing significant audit
procedures or to review reports prior to their issuance).
When used for planning purposes, analytical procedures assist the auditors in planning the nature,
timing, and extent of audit procedures that will be used for the specific accounts. The approach used is
one of obtaining an understanding of the client's business and transactions, and identifying areas that
may represent higher risks. The auditors will then plan a more thorough investigation of these potential
problem areas, and perform a more effective audit. PSA 520 requires the auditors to perform analytical
procedures as a part of the planning process for every audit.
78
2. Establishment of an Engagement or Audit Team
An audit team consists of people with different levels of expertise and experience. The team usually is
composed of an engagement partner, a manager, at least one senior, and one or more staff auditors. In
determining the number of people who will be assigned to an engagement, an auditor normally
considers the audit's size and complexity, the availability and experience of personnel, the necessity
for special expertise, the opportunity to train personnel, and the continuity and rotation of personnel.
An engagement involving an entity in a regulated industry, such as banking, also requires that the
major members of the audit team have necessary knowledge and experience in that industry.
Predecessor Auditor
The successor auditor's examination may be greatly facilitated by consulting with the predecessor
auditors and reviewing the predecessor's working papers. Communication with the predecessor
auditors can provide the successor CPA with background information about the client, details
about the client's system of internal control, and evidence as to the account balances at the
beginning of the year under audit. Auditors are ethically prohibited from disclosing confidential
information obtained in the course of an audit without the consent of the client.
The successor auditor should obtain the client's consent before making inquiries from the
predecessor auditors.
If the auditor is unable to obtain cooperation from the preceding auditors, or if he feels that the
work done by the preceding auditors does not meet the requirements of PSAs he may have to treat
the audit of the new client, previously audited by other accountants, just as he would the first audit
of a client who has never been audited before.
79
Other CPAs
When a portion of the client [eg. subsidiary in a distant city] is audited by another CPA firm,
efforts may be coordinate. For example, if the accountants of the subsidiary are to be consolidated
with the overall enterprise, and if that subsidiary is audited by another CPA firm, the auditors
must coordinate timing of necessary reports and procedures to be performed.
Specialists
CPAs may lack the qualifications necessary to perform certain technical tasks relating to the audit.
A specialist brings unique knowledge and judgment in a field other than accounting and auditing.
An auditor might decide to have an art appraiser place values on works of art, a mineralogist
determine the physical characteristics of mineral reserves, or an actuary provide data related to a
group’s life expectancy. Effective planning involves arranging for the appropriate use of
specialists both inside and outside of the client organization.
The auditors should obtain an understanding with the client as to the extent to which the client's
staff, including the internal auditors, can help prepare for the audit. The client's staff should have
the accounting records up-to-date in when the auditors arrive. In addition, many audit working
papers can be prepared for the auditors by the client’s staff, thus reducing the cost of the audit and
freeing the auditors from routine work. The auditors may set up the columnar headings for such
working papers and give instructions to the client’s staff as to the label Prepared by clients, or
PBC, and also the initials of the auditor who verifies the work performed should by the clients’
staff. Working papers prepared by the client should never be accepted at face value; such papers
must be reviewed and tested by the auditors.
80
Among the tasks that may be assigned to the client's employees are the preparation of a trial
balance of the general ledger, preparation of an aged trial balance of accounts receivable,
analyses of accounts receivable written off, lists of property additions and retirements during
the year, and analyses of various revenue and expense accounts. Many of these "working
papers" may be in the form of computer spreadsheets and other computerized data files.
Internal Auditors
Internal auditors can affect the audit in two ways. First, they can enhance internal control. For
example, if internal auditors determined that bank reconciliations were properly prepared
and all cash receipts were deposited, the entity's controls would enhance the reliability of the
accounting records. In such cases, independent auditors would be able to reduce the extent of
substantive testing. In deciding whether to reduce the amount of testing for specific
assertions because of work performed by internal auditors, the independent auditor should
consider (1) the materiality of the amount, (2) the risk of misstatement, and (3) the degree of
subjectivity involved in evaluating the accumulated audit evidence. As these factors increase,
the auditor is less likely to rely on the internal auditor's work.
The second way internal auditors affect an audit is by assisting independent auditors in
performing specific audit procedures. For example, an internal auditor may observe client
personnel taking the inventory.
When planning and performing audit procedures and in evaluating the results thereof, the auditor
should consider the appropriateness of management’s use of the going concern assumption in the
preparation of the financial statement.
PSA 570 requires auditors to evaluate whether substantial doubt exists about an entity’s ability to
continue as a going concern, based on procedures planned and performed to obtain evidence about the
management assertions embodied in the financial statement. That is, an auditor is not required to
design specific procedures to evaluate whether
81
an entity is a going concern. But when the information obtained during the audit raises substantial
doubt about the entity’s ability to continue in operation for a year following the date of the financial
statement being audited, the auditor should add a paragraph calling attention to the fact that the
statement have been prepared assuming that the entity will continue as going concern.
Transactions with related parties are important to auditors because they will be disclosed in the financial
statement if they are material. Financial reporting standards require disclosure of the nature of the related
party relationship; a description of transactions, including peso amounts; and amounts due from and to
related parties. Most auditors assess inherent risk as high for related parties and related party transactions,
both because of the accounting disclosure requirement and the lack of independence between the parties
involved in the transactions.
A related party is defined as an affiliated company, a principal owner of the client company, or any other
party with which the client deals where one of the parties can influence the management or operating
policies of the other. A related party transaction is any transaction between the client and a related party.
Common examples include sales or purchase transactions between a parent company and its subsidiary,
exchanges of equipment between two companies owned by the same person, and loans to officers. A less
common example is the exercise of significant management influence on an audit client by its most
important customer.
Because material related party transactions must be disclosed, it is important that all related parties be
identified and included in the permanent files early in the engagement. Finding undisclosed related party
transactions is thereby enhanced. Common ways of identifying related parties include inquiry of
management, review of SEC filings, and examination of stockholders’ listing to identify principal
stockholders.
82
6. Client's Legal Obligations
For new clients for which historical information relating to these matters is unavailable, the auditor
should review information relating to prior years. For example, instead of reading only the changes to
the articles of incorporation and by-laws, the auditor should read the articles of incorporation and
by-laws since the inception of the entity, making appropriate summaries for the permanent file. The
auditor should also read all contracts having an impact on the current year.
Pertinent current-year information that auditors should review includes (1) minutes of directors' and
stockholders' meetings, (2) changes to articles of incorporation or by-laws, and (3) any significant
contracts executed during the year. By reading the minutes, an auditor will obtain information about
significant events that have or will have an impact on the client. For example, an auditor should be alert
to the following:
Major contracts or agreements, including merger and acquisition agreements, debt agreements,
compensation agreements, and asset purchase agreements
Information about current situations and future business plans
Authorization of dividends
An audit program is a set of audit procedures specifically designed for each audit. The program which
includes both substantive tests and tests of controls will enable the auditor to express an opinion on the
financial statements taken as a whole.
1) the broad phases of the program can be outlined at the time of engagement;
2) other details of the program can be identified after the review of internal control structure and
accounting procedures has the begun; and
3) procedures on specific phases of the audit can be further challenged and revised as the work
progresses.
83
On recurring engagement, the program for the preceding audit should be studied before preparing the
program for the current audit. The program foe the current audit should reflect modifications or are required
by the experience gained in the business, internal control or accounting methods of the client.
A time budget is an estimate of the total hours an audit is expected to take. It is based on the
information obtained in the first major step in the audit that is, obtaining an understanding of the client.
It takes into consideration such things as:
a) the client's size as indicated by its gross assets, sales, number of employees
b) location of client facilities
c) the anticipated accounting and auditing problems
d) the competence and experience of staff available.
The total time must be allocated by the preparation of work schedules indicating who is to do what and
how long it should take.
For repeat engagement, the development of time budget is facilitated by reference to the preceding
year's detailed nine records.
84
Figure 3-3: Time Budget
DELVEE AND JATCEE, INC.
Time Accounting and Budget
December 31, 20x7
Audit Area Staff Staff In-Charge Manager Partner Support Budgeted Actual Explanation of
Assistant 1 Assistant Senior Hours Hours Hours Variance
2
Cash 30 2 32 28
Accounts Receivable 60 5 65 110 See WP 20: Many
expectations to
confirmation
request
Inventory 30 30 5 65 96 See WP 30:
Plant Asset 20 10 30 35 Failure to achieve
proper cutoff
Investment 5 5 7
Other Assets 5 5 3
Accounts payable 10 10 3 23 22
Long-term debt and equity 10 10 20 Debt
restructuring
required more
audit hours
Revenue and expenses accounts 5 5 7
Payroll 10 5 15 12
Pension, profit sharing etc. 20 20 23
Planning, review and 25 10 5 40 38
supervision
Reports 10 5 15 15
Taxes 20 5 3 28 26
Encoding and proofreading 8 8 7
85
Figure 3-4: Portion of an Audit Budget and Time Summary.
Permanent file
Financial statement comparisons
Preparation of report
86
9. Assignment of Personnel to the Engagement
Staff must, therefore, be assigned with that standard in mind. On larger engagements, there are likely to
be one or more partners and staff at several experience levels doing the audit. Specialists in such
technical areas as statistical sampling and computer auditing may also be assigned. On smaller audits
they may be only one or two staff members.
A major consideration affecting staffing is the need for continuity from year to year. An inexperienced
staff assistant is likely to become the most experienced non partner on the engagement within a few years.
Continuity helps the CPA firm maintain familiarity with the technical requirements and closer
interpersonal relations with client personnel.
Another consideration is that the persons assigned be familiar with the client's industry.
PSA 315 requires a discussion among the engagement team members and a determination by the
engagement partner of which matters are to be communicated to those team members not involved in the
discussion. This discussion shall place particular emphasis on how and where the entity's financial
statements may be susceptible to material misstatement due to fraud, including how fraud might occur. The
discussion shall occur setting aside beliefs that the engagement team members may have that management
and those charged with governance are honest and have integrity.
The auditor shall include the following in the audit documentation of the auditor's understanding of the
entity and its environment and the assessment of the risks of material misstatement:
a) The significant decisions reached during the discussion among the engagement team regarding
the susceptibility of the entity's financial statements to material misstatement due to fraud;
misstatement and due to fraud at
b) The identified and assessed risks of material the financial statement level and at the assertion
level.
The engagement partner and other key management team members shall discuss the susceptibility of the
entity’s financial statement to material misstatement, and the application of the applicable financial
reporting framework to the entity’s facts and circumstances. The engagement partner shall determine which
maters are to be communicated to engagement team members not involved in the discussion.
87
Key Areas to Address During the Engagement Team Planning Meeting
Key Areas to
Purpose: To have an open discussion
Address
Share insights on the entity, The Entity
such as the people, History and business objection
operations and objectives The corporate culture
Changes in operations, personnel, or system.
Application of the applicable financial reporting framework to the
entity’s facts and circumstances
Management
The nature/structure of the entity and management.
The attitude toward internal control.
Incentives to commit fraud.
Unexplained changes in the behavior or lifestyle of key employees
Any indications of management bias
88
Response to Risk
What possible audit procedures/ approaches might be considered to
respond to the risk identified above?
Consider whether an element of unpredictability will be incorporated
into the nature, timing and extent of the audit procedures to be
performed.
89
Figure 3-5 shows an illustration of a memo on audit team discussions.
3. What can we learn from past experience such as issues / events that caused delays and areas of
over-/under-auditing?
4. Any new concerns about management integrity, going concern, litigation, etc.?
5. Changes this period in business operations and / or financial condition, industry regulations,
accounting policies used, and people
6. .Susceptibility of the financial statements to fraud. In what possible ways could the entity be
defrauded? Develop some possible scenarios, and then plan procedures that would confirm or
dispel any suspicions.
9. Consider the need for specialized skills of consultants, testing internal control vs. substantive
procedures, the need to introduce unpredictability in some audit tests, and work could be completed
by the client.
90
10. Scheduling of Work
Audit work that can always be performed during the interim period includes the consideration of
internal control, issuance of management letter, and substantive tests of transactions that have occurred
to the interim date.
Interim tests of certain financial statement balances, such as accounts receivable, may also be
performed, but this results in additional risk that must be controlled by the auditors. Significant errors
or irregularities could arise in these accounts during the remaining period between the time that the
interim test was performed and the statement of financial position date. Thus, to rely on the interim test
of a significant account balance, the auditors most perform additional tests of the account during the
remaining period.
Performance of other substantive tests is scheduled near at, and after year-end. Consideration should
be given to such factors as:
a) Deadline for submitting final audit report and filing of income tax returns
b) Ability of the client's staff to submit required schedules
c) Other audit clients
It is far easier to plan for a repeat engagement than planning for a first audit of a new client. The working
papers in the previous year’s audit provide a wealth of information useful in planning the recurring
engagement. Of course, the auditor-in-charge of a repeat engagement would have a good working
knowledge of the client’s business. ’The audit however should not merely duplicate last year’s audit
program but should modify his approach to the audit for any changes in the client’s operations, internal
control structure, or business environment.
91
Special Consideration in the Audit of Small Entities (PAPS 1005)
The Philippine Standards on Auditing [PSAs] contain basic principles and essential statement of any entity,
irrespective of its size, its legal form, ownership or management structure, or the nature of its activities. The
AASC recognizes that small entities give rise to a number of special audit considerations.
The Philippine Auditing Practice Statement 1005, "The Special Consideration in the Audit of Small
Entities," which was made effective for audits of financial statements for periods beginning on or after
December 15, 2004 describes the characteristics commonly found in small entities and indicates how they
may affect the application of PSAs. Reference may therefore be made by the auditor to PAPS 1005 when
handling audit of small entities.
92
REVIEW QUESTIONS
Questions
1. Criticize the following statement: "Throughout this audit, for all purposes, we will define a
'material amount' as P500,000."
2. Suggest some factors that might cause an audit engagement to exceed the original time estimate.
Would the extra time be charged to the client?
3. What problems are created for a CPA firm when audit staff members under report the amount of
the time spent in performing specific audit procedures?
4. The overall audit strategy, the audit plan, and the time budget are three important working papers
prepared early in an audit. What functions do these working papers serve in the auditors'
compliance with generally accepted auditing standards? Discuss.
5. When planning an audit, the auditors should assess the levels of risk and materiality for the
engagement. Explain how the auditors' judgments about these two factors affect the auditors'
planned audit procedures.
6. Define the following terms: (a) performance materiality, (b) tolerable misstatement, (c) clearly
trivial.
7. Define the term misstatement and describe characteristics that would make a misstatement
material.
8. The audit report provides reasonable assurance that the financial statements are free from material
misstatements. The auditor is put in a difficult situation because materiality is defines from a
user's viewpoint, but the auditor must assess materiality in planning the audit to ensure that
sufficient audit work is performed to detect material misstatements.
a. Three major dimensions of materiality are (1) the peso magnitude of item, (2) the nature
b. Once the auditor develops an assessment of materiality, can it change during the course of
the audit? Explain. If it does change, what is the implication of a change for audit work that
has already been completed? Explain.
93
9. How inherent risks of material misstatements related to internal controls? Why is it important to
assess inherent risks of material misstatement prior to evaluating the quality of an organization's
internal controls?
10. Explain how concepts of audit risk and materiality are related. Must an auditor make a decision on
materiality in order to determine the appropriate level of audit risk?
11. Brainstorming is a group discussion designed to encourage auditors to creatively assess client
risks, particularly those relevant to fraud.
1. The concept of materiality will be least important to the CPA in determining the
a. scope of the audit of specific accounts.
b. specific transactions that should be reviewed.
c. effects of audit exceptions upon the opinion.
d. effects of the CPA's direct financial interest in a client upon his or her independence
2. Edison Corporation has a few large accounts receivable that total P1,400,000. Victor Corporation
has a great number of small accounts receivable that also total P1,400,000. The importance of a
misstatement in any one account is therefore greater for Edison than for Victor. This is an
example of the auditor's concept of
a. Materiality
b. Comparative analysis
c. Reasonable assurance
d. Relative risk
94
3. Which of the following elements ultimately determines the specific auditing procedures that are
necessary in the circumstances to afford a reasonable basis for an opinion?
a. Auditor judgment
b. Materiality
c. Inherent risk
d. Reasonable assurance
5. Inherent risk and control risk differ from planned detection risk in that they
a. arise from the misapplication of auditing procedures.
b. may be assessed in wither quantitative or nonquantitative terms.
c. exist independently of the financial statement audit.
d. can be changed at the auditor's discretion.
95
7. In planning and performing an audit, auditors are concerned about risk factors for two distinct
types of fraud: fraudulent financial reporting and misappropriation of assets. Which of the
following is the risk factor for misappropriation of assets?
a. Generous performance-based compensation systems.
b. Management preoccupation with increased financial performance.
c. An unreliable accounting system.
d. Strained relationships between management and the auditors.
8. Which portion of an audit is least likely to be completed before the balance sheet date?
a. Test of controls
b. Issuance of an engagement letter
c. Substantive procedures
d. Assessment of control risk
9. Which of the following should the auditors obtain from the predecessor auditors before accepting
an audit engagement?
a. Analysis of balance sheet accounts.
b. Analysis of income statement accounts.
c. All matters of continuing accounting significance.
d. Facts that might bear in the integrity of management.
10. Which of the following items would typically not be included in an audit program?
a. A list of audit procedures to be performed.
b. An indication of who performed the procedure.
c. A work paper heading.
d. All of the above would typically be included in an audit program.
96
Exercises
Exercise 1:
The following information shows the past two periods of results for a fictional company, Amos
Manufacturing, and a comparison with industry data for the same period:
a. From the preceding data, identify potential risk areas and explain why they represent potential
risk. Briefly indicate how the risk analysis should affect the planning of the audit
management.
b. Identify any of the above data that should cause the auditor to increase the level of
professional skepticism.
Exercise 2
Auditors make materiality judgments during the planning phase of the audit in order to be sure
they ultimately gather sufficient evidence during the audit to provide reasonable assurance that the
financial statements are free of material misstatements. The lower the materiality threshold that an
auditor has for an account balance, the more the evidence that the auditor must collect. Auditors
often use quantitative benchmarks such as 1% of total assets or 5% of net income to determine
whether misstatements materially affect the financial statements, but ultimately it is an auditor's
individual professional judgment as to whether a given misstatement is or is not considered
material.
97
a) What is the relationship between the level of riskiness of the client and the level of
misstatement in an account balance that an auditor would consider material? For example,
assume that Client A has weaker controls over accounts receivable compared to Client B
(therefore, Client A is riskier than Client B). Assume that Client B is similar in size to
Client A and that the auditor has concluded that a misstatement exceeding P5,000 would
be material for Client B's accounts receivable account. Should the materiality threshold
for Client A be the same as, more than, or less than for Client B? Further, which client will
require more audit evidence to be collected, Client A or Client B?
b) How might an auditor's individual characteristics affect his or her professional judgments
about materiality?
c) Assume that one auditor is more professionally skeptical than another auditor, and that
they are making materiality judgment in part (a) of this problem. Compare the possible
alternative monetary thresholds that a more versus less skeptical auditor might make for
Client A.
98
Chapter
PHASE I - RISK
ASSESSMENT:
PERFORMANCE OF RISK
ASSESSMENT PROCEDURES
99
CHAPTER4
PHASE I - RISKASSESSMENT:
PERFORMANCE OF RISKASSESSMENT
PROCEDURES
This stage involves the identification and assessment of the risk of material misstatements whether due to
fraud or error at the financial statement and assertion levels, through understanding the entity and its
environment, including the entity's internal control, thereby providing a basis for designing and
implementing responses to the assessed risks of material misstatement.
The following are the activities involve in the performance of risk assessment procedures:
A. Identification of Inherent Risks (Business and Fraud Risks) and Significant Risks) and Significant
Risks
B. Understanding the Design / Implementation of Relevant Internal Controls
C. Concluding the Risk Assessment Phase
A. Identification of Inherent Risk (Business and Fraud Risks) and Significant Risks
Identification of risk is the foundation of the audit. It is based upon, and forms an integral part of,
the auditor's procedures to understand the entity and its environment. Without a solid
understanding of the entity, the auditor may miss certain risk factors. For examples, if a client's
sales were increasing, it would be important for the auditor to know that the industry sales as a
whole were actually in sharp decline.
100
The objective of the risk assessment phase of the audit is to identify sources of risk, and then to assess
whether they could possibly result in a material misstatement in the financial statements. This provides the
auditor with the information needed to direct audit effort to areas where the risk of material misstatement is
the highest, and away from less risky areas.
Risk identification answers the question what could go wrong and result in a misstatement in the financial
statement.
Performance of risk assessment procedures seeks to determine the significance of each risk by considering
the following:
TYPES OF RISKS
The difference between business risk and fraud risk is that fraud risk results from a person's deliberate
actions.
101
Business Risk
Business risks result from significant conditions, events, circumstances, actions, or inactions that could
adversely affect the entity's ability to achieve its objectives and execute its strategies. Business risk also
includes events that arise from change, complexity, or the failure to recognize the need for change. Change
may arise, for instance, from:
Fraud Risk
Fraud risk relates to events or conditions that indicate an incentive or pressure to commit fraud or provide
an opportunity to commit fraud.
The term "fraud" refers to an intentional act by one or more individuals among management, those charged
with governance, employees, or third parties involving the use of deception to obtain an unjust or illegal
advantage.
Fraud involving one or more members of management or those charged with governance is referred to as
"management fraud." Fraud involving only employees of the entity is referred to as "employee fraud." In
either case, there may be collusion within the entity or with third parties outside of the entity.
SOURCES OF RISKS
Errors and fraud in financial statements arise from risk factors that have their origin in one or more of the
six required areas of understanding the entity.
102
b. External factors such as
state of the economy and changes in government regulations
changes in industry
deliberate sabotage of an entity's products or services
inability to obtain required resources (materials or skilled personal)
d. Performance indicators
Failure to. use performance measures that assess the entity's performance and achievement of
objectives
Failure to use measures to improve operations or take corrective actions.
e. Accounting policies
Inconsistent application of accounting policies
Inappropriate use of accounting policies
f. Internal control
Inadequate management oversight of day-to-day operations
Poor or nonexistent controls over entity-level activities as well as transactions.
Poor safeguarding of assets
The starting point is to obtain a basic understanding or frame of reference for designing the risk assessment
procedures to be performed. Without this understanding, it would be difficult, if not impossible, to identify
what errors and fraud could occur in the financial statements.
Obtain (or update) relevant basic information about the entity, its objectives, culture, operations, key
personnel, and the internal organization and control.
103
Sources of Information about Entity
The first step in the risk assessment process is to gather (or update) as much relevant information about the
entity as possible. This information provides an important frame of reference for identifying and assessing
possible risk factors.
Information about the entity and its environment can be obtained from both internal and external sources.
The information gained from risk assessment procedures conducted before engagement acceptance a
continuance can be used as part of the audit team's understanding of the entity.
104
Step 2: Design, Perform and Document Risk Assessment Procedures
Step 3: Relate or Map the Risks Identified to Material Financial Statement Areas
For each risk factor (risk cause) identified, identify the effect (specific misstatements such as fraud and
error) that could occur in the financial statements as a result. Note that a single risk factor can result in a
number of differing types of misstatements that may affect more than just one financial statement area.
Identify the material account balances, class of transactions, and disclosures in the financial
statements.
Relate or map the risk identified to the specific financial statement areas, disclosure, and assertions
affected. Is the risk identified is pervasive, then related it to the financial statements as a whole.
Identifying the effect of risks by financial statement area helps in assessing risks at the assertion level.
Identifying the effect of pervasive risks helps in assessing risks at the financial statement level.
105
HOW TO IDENTIFY FRAUD RISK
Although fraud can occur at any level in the organization, it tends to be more is serious (and involve
higher monetary amounts) when senior management is involved.
Some of the major conditions that create an environment for fraud include:
Ineffective corporate governance ;
Lack of leadership by management and poor "tone at the top"
High incentives provided for financial performance;
Taxes or other expenses that are considered very high or onerous;
Complexity in the entity's rules, regulations, and policies;
Unrealistic expectations from bankers, investors, or other stakeholders;
Downward and unexpected shifts in profitability;
Unrealistic budget targets for staff to attain; and
Inadequate internal control, especially in the presence of organizational change.
There are three conditions that often provide clues to the existence of fraud. Forensic accountants often
refer to this as the "fraud triangle" because when all three conditions are present, it is highly likely that fraud
may be occurring.
Opportunity
A poor corporate culture and a lack of adequate internal control procedures can often create confidence
that a fraud could go undetected.
Rationalization
Rationalization is the belief that a fraud has not really been committed. For example, the perpetrator
rationalizes that “this is not a big deal” or “I am only taking what I deserve.”
106
Sources of Fraud Risk
Excessive pressure exists for management to meet the requirements or expectations of third parties or
those charged with governance (such as earnings targets or compliance with onerous environmental
regulations, etc.).
Personal financial obligations may create pressure on management or employees with access to cash or
other assets susceptible to theft to misappropriate those assets.
Adverse relationships between the entity and employees with access to cash or other assets. For
example:
Known or anticipated future employee layoffs,
Recent or anticipated changes to employee compensation or benefit plans, and
Promotions, compensation, or other rewards inconsistent with expectations.
Attitudes
Management has a known history of violations of laws and regulations, or allegations of fraud.
Management exhibits changes in behavior or lifestyle that may indicate assets have been
misappropriated.
Senior managers demonstrate a poor ethical example (such as inflating expense accounts and
committing petty thefts, etc.). Management has overridden existing controls.
Rationalizations
Management is interested in employing inappropriate means to:
Minimize reported earnings for tax-motivated reasons, and
Increase reported earnings to avoid violating bank covenants, increase the sale price of the
entity, or meet targets set by a third party.
Employee behavior indicates displeasure or dissatisfaction with the entity.
Low morale exists among senior management.
Management does not enforce the entity's values or ethical standards.
107
3. Opportunities
Nature and Determination of Significant risks and the Consequences for the Audit
Significant risk is where the assessed risk of material misstatement is so high that in the audit’s judgement
it will required special audit consideration.
1. High-risks activities
These include operations or event where a material misstatement could easily occur. Example are:
a) Inventory of high-value diamonds or gold bars held by a jewelry store;
b) Identification of new complex accounting system being introduced.
108
2. Large non-routine transactions (size or nature)
These are significant related party transactions outside the entity's normal course of business.
Examples are:
a) a major sales or supply content;
b) sale of the business to the third party;
c) unusual value of routine transactions with a related party.
When a risk is classified as being "significant", the auditor should respond as outlined below:
1. Evaluate internal control design and implementation over lack significant risk
2. Design an audit response to the identified significant risks.
3. No reliance can be placed on evidence obtained in previous period.
4. Substantive analytical procedures alone are sufficient.
Documentation is required for identified significant risks. This simply may be an extension of the
information already documented.
109
Illustrative Documentation of Risk Identification and Implications to Financial Statement
CLIENT: XYZ COMPANY
Business Risk
Risk Event / Sources Implication of the Risk Factor to FS Assertions
1. Downturn in economy a. Receivable may be difficult to collect V
b. Inventory write-down may be required due to V
obsolescence
c. Breach of debt covenants P
2. New sales being sought in a. Foreign exchange risks in receivables A
other countries
3. General IT controls are a. Data integrity may be compromised or data may even P
weak in a number of areas be lost
4. Inventory clerk known to a. Inventory balance may be misstated CAEV
make error
Fraud
Pressures
1. Minimize tax burden a. Management bias in estimates (such as valuation of CAV
inventory) to reduce income
b. Unauthorized journal entries or manipulation of P
financial statements.
2. Bonus to salesman based on Inflated sales to meet thresholds E
sales
3. Giving bribes to facilities Damage to reputation, overstatement of expenses, CAE
service or to obtain contracts unaccrued fines
4. Rapid growth putting Financial statement manipulation to avoid violation of P
pressure on financing bank covenant
Opportunities
1. High incidence of cash sales Goods/Cash Stolen E
2. Transaction with related Sales/ Purchases may not be valid, nor properly valued P
parties or disclosed in the financial statement
3. High volume, easily Goods stolen from inventory E
transportable items of
inventory
Key:
P=Persuasive (all assertions), C= Completeness, A=Accuracy E=Existence, V=Valuation
110
B. Understanding the Design and Implementation of Relevant Internal Controls
PAS 315.12 requires that the auditor shall obtain understanding of internal control relevant to the audit.
Although most controls relevant to the audit are likely to relate to financial reporting, not all controls that
relate to financial reporting are relevant to the audit. It is a matter of the auditor's professional judgment
whether a control, individually or in combination with others is relevant to the audit.
a. Control Environment
The auditor shall obtain understanding of the control environment. As part of obtaining this
understanding, the auditor shall evaluate whether:
a) Management with the oversight of those charged with governance, has created and maintain a
culture of honesty and ethical behavior; and
b) The strengths the control environment elements collectively provide an appropriate foundation
for the other components of internal control, and whether those other components are not
undermined by deficiencies in the control environment.
b. Risk Assessment
The auditor shall obtain an understanding of whether the entity has a process for:
c. Information System
The auditor shall obtain an understanding of the information system, including the related business
processes, relevant to financial reporting, including the following areas:
a) The classes of transactions in the entity's operations that are significant to the financial statements;
111
b) The procedures, which both information technology (IT) and manual systems, by which those
transactions are initiated, recorded, processed, corrected as necessary, transferred to the general
ledger and reported in the financial statement.
c) The related accounting records, supporting information and specific accounts in the financial
statements that are used to initiate, record, process and report transactions; this includes the
correction of incorrect information and how information is transferred to the general ledger. The
records may be either manual or electronic form;
d) How the information system captures events and conditions, other than transactions, that are
significant to the financial statements;
e) The financial reporting process used to prepare the entity's financial statement, including
significant accounting estimates and disclosures; and
f) Controls surrounding journal entries, including non-standard journal entries used to record
non-recurring, unusual transactions or adjustments.
d. Control Activities
The auditor shall obtain an understanding of control activities relevant to the audit, being those the
auditor judges it necessary to understand in order to assess the risks of material misstatement at the
assertion level and design further audit procedures responsive to assessed risks. An audit does not
require an understanding of all the control activities related to each significant class of transactions,
account balance, and .disclosure in the financial statements or to every assertion relevant to them.
In understanding the entity’s control activities, the auditor shall obtain an understanding of how the
entity has responded to risk arising from IT.
e. Monitoring
The auditor shall obtain an understanding of the major activities that the entity uses to monitor internal
control over financial reporting, including those related to those control activities related to the audit,
and how the entity initiates remedial actions to deficiencies in its controls.
112
Evaluating Internal Control Design and Implementation
The four steps in evaluating control design and implementation are shown in Figure 4-3.
1. Risk Identification
Yes No
No
Report significant deficiencies in control to
management and
those charged with governance
Yes
113
Illustrative Documentation of Identification and Evaluation of Relevant Internal Control
This is the first and most important steps in evaluating internal control. This requires identification of the
risks which need to be mitigated by internal control. The question this step seeks to find answer to is:
"What risks, if not mitigated by internal control could result in material misstatement in the financial
statement?"
The risk could be identified as a result of obtaining an understanding of the entity with persuasive risk
factors and the used transactional risk factors associated with business procedures such as sales purchasing
and payroll. Examples are:
This step involves inquiry about controls and evaluation of controls that management has put in place to
address the risks that have been identified in Step 1 above.
"Are there controls capable of effectively preventing or detecting and correcting the material misstatements
identified in Step 1?”
In relation to the three risks identified in Step 1, the following possible controls may be inquired about and
evaluated
114
Risk 1 No emphasis is placed on need for integrity and ethical values.
Possible Controls
a) Management continually demonstrates through words and actions, a commitment to high
ethical standards.
b) Management removes or reduces incentives that might cause personnel to engage in
dishonest or ethical acts.
c) Adoption of a Code of Conduct that sets out expected standards of ethical and moral
behavior.
d) Employees are always disciplined for improper behavior.
Possible Controls
a) Management specific required knowledge and skills for employee positions.
b) Job descriptions exist and are effectively
c) Management provides personnel with access to training and professional development
programs on relevant topics
d) Staff are compensated and rewarded for good performance.
Risk 3 Management has a poor attitude toward internal control and/or managing business risks.
Possible Controls
a) Management demonstrates positive attitudes and actions toward the establishment and
maintenance of sound internal control over financial reporting.
b) Management emphasizes appropriate behavior to operating personnel.
c) Management has established procedures to prevent unauthorized access to or destruction of
assets, documents and records.
115
Step 3: Control Implementation
The third step is to determine whether the controls exist and are in use by the entity through inquiry and
testing.
If this question is answered yes, the conclusions auditor then proceeds to Step 4. . Where the auditor
documents the result and conclusion reached.
If the question is answered no, the auditor then reports significant deficiencies in control to management
and those charged with governance. The auditor then documents the results and conclusion reached.
If the auditor determines, through inquiry and testing, that the company has strong risk management and
control processes in place, the auditor may be able to focus the audit program on testing internal controls
and developing corroborative evidence based on more limited direct tests of account balances. On the other
hand, if the company does not have an effective risk management process in place, the auditor will identify
areas where account balances are more likely to be misstated and concentrate direct tests of account
balances in those areas.
Based on the foregoing, the auditor develops expectations and makes an assessment of the risk that a
particular account balance may be misstated. If the may be able to gain satisfaction regarding the account
balance without directly testing it. Other techniques, such as using substantive analytical procedures or
analyzing the quality of the control system, may yield persuasive evidence about the correctness of an
account balance. This is not meant to imply that an auditor can perform a complete audit without ever
directly testing some account balances; it means that the amount of testing can be minimized if risks are
adequately addressed. However, if there is a high risk that an account balance may misstated, the auditor
should direct more attention to the audit of that account.
116
Illustration Documentation of Control Deficiencies and Impact on Audit Response
Example 1
Risk factor / assertion affected Management has not considered or assessed the risk
of fraud occurring.
Auditor, Thought Process
a.) Deficiency Members of the management team trust each other
and are reluctant to introduce costly policies etc that
address the risk of fraud.
b.) Potential on the financial statement Management could override controls and materially
manipulate the financial statements.
c.) Is deficiency considered significant YES
d.) Audit response Review the specific procedures performed on
journal entries, related parties and revenue
recognition.
Example 2
Risk factor/ Assertion affected Sales/services recorded in wrong accounting period.
Auditor’s thought Process
a.) Deficiency identified No controls existing to prevent this from occurring a
number of cutoff errors have been found in
conducting the test of details.
b.) Potential effect on the financial statement Revenues misstated could be materially misstated in
the financial statements.
c.) Is deficiency considered significant? YES
d.) Audit response Additional audit procedure should be performed
relating to cutoff.
Example 3
Risk factor/ Assertion affected
Auditor’s thought Process
a.) Deficiency identified Client does not provide back-up document to
support their estimates
b.) Potential effect on the financial statement Considering the size of the estimates an error could
result in a material error in financial statement
c.) Is deficiency considered significant? YES
d.) Audit response Obtain evidences to support the assumption and per
re-calculation.
117
Practical Pointers
The auditor’s testing of the internal audit work be done limited but should be sufficient to formulate an
opinion on whether internal audit's conclusions are supported by independent evidence on the
operation of controls.
To obtain evidence about whether a control is effective, the auditor must directly test the control. The
auditor cannot infer the effectiveness of a control from the absence of misstatements in the financial
statements.
The external auditor must perform enough work to make an independent decision about the quality of
the client's internal controls.
The more material the account is, the more evidence about internal controls should be gathered
independently by the external auditor.
Auditors are required to assess control risk for each relevant assertion and for important classes of
transactions and account balances as a basis for planning the audit.
Not all controls need to be tested. Further, controls for all assertions need not be tested if the auditor
believes that a misstatement related to a particular assertion would not be material.
Once the significant accounts and their relevant assertions, as well as the processes related to those
accounts, have been identified, the auditor determines the important controls, such as those shown in
the immediately preceding table, that need to be tested. The nature of the testing will vary with the
nature of the process, the materiality of the account balance, and the control.
118
C. Concluding the Risk Assessment Phase
From the audit risk model, we know that companies with strong internal controls should require less
substantive testing of account balances. We also know that greater computerization of processes
increases the likelihood of consistent processing throughout the year. The fundamental questions that
the auditor must address to determine the optimal amount of audit work are as follows:
1. How much assurance can be obtained regarding audit risk when internal control is present and
working?
2. If control activities within major processes are working properly throughout the year, what is the
residual risk that remains that an account balance can still be misstated?
3. What is the risk that the auditor's evaluation of internal controls might be incorrect?
4. Which account balances contain more than an acceptable amount of risk that a material
misstatement could occur?
5. How could a misstatement in a material account balance most likely occur?
6. What are the most effective substantive tests of account balances to determine whether there is a
misstatement in the account balance?
The auditor must answer these six important questions to plan an effective integrated audit. There is no
one right answer - all of the questions are interrelated. For example, the residual risk of a material
misstatement is dependent on the joint answer to the first three questions. The remaining three
questions address the identification of accounts that might be misstated, how a misstatement could
occur, and how the auditor would most effectively determine if a misstatement did occur.
119
REVIEW QUESTIONS AND EXERCISES
Questions
1. Who participates in the pre-audit conference, and what topics should be covered?
2. Why must the auditor test the information system prior to testing transactions and balances?
4. Identify and describe the two components of the risk of material misstatement.
5. Define inherent risk. Can the auditors reduce inherent risk by performing audit procedures?
6. Distinguish between the component of audit risk that the auditors gather evidence to assess
versus the component of audit risk that they collect evidence to restrict.
7. Define internal control over financial reposing. What is the difference between internal control
and internal control over financial reporting? What are the implications of the difference to the
auditor?
8. What is an organization's control environment? What are the major elements of a control
environment?
9. One element of the control environment is the organization's commitment to financial reporting
competencies. In your view, is the auditor capable of evaluating the competency of the accounting
staff? How would the auditor go about evaluating the competency of the counting department and
the competencies of those making judgments on financial reporting and issues?
10. What is the implication of a material misstatement in the account balances at year end in terms of
providing feedback on the effectiveness of internal control over financial reporting? Explain.
120
11. What are the primary factors that should be considered in determining whether the auditor needs
to directly test year-end account balances?
12. Assume that the auditor's tests of internal controls did not yield any material weaknesses in
controls. However, during the audit, a, material misstatement in an important account was found.
Does the auditor have to analyze the cause of the misstatement and report materiel weakness in
internal control? Explain your answer.
13. Explain the relationship between risk analysis, internal control, and material account balances in
designing an approach to an integrated audit. In doing so, explain the differences between
business risks and the risk that an account balance may be misstated.
Exercises
Exercise 1
Michael Reyes, CPA, is considering audit risk at the financial statement level in planning the audit of
National Bank (NB) Company's financial statements for the year ended December 31, 20X1. Audit
risk at the financial statement level is influenced by the risks of material misstatements (including
fraud risks), which may be indicated by a combination of factors related to management, the
environment, and the entity. For each of the following factors, indicate whether it increases or
decreases the risk of material misstatement and (2) whether it creates a risk of fraud.
121
e. NB's board of directors is controlled by Smith, the
majority stockholder, who also acts as the chief
executive officer.
Exercise 2
Required:
For each "segregation of duties" problem identified here:
a. Identify the risk to financial reporting that is associated with the inadequacy of the segregation of
duties.
b. Identify other controls, if any that might mitigate the segregation of duties risks.
c. If a control is identified that would mitigate the risks, briefly indicate what evidence the auditor
would need to gather to determine that the control is operating effectively.
122
The inadequate segregation of duty situations to be considered are as follows:
(1) The same individual handles cash receipts, the bank reconciliation, and customer complaints.
(2) The same person prepares billings to customers and also collects cash receipts and applies them to
customer accounts.
(3) The person who prepares billings to customers does not handle cash, but does the monthly bank
reconciliation, which, in turn, is reviewed by the controller.
(4) The controller is responsible for making all accounting estimates and adjusting journal entries. The
company does not have a CFO and has two clerks who report to the controller.
(5) A start-up company has very few transactions, less than P 1 million in revenue per year, and has only
one accounting person. The company's transactions are not complex.
(6) The company has one computer person who is responsible for running packaged software. The
individual has access to the computer to update software and can also access records.
Exercise 3
The auditor is evaluating the internal control of a new client. Management has prepared its assessment of
internal control and has concluded that it has some deficiencies but no significant deficiencies and no
material weaknesses. However, in reviewing the work performed by management, including the internal
auditor, the auditor serves the following:
Sample sizes taken by the internal auditor were never more than ten transactions, and most of the tests
were based on a sample performed as part of a walkthrough of a transaction.
Management has fired the former CFO and a new CFO has not been appointed, but management
indicates it has depth in the accounting area and is searching for a new CFO.
The company has no formal whistle blowing function because management has an "open-door" policy
so that anyone with a problem can take it up the line.
Management's approach to monitoring internal control is to compare budget with actual expenses and
investigate differences.
In response to inquiries by the auditor, management responds that its procedures are sufficient to support its
report in internal control.
123
There auditor's is subsequent work yields following:
Many control procedures do not operate in the way described by management, and the procedure are
not effective.
There is no awareness of, or adherence to, or adherence to, the company’s code of conduct.
The accounting department does not have a depth of talent; more over, although the department can
handle most transactions it is not capable of dealing with newer contracts that the firm has entered into.
The response of management is: “That is why we pay you auditors the Big Bucks-Help us make these
decision.”
The auditor reaches a conclusion that there are material weaknesses in internal control, thus differing from
management's assessment. Management points out that every issue on which there is a subjective issue, and
there is no one position that is better than the others. Management's position is that these are management's
financial statements, and the auditor should accommodate management's view because there are no right
answers.
Required:
a. Identify the audit approach the auditor could utilize to gather evidence regarding the effectiveness of
the organization's code of ethics.
b. The partner in charge of the job appears to be persuaded that the differences are of only a subjective
nature and is proposing that an unqualified opinion on internal controls be issued. Recognize that this
is a first-year client-and an important one to the office. Apply the ethical framework developed earlier
to explore the actions that should be taken by the manager on the audit regarding (1) whether to
disagree with the partner, and (2) if there is a disagreement, to what level it should be taken in the firm.
c. Given the deficiencies noted, does the information support that there is a material weakness in internal
control? If yes, what are the major factors that lead you to that conclusion?
d. Assume that the engagement team makes a decision that there is a material weakness in internal
control. Write two or three paragraphs that describe those weakness.
124
UNIT III
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE II - RISK RESPONSE:
TEST OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS
Chapter
5 Designing Overall Responses
and Further Audit
Procedures
125
8 Audit of the Expenditure Cycle
Continued
126
Chapter
PHASE II -
RISK RESPONSE:
DESIGNING OVERALL
RESPONSES AND FURTHER
AUDIT PROCEDURES
127
CHAPTER 5
PHASE II - RISK RESPONSE:
DESIGNING OVERALL RESPONSES AND
FURTHER AUDIT PROCEDURES
INTRODUCTION
The Risk Response Phase in the Risk-Based Audit Approach includes following steps:
(a) Designing the overall audit responses and further audit procedures. This will require:
i. Updating overall audit strategy
ii. Developing response to assessed risks
iii. Briefing team on audit plans as required
The starting point for designing an effective audit response is the listing of assessed risks that was
developed at the conclusion of the risk assessment phase of the audit.
OVERALL RESPONSE
The auditor shall design and implement overall responses to address the risks identified and assessed at the:
financial statement level; and
assertion level for financial statement areas and disclosures.
An assessment of the risks of material misstatement is required at the financial statement and assertion
levels to obtain evidence that addresses risk assessments developed for each relevant assertion.
128
Areas that the auditor would address in developing an overall response shall include the determination of:
The extent that the audit team needs to be reminded about the use of professional skepticism;
Which staff to assign, including those with special skills, or whether to use experts;
The extent of supervision required throughout the audit;
The need for incorporating some elements of unpredictability in the selection of further audit
procedures to be performed; and
Any general changes that need to be made to the nature, timing, or extent of audit procedures.
These could include the timing of procedures (interim or period-end), or new/extended
procedures to address specific risk factors such as fraud.
TYPES OF RESPONSE
Assessed Risk:
Auditor’s Response
Examples include:
Professional skepticism Substantive Test of
Procedure Control
Level of staff assigned
Result
Sufficient appropriate audit evidence to reduce audit risk to an acceptably low level
129
AUDIT PROCEDURES
In developing the detailed audit plan, the auditor would use his/her professional judgment to select the
appropriate types of possible audit procedures. To obtain the required reasonable assurance, the auditor
applies the audit procedures that' in the judgment and based on the PSAs are deemed appropriate in the
circumstances and in determining the audit procedures to be performed in conducting an audit in
accordance with Philippine Standards on Auditing, the audits should comply with each of the PSAs relevant
to the audit.
An effective audit program will be based on an appropriate mix of procedures that collectively reduce audit
risk to an acceptably low level: Audit procedures are the methods or acts that auditors use to gather
evidence to determine the validity of financial statement assertions. One way for the auditors to increase the
amount of evidence obtained is to select a more effective audit procedure. For example, if the auditors want
to increase the amount of evidence about the existence of accounts receivable, they could decide to confirm
the accounts rather than rely upon the inspection of internal documents.
The various types of an audit procedures available to the auditor are categorized as follows.
These are audit procedures designed to evaluate the operating effectiveness of controls in
preventing, or detecting and correcting, material misstatements at the assertion level.
1) No Trail
This type does not leave a visible trail m the supporting documents of the performance of
control procedure by the client's employee. The auditor makes inquiries and observation of
office personnel and routines to determine how control procedures are performed and who
performs them.
130
2) Documentary Trail
This type leaves a visible trail in the supporting documents. Hence, the auditor inspects the
documents supporting a particular type of transaction to see whether a control procedure,
such as approval or other checking, was performed and who performed it as indicated by
signatures or initials.
These are audit procedures designed to detect material misstatements at the assertion level. Substantive
procedures comprise:
i. Tests of details (of classes of transactions, account balances and disclosures), and
ii. Substantive analytical procedures.
The auditor applies compliance tests when the purpose is to see whether prescribed accounting control
procedures are being followed. This evaluation identifies the control procedures that can be relied on in
performing restricted substantive tests. Substantive tests are applied when the auditor's purpose is to
see whether the peso amount of an account is properly stated. Thus, there is a relationship between the
amount of reliance and the amount of additional work that will be needed.
Irrespective of the assessed risks of material misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.
131
Tests of details are also referred to as follows:
૦ Tests of Transactions
These are test of the processing of individual transactions by inspection of the documents and
accounting records involved in processing. For example, tracing a sample of receiving reports to
the purpose journal to see whether receipts of merchandise have been recorded as purchases.
૦ Tests of Balances
These are test applied directly to the details of balances in general ledger accounts. For example,
confirming the balances of accounts in the accounts payable subsidiary ledger with individual
customers. These test have the objective of establishing the correctness of the accounts they relate
to.
Some auditors refer to tests of balances as direct tests of balances to emphasize the substantive
nature of the test as directly supporting an account balance. It should be noted that substantive
tests and compliance tests of control procedures that leave a documentary trail both involve the
inspection of documents supporting the transactions. For this reason, these tests are often applied
together to the same group of documents. In that case, the test is referred to as a dual purpose test
because it has both compliance and substantive objectives.
Analytical types of test involve study and comparison of relationships among accounting data and
related information. They identify unusual fluctuation for investigation and focus on the rationale
of relationship. They are substantive that may achieve specific audit objectives if the evidential
matter is considered persuasive by the auditor. Auditing standards require the application of
analytical procedures at planning and overall final review stage of audits. The auditors may also
decide to use them during the audit as substantive test to provide evidence as to be the
reasonableness of the specific account balances.
132
Figure 5-2 presents examples of analytical procedures that involve comparison.
Audit procedures vary according to the risks associated with the client and the methods used to records
transactions. The following framework identifies audit procedures according to three major phases of the
audit:
2. Assess Risk of Material Misstatement: Understand and Test Internal Controls and System
Processing
133
e. Determine the effectiveness of procedures that the client has developed to monitor the continued
effectiveness of internal controls over financial reporting.
f. Select transactions and trace through processing to determine if controls are working properly.
b. Testimonial evidence:
(1) Inquire of client personnel
(2) Inquire of outside parties
c. Auditor-generated evidence:
(1) Direct observation
(2) Perform recomputations, including recalculations and mathematical test
(3) Reprocess transactions from origin to final records
(4) Vouch transactions from final records back to origin
(5) Physically examine assets
(6) Perform analytical procedures
(7) Auditor analysis through reasoning and examining integrated portions of the evidence
Evidence of these procedures has strengths and weaknesses that should be considered in
determining the optimal approach for a client. The auditor looks at the relative weight of evidence
from the three basic phases of the audit, including the test controls, and considers the costs of
procedures and the persuasiveness of evidence needed for a particular account balance related
management assertion(s).
After the auditor has developed specific audit objectives in relation to the assertion for a particular account
balance or class of transactions, the next step is to select audit procedures to achieve these objectives.
134
In determining which audit procedures to use to obtain evidence, the auditor must consider whether one or
more procedures will provide evidence that can reduce the risk of that assertion being misstated to an
acceptable low level. It is possible that more than one audit procedure may be required to determine the
validity of an assertion. In some cases however, an audit procedure may provide evidence about the validity
of more than one assertion.
The selection of particular procedures to achieve specific audit objectives in influenced by the following
considerations:
1. The nature and maternity of the particular component of the financial statements (account balance
or class of transaction).
2. The nature of the audit objective to be achieved.
3. The reliance that can be placed on internal control structure.
4. The relative risk of material errors or irregularities,
5. The kinds and competence of available evidence.
6. The expected efficiency and effectiveness of possible audit procedures.
Auditing standards suggest that the auditor must use professional judgment in determining the nature,
timing and extent of audit procedures appropriate in a particular situation. The procedure should satisfy the
auditor's objectives so that the evidence gathered enables the auditor to verify the assertions in the financial
statements. Thus the combination of the auditor's reliance on internal control (structure) and on selected
substantive tests should provide a reasonable basis for his opinion on the financial statements.
The Philippine Standards on Auditing require that the auditor shall conform with the following guidelines:
1. The auditor shall design and implement overall response to address the assessed risks of material
misstatement at the financial statement level.
2. The auditor shall design and perform further audit procedures whose nature timing and extent are
based on and are responsive to the assessed risks of material misstatement at the assertion level.
135
3. In designing the further audit procedures to be performed, the auditor shall:
a) Consider the reasons for the assessment given to the risk of material misstatement at the
assertion level for each class of transactions, account balance and disclosure, including:
i. The likelihood of material misstatement due to the particular characteristics of the
relevant class of transactions, account balance, or disclosure (that is, the inherent risk);
and
ii. Whether the risk assessment takes account of relevant controls (that is, the control risk),
thereby requiring the auditor to obtain audit evidence to determine whether the controls
are operating effectively (that is, the auditor intends to rely on the operating
effectiveness of controls in determining the nature, timing and extent of substantive
procedures); and
b) Obtain more persuasive audit evidence the higher the auditor's assessment of risk.
4. The auditor shall develop an audit plan that shall include a description of:
a) The nature, timing and extent of planned risk assessment procedures;
b) The nature, timing and extent of planned further audit procedures at the assertion level; and
c) Other planned audit procedures that are required to be carried out so that the engagement
complies with PSAs.
5. When designing and performing audit procedures, the auditor shall consider the relevance and
reliability of the information to be used as audit evidence.
6. When designing tests of controls and tests of details, the auditor shall determine means of
selecting items for testing that are effective in meeting the purpose of the audit procedure.
136
TESTS OF CONTROLS
1. The auditor shall design and perform tests of controls to obtain sufficient appropriate audit evidence as
to the operating effectiveness of relevant controls if:
a) The auditor's assessment of risks of material misstatement at the assertion level includes an
expectation that the controls are operating effectively (that is, the auditor intends to rely on the
operating effectiveness of controls in determining the nature, timing and extent of substantive
procedures); or
b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at the
assertion.
2. In designing and performing tests of controls, the auditor shall obtain more persuasive audit evidence
the greater the reliance the auditor places on the effectiveness of a control.
a) Perform other audit procedures in combination with inquiry to obtain audit evidence about the
operating effectiveness of the controls, including:
i. How the controls were applied at relevant times during the period under audit.
ii. The consistency with which they were applied.
iii. By whom or by what means they were applied.
b) Determine whether the controls to be tested depend upon other controls (indirect controls) and, if
so, whether it is necessary to obtain audit evidence supporting the effective operation of those
indirect controls.
4. If the auditor pans to rely on controls over a risk the auditor has determined to be a significant risk, the
auditor shall test those controls in the current period.
137
SUBSTANTIVE TESTS
1. Irrespective of the assessed risks of materials misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.
2. The auditor shall consider whether external confirmation procedures are to be performed as
substantive audit procedures.
3. The auditor's substantive procedures shall include the following audit procedures related to the
financial statement closing process:
a) Agreeing or reconciling the financial statements with the underlying accounting records; and
b) Examining material journal entries and other adjustments made during the course of
preparing the financial statements.
4. If the auditor has determined that an assessed risk of material misstatement at the assertion level is
a significant risk, the auditor shall perform substantive procedures that are specifically responsive
to that risk. When the approach to a significant risk consists only of substantive procedures, those
procedures shall include tests of details.
5. If substantive procedures are performed at an interim date, the auditor shall cover the remaining
period by performing:
a) Substantive procedures, combined with tests of controls for the intervening only,
b) If the auditor determines that it is sufficient, further substantive procedures only,
that provide a reasonable basis for extending the audit conclusions from the interim date to the
period end.
6. The auditor shall perform audit procedures to evaluate whether the overall presentation of the
financial statements, including the related disclosures, is in accordance with the applicable
financial reporting framework.
138
ILLUSTRATIVE COMPREHENSIVE CASE STUDY ON RISK ASSESSMENT AND RISK
RESPONSE
CASE FACTS:
Introduction
Mercury Technologies and Networks, Inc. (MTN) designs, develops, manufactures, markets, services and
supports a wide range of computer systems and networking hardware and software.
The CPA firm of Villamor & Co ., has audited the financial statements of MTN for the past three years. For
this year's audit, the staff of the firm has prepared audit planning working papers.
Read through the information for you to obtain an understanding of the nature of the information that is
important to planning an audit engagement.
The statement of financial position and statement of comprehensive income for the company for
20X6.
A trial balance for December31, 20X7, with comparative amounts for 20X6.
The analytical ratios working paper that is partially completed. (The. ratios for 20X7 have been
left off.)
The audit plan for the audit of the financial statements for the year ended December 31, 20X7.
A fraud risk assessment.
139
MERCURY TECHNOLOGIES AND NETWORKS INC.
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 20X6
(In P000'S)
Assets
Current Assets
Cash P 27
Trade receivables, less allowance for doubtful accounts P10 844
Accounts receivable - officers 57
Inventory 696
Prepaid expenses 40
Total current assets P 1,664
Non-current assets
Equipment and leasehold equipment, at cost
Office equipment and furniture P 281
Leasehold improvements 17
P 298
Less accumulated depreciation 125
Total fixed assets P 1,836
Total assets
Shareholders' equity
Ordinary shares, P1 par value; 100,000 shares authorized;20,000 shares issued and
P 20
outstanding
Additional paid-in-capital 42
Retained earnings 690
Total shareholders' equity 752
Total liabilities and shareholders' equity P 1,836
140
MERCURY TECHNOLOGIES AND NETWORKS, INC.
STATEMENT OF COMPREHENSIVE INCOME AND RETAINED EARNINGS
YEAR ENDED DECEMBER 31, 20X6
(In P000's)
Net sales P 10,227
Cost of goods sold 6,867
Gross profit P 3,360
Selling expenses:
Salaries P 513
Payroll benefits and taxes 97
Advertising and promotion 82
Travel and entertainment 38
Miscellaneous 16 P 746
Operating and administration expenses:
Operating salaries P 803
Administrative salaries 438
Payroll benefits and taxes 223
Rent 124
Utilities 92
Insurance 110
Legal and accounting 73
Bad debt 34
Supplies 93
Depreciation 25
Software development 83
Miscellaneous 42
Total selling,operating and administrative expenses 2,140 P 2,886
Operating income P 474
Interest expense 69
Income before income taxes P 405
Income taxes:
Current P 71
Deferred 3 P 74
141
MERCURY TECHNOLOGIES AND NETWORKS, INC.
WORKING STATEMENT OF FINANCIAL POSITION
YEAR ENDED DECEMBER 31, 20X7
(In P000's)
Account # Balance 12/31/X6 Unadjusted Trial Balance Adjustment Adjusted Balance
Account name Dr Cr Dr Cr Dr Cr Dr Cr
101 Cash-First National Bank ₱27.00 ₱46.00
102 Cash in register 1 1
103 Accounts receivable- trade 853 1023
104 Accounts receivable -officers 57 84
105 Allowances for bad debts ₱10.00 ₱10.00
106 Inventories 696 903
107 Prepaid expenses 40 42
201 Furniture and fixture 35 41
202 Office equipment 245 305
203 Leasedhold improvements 17 17
204 Accumulated depreciation 125 154
211 Software development cost 58
301 Accounts payable - trade 505 586
311 Capital lease obligations-current 20 21
321 Accrued liabilities 115 130
331 Unearned service revenue 22
341 Note payable 309 365
441 Capital lease obligations - non current 135 114
501 Share capital 20 20
511 Paid-in-capital 42 41
517 Retained earnings 690 689
591 Dividends 90
₱2,610.00 ₱2,152.00
458
Prepared by Reviewed by ₱1,971.00 ₱1,971.00 ₱2,610.00 ₱2,610.00
Initial Date Initial Date
142
MERCURY TECHNOLOGIES AND NETWORKS, INC.
WORKING PROFIT AND LOSS
YEAR ENDED DECEMBER 31, 20X7
(P000's)
Account # Balance 12/31/X6 Unadjusted Trial Balance Adjustment Adjusted Balance
Account name Dr Cr Dr Cr Dr Cr Dr Cr
601 Sales of computers ₱9,044
602 Services revenue 187
603 Consulting revenue 996
701 Cost of sales ₱6,867 ₱7,397
702 Salaries - sales 513 584
703 Payroll benefits 97 125
704 Advertising & entertainment 82 93
705 Travel & entertainment 38 45
706 Miscellaneous exp. - sales 16 22
707 Salaries - operations 803 984
708 Salaries - administrative 438 596
709 Payroll benefits - admin 223 320
711 Rent 124 167
712 Utilities 92 111
721 Insurance 110 94
722 Legal & accounting 73 92
731 Bad debt expense 34 56
741 Supplies 93 120
751 Depreciation 25 29
761 Software development 83 63
771 Miscellaneous exp. - administrative 42 45
781 Internet expense 69 77
791 Current income taxes 71 122
792 Deferred income taxes 3 3
₱9,896 ₱10,227 ₱11,145 ₱11,603
801 P & L Summary 331 458
Prepared by Reviewed by ₱10,227 ₱10,227 ₱11,603 ₱11,603
Initial Date Initial Date
143
MERCURY TECHNOLOGIES AND NETWORKS, INC
ANALYTICAL REVIEW RATIOS
FOR THE YEAR ENDED DECEMBER 31, 20X7
(In P000's)
Ending Ending
Ratio Industry
12/31/X7 12/31/X6
Current ratio 1.752 1.3
Days' sales in accounts receivable, computed with
33.224 37
average accounts receivable
Prepare by Reviewed by
Initial Date Initial Date
144
Mercury Technologies and Networks, Inc.
Audit Plan
December 31, 20X7
Date
Prepared by: KC Lopez (Senior) August 14, 20X7
Reviewed by: Jo Hernandez (manager) August 28, 20X7
Audit Objective
Audit of the financial statements of Mercury Technologies and Networks, Inc. (MTN) for the year ended
December 31, 20X7. Also, the company's debt agreement with Eastern Financial Services requires the
company to furnish the lender a report by our firm on MTN's compliance with various restrictive debt
covenants.
MTN sells and installs microcomputers and networking hardware and software to business customers. The
company's primary competitive strategy is to maintain a high level of technical expertise and a broad range
of services. The company provides repair, maintenance, training, and software customization services.
MTN has also begun developing its own computer networking software to be sold as a product to its
customers and MTN competes with large retailers of microcomputers. The market for microcomputers and
related products is extremely competitive. The company also competed with other value-added resellers
who provide microcomputers and software products directly to customers. To effectively compete, the
company must be able to obtain inventories of state-of-the-art equipment on a timely basis. Because the
company does not have the buying power of some of its competitors, it generally must charge a higher
price for its products. Its customers are willing to pay the higher price because of the high level of expertise
and service that the company provides.
Planning Meetings
On July 20, Jo Hernandez and I met with Janelle Santos, controller, and Gian Basco, president, of MTN to
discuss the planning of the audit for the current year. On August 2, a planning meeting was held in our
office with all members of the engagement team assigned to the audit.
145
Audit Approach
The company has had no significant changes in its internal control from the prior year. Therefore, consistent
with the approach used in last year's audit, we plan to perform tests of controls to assess control risk at less
than the maximum for most financial statement assertions.
Risks
As described above, MTN is in a very competitive business that is sensitive to economic conditions
MTN is a closely held company owned by five shareholders, Miguel Lee, Patrick Lee, Francis Lee,
Rain Young, and JC Young. Miguel and Patrick are active members of the company's board of
directors. None of the other owners take an active part in management of the business.
Audited financial statements are required by Bank of the Philippine Islands as a part of the
company's line of credit agreement.
The officers receive significant bonuses based on quarterly results. (see P10 for implications of this
risk)
These factors indicate that the engagement to audit MTN has high risk.
The company began offering for sale extended warranties on computers during the current year. We need to
review the method of revenue recognition to determine whether it complies with the requirements of PAS
18, Revenue.
In the prior year, MTN began developing networking software products for sale. This year the company has
started capitalizing certain costs of development. We need to review the method of accounting for the cost of
software development to determine whether it complies with the requirements of PAS 38,Intangibles.
Planning Materiality
Because the firm has experienced steady growth in sales and earnings over the last three years, we believe
that operating results are the most appropriate basis for estimating planning materiality as described on the
next page:
146
Comparison of Bases Computation of Planning Materiality
Financial Annualized for Materiality
Base Amount Percentage
Statement Base 12/31/X7 Estimate
Sales P11,000,000 Sales P11,000,000 1% P110,000.00
Total assets 2,000,000 Total assets 2,000,000.00 1 20,000.00
Pretax net income 525,000 Pretax net income 525,000.00 10 52,500.00
The range for planning materiality is from P20,000 to P110,000. Based on the company's steady growth in
sales and earnings and the fact that the company is not a public company, we have selected P70,000 as a
reasonable materiality amount for planning purposes.
Based on discussions with Ms. Santos, the following are tentative dates of importance for the audit:
147
Fraud Risk Assessment
8.14.X7
148
REQUIREMENTS
1. The audit plan for the audit of Mercury Technologies and Networks, Inc, appears on pages 118
through 126. Review each major section of the audit plan and briefly describe the purpose and
content of the section.
2. In the audit plan for the audit of Mercury Technologies and Networks, Inc., there is a section on
significant accounting and auditing matters. The first of the matters described in this section
involves the appropriate accounting for the sale r extended warranty contracts. Research this
accounting issue and write a brief memorandum for the working papers describing the issue
and summarizing the appropriate method of accounting for the revenue received from these
contracts.
3. In the audit for the audit of Mercury Technologies and Networks, Inc., there is a section on
significant accounting and auditing matters. The second matter described involves capitalizing
the costs of developing a software program for sale.
Required:
a. Research this issue and write a brief memorandum for the working
papers describing the issue and summarizing the appropriate method of
accounting for the development costs.
b. Based on your research, describe the major audit issue that you believe
will be involved in auditing the software development costs.
149
4. A partially completed analytical ratios working paper for Mercury Technologies and Networks, Inc., is
presented on page 122.
Required:
a. Complete the working paper by computing the financial ratios for 20X7.
b. After completing part (a), review the ratios and identify financial statement accounts that should
be investigated because there ratios are not comparable to priorytear ratios and industry ages.
c. For each account identified in part (b). list potential reasons for the unexpected account balances
and related ratios.
CASE ANALYSIS
BUSINESS AND To describe the nature of MTN sells and services micro-computers
INDUSTRY MTN's business and industry networking hardware and software to
CONDITIONS business customers. The industry is
sensitive at economic conditions and
competitive with MTN competing with
companies much larger than itself.
PLANNING MEETINGS To indicate meetings held At this point, one meeting has been held
with client and with CPA with client personnel and one with the
engagement team. engagement team
150
Section Purpose Content
AUDIT APPROACH To describe the overall approach Consistent with the previous
to be taken on the audit. year's audit, the CPAs will plan to
perform tests of controls to assess
control risk at less than the
maximum for most assertions
RISK To describe factors affecting the The engagement has high risk.
risk of the engagement. The primary risk factors are: (1)
management domination by a few
individuals, (2) existence of a line
of credit agreement, and (3) the
owners have entered into an
agreement to sell the business and
the audited financial results will
significantly affect the sales price.
This last risk results in a fraud
risk.
SIGNIFICANT ACCOUNTING To describe particular accounting Two particular concerns exist: (1)
AND AUDITING MATTERS and auditing matters of concern. proper accountin for extended
warranties and (2) capitalization
of software costs.
PLANNING MATERIALITY To identify an amount to be used Based on an analysis of sales,
as a measure for planning total assets, and pretax net
materiality income, an amount of P70,000
will be used as a measure of
planning materiality.
SCHEDULING AND To provide the schedule for major The section includes major dates
STAFFING PLAN portions of the audit, and the beginning with interim audit work
staffing requirements for the through the issuance of an
engagement. updated management letter. A
total of 118 hours are budgeted
for the audit.
151
Requirement (2) Research made on MTN Extended Warranty Contracts
The Philippine Accounting Standards require that revenue from extended warranties be deferred and
recognized in income on a straight-line basis over the contract period except when sufficient historical
evidence indicates that the costs of performing services under the contract are incurred on other than a
straight-line basis. In those circumstances revenue should be recognized over the contract period in
proportion to the costs expected to be incurred in performing the services. Because the company has no
historical experience with these warranties, revenue should be deferred and recognized on a straight-line
basis.
The costs related to extended warranties include those directly related to acquisition of the warranty and
other costs. Costs directly related to the acquisition of a warranty contract that would not have been
incurred but for the acquisition of the contract should be deferred and charged to expense in proportion
to the revenue recognized. All other costs (e.g., costs of services performed, general and administrative,
advertising expenses) should be charged to expense as incurred.
In circumstances in which the sum of expected costs of providing services and unamortized acquisition
costs exceed unearned revenue a different approach is appropriate-a loss should be recognized first by
charging any unamortized acquisition costs to expense. If the loss is greater than the unamortized costs,
a liability should be recognized for the excess amount of costs.
KC Lopez
(September 30, 20X7),
152
Requirement (3) Research made on Capitalization of Software Development Costs
(a)
In 20X6, MTN began developing networking software product for sale. This year the company has
started capitalizing certain costs of development. PAS 38, Intangibles, provides guidance in this area.
PAS 38 makes clear that the nature of the activity for which the software is being developed should be
considered in determining whether software costs should be included or excluded in research and
development. PAS 38 indicates that to the extent that the acquisition, development, or improvement of a
process by an enterprise for use in its selling or administrative activities includes costs for computer
software, those costs are not research and development costs. Examples of such costs include
development of a general management information system and the computerized reservation system of
an airline. This does not appear to be the type of costs involved in this situation.
PAS 38 further clarifies the issue by stating that all costs incurred to establish the technological
feasibility of a computer software product to be sold, leased or otherwise marketed are research and
development costs. The technological feasibility of a product is established when the enterprise has
completed all planning, designing, coding, and testing activities that are necessary to establish that
the product can be produced to meet its design specifications including functions, features, and
technological performance requirements. PAS 38 provides a summary of tests to indicate whether
technological feasibility has been established.
KC Lopez
(October 15, 20X7)
153
b) The major audit issue involved will be determining that the client has properly involved categorized in
establishing costs technological between research feasibility) and and development those costs (those
that should costs be capitalized. The auditors will have to determine at what point the software product
reached the point of technological feasibility.
154
Supporting Computations for 20X7 ratios (P000's)
155
(b) and (c) This part of the case reveals how difficult ratio analysis is when there are no major
changes in ratios. However, the following might be considered in comparing the current year's
ratios with those of lay year's.
Overstatement of sales
Understatement of receivables
Inventory Turnover
Change in inventory policy
Inventory obsolescence
Overstatement of inventory
Understatement of purchases
Inventory obsolescence
Overstatement of inventory
Understatement of purchases
Reduction of costs
A number of the other ratios show significant changes which seem due primarily the increased level of
profitability.
156
REVIEW QUESTIONS AND EXERCISES
Questions
1. What are examples of how an auditor might change (a) the nature of risk response, (b) the
timing of risk response, and (c) the extent of risk response?
4. What are the five types of tests auditors use to determine whether financial statements are
fairly stated? Identify which tests are performed to reduce control risk and which tests are
performed to reduce planned detection risk.
5. What is the purpose of tests of controls? Identify specific accounts on the financial
statements that are affected by performing tests of controls for the acquisition and payment
cycle.
6. Distinguish between a test of control and a substantive test of transactions. Give two
examples of each.
7. A considerable portion of the tests of controls and substantive tests of transactions are
performed simultaneously as a matter of audit convenience. But the substantive tests of
transactions procedures and sample size, in part, depend on the results of the tests controls.
How can the auditor resolve this apparent inconsistency?
8. Distinguish between substantive tests of transactions and tests of details of balances. Give
one example of each for the acquisition and payment cycle.
9. Assume that the client's internal controls over the recording and classifying of fixed asset
additions are considered weak because the individual responsible for recording new
acquisitions has inadequate technical training and limited experience in accounting. How
would this situation affect the evidence you should accumulate in auditing fixed assets as
compared with another audit in which the controls are excellent? Be as specific as possible.
157
10. The following are three decision factors related to assessed control risk effectiveness of
internal controls, cost-effectiveness of a reduced assessed control risk, and results of tests of
controls. Identify the combination of conditions for these three factors that is required before
reduced substantive testing is permitted.
11. Why is it desirable to design tests of details of balances before performing tests of controls
and substantive tests of transactions? State the assumptions that the auditor must make in
doing that. What does the auditor do if the assumptions are wrong?
Questions No. 1 through 4 deals with tests of controls. Choose the best response.
2. Which of the following would be least likely to be included in an auditor's tests of controls?
a. Documentation c. Inquiry
b. Observation d. Confirmation
3. The two phases of the auditor's involvement with internal control are sometimes called
"understanding and assessment" and "tests of controls".
In the tests of controls phase, the auditor attempts to obtain:
a. A reasonable degree of assurance that the client's internal controls are operating effectively
on a consistent basis throughout the year.
b. Sufficient, competent evidential matter to afford a reasonable basis for the auditor's opinion.
158
c. Assurances that informative disclosures in the financial statements are reasonably adequate.
d. Knowledge and understanding of the client's prescribed procedures and methods.
Questions No. 5 through 7 concern types of audit tests. Choose the best response.
6. To support the auditor's initial assessment of control risk below maximum, the auditor performs
procedures to determine that internal controls are operating effectively. Which of the following
audit procedures is the auditor performing
a. Tests of details of balances.
b. Substantive test of transactions.
c. Tests of controls.
d. Tests of trends and ratios.
7. The auditor faces risk that the audit will not detect material misstatements that occur in the
accounting process. To minimize this risk, the auditor relies primarily on
a. Substantive test.
b. Tests of controls.
c. Internal control.
d. Statistical analysis.
159
Questions No. 8 and 9 concern the sequence and timing of audit tests choose the best response.
8. A conceptually logical approach to the auditor's evaluation of internal control consists of the
following four steps:
A. Determine the internal controls that should prevent or detect errors and fraud.
I. Identify weaknesses to determine their effect on the nature, timing, or extent of auditing
procedures to be applied and suggestions to be made to the client.
II. Determine whether the necessary procedures are prescribed and are being followed
satisfactorily.
III. Consider the types of errors and fraud that could occur.
What should be the order in which these four steps are performed?
a. I, II, III, and IV.
b. I, III, IV, and II.
c. .III, IV, I, and II.
d. IV, I, III, and II.
9. The sequence of steps in gathering evidence as the basis of the auditor's opinion is:
a. Substantive tests, initial assessment of control risk, and test of controls.
b. Initial assessment of control risk, substantive tests, and tests of controls.
c. Initial assessment of control risk, tests of controls, and substantive tests.
d. Tests of controls, initial assessment of control risk, and substantive tests.
10. Which of the following statements is true regarding the concept of materiality?
a. Materiality is the magnitude of an omission or misstatement of accounting information that,
in light of surrounding circumstances, makes it probable that the judgment of a reasonable
person relying on the information would have been changed or influenced by the omission or
misstatement.
b. Materiality is the magnitude of an omission or misstatement, of accounting information that,
in light of surrounding circumstances, makes it possible that the judgment of a reasonable
person relying on
160
the information would have been changed or influenced by the omission or misstatement
c. A fact is material if there is a substantial likelihood that the fact would have been viewed by
the reasonable investor as having significantly altered the total mix of information made
available.
d. Both (a) and (c) are correct.
11. Which of the following statements is true concerning the concept of performance materiality?
a. Performance materiality is set less than overall materiality and helps the auditor determine
the extent of audit evidence.
b. If performance materiality is set too low, the auditor might not perform sufficient procedures
to detect material misstatements in the financial statements.
c. If performance materiality is set too high, the auditor might perform more substantive
procedures than necessary.
d. Performance materiality is essentially the same posting materiality.
12. Which of the following statements represent the appropriate directional relationships between the
concepts of inherent risk, control risk, audit risk, and detection risk?
a. As inherent risk goes up, audit risk goes up.
b. As inherent risk goes up, audit risk goes down.
c. As control risk goes up, detection risk goes up.
d. As control risk goes up, inherent risk goes down.
13. Which of the following statements is true regarding the concept of control risk?
a. When control risk is high, the auditor is concerned that a misstatement may not be prevented,
or that is a misstatement exists in the organization's financial statements that it will not be
detected, and therefore corrected by management.
b. Some organizations have zero control risk because they have made a significant commitment
to the effective design and operation of controls.
c. Control risk relates to the susceptibility of an assertion to a misstatement, due to either error
or fraud, before consideration of any related controls.
d. All of the above are true.
161
14. Which of the following statements is true regarding analytical techniques?
a. Ratio analysis takes advantage of economic relationships between two or more accounts.
b. Ratio and trend analysis are generally carried out through a comparison of client data with
expectations based on industry data, prior- period data, and expectations developed from
industry trends client budgets, and so on.
c. Developing expectations is the first step in performing analytical procedures.
d. All of the above are true.
16. Which of the following statements is false regarding the nature, timing, and extent of risk
responses?
a. The nature of risk response refers to the types of audit procedures applied given the nature of
the account balance and the most relevant assertions regarding that account balance.
b. The timing of risk response refers to when audit procedures are conducted and whether those
procedures are conducted at announced or predictable times.
c. When the risk of material misstatement is low,the auditor conducts the audit procedures
closer to year end, on an unannounced basis, and includes some element of unpredictability
in the timing of procedures.
d. The extent of risk response refers to the sufficiency of evidence that is necessary given the
client's assessed risks, materiality, and the acceptable level of audit risk.
162
Exercises
Exercise 1
For each of the following controls, identify whether the control leaves an audit trail. Also identify
a test of control audit procedure the auditor can use to test the effectiveness of the control.
a. An accounting clerk accounts for all shipping documents on a monthly basis and initials the
monthly shipping log.
b. Bank reconciliations are prepared by the controller, who does not have access to cash
receipts.
c. As employees check in daily by using time clocks, a supervisor observes to make certain that
no individual "punches in" more than one time card.
d. Vendors' invoices are approved by the controller after she examines the purchase order and
receiving report attached to each invoice.
e. The cashier, who has no access to accounting records, prepares the deposit slip and delivers
the deposit directly to the daily.
f. An accounting clerk verifies the price, extensions, and footing of all sales invoices in excess
of P300 and initials the duplicate sales invoice when he has completed the procedure.
g. All mail is opened and cash is prelisted daily by the president's secretary, who has no other
responsibility for handling assets or recording accounting data
Exercise 2
Maria Cabrera, CPA, follows the philosophy of performing interim tests of controls and substantive
tests of transactions on every December 31 audit as a means of keeping overtime to a minimum.
Typically, the interim tests are performed some time between August and November.
Required:
a. Evaluate her decisions to perform interim tests of controls and substantive tests of
transactions.
b. Under what circumstances is it acceptable for her to perform no additional tests of controls
and substantive tests of transactions work as a part of the year-end audit tests?
c. If she decides to perform no additional testing, what is the effect on other tests she performs
during the remainder of the engagement?
163
Exercise 3
Following are several decisions that the auditor must make in an audit Letters indicate alternative
conclusions that could be made:
Required:
a. Identify the sequence in which the auditor should make decisions 1-4 above.
b. For the auditor of the sales and collection cycle and accounts receivable, an auditor reached the
following conclusions: A,D,E,H.Put the letters in the appropriate sequence and evaluate whether
the auditor's logic was reasonable. Explain your answer.
c. For the audit of inventory and related inventory cost records, an auditor reached the following
conclusions: B, C, E, G. Put the letters in the appropriate sequence and evaluate whether the
auditor used good professional judgment. Explain your answer.
d. For the audit of property, plant, and equipment and related acquisition records, an auditor reached
the following conclusions: A, C, F, G. Put the letters in the appropriate sequence and evaluate
whether the auditor used good professional judgment. Explain your answer.
e. For the audit of payroll expenses and related liabilities, an auditor recorded the following
conclusions: D, F. Put the letters in the appropriate sequence and evaluate whether the auditor
used good professional judgment. Explain your answer.
164
Exercise 4
Hazel Jess, a new staff auditor, is confused by the inconsistency of the three audit partners she has been
assigned to on her first three audit engagements. On the first engagement, she spent a considerable
amount of time in the audit of cash disbursements by examining canceled checks and supporting
documentations, but almost no testing was spent in the verification of fixed assets. On the second
engagement, a different partner had her do less intensive tests in the cash disbursements area and take
smaller sample sizes than in the first audit, even though the company was much larger. On her most
recent engagement under a third audit partner, there was a thorough test of cash disbursement
transactions, far beyond that of the other two audits, and an extensive verification of fixed assets. In
fact, this partner insisted on a complete physical examination of all fixed assets recorded on the books.
The total audit time on the most recent audit was longer than that of either of the first two audits
despite the smaller size of the company. Hazel's conclusion is that the amount of evidence to
accumulate depends on the audit partner in charge of the engagement.
REQUIRED:
a. State several factors that could explain the difference in the amount of evidence accumulated in
each of the three audit engagements as well as the total time spent.
b. What could the audit partners have done to help Hazel understand the difference in the audit
emphasis on the three audits?
c. Explain how these three audits are useful in developing Hazel's professional judgment. How
could the quality of her judgment have been improved on the audits?
165
Exercise 5
The following are three situations in which the auditor is required to develop an audit strategy:
1. The client has inventory at approximately 50 locations in the Philippines. The inventory is
difficult to count and can be observed only by traveling by automobile. The internal controls over
acquisitions, cash disbursements, and perpetual records are considered effective. This is the fifth
year that you have done the audit, and audit results in past years have always been excellent. The
client is in excellent financial condition and is privately held.
2. This is the first year of an audit of a medium-sized company that is considering selling its
business because of severe underfinancing. A review of the acquisition and payment cycle
indicates that controls over cash disbursements are excellent, but controls over acquisitions
cannot be considered effective. The client lacks receiving reports and a policy as to the proper
timing to record acquisitions. When you review the general ledger, you observe that there are
many large adjusting entries to correct accounts payable.
3. You are doing the audit of a small loan company with extensive receivables from
customers. Controls over granting loans, collections, and loans outstanding are
considered effective, and there is extensive follow-up of all outstanding loans weekly.
You have recommended a computer system for the past 2 years, but management
believes the cost is too great, given their low profitability. Collections are an ongoing
problem because many of the customers have severe financial problems. Because of
adverse economic conditions, loans receivable have significantly increased and
collections are less than normal. In previous years, you have had relatively few adjusting
entries.
REQUIRED:
a. For audit 1, recommend an evidence mix for the five types of tests for the audit of
inventory and cost of goods sold. Justify your answer. Include in your recommendations
both tests of controls and substantive tests.
b. For audit 2, recommend an evidence mix for the audit for the acquisition and payment
cycle, including accounts payable. Justify your answer.
c. For audit 3, recommend and evidence mix for the audit of outstanding loans. Justify your
answer.
166
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE REVENUE
AND COLLECTION CYCLE
1. Enumerate and describe the steps involved in auditing the revenue and
collection cycle.
2. Describe the nature and the major classes of transactions in the revenue
and collection cycle.
3. Explain the process of analyzing and recording sales, sales adjustments
and cash receipts transactions and the corresponding documents and
records used.
4. Apply the risk assessment and risk response phases of the respective
audit process, test of controls and substantive tests of transactions to
sales, sales adjustments and cash receipts.
167
CHAPTER 6
AUDIT OF THE REVENUE AND
COLLECTION CYCLE
INTRODUCTION
This chapter begins with an explanation of the revenue collection cycle and the internal control
environment and objectives pertaining thereto. Then, consideration is given to compliance tests of
controls and substantive tests over revenue and cash receipts transactions.
In performing the audit of the revenue and collection cycle, the auditor should be able to:
1. Identify the activities and types of transaction that occur in a company's revenue cycle;
2. Relate the effect of controls on the assertions embodied in the financial statements, sales
adjustments, and cash receipts transactions;
3. Determine the essential features of internal control over the transactions in the revenue and
collection cycle;
4. Prepare and perform the audit procedures for compliance tests of controls over these
transactions; and
5. After evaluating the effectiveness and of internal control, perform substantive tests of
transactions to meet transaction-related audit objectives for revenue and collection cycle.
these tests of transactions are not directly related to the key controls but their extent depends
in part, on which key controls exists and on the results of the tests of controls.
6. Design tests of details of accounts affected by the revenue and collection cycle and analytical
procedures to satisfy balance-related audit objectives.
Steps 1 to 5 are discussed in this chapter while Step number 6 is addressed in Chapters 11 and.12.
168
NATURE OF THE REVENUE AND COLLECTION CYCLE
Basic Considerations
The revenue and collection cycle involves the process of receiving a customer's order, approving
credit for a sale, determining whether the goods are available for shipment, shipping the good, billing
the customer, collecting cash, and recognizing the effect of this process on other related accounts such
as accounts receivable, inventory, and sales commission expense.
In the revenue cycle, the most significant accounts include revenue and accounts receivable. The
auditor will likely obtain evidence related to each of the financial statement assertion discussed in this
Chapter for both accounts. However, for specific accounts and specific clients, some assertions are
more relevant than other assertions. For many clients, the existence assertion related to revenue may
be one of the more relevant assertions, especially if the client has incentives to overstate revenues. For
accounts receivable, the more relevant assertions are usually existence and valuation.
The revenue and collection cycle of an entity consists of the activeness relating to the exchange of
goods and services with customers and the collection of the revenue in cash. Different entities may
have different sources of revenue. The discussions and illustrations in this chapter are based on a
merchandising company. However, much of the commentary can easily be adapted to the other types
of entities.
Generally, the classes of transactions in the revenue and collection cycle involve:
B. Sales adjustments (discounts, returns and allowances and uncollectible accounts provisions
and write-offs); and
Figure 6-1 also shows that with the exception of cash sales, every transaction and amount ultimately is
included in one if two balance sheet accounts, accounts receivable or allowance for uncollectible
accounts. For simplicity, assume that the same internal controls exist for both cash and credit sales.
169
PROCESSING REVENUE TRANSACTIONS
The revenue process may vary from client to client and each client may have more than one revenue
process. For example, a sales transaction for a shirt in a department store differs from a sale of
construction equipment, and both of these differ from a book sale on an Internet site. The Internet sale
and the retail sale most likely require cash or credit card for payment. The construction equipment sale
most likely involves an account receivable, or a loan may be arranged with a third party. Some sales
transactions involve long-term contractual arrangements that effect when and how revenue will be
recorded. Some organizations generate detailed paper trails for sales documentation; others maintain
an audit trail only in computerized form. Not-withstanding these differences, most sales transactions
include the procedures and related documents shown in Figure 6-1.
1. Sales
3. Sales discounts
4. Cash in bank
170
REVENUE AND COLLECTION CYCLE ACCOUNTS
Accounts typically affected by Sales Transactions are shown in the Figure 6-1 Below
Figure 6-1 : Accounts typically affected by Sales Transaction
Directly Related Accounts
Cash
Beginning Balance Disbursement
Cash Sales
Collections
Other Receipts
Sales Ending Balance
Cash Sales
Credit Sales
Accounts Receivable Sales Discounts
Beginning Balance Collections Sales Discounts
Credit Sales Sales Discounts
Returns and Allowances
A/R Subdiary Ledger Write-offs Sales Returns and Allowanes
Customer A Ending Balance return and Allowance
Customer B
Customer C
etc Allowance for Doubtful Accounts Bad Debt Expenses
Total Write osff Beginning Balance Provision
Provision
Ending Balance
Several important documents and records are typically used in the revenue and collection cycle.
Sales order
A prenumbered document for recording A sales order contains the seller's
the description, quantity, and related understanding of the sales terms. A seller
information for goods ordered by a should account for the numerical
customer. This is frequently used to show sequence to help ensure that shipments
credit approval and authorization for are made for sales orders and that all
shipment. sales are billed.
172
Sales invoice
A prenumbered document indicating the A salesinvoice indicates credit terms,
description and quantity of goods sold, the shipping terms, and price charged for
price including freight, insurance, terms, merchandise. Sellers should account for
and other relevant data. the numerical sequence to help ensure
that all sales are recorded.
Credit memo
A prenumbered document indicating a A credit memo provides evidence that a
reduction in the amount due from a seller has reduced the amount previously
customer because of returned goods or an billed to a customer. Sellers should
allowance granted. It often takes the same account for the numerical sequence to
general form as a sales invoice, but it help ensure that all credit memos are
supports reductions in accounts receivable recorded.
rather than increases.
Remittance advice
A document that a customer attaches to a A remittance advice usually indicates the
check in payment of an invoice. The date and amount of payment and the
document may be a turnaround document, invoices paid. Sellers generally file
a part of a check, or statement identifying remittance advices by date.
the invoices being paid. Remittance
advices facilitate recording cash receipts.
Is a customer does not return a remittance
advice, the employee opening the mail
generally prepares one.
Monthly statement
A document sent to each customer A statement mailed to a customer
indicating the beginning balance of reporting a beginning balance and
accounts receivable, the amount and date transactions that occurred during the
of each sale, cash payments received, period. if the statement is inaccurate,
credit memos issued, and ending balance many customer would contract the seller.
due.
173
Accounting Records in the Revenue and Collection Cycle
Sales journal
A journal for recording sales transactions. A detailed sales journal includes each sales transaction. It
usually indicates gross sales for different classifications, such as product lines, the entry to accounts
receivable, and miscellaneous debits and credits. The sales journal can also include sales returns and
allowances transactions.
A journal similar to the sales journal except the merchandisers use it to record returns of merchandise
or adjustments to invoice prices.
A journal for recording cash receipts from collection, cash sales, and all other cash receipts.
General journal
A journal in which are recorded all transactions for which a special journal has not been created. Sales
and collections cycle transactions frequently recorded in the general journal include entries to estimate
uncollectible accounts expense and entries to estimate uncollectible accounts expense and entries to
write off accounts identified as uncollectible.
A file recording individual sales, cash receipts, and sales return allowances for each customer and
maintaining customer account balances.
A listing of the amount owed by each customer at a point in time. This is prepared directly from the
accounts receivable master file.
174
AUDITING THE REVENUE AND COLLECTION CYCLE
The auditor obtains information that is useful in assessing the risk of material misstatement. This
includes information about
(a) Inherent risks at the financial statement level (e.g ., client's business and operational risks
(b) Fraud risks (e.g ., feedback on strengths and weakness in internal control; results from
preliminary analytical procedures.
Once the risks of material misstatement have been identified, the auditor then determined how be
best to respond to them as part of the audit opinion formation process.
An important inherent risk related to revenue transactions is the timing of revenue recognition.
Revenue may only be recognized when it is realized or is realizable and earned. Through these
concepts seem simple, they are often difficult to apply in practice. Further, complex sales transactions
often make it difficult to determine when a sale has actually taken place. For example, a transaction
might be structured so that title passes only when some contingent situations are met, or the customer
may have an extended period to return the goods.
To audit the revenue cycle, the auditor must understand the following:
The earnings process and the nature of the obligations that exterd beyond the normal shipment of
goods.
The impact of unusual terms, and when title has passed to the customer. The right of the customer
to return a product, as well as the returns history.
The proper treatment of sales transactions made with recourse of that have an abnormal or
unpredictable amount of returns.
175
Accounts Receivable: Identifying Inherent Risks
The primary inherent risk associated with receivables is that the net amount is not collectible, wither
because the receivables recorded do not represent genuine claims or an insufficient allowance exists
for uncollectible accounts.
The most relevant financial statement assertions for receivables are usually existence and valuation.
Other important risks may be related to ownership due to the company selling or pledging receivables.
Some of the inherent risks affecting receivables include the following:
Receivables are pledged as collateral against specific loans with restricted use (disclosure of such
restrictions are required).
Receivables are incorrectly classified as current when the likelihood of collection during the next
year is low.
Payment is not required until the purchaser sells the product to its end customers.
Accounts receivable are aged incorrectly, and potentially uncollectible amounts are not
recognized
Auditing standards state that auditors should ordinarily presume there is a risk of material
misstatement caused by fraud relating to revenue recognition.
Fraud Schemes
Fraud investigations undertaken by the SEC and other government agencies have uncovered a wide
variety of methods used to misstate accounts in the revenue cycle, including:
Recognition of revenue on shipments that never occurred
Hidden side letters, agreements containing contract terms that are not part of the formal contract,
giving customers an irrevocable right to return the product.
Early recognition of sales that occurred after the end of the fiscal period
176
Shipment of more product than the customer ordered
Shipping goods that had been returned and recording the reshipment as a sale of new goods before
issuing credit for the returned sale
Incorrect aging of accounts receivable and not recording write-downs of potentially uncollectible
amounts
The examples but a few of the revenue risk factors to which auditors should be alert. Identifying these
risk factors involves the auditor:
Assessing motivation to enhance revenue because of either internal or external pressures
Reviewing the financial statements through preliminary analytical procedures to identify account
balances that differ from expectations or general trends in the economy.
Recognizing that not all of the fraud will be instigated by management; for example, a CFO or
accounting staff person may engage in misappropriating assets for his or her own use.
Becoming aware of representations made by management to analysts and the potential effect of
those expectations on stock prices
Determining whether the company's performance is significantly different from that of the rest of
the industry of the economy.
Determining whether the company's accounting is being investigated by organizations such as the
SEC
Considering management compensation schemes, especially those that rely on stock options and
therefore current stock prices.
Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement in the revenue and accounts receivable accounts, the auditor needs to understand the
controls that the client has designed and implemented to address those risks.
Such understanding is normally gained by means of a walkthrough of the process, inquiry, observation,
and review of the client's documentation. The auditor considers both entity wide controls and
transaction controls at the account and assertion levels. This understanding provides the auditor with a
basis for making an initial control risk assessment.
177
Performing Preliminary Analytical Procedures
When planning the audit, the auditor is required to perform preliminary analytical procedures. These
procedures can help auditors identify areas of potential misstatements. Auditors do not look at just the
numbers when performing analytical procedures. Possible expected relationships in the revenue cycle
include the following:
Revenue growth, receivables growth, and gross margin are consistent with the activity in the
industry.
There is no unusual concentration of sales made to customers(in comparison with the prior year).
The accounts receivable turnover is not significantly different from the prior year.
The ratio of the allowance for doubtful accounts total receivables or to credit sales is similar to the
prior year.
Revenue is increasing even though there is strong competition and a major competitor has
introduced a new product.
Revenue increases are now consistent with the industry or the economy. Gross margins are higher
than average, or there is an unexpected change in gross margins.
Large increases in revenue occur near the end of the quarter or year. Revenue has grin and net
income has increased, but there is negative cash flow from operations.
Trend analyses of account balances and ratios are preliminary analytical procedures that are routinely
used on revenue cycle accounts. Examples of ratios the auditor might consider for revenue cycle
accounts are as follows:
Turnover of receivables (ratio of credit to average net receivables) or the number of days' sales in
accounts receivable Average receivables balance per customer
Aging of receivables
178
Bad debt expense as a percentage of net credit sales
PHASE II – RISKRESPONSE
Once the auditor understands the risks of material misstatement, the auditor is in a position to
determine the appropriate audit procedures to perform. Audit procedures should be proportional
to the assessed risks, with areas of higher risk receiving more audit attention and effort.
Responding to identified risks typically involves developing an audit approach that contains
substantive procedures (for examples, tests of details and, when appropriate, substantive
analytical procedures) and tests of controls, when applicable. The sufficiency and appropriateness
of selected procedures will vary to achieve the desired level of assurance for each relevant
assertion. While audit firms may have a standardized audit program for the revenue cycle, the
auditor should customize the audit program based on the assessment of risk of material
misstatement.
The auditor may develop an audit program that consists of first performing limited tests of
operating effectiveness of controls, then performing limited substantive analytical procedures,
and finally performing substantive tests of details. If the high risk is high, the auditor will want to
obtain a great deal of evidence directly from tests of details. In contrast, consider a client where
the auditor has assessed the risk of material misstatement related to the completeness of revenues
as low, and believes that the client has implemented effective controls in this area. For this client,
the auditor can likely perform tests of controls, gain a high level of assurance from substantive
analytical procedures such as reasonableness test, and then complete the substantive procedures
by performing tests of details at a limited level.
179
A. AUDIT OF SALES TRANSACTION
b. Approving credit
e. Billing customers
Figure 6-2 shows a flowchart of the manual system for executing sales transactions. The purpose of
the flowchart is to assist in identifying control points and the necessary control features related to each
point. The presentation reflects the segregation of functions considered characteristics of satisfactory
internal control.
180
Figure 6-2: Internal Control Flowchart for Processing
181
I. Obtaining Evidence About Internal Control Operating Effectiveness In The Revenue Cycle
Custody
182
II. Tests of Controls Over Sales and Receivables
Controls are important because of their effect on the assertions embodied in the financial
statements. Auditors identify specific assertions for each general assertion to be tested. The
general and specific audit assertions for Sales and Receivables are as follows:
Assertions
General Specific
1. Existence or occurrence 1. Recorded sales are for shipments actually
made to customers.
2. Completeness 2. All sales transactions that occurred are
recorded.
3. Rights and obligations 3. Sales recorded represent only sales
transactions.
4. Valuation or allocation 4. Sales are correctly billed and recorded.
5. Presentation and disclosure 5. Sales and accounts receivable are recorded to
result in presentation and disclosure in
accordance with PAS/PFRS.
Discussion:
A. Existence or Occurrence: Recorded sales are for shipments actually made to customers.
183
2. A clerk independent of accounts 2. The auditor can observe whether a clerk
receivable prepares and mails independent of the accounts receivable
monthly statements to customers for bookkeeper prepares and mails monthly
all trade accounts receivable and statements and follows up any complaints. He
follows up on any complaints can also examine files on complaints received
shipping for selected months.
B. Completeness: All sales transaction that occured are recorded
3. Prenumbered shipping documents 3. The auditor can observe the client performing
are accounted for to determine that a the procedure or select a sample of shipping
sales invoice is prepared for all orders and examine the invoice that bills the
shipments sale. The presence of a sales invoice copy
indicates that the shipment was billed.
3. Prenumbered sales invoices are 4. The auditor can observe the clerk recording
accounted for to determine that all sales if he or she is accounting for the
sales are recorded. numerical sequence of invoices and determines
why any missing
invoices have not been processed. The auditor
can also select a sample of sales invoice copies
to trace into the sales journal.
5. Procedures to ensure timely 5. The auditor should inquire how procedures are
recording if sales and proper cut-off followed, observe procedures being followed
are established and inspect report on the shipments that the
shipping clerk sends to the billing clerk. Proper
cut-off also provides evidence about the
existence of transactions.
184
D. Valuation or Allocation: Sales are correctly billed and recorded.
7. For all goods shipped, goods are 7. The auditor observes that the control is
counted and descriptions and being performed and examines a sample of
quantities are compared to quantities shipping orders for the signature on the
and descriptions on sales orders and shipping documents that indicates that the
shipping documents prior to counting and comparison occurred.
shipping.
10. The accounts receivable subsidiary 10. To tests this control, the auditor
ledger is balanced to the general observes that is being performed. The
ledger auditor may also foot the accounts
control account regularly. The receivable subsidiary ledger and compare
absence of this control results in the the total with the balance appearing in the
possibility of careless recordkeeping general ledger control account
and omission
of postings of sales or payments.
185
E. Presentation and Disclosure: Sales and accounts receivable are
recorded to result in presentation and disclosure in accordance with PAS/PFRS
11. Sales must be properly classified to 11. The auditor can test this control by
generate accurate segment determining that the invoice copy contains
reporting. Entities may require a the signature that indicates approval of
second person to independently account classification used.
review or check the account coding
on invoices
An audit program for tests of controls for sales is presented in Figure 6-4. The audit procedures are
those included in the foregoing discussions, but they have been restated to enable the auditor to select
a minimum number of samples for testing. It will be noted that to test for existence or occurrence, the
auditor tests from accounting records back to underlying documents that indicate that the transaction
occurred. To test whether all transactions are recorded, an auditor compares pre-numbered documents
to entries in the accounting records. The auditor can also observe the presence of some controls, rather
than examine a sample of documents to obtain evidence about a control.
186
Figure 6-4: Sample Audit Program for Tests of Controls
Over Sales Transactions
1. Proper pricing
2. Mathematical accuracy.
3. Terms.
d. Examine signature evidencing recheck of account coding.
2. For a sample of shipping documents, examine signature indicating that for goods shipped, goods
are counted quantities and descriptions of the goods shipped are compared to quantities and
descriptions on sales orders and shipping documents prior to shipping, and the transactions are
recorded in the sales journal.
3 Discuss the procedures followed with the person (independent of the bookkeeper) who mails to
customers monthly statements for all trade accounts receivable and follows up on any
complaints. Review the client's correspondence files reflecting resolution of these items.
5 Observe that the accounts receivable subsidiary ledger is balanced to the general ledger control
account regularly
6 Examine evidence of accounting for the sequence of sales orders, shipping documents, and sales
invoices.
187
Briefly, the foregoing tests of controls over sales transactions may reveal the following weaknesses,
possible errors and misstatements:
2a. Ineffective billing process in 2a. Recording sales based on 2. Recording unearned revenue
which billing is not tied to the receipt of orders from
shipping information. customers rather than the
shipment of goods.
188
4. Ineffective cutoff procedures in the 4. Recording sales in the wrong 4. Early (lato) recognition
shipping department period based on incorrect of revenue - "cutoff-error"
shipping information
5. Ineffective board of directors, audit 5. Recording sales when the 5. Recording revenue when
committee, or internal audit function; customer is likely to return the significant uncertainties
top management action not conducive goods. exist
to ethical conduct; undue pressure to
meet sales targets
6. Aggressive attitude of management 6. Recording sales when the 6. Recording revenue when
toward financial reporting; customer's payment is significant uncertainties
incompetent chief accounting officer contingent upon the customer exist
receiving financing or selling
the goods to another party
(e.g., consignment sales)
7. Ineffective board of directors, audit 7. Recording franchise revenue 7. Recording revenue when
committee, or internal audit function; when franchises are sold even significant services still
top management action not conducive though an obligation to must be performed by
to ethical conduct; undue pressure to perform significant services seller
meet sales targets. still exists.
189
IV. Substantive Tests of Sales Transactions
In deciding on substantive tests of transactions, some procedures are commonly employed on ever
audit regardless of the circumstances where as others are dependent on the adequacy of the controls
and the results of the tests of controls. The following schedule shows the substantive audit procedures
for sales transactions, the related audit objectives and assertion:
190
IV. Valuation or C. To determine that recorded 7. Recomputed information on
Allocation sales are for the amount of sales invoices.
goods shipped and are 8. Trace entries in sales journal
correctly billed and recorded. to sales invoices.
9. Trace details on sales
invoices to shipping
documents, price tests and
customer's orders.
V. Presentation D. To determine that sales 10. Examine document
transactions are properly supporting sales transactions
classified. for proper classification
*This analytical procedure can also apply to other objectives including competence, valuation
and proper cutoff
1-5. For a sample of entries in the sales journal, compare sales invoice copy, customer order and
shipping document.
To test the existence of sales, some auditors examine the sales invoice, the customer's order, the sales
order bearing credit approval and the shipping document for a sample of entries in the sales journal. If
an entity has a procedure to accumulate these documents before recording a sale, their accumulation is
an indication that the control was performed. Other procedures may include
a) Trace from the entry removing the goods from inventory to the perpetual inventory record.
b) Examine the cash receipts in payment for the sale.
c) Confirm the existence of individual transactions with the customers.
6. For a sample of shipping documents, trace sales invoice and entry into sales journal and
accounts receivable subsidiary ledger. Perform cutoff tests.
For a sample of shipping documents, the auditors may examine the sales invoice and determine
that an entry was made in the sales journal and the accounts receivable subsidiary ledger. When
testing to determine that all transactions have been recorded, auditors start with a renumbered
document, such as a bill of lading or a delivery ticket and trace it into the journals and ledgers.
191
For a sample of sales invoices, examine the customer order and shipping document to determine
whether the transaction should have been recorded as a consignment transaction rather than as a
sale.
To determine that the entity has a right to receivable arising from the sales transactions recorded, the
auditor examines a sample of sales transactions and be alert for indications of consigned shipments
treated as sales. Auditors should also investigate the procedure from recording movements of
merchandise among the various units of the company.
7-9. For a sample of entries in the sales journal, (a) examines sales invoice, shipping document and
customer order for consistency of descriptions and quantities; (b) examine sales orders for credit
approval; and (c) check prices and extensions. Foot sales journal and general ledger account.
This audit procedure for verification of a sales transaction that has been selected for testing may begin
with a comparison of the customer's purchase order, the client's sales order, and the duplicate copy of
the sales invoice. The descriptions and quantities of items are compared on these three documents and
traced to the duplicate copy of the related shipping document. The credit manager's signature denoting
approval of the customer's credit should appear on the sales order.
The extensions and footings on each invoice in the sample should be proved to be arithmetically
correct. After proving the accuracy of selected individual invoices, the auditors next trace the invoices
to the sales journal and to postings in the accounts receivable subsidiary ledger. In addition, the date of
each invoice should be compared with two other dates:
10. For a sample of entries in the sales journal, verify the accuracy of account coding.
Auditors may review entries in the ales journal and the supporting sales invoice to determine whether
the sales invoice was coded correctly and whether it results in proper presentation and disclosure of the
transaction in the financial statement.
192
B. AUDIT OF SALES ADJUSTMENTS TRANSACTIONS
Figure 6-5 shows the manual system for processing and recording sales returns and account
write-offs.
193
Figure 6-5: Sales Returns and Account Write-offs
194
I. Evaluation of Internal Control Over Sales Adjustments Transactions
The auditor may use the following internal control questionnaire in evaluating the effectiveness of the
client's system over the sales adjustments transactions (Figure 6-6)
A concern about these transactions is that a transaction may be recorded to cover a material
misappropriation of cash receipts. Auditors generally pay little attention to these adjustments unless
they are a material amount or individual adjustments are large.
195
196
II. Tests of Controls over Sales Adjustment Transactions
197
III. Sample Audit Program for Test of Controls:
Sales Adjustments Transactions
Done
Audit Procedures WP Ref By Date
1. Account for credit memoranda.
2. Prove the footing of credit memorandum to the general ledger
3. Trace the posting of credit memorandum to the general ledger.
4. Review credit memoranda for approval
5. Check credit memoranda concerning returned goods for. (a)
arithmetical accuracy; (b) quantities returned (by reference to
the original invoice or record of the selling price.
The foregoing tests of controls over sales adjustments transactions may reveal the following
weaknesses and possible errors;
198
IV. Substantive Tests for Sales Returns and Allowances
The audit objectives are essentially the same for processing credit memos for returns and
allowances as those described for sales, with two important differences.
1. The first relates to "materiality." If the amount of sales returns and allowances are so
immaterial, they can be ignored in the audit altogether
2. The second relates to "emphasis on objective.” For sales returns and allowances, the
primary emphasis is normally on testing the validity of recorded transactions as a means of
uncovering any diversion of cash from the collection of accounts receivable that has been
covered by a fictitious sales returns or allowance.
Naturally, the auditor also gives due attention to the other objectives and should be able to
arrive at suitable substantive tests of transactions which are essentially the same as for sales to
verify amounts.
199
C. AUDIT OF CASH RECEIPTS TRANSACTIONS
Basic Considerations
A high volume of transactions flows through cash accounts. Because of the vulnerability to error or
fraud, organizations and auditors usually emphasize the quality of controls over the cash transactions.
In this chapter, we examine approaches that auditors take to assess risks associated with cash and to
evaluate controls over cash accounts. This chapter primarily involves performing risk assessment
procedures, tests of controls, and substantive procedures for cash.
There are a variety of sources of cash receipts. Cash receipts may result from revenue transactions,
short and long-term borrowing, issuance of share capital, and sale of marketable securities, long-term
investments and other assets. The scope of this chapter is limited to cash receipts from sales
transactions which include cash sales and collections from trade customers on credit sales.
Figure 6-7 shows a flowchart of a manual system for executing cash receipts transactions.
III. Illustrative Audit Program for Test of Controls: Cash Receipts Transactions
200
Figure 6-7:
7: Cash Receipts from Customer Flowchart
201
I. Evaluation of Internal Control over Cash Receipts Transactions
Figure 6-8 shows an Control Questionnaire which can be used evaluating internal control over cash receipts
transactions.
Recording
1. Are accounting personnel prohibited from handling cash?
Custody
1. Is cash stored is safes or vaults prior to deposit?
202
Il. Tests of Controls over Cash Receipts Transactions
Although entities receive cash from many sources, this section focuses on collections of cash from
customers. Auditors are interested in the effect of controls on the financial statement assertions
embodied in the cash transactions. In testing cash collections, auditors focus on the following audit
assertions:
General Specific
1. Existence or occurrence 1. Recorded receipts represent actual collections of cash from
customers.
3. Rights and obligations 3. All cash receipts are deposited intact in the account of the
client.
4. Valuation or allocation 4. Debits to cash and credits to accounts receivable are valued
at amounts received.
Discussion:
A. Existence or Occurrence: Recorded receipts represent actual cash collections from customers.
203
3. Duties of handling cash receipts are segregated The auditor can tests this control by
from posting to account receivable. A person observing the separation of duties and
performing both functions could misappropriate inquiring of client personnel about their
responsibilities.
cash and conceal the shortage by making an entry
directly to the customer's accounts/.
4. A bank reconciliation is prepared month by a The auditor tests this control by observing
person not -involved in handling cash, accounts the bank reconciliation have been prepared
receivable, general ledger records. The reconciler by an independent employee.
should receive the unopened bank statement and
maintain control over it until the reconciliation is
completed.
6. Checks should be restrictively endorsed as soon To test this control, auditors observe the
as they are received. This control prevents an procedure in effect.
authorized employee from gaining access to
check and cashing it.
7. A daily cash summary is prepared and reconciled Auditors can inquire of employees who
to total of prelisting and over-the counter receipts. carry out the procedure about the regularity
The summary total is compared to the total in to and consistency of its performance.
cash receipts journal and the total on the validated
deposit ticket. This control ensures that- all cash
receipts are deposited and recorded.
204
8. The cash receipts journal total is independently To test this control, the auditor observes
reconciled to total posted to accounts receivable. the procedures and make inquiry of
This control ensures postings to accounts personnel performing the procedure.
receivable.
C. Rights and Obligations: All cash receipts are deposited in the bank account of the client.
D. Valuation or Allocation: Debits to Cash and Credits to Accounts Receivable are valued at
amounts received.
E. Presentation and Disclosure: Cash receipts transactions are recorded to result in presentation
and disclosure in accordance with PAS / PFRS.
205
lll. Sample Audit Program for Test of Controls: Cash Receipts Transactions
WP Done
Audit Procedures Ref By Date
1. Compare remittances or other details of cash receipts with the entries
on the receipts book.
6. Test posting to the general ledger to the customer' ledger, and to other
subsidiary ledger.
Possible error that may result because of control weakness over cash receipts transactions follow:
206
2. Inadequate controls for reconciling 2a. Cashier fails to ring up 2a. Failure to record
cash register tapes and accounting and record cash sales receipts from cash sales.
records; inadequate controls for embezzles cash.
reconciling bank accounts 2b. Bookkeeper omits the 2b. Unrecorded cash
recording of the receipts receipts are not deposited in
from one cash register for the bank or recorded cash
the day. receipts are not deposited in
the bank.
3. Sales not coded on cash register 3. Sale of product A 3. Credits to wrong sales
tapes. recorded as a sale of Product account are committed.
B.
4. Lack of segregation of duties 4a. Cashier abstract or 4a&b. Failure to record cash
between personnel who have access embezzles cash payments by from collection of accounts
to cash receipts and those who make customers on receivables receivable.
without recording
entries into the accounts receivable
collections from customers.
records.
7. Ineffective board of directors, audit 7. Keeping the cash receipts 7. Erroneous presentation of
committee or internal audit function; journal open to record next a more liquid position.
undue pressure to show improved years cash receipts
collections in the current
financial position; top management
year;
actuations 'not conducive to ethical
conduct.
207
8. Failure to list and 8. Recording cash receipts "Cut-off " error (early or late recognition
deposit cash receipts on based on erroneous information of cash receipts) is committed.
timely basis. about date of receipt.
II. Completeness B. To determine that all 2. For a sample of days, verify that all
receipts of cash and checks cash receipts are recorded by
are recorded. reconciling daily listing(s) of cash
receipts and validated deposit ticket
to cash receipts journal.
208
Discussion of Audit Procedures
1. For a sample of entries in cash receipts journal, trace to the prelisting of cash receipts and to
remittance advice. For a sample of entries, reconcile daily deposit to validated deposit ticket.
To test the credits to accounts receivable, an auditor can trace from the entry in the accounts
receivable ledger to a cash receipts listing to a deposit ticket listing the payment and to the
customer's remittance advice. These documents provide evidence that a collection was made.
2. For a sample of days, verify that all cash receipts are recorded by reconciling daily listing(s)
of cash receipts and validated deposit ticket to cash receipts journal.
To test whether all cash receipts are recorded, the auditor compares the names and amounts
included in the prelisting for selected days with the entries in the cash receipts journal. Any
discrepancies may suggest that lapping is occurring. To test for lapping, an auditor identifies a
period of several consecutive days and trace the names and amounts from the prelisting of cash
receipts to the validated deposit ticket to the cash receipts journal, and to the posting in the
accounts receivable subsidiary ledger. All dates, names and amounts should be consistent. If the
details are consistent, lapping did not occur during the time period examined.
Auditors also test the mathematical accuracy of the recording of cash collections by footing the
cash receipts journal, and by footing the accounts receivable subsidiary ledger and reconciling it
to the control account.
3. For a sample of entries in cash receipts journal, examine remittance advice and verify that
discount taken was appropriate. Foot accounts receivable subsidiary ledger and reconcile to
the general ledger account.
To determine whether the credit to accounts receivable is proper, the auditor selects transactions
from the cash receipts journal and re-computes the cash discounts allowed to customers who
have made payments. Auditors may also verify its approval by re-performing the procedure that
should have been performed when credit was approved.
4. Review account coding for a sample of entries in the cash receipts journal.
To determine that the transaction was coded correctly and will result in proper presentation and
disclosure, the auditors compare entries in the cash receipts journal with the remittance advises.
209
REVIEW QUESTIONS
Questions
1. How do different levels of control risk in the revenue and collection cycle affect the nature,
timing and extent of accounts receivable confirmation procedures?
2. What feature(s) of cash receipts internal control system would be expected to prevent (a)
an employee's absconding with company funds and replacing the funds during the audit
engagements with cash from the employee pension fund, and (b) the cash receipts journal
and recorded cash sales from reflecting more than the amount shown on the daily deposit
slip?
3. What is the meaning of strength in the transaction processing controls of the revenue and
collection cycle? A weakness? Why are the weaknesses not subject to test of controls
auditing?
4. Why is it necessary to evaluate the control after the test of controls audit of the revenue and
collection cycle when an evaluation was already made after the understanding phase?
5. Describe the processing of transactions in the sales and collections cycle in the following
functions:
a. Order entry
b. Credit approval
c. Warehousing
d. Shipping
e. Customer billing
f. Collecting accounts receivable
g. Granting credit for returns and allowances
h. Recording uncollectible accounts expense
i. Writing off collectible accounts
6. Identify features of the following documents that facilitate control and explain how they do
so:
a. Shipping document
b. Remittance advice
c. Uncollectible account form
210
7. Why do people perpetrate fraud involving sales transactions?
11. When an entity's controls for collection are ineffective, what potential misstatements could
arise in the financial statements?
2. To gather audit evidence that uncollected items in customers' accounts represented valid trade
receivables, the auditor would select a sample of items from the population represented by the
a. Customer order file
b. Bill of lading file
c. Subsidiary customers' accounts ledger
d. Sales invoice file
3. Tracing copies of sales invoices to shipping documents will provide evidence that all
a. Recorded sales were shipped.
b. Invoiced sales were shipped
c. Shipments to customers were invoiced.
d. Shipments to customers were recorded as sales.
211
4. Tracing copies of sales invoices to shipping documents will provide evidence that all
a. Shipments to customers were recorded as receivables.
b. Billed sales were shipped.
c. Debit to subsidiary accounts receivable ledger are for sales shipped.
d. Shipments to customers were billed.
5. To achieve good internal control, which department should perform the activities of matching
shipping documents with sales order and preparing daily sales summaries?
a. Billing
b. Shipping
c. Credit
d. Sales order
6. Which of the following would the auditor consider to be an incomplete operation for a cashier if
the cashier receives remittances from the mailroom?
a. Posting the receipts to the accounts receivable subsidiary ledger cards.
b. Making the daily deposit at the local bank.
c. Preparing the daily deposit
d. Endorsing the checks
7. The most likely result of ineffective internal controls in the sales cycle is that
a. Fictitious transactions could be recorded, causing an understatement of revenues and an
overstatement of receivables.
b. Irregularities in recording transactions in the subsidiary accounts could delay the shipment
of goods.
c. Omission of shipping documents could go undetected, causing an understanding of
inventory
d. Final authorization of credit memos by personnel in the sales department could permit an
employee defalcation scheme.
8. For the most effective internal control, monthly bank statements should be received directly
from the banks and reviewed by the
a. Controller
b. Cash receipts accountant
c. Cash disbursements accountant
d. Internal auditor
212
9. Which of the following describes the most effective preventive control to ensure proper
handling of cash receipt transactions?
a. Have bank reconciliations prepared by an employee not involved with ash collections and
then have them reviewed by a supervisor.
b. Have one employee issue a pre-numbered receipt for all cash collections have another
employee match daily totals of pre-numbered receipts to bank deposits.
c. Use predetermined totals (hash totals) of cash receipts to control posting routines.
d. Have the employee who receives customer mail prepare the daily bank deposit; have
another employee actually make the deposit.
10. As payments are received, one mailroom employee is assigned the responsibility of prelisting
receipts and preparing the deposit slip prior to forwarding the receipts, the deposit slip, and the
remittance advices to accounts receivable for posting. Accounts receivable personnel refoot the
deposit slip, stamp a restrictive endorsement on the back of each check, and then forward the
receipts and the deposit slip to the treasury department. Which of the following is a reasonable
assessment of internal control in this process?
a. Internal control is adequate.
b. Internal control is inadequate because mailroom employees should not have access to cash.
c. Internal control is inadequate because treasury employees should prepare the deposit slip.
d. Internal control is inadequate because of a lack of segregation of duties.
11. For effective internal control, employees maintaining the accounts receivable subsidiary ledger
should not also approve
a. Employee overtime wages
b. Credit granted to customers
c. Write-offs of customer accounts
d. Cash disbursements
12. During an audit of the accounts receivable function, you found that the accounts receivable
turnover rate had fallen from 7.3 to 4.3 over the last three years. What is the most likely cause
of the decrease?
a. An increase in the discount offered for early payment
b. A more liberal credit policy
213
c. A change form net 30 to net 25
d. Greater cash sales
13. Shipping documents should be traced to and compared with sales records or invoices to
a. Determine whether payments are properly applied to customer accounts.
b. Ensure that shipments are billed to customers.
c. Determine whether unit prices billed are in accordance with sales contracts.
d. Ascertain whether all sales are supported by shipping documents.
14. An auditor noted that the accounts receivable department is separate from other accounting
activities. Credit is approved by a separate credit department. Control accounts and subsidiary
ledgers are balanced monthly. Similarly, accounts are aged monthly. The accounts receivable
manager writes off delinquent accounts after one year or sooner, if a bankruptcy or other
unusual circumstance is involved. Credit memoranda are pre-numbered and must correlate with
receiving reports. Which of the following areas could be viewed as an internal control weakness
of the above organization?
a. Write-offs of delinquent accounts
b. Credit approvals
c. Monthly aging of receivables
d. Handling of credit memos
15. Checks from customers are received in the company mailroom each day. Which of the
following controls should be in place to safeguard them?
a. Establish a separate post office box for customer payments.
b. Forward all checks to the cashier upon receipt.
c. Require a specific mail clerk to list and restrictively endorse each check.
d. Provide bonding protection for mail clerks,
214
Exercises
Exercise 1
1. No collection was ever made for a sale to Sister Company because the invoice was never
billed.
2. A cash collection for the account of Rain Company was misappropriated by the cashier
3. The accounts receivable clerk posted to the Kiko's account a sale made to Josie.
4. A shipment included four pairs of JC-1 clamps rather than four individual clamps.
5. A properly executed invoice for a valid sale was not recorded.
6. An order was never billed because the shipping document was misplaced
7. In an attempt to meet profit goals, more goods were shipped than customers had ordered.
8. A sale that occurred on December 31, the last day of the accounting period, was recorded
in the next accounting period.
Required:
Exercise 2
The following questions related to cash are included on the internal control questionnaire for Niko
Company.
1. Do different people handle cash and maintain the records of cash receipts?
2. Is a prelisting of cash made immediately for mail receipts?
3. Are cash receipts deposited intact daily?
4. Is monthly bank reconciliation prepared by someone not involved in handling cash?
5. Does an employee verify and approve cash discounts taken?
6. Does someone other than the cashier obtain the validated deposit slip and compare the balance
to the cash summary?
215
Required:
For each of the six questions on the Niko Company internal control questionnaire,
a. Identify the financial statement assertion to which the control relates.
b. Identify a potential misstatement that could arise from the absence of the control
c. Identify the test of controls an auditor might perform the controls that exist.
Exercise 3
You are performing tests of controls for sales transactions for Ver Co., a distributor or consumer
electronics. While talking to Rain Yee, the senior sales clerk, you mention that your television has
just broken. A short time later, the sales manager comes around and offers you the opportunity to
purchase goods at the same price paid by employees, which is substantially below prices offered by
discounters. He informs you that employees frequently take advantage of this benefit for themselves
and for close friends. He informs you that all you need to do is order the goods from Rain Yee and
pay her with cash or a check.
Exercise 4
After determining that computer controls are valid, Honey is reviewing the sales system of Babe
Corporation to determine how a computerized audit program may be used to assist in performing
tests of Babe's sales records.
Babe sells crude oil from one central location. All orders are received by mail and indicate the
preassigned customer identification number, desired quantity, proposed delivery date, method of
payment, and shipping terms. Because price fluctuates daily, orders do not indicate a price. Price
sheets are printed daily and details are stored in a permanent disk file. The details of orders are also
maintained in a permanent file.
Each morning the shipping clerk receives a computer printout with details of customers' orders to be
shipped that day. After the orders have been shipped, the shipping details are entered into the
computer, which simultaneously updates the sales journal, perpetual inventory records, accounts
receivable and sales accounts.
216
The details of all transactions, as well as daily updates, are maintained on disks that are available for
Honey to use in performing the audit.
Required:
a. How may Honey use a computerized audit program to perform substantive tests of Babe's sales
records in their machine-readable form? Do not discuss accounts receivable and inventory.
b. After Honey performs these tests with the assistance of the computer, what other auditing
procedures should Honey perform to complete the examination of Babe's sales record?
Exercise 5
The following are audit procedures in the sales and collection cycle.
1. Examine a sample of shipping documents to determine if each has a sales invoice number
included on it.
2. Discuss with the sales manager whether any sales allowances have been granted after the
statement of financial position date that may apply to the current period.
3. Add the columns on the aged trial balance and compare the total with the general ledger
4. Observe whether the controller make an independent comparison of the total in the general
ledger with the trial balance of accounts receivable.
Required:
a. For each procedures, identify the applicable type of audit evidence.
b. For each procedures, identify which of the following it is:
1) Test of control
2) Substantive test of transactions
3) Analytical procedure
4) Test of details of balances
c. For those procedures you identified as a test of control or substantive test of transactions, what
internal control objective of objectives are being satisfied?
d. For those procedures you identified as a test of details of balance, what audit objectives or
objectives are being satisfied?
217
Problem
An improper cutoff of transaction around year-end occurs when journal entries are record in the wrong
year. In case, you are to determine the effects of various cutoff misstatement relating to recording cash
receipts received on accounts receivable and the recording of credit sales. To effectively consider the
effect of an improper cutoff, it is helpful to consider the underlying journal entries
An example of a possible improper cutoff is to “close” the cash receipts journal on December 30 and
included December 31 ). As a result, cash is understated by P3,000, while accounts receivable is
overstated by P3,000 for the year just ended. The effect of closing the sales journal depend upon
whether a periodic inventory or perpetual inventory system is in use. The effects of “leaving open”
journals past year-end and dating January entries as of December may be determined in a similar
manner.
Required:
Assume that the client made the following actual credit sales and received cash receipts as follows
after 12/29/20X8:
218
Determine the overstatements and understatements that would result from the following situations.
Assume that each situation is independent of one another. As an illustration, situation 1 has been
solved for you. To simplify the problem, in the case of perpetual inventory, assume that the year-end
inventory count did not identify and correct the misstatement(s).
Note: The Substantive Tests of Details of Balances of the Principal Accounts affect by the
Revenue and Collection Cycle are covered in …
Chapter 11 - Audit of Cash Balances
Chapter 12 - Audit of Trade Receivable, Allowances for
Doubtful Accounts and Sales
219
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
EXPENDITURE CYCLE
4. Apply the risk assessment and risk response phases of the audit
process, i.e., test of controls and substantive tests of transactions in
the expenditure cycle.
220
CHAPTER 7
AUDIT OF THE EXPENDITURE CYCLE
INTRODUCTION
This chapter covers the explanation of the expenditure (or acquisitions and disbursements) cycle and
the internal control environment and objectives pertaining thereto. Then, consideration is given to
internal controls over the expenditure transactions and to the study and evaluation of controls over
these two classes of transactions.
The following activities should be undertaken by the auditor in relation to the audit of the
expenditure cycle:
1. Diagram the flow of transaction is a typical expenditure cycle, the specific accounts affected
and the elements of control within the cycle.
2. Relate the effect of controls on the assertions embodied in the financial statement
3. Determine the essential features of internal control over the transactions in the expenditure
cycle.
4. Prepare an audit program to gather evidence regarding compliance with control procedures that
reduce control risk.
5. Evaluate effectiveness of controls and perform the substantive tests of transactions to gather
evidence to determine whether financial statement assertions are materially correct on accounts
affected by the expenditure cycle
6. Design tests of details of account balances and analytical procedures to satisfy balance-related
audit objectives.
Steps 1 to 5 are discussed in this chapter while Step no. 6 is covered in Chapters 11 and 13.
221
NATURE OF THE EXPENDITURE CYCLE
Basic Considerations
The expenditure cycle involves the activities associated with the acquisition and payment of goods
and services, plant assets and labor. For a trading concern, the major classes of transactions in this
cycle are:
For a manufacturing firm, production cycle transactions and inventory warehousing transactions are
included in the expenditure cycle in addition to the above-mentioned major classes of transactions.
This chapter does not include the acquisition of all plant and intangible assets, short-term or
long-term securities, the issuance and redemption of long-term debt and the issuance or requisition
of a company's share capital. These transactions are considered to be part of the investing and
financing cycles, the audit of which are tackled in Chapters 9 and 10.
Transactions in the expenditure cycle often affect more financial statement accounts than the other
cycles combined. On the statement of financial position, the expenditure cycle impacts on all current
assets, except marketable securities and receivables, all plant and intangible assets, and many current
liabilities. Transactions in this cycle involve major expenses reflected in the Income Statements such
as salaries and wages, taxes, utilities, advertising, repairs and other expenses manufacturing costs (if
applicable).
Typical accounts included in the acquisition and payment cycle are shown by T- accounts in Figure
7-1. Note the large number of accounts affected by this cycle. To keep the illustration manageable,
only the control accounts are shown for the three major categories of expenses used by most
companies. For each control account, examples of the subsidiary expense accounts are also given.
Because of the large number of accounts in the cycle, it is not surprising that it often takes more time
to audit the acquisition and payment cycle than any other.
Figure 7-1 shows that every transaction is either debited or credited to accounts payable. Because
many companies make acquisitions directly by check or through petty cash, the figure is an
oversimplification. We assume that cash disbursement transactions are processed in the same manner
as all others.
222
Figure 7-1 : Accounts in theAquisition and Payment Cycle
Raw material Merchandise
Cash in Bank purchases inventory
Accounts payable
Purchase return Cash Acquisitions of Property, plant and
and allowances disbursements goods & services equipment
Purchase
returns &
allowances
Purchase
Purchase discounts discounts Prepaid expenses
Selling expenses
Subsidiary accounts
Commisions
Travel expenses
Manufacturing Delivery expenses Administrative
Expense control Repairs expense control
Account Advertising account
Subsidiary accounts Subsidiary accounts
Repair & Supplies
Maintenance Officers' travel
Taxes Legal
Supplies Auditing fees
Freight in taxes
Utilities
223
PROCESSING EXPENDITURE TRANSACTIONS
Summary of Business Functions in the Expenditure Cycle and Related Documents and
Records
The acquisition and payment cycle involves the decisions and processes necessary for obtaining the
goods and services for operating a business. The cycle typically begins with the initiation of a
purchase requisition by an authorized employee who needs the goods or services and ends with
payment for the benefits received. Although the discussion that follows deals with a small
manufacturing company that makes tangible products for sale to third parties, the same principles
apply to a service company, a government unit, or any other type of organization.
There are four business functions shown in the third column of Figure 7-2. These functions occur
in every business in the recording of the three classes of transactions in the acquisition and payment
cycle. Observe that the first three business functions are for recording the acquisition of goods and
services on account and the last process if for recording the cash disbursements for payments to
vendors. Processing purchase returns and allowances and purchase discounts are also business
functions in the cycle, but these are not separately shown on Figure 7-2 because the amounts are not
significant for most companies.
This section explains the four business functions in Figure 7-2 and describes typical documents
and records for each function. These documents and records are shown in the fourth column of
Figure 7-2. It is essential to understand the business functions and documents and records in a
company before assessing control risk and designing test of controls and substantive tests of
transactions.
1. Purchases
2. Accounts and notes payable-trade
3. Purchase returns and allowances
4. Cash in bank (credit for cash disbursements)
5. Purchase discount
6. Inventories (merchandise; finished goods; raw materials; goods in process)
7. Manufacturing and operating expenses (selling and administrative) requiring cash
payments.
224
Figure 7-2 Classes of Transactions, Accounts, Business Functions, and Related Documents
and Records for the Acquisition and Payment Cycle
225
Documents Used in the Expenditure Cycle and their Audit Significance
226
Vendor’s statement
A statement prepared monthly by the vendor Vendor’s statements may be used to
indicating the beginning balance, acquisitions, determine that all transactions recorded on
returns and allowances, payments to the vendor, the statements have been recorded in the
and ending balance. books.
Purchased journal
A file for recording the individual payments made by check. It contains the total cash paid, the
debit to accounts payable at the amount the transaction was recorded in the acquisition
transaction file, discount taken, and other debits and credits.
A file for recording individual acquisitions, cash disbursements, and acquisition returns and
allowances for each vendor.
These records in a manufacturing company are used to summarize transactions affecting Raw
Materials, Goods in Process, Finished Goods, Labor Costs and Manufacturing Overhead.
227
AUDIT OF THE EXPENDITURE CYCLE
As part of performing risk assessment procedures, the auditor obtains information that is
useful in assessing the risk of material misstatement. This includes information about
inherent risks at the financial statement level (for example, the client’s business and
operational risks, financial reporting risks) and at the account and assertion levels, fraud
risks including feedback from audit team brainstorming sessions, strengths and
weaknesses in internal control, and results from preliminary analytical procedures.
Once the risks of material misstatement have been identified, the auditor then determines
how best to respond to them as part of the audit opinion formulation process.
Inventory is usually material, complex and subject to manipulation. Given the large
number of inventory-related fraud that have been perpetrated, auditors should exercise
particularly high levels of professional skepticism in audits of inventory and cost of goods
sold accounts.
228
Identifying Fraud Risk Factors
Because of the volume of transactions, as well as the ability to physical move inventory,
the acquisition and payment cycle is often the subject of fraud. Most of the frauds in this
cycle involve overstatement of inventory or assets and understanding of expenses. Many
disbursements frauds involve fictitious purchases or, in some cases, kickbacks on the
purchasing agent.
229
Figure 7-3 identifies some of the possible fraudulent schemes for manipulating inventory
and cost of goods sold.
Figure 7-3: Approaches for Manipulating Inventory and Cost of Goods Sold
Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement in the acquisition and payment cycle accounts, the auditor needs to
understand the controls that the client has designed and implemented to address those
risks. Remember, the auditor is required to gain an overall understanding of internal
controls for both integrated audits and financial statement only audits. Such understanding
is normally gained by means of a walkthrough of the process, inquiry, observation, and
review of the client’s documentations. The auditor considers both entity-wide controls and
transaction controls at the account and assertion levels. This understanding provides the
auditor with a basis for making an initial control risk assessment.
230
Overview of Common Controls in the Requisition Process
Written requisitions are made for specific products by the production manager or
stockroom manager.
Computer-generated requisitions are generated based on current inventory levels and
production plans.
An agreement is signed with the supplier whereby the supplier agrees to ship
merchandise (just in time) according to the production schedule set by manufacturer.
Along-term supply contact is negotiated specifying price, quality of products,
estimated quantities, penalties for product shortages or quality problems, and so forth.
Specific purchase orders are not issued; rather, the production plan is communicated
to the supplier with the specified delivery dates. The production plan serves as the
requisition.
Supplies Purchases
231
Performing Preliminary Analytical Procedures
When planning the audit, the auditor is required to perform preliminary analytical procedures.
These procedures can help auditors identify areas of potential misstatements.
The following are examples of possible expected relationships in the acquisition and payment
cycle:
Assume that the company’s production and pricing strategies have remained the same
during the past year. Gross margin is expected to be stable and consistent with the industry
average.
Assume that the company has introduced a new product with a low price point and
significant customer demand. Inventory turnover is expected to increase, and days’ sales in
inventory are expected to decrease.
Assume that the company has invested in a new manufacturing process that results in
significantly less waste and overall increases in efficiency during the production process.
Cost of goods sold is expected to decline, and gross margin is expected to increase.
The following relationships might suggest a heightened risk of fraud in the acquisition or
payment cycle:
232
PHASE II- RISK RESPONSE
Once the auditor has developed an understanding of the risks of material misstatement, the
auditor can determine the appropriate audit procedures to perform. Audit procedures should be
proportional to the assessed risks, with areas of higher risk receiving more audit attention and
effort. Responding to identified risks typically involves developing an audit approach that
contains substantive procedures (for example, test of details and, when appropriate, substantive
analytical procedures) and tests of controls, when applicable. The appropriateness and
sufficiency of selected procedures vary to achieve the desired level of assurance for each
relevant assertion. While audit firms may have a standardized audit program for auditing the
acquisition and payment cycle, the auditor should customize the audit program based on the
assessment risk of material misstatement.
The auditor may develop an audit program that consists of first performing limited tests of
operating effectiveness of control, then performing limited to moderate substantive analytical
procedures, and finally performing extensive substantive tests of details. Because of the high
risk, the auditor will want to obtain a great deal of evidence directly from tests of details. In
contrast, consider a client where the auditor has assessed the risk of material misstatement
related to the existence of inventory as low, and believes that the client has implemented
effective controls in this area. For this client, the auditor will likely perform tests of controls,
gain a high level of assurance from substantive analytical procedures such as a reasonableness
test, and then complete the substantive procedures by performing tests of details at a limited
level.
233
AUDITING ACQUISITION TRANSACTIONS
Figure 7-4 shows a flowchart of the manual system for executing acquisition and purchases
transactions. While Figure 7-5 shows the flowchart of purchase returns.
234
Figure 7-4:
4: Purchases Flowchart
Figure 7-5: Purchase Returns
I. Evaluation and Obtaining Evidence About Internal Control Operating Effectiveness
in the Acquisition Cycle
For integrated audits, the auditor will test the operating effectiveness of important controls
as of the client’s year end. If the auditor wants to rely on controls for the financial
statement audit, the auditor will test the operating effectiveness of those controls
throughout the year.
Figure 7-6 illustrates an internal control questionnaire for acquisition of goods and
services that may be used in obtaining evidence on the operating effectiveness in the
acquisition cycle.
237
Recording
1. Are all issued vouchers accounted for in
journalizing?
2. Are voucher register entries reviewed for
reasonableness?
3. Are unpaid voucher file and perpetual inventory
records independently maintained?
4. Are there periodic independent reconciliations of
control accounts and subsidiary records?
Custody
1. Are goods stored in locked areas with restricted
access?
2. Are there periodic independent comparisons of
inventory records with goods on hand?
For integrated results, the auditor will test the operating effectiveness of important controls
as the client’s year end. If the auditor wants to rely on controls for the financial statement
audit, the auditor will test the operating effectiveness of those controls throughout the year.
General Specific
1. Existence or occurrence 1. Recorded acquisitions are for items that
were acquired.
2. Completeness 2. Acquisition that occurred are recorded.
3. Rights and obligations 3. Recorded acquisitions are the entity’s
purchases and liabilities.
4. Valuation or allocation 4. Acquisitions are recorded for the proper
amounts.
5. Presentation and disclosure 5. Acquisitions are recorded to result in
presentation and disclosure in accordance
with PAS / PFRS.
In many instances, more than one control is required to ensure the validity of an assertion.
Because specific controls may vary with the client, the tests of controls discussed in this
section should be viewed as illustrative only.
238
The following sections present the controls an entity should have to ensure the propriety of
each assertion and the tests an auditor might perform to determine the effectiveness of the
controls on acquisitions transactions.
Discussion:
A. Existence or Occurrence: Recorded acquisitions are for items that were acquired.
239
C. Rights and Obligations: Recorded acquisitions are the entity’s purchases and
liabilities.
6. Receiving reports should be prepared by 6. To test this control, the auditor should
persons having access only to a blind observe that the procedure is being
copy of purchase order details. Requiring performed.
a purchase order for the recording of all
acquisitions will preclude recording
consigned goods as well as goods
ordered for personal use of employees.
7. Invoice amounts are verified by a clerk 7. The auditor should examine the voucher
by reference to the purchase orders and for signature indicating performance.
receiving reports. Mathematical
accuracy of the invoice is also
rechecked.
240
III. Illustrative Audit Program For Tests Of Controls: Acquisition Transactions
The following audit program summarizes the audit procedures that auditors may use to test
controls on acquisitions transactions.
Done
WP
Audit Procedures Ref By Date
1. For a sample of purchases, examine the related purchase
requisition and purchase order.
2. For a sample of purchases, trace the transaction to the voucher
register and the perpetual inventory records maintained in stores.
3. Check vendor invoice for mathematical accuracy.
4. Trace posting from the voucher register to the general ledger.
Possible errors that may result due to control weaknesses over acquisitions transactions follow:
Internal Control
Weaknesses or Factors That
Increase the Risk of the Examples of Fraud / Error Description of Possible
Misstatement Errors or Misstatement
1. Documentation of 1. A purchase order is 1. Unauthorized purchases;
purchase transactions, made for goods that Payments made to
incomplete and have not been vendors for goods and
inadequate; ineffective authorized or requested. services not authorized.
controls for matching
purchase requisitions
with purchase orders.
2. Ineffective controls for 2. Goods are ordered but 2. Misappropriation of
matching invoices with delivered to an goods purchases.
receiving documents inappropriate address
before disbursements are and stolen.
authorized.
241
3. Inadequate segregation 3. A bookkeeper prepared 3. Inaccurate recording of a
of duties of records a check to himself and purchase or
keeping and preparing records it as having been disbursements.
cash disbursements, or issued to a major
check signer does not supplier.
review and cancel
supporting documents.
4. Ineffective controls for 4. A purchase is recorded 4. Duplicate recording or
review and cancellation when an invoice is purchases.
of supporting documents received from a vendor
by the check signer. and recorded again
when a duplicate
invoice is sent by the
vendor.
5. Accounting manuals not 5. Purchase of 5. Error in recording
used. merchandise purchase transactions.
erroneously recorded as
purchase of equipment.
242
IV. Substantive Tests Of Acquisition Transactions
243
Discussion of Audit Procedures
To test the existence of acquisitions transactions in the voucher register, an auditor should
examine for selected transactions, the underlying documents — the voucher, purchase
order, receiving report, and vendor's invoice. The auditor should also physically inspect
additions to fixed assets to substantiate their existence and trace inventory purchases to
perpetual records. The auditor can scan the voucher register as well as files of check copies
to them for possible duplicate payments of invoices.
2. Trace a sequence of receiving reports to entries in the voucher register. Test cutoff.
Account for sequence of entries in the voucher register.
The auditor may select a sequence of receiving reports and vouchers to determine that
entries have been made for them in the voucher register or purchases journal. He / She can
perform a cut-off test at year-end to as certain that all acquisitions occurring during he year
have been recorded.
The auditor should examine supporting documents to as certain that goods were not
received on consignment, that the goods were not delivered to another location, simply
that the ordered goods were received. These supporting documents include the voucher,
vendor's invoice, receiving report, purchase order, and purchase requisition.
To ensure that acquisitions are recorded for proper amounts, auditor may select a sample
of transactions and examine the purchase requisition trace the price to the purchase order;
compare the quantity on the invoice with the quantity in the receiving report and
recalculate the invoice total. The auditor might also choose to perform the substantive
testing of prices paid by tracing prices in published catalogs at the time of the purchase.
244
5. Check accuracy of accounts on invoices by reference to chart of accounts.
Auditors can review documents underlying entries in the voucher register to determine
whether the invoice was correctly coded and will be properly presented and disclosed in
the financial statements. This procedure can be performed simultaneously with substantive
tests of valuation.
I. Evaluation and Obtaining Evidence About Internal Control over Cash Disbursements
Transactions
II. Tests of Controls over Cash Disbursements Transactions
III. Illustrative Audit Program for Cash Disbursements Transactions
IV. Substantive Tests of Cash Disbursements Transactions
Typically, the cash disbursement transactions involve the following business activities.
b. Submission of approved vouchers and supporting papers and unsigned check to the
Finance Department.
245
Figure 7-7:
7: Cash Disbursement Processing
I. Evaluation and Obtaining Evidence about Internal Control over Casb Disbursements
Transactions
Yes No NA Remarks
Executing
1. Are all disbursements (except for petty cash) made
by checks?
2. Are imprinted and renumbered checks used?
3. Is a check-protection device used in printing the
check amount?
4. Is each check supported by an approved voucher?
5. Is supporting documentation mutilated after
payment?
6. Are two signatures required on each check?
7. Does last check signer mail the check and
remittance advice?
8. Are there prohibitions against issuing checks to cash
or bearer?
9. Is the signing of blank checks prohibited?
10. Is daily summary of checks prepared and
agreed to checks issued?
Recording
1. Are accounting personnel prohibited from
signing checks?
2. Are daily summaries of checks compared with check
register totals?
3. Are checks recorded in numerical
sequence?
Custody
1. Are there periodic independent reconciliations of
bank accounts?
247
II. Test of Controls over Cash Disbursements Transactions
Auditors are interested in the effect of controls in the financial statements assertions
embodies in the cash disbursements. Auditors address the following assertions when
testing cash disbursements:
General Specific
1. Existence or occurrence 1. Recorded cash disbursements occurred.
2. Completeness 2. All cash disbursements made are recorded
3. Rights and obligations 3. All cash disbursements made are for
obligations of the entry.
4. Valuation or Allocation 4. Debits to various accounts and credits to cash
are valued at proper amounts.
5. Presentation and disclosure 5. Cash disbursements are recorded to result in
presentation and disclosure inaccordance
with PAS / FRS.
The following sections present the controls an entity should have to ensure the propriety of
each assertion and the tests an auditor might perform to determine the effectiveness of the-
controls on cash disbursement transactions.
Discussion:
248
b. Completeness: All cash disbursements made are recorded.
3. Checks should be prenumbered and 3. To test this control, the auditor should
accounted for to ensure that all checks observe whether employee who prepares
that were written are entered in the the check register accounts for the
check register. sequence of the checks.
4. Employee who does not handle cash 4. He auditor observes that the employee
disbursements and cashreceipts. who prepares the reconciliation does not
handle cash receipts or disbursements. In
addition, the auditor inspects the
reconciliation.
c. Rights and Obligations: All cash disbursements made for obligations of the entity.
5. Check signer who is independent of 5. The auditor tests this control by inquiring
voucher preparation should examine the about the segregation of duties; and
supporting documentation before signing observing whether separation really
checks to determine that the payment is exists. He / She can also inquire about the
for an obligation of the entity. check signer's procedures for reviewing
documents in support of cash
disbursement and may observe the check
signer performing these procedures.
d. Valuation and Allocation: Debits to various accounts and credits to cash are valued at
proper amounts.
6. Amounts (including discounts taken) and 6. To test this control, the auditor should
calculations on vendors' invoices are observe the procedure. He / She can
independently verified. Employee signs examine signatures on paid invoices.
the voucher after verification is done.
249
e. Presentation and Disclosure: Cash disbursements are recorded to result in presentation
and disclosure in accordance with PAS / PFRS.
7. Chart of accounts adequately describes 7. The auditor can test this control by
accounts to be used, and account coding observing the procedure, he can also
is assigned by one person and checked by examine the signatures of the employees
another. performing the review account coding.
In summary, typical audit procedures employed by the auditor in testing disbursement for
the period under consideration include the following:
Done
Audit Procedures WP
Ref
By Date
250
Possible errors that may result due to control weaknesses over payments to vendors
follows:
Internal Controls
Weaknesses or Factors Examples of Fraud/Error Description of Possible
That Increase the Risk of Errors or Misstatement
the Misstatement
251
IV. Substantive Tests Of Transactions: Cash Disbursements
III. Rights and Obligations C. To determine that all cash 3. Examine underlying
disbursements made were documents.
the entity’s obligations.
252
DISCUSSION OF AUDIT PROCEDURES
Auditors examine the documents underlying cash disbursements such as receiving reports,
purchase order, purchase requisitions, and vendors' invoice for consistency with each other and
with the entry in the cash disbursements journal. Approvals on these documents provide
evidence that the transaction occurred and that the payment was the entity's debt. Checks with
appropriate endorsements which have been paid by the bank provide evidence about the
existence of the transactions. The auditor likewise recomputes the discount taken to verify
proper valuation of cash disbursement transactions. Accuracy of accounts charged may also be
verified by the auditor by reference to the chart of accounts.
The auditors may prepare a proof of cash which reconciles cash disbursements as recorded on
the bank with cash disbursement recorded by the bank.
The auditors can prepare a bank reconciliation or test a bank reconciliation prepared by the
client for an interim period. When preparing the bank reconciliation, the auditor should receive
the bank sentence directly from the bank. If the bank statement has been opened by the client's
employees, the auditor generally compares the individual entries on it with the documents
returned by the bank and looks for erasures, changes or other irregularities on the statement.
REVIEW QUESTIONS AND PROBLEMS
Questions
4. When an entity's controls are ineffective for payments, what potential misstatements
could arise in the financial statements?
6. Give two reasons audit work on cash is likely to be more extensive than might appear
to be justified by the relative amount of the balance sheet figure for cash.
8. During your audit small manufacturing firm, you find numerous checks for large
amounts drawn payable to the treasurer and charged to the Miscellaneous Expense
account. Does this require any action by the auditor? Explain.
9. During your reconciliation bank of accounts in an audit, you find that a number of
checks for small amounts have been outstanding for more than a year. Does this
situation call for any action by the auditor? Explain.
254
10. Explain the objectives of each of the following audit procedures for cash:
a. Obtain a cutoff bank statement subsequent to the balance sheet date.
b. Compare paid checks returned with the bank statement to the list of outstanding
checks in the previous reconciliation.
c. Trace all bank transfers during the last week of the audit year and the first week
of the following year.
d. Investigate any checks representing large or unusual payments to related parties.
3. The accounts payable department receives the purchase order to accomplish all the
following except
a. Comparing the invoice price to the purchase order price.
b. Ensuring that the purchase had been properly authorized.
c. Ensuring that the goods had been received by the party requesting them.
d. Comparing the quantity ordered to the quantity purchased.
4. For effective internal control, which of the following individuals should be
responsible for mailing signed checks?
a. Receptionist
b. Treasurer
c. Accounts payable clerk
d. Payroll clerk
5. If internal control is properly designed, the same employee should not be permitted to
a. Sign checks and cancel supporting documents.
b. Receive merchandise and prepare a receiving report.
c. Prepare disbursement vouchers and sign checks.
d. Initiate a request to order merchandise and approve merchandise ordered.
6. In a properly designed accounts payable system, a voucher is prepared after the
invoice, purchase order, requisition, and receiving report have been verified. The next
step in the system is to
a. Cancel the supporting documents.
b. Enter the check amount in the check register.
c. Approve the voucher for payment.
d. Post the voucher amount to the expense ledger.
Exercises
Exercise 1
Henry Martin is responsible for preparing checks, recording cash disbursements, and
preparing bank reconciliations for Star Corporation. While reconciling the October bank
statement„ Martin noticed that several checks totaling P9,370 had been outstanding for
more than one year. Concluding that these checks would never be presented for payments,
Martin prepared a check for P9,370 payable to himself, forged the treasurer's signature,
and cashed the cheek. Martin made no entry in the accounts for this disbursement and
attempted to conceal the theft by destroying the forged check and omitting the
long-outstanding checks from subsequent bank reconciliations.
Required:
1. Identify the weaknesses in Star Corporation's internal control.
2. Explain several audit procedures that might disclose the fraudulent disbursement.
256
Exercise 2
You are the auditor in charge of the audit of Circle Corporation. In the audit of
investments, you have just been given the following list of securities held by Circle
Corporation at December 31, 20X3.
CIRCLE CORPORATION
Schedule of Marketable Securities
December 31, 20X3
Required:
1. Identify the potential audit problems that may be indicated by the schedule.
2. To value the shares of Rectangle Corporation, management has employed a
securities, valuation firm. Explain the audit considerations involved in auditing the
value developed by the valuation firm.
Exercise 3
Items a through l represent possible errors and fraud that you suspect may be present at
Rex Company. The accompanying List of Auditing Procedures represents procedures that
the auditor would consider performing to gather evidence concerning possible errors and
fraud. For each item, select one or two procedures, as indicated, that the auditor most likely
would perform to gather evidence in support of that item. The procedures on the list may
be selected once, more than once, or not at all.
a. The auditor suspects that a kitting scheme exists because an accounting department
employee who can issue and record checks seems to be leading an unusually
luxurious lifestyle.(Select only 1 procedure.)
b. An auditor suspects that the controller wrote several checks and recorded the cash
disbursements just before year-end but did not mail the checks until after the first
week of' the subsequent year. (Select only 1 procedure.)
c. The entity borrowed funds from financial institution. Although the transaction was
properly recorded, the auditor suspects that the loan created a lien on the entity's real
estate that is not disclosed in its financial statements. (Select only 1 procedure.)
d. The auditor discovered an unusually large receivable from one of the entity's new
customers. The auditor suspects that the receivable may be fictitious because the
auditor has never heard of the customer and because the auditor's initial attempt to
confirm the receivable has been ignored by the customer. (Select only 2 procedures.)
e. The auditor suspects that fictitious employees have been placed on the payroll by the
entity's payroll supervisor, who has access to payroll records and to the paychecks.
(Select only 1 procedure.)
f. The auditor suspects that selected employees of the entity received unauthorized
raises from the entity's payroll supervisor, who has access to payroll records. (Select
only 1 procedure.)
g. The entity's cash receipts of the first few days of the subsequent year were properly
deposited in its general operating account after the year-end. However, the auditor
suspects that the entity recorded the cash receipts in its books during the last week of
the year under audit. (Select only 1 procedure.)
h. The auditor suspects that vouchers were prepared and processed by an accounting
department employee for merchandise that was either ordered nor received by the
entity. (Select only 1 procedure.)
i. The details of invoices for equipment repairs were not clearly identified or explained
to the accounting department employees. The auditor suspects that the bookkeeper
incorrectly recorded the repairs as fixed assets. (Select only 1 procedure.)
j. The auditor suspects that a lapping scheme exists because an accounting department
employee who has access to cash receipts also maintains the accounts receivable
ledger and refuses to take any vacation or sick days. (Select only 2 procedures.)
k. The auditor suspects that the entity is inappropriately increasing the cash reported in
its balance sheet by drawing a check on one account and not recording it as an
outstanding check on that account and simultaneously recording it as a deposit in a
second account. (Select only 1 procedure.)
l. The auditor suspects that the entity's controller has overstated sales and accounts
receivable by recording fictitious sales to regular customers in the entity's books.
(Select only 2 procedures.)
Note: The Substantive Tests of Details of Balances of the Principal Accounts affected by the
Expenditure Cycle are covered in …
259
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
EXPENDITURE CYCLE …
CONTINUED
3. Apply the risk assessment and risk response phases, i.e., test of controls and
substantive tests of transactions to the above mentioned transactions.
CHAPTER 8
The production cycle involves the conversion of raw materials into finished goods. It includes
production planning and control of the types and quantities of products to be manufactured, the
inventory levels (raw materials, finished goods) to be maintained, and the activities pertaining
to the manufacturing process. This cycle interfaces with both the revenue and expenditure
cycles.
Figure 8-1 shows a flowchart that identifies and describes the principal components of internal
control over production.
Production Order
A prenumbered form used to instruct a quantity of Records approval for production
a particular product. personnel to procedure products.
Bill of Materials
A list of raw material components required to Indicates components to be used in
produce a product. producing a product.
Materials Requisition
A prenumbered form used to request and approve Records approval to issue materials to
the issuance of materials from inventory production.
Materials Requisition Summary
A form that summarizes the materials Records materials used in any given
requisitioned by job or by process, for a period period and is the basis for assigning costs
such as a day, a week, or a month. to an account.
Cost Accumulation Report
A form that accompanies goods as they are transferred Records cost of raw materials
through production. As additional costs are incurred, the placed in production.
costs are recorded on the report.
Labor Ticket
A prenumbered form on which time worked on job is Record the specific activity of a
recorded. laborer and is the basis for
assigning costs to an accounts.
Labor Ticket Summary
A form that summarizes the daily labor tickets by job or Records labor used in production
by process. on any given day.
Completed Production Report
A report that summarizes costs for cost control purposes Provides a basis for inventory
and for determining the amount of cost to assign to valuation.
goods remaining in the production process.
General Journal
The journal in which entries not entered in a special journal, such as the transfer of raw
materials to work in process, are made.
Subsidiary ledgers are maintained for raw materials, work in process, finished goods, and
manufacturing overhead. Each subsidiary ledger includes a group of detailed records. For
example, a subsidiary ledger for raw materials includes a record for each type of material.
This chapter discussed the audit of the inventory and warehousing cycle. Because of the
difficulties associated with establishing the existence and valuation of inventories, the cycle is
often the most time-consuming and complex part of the audit. The cycle is also unique because
many of the tests of the inputs to the cycle are tested as part of the audit of other cycles. Tests
performed as part of the inventory and warehousing cycle focus on the cost accounting records,
physical observation, and tests of the pricing and compilation of the ending inventory balance.
262
Figure 8-1:
1: Production Flowchart
A questionnaire that may be used in gathering information about prescribed controls over
manufacturing transactions is shown in Figure 8-3.
265
Recording
1. Are standard costs used? If so, are they
reviewed and revised periodically?
2. Does the accounting manual give
instructions for proper classification of
cost accounting transactions?
3. Are summary entries for direct materials
and direct labor reviewed and approved
by the cost accounting supervisor?
4. Is there verification of correct
application of overhead job cost sheets?
5. Is there segregation of functions between
general accounting and cost accounting?
6. Are there periodic reconciliations of
work in process and finished goods with
subsidiary records?
Custody
1. Is work in process tagged during
production?
2. Are finished goods stored in locked
warehouses?
3. Are perpetual finished goods records
periodically compared with goods on
hand?
Controls related to production transactions are important to auditors because they affect
the assertions embodied in the financial statements. Auditors perform one or more audit
procedures to test the assertions, including the following:
General Specific
1. Existence or occurrence 1. Recorded production transactions occurred.
266
DISCUSSION:
The following sections present the controls an entity should have to ensure the propriety of each
assertion, and the tests an auditor might perform to determine the effectiveness of the controls
on production transactions.
3. Production orders are prenumbered and 3. To test this control the auditors should
accounted for to determine that all observe the procedure and account for a
production is recorded. numerical sequence of production orders.
4. Materials requisitions are prenumbered 4. The auditor should observe the procedure
and accounted for by an accounting clerk. and account for numerical sequence of
materials requisitions.
5. Time charged on labor ticket is 5. The auditor,could observe if a clerk
reconciled to employee time cards. reconciles the time charged on completed
labor tickets to the total hours for which
production workers are paid.
267
C. Valuation or Allocation: Production transactions are recorded for the proper amount.
6. Value for transactions are based on a bill 6. To test this control, the auditor should
of materials, approved ticket and rates for trace the amounts to the bill of materials
labor, and predetermined overhead rates. time cards and overhead rates assigned
costs may then be traced to authorized
price lists and underlying schedules.
7. Overapplied or underapplied overhead is 7. The auditor should observe the signature
reviewed periodically, and rates are indicating that the overhead rate has been
adjusted as necessary. reviewed.
8. The chart of accounts should adequately 8. The auditor should examine the chart of
describe the accounts to be used; and accounts and examine the signature of
account coding is independently the employee performing the procedure.
checked.
WP `
Audit Procedures Ref By Date
1. Select a sample of production orders.
a. Determine if production order was authorized.
b. Match to bill of materials and manpower
needs.
c. Trace bills of materials to material requisitions,
material issue slips, materials-used reports, and
into job cost sheets.
d. Trace manpower needs to job time sheets,
labor reports and into job cost sheets.
2. Select a sample of issue slips from the raw materials
stores file.
a. Determine if a matching requisition is
available for every issue slip.
b. Trace to materials-used reports into job cost
sheet.
3. Select a sample of clock timecards from the payroll
file. Trace a job time tickets, labor reports, and into
job cost time sheets.
268
4. Select a sample open and dosed job cost sheets.
a. Recalculate all costs entered.
b. Vouch labor costs to job tickets and reports.
c. Compare labor reports to summary of payroll.
d. Vouch material costs to issue slips and
materials-used reports.
e. Compare materials-used reports to material
requisitions and bill of materials.
f. Vouch overhead charges to overhead analysis
schedules.
g. Trace selected overhead amounts from analysis
schedules to cost allocations and to invoices of
accounts payable vouchers.
5. Reconcile the open job cost sheets to work-in
process inventory control account.
6. Select a sample of transfers from work-in process
and trace to
a. Transfers to finished goods perpetual records
comparing unit costs and quantities.
b. Summary transfer entries in general ledger
control accounts.
7. Select a sample of transfers from finished goods and
trace to
a. Shipping documents comparing quantities and
unit costs, coordinating with tests of sales in
the revenue / receipt cycle.
b. Summary of cost of sales and sales entries.
The foregoing test of controls may reveal the following weaknesses and possible errors:
269
4. Lack of periodic test counts and 4. Undetected inventory shrinkage or
comparison of physical inventory with recording errors.
perpetual records. 5. Undetected errors in recording or posting
5. Failure to agree subsidiary inventory and overhead accounts.
overhead ledgers to controlling accounts
on regular basis.
On the basis of the preliminary evaluation and the results of compliance testing, the auditor
makes a final evaluation of the controls over production transactions. The auditor then
determines the nature, timing and extent of substantive tests to be done on account balances
affected by the production cycle.
270
DISCUSSION OF AUDIT PROCEDURES
Purchasing and receiving raw materials or goods have been discussed in the acquisitions and
disbursements cycle while the selling of goods has been discussed in the sales and collections
cycle. Warehousing or storage of such materials or goods results in a very significant current
asset for many manufacturing, wholesale, and retail operations.
Entities store supplies, replacement parts, raw materials, and finished goods. Although the
stored goods may differ, the basic controls and the tests of controls than an auditor
performs similar. Hence, we, discuss here only one example, the storage of raw materials.
Auditors perform one or more audit procedures to test the following assertions related to
inventory warehousing:
General Specific
1. Existence or occurrence 1. Recorded inventory warehousing
transactions occurred.
2. Completeness 2. All inventory warehousing transactions
that occurred are recorded.
271
3. Rights and obligations 3. Inventory warehousing transactions are
for goods that belong to the entity.
4. Valuation or allocation 4. Inventory warehousing transactions are
recorded for the proper amounts.
5. Presentation and disclosure 5. Inventory warehousing transactions are
recorded to result in presentation and
disclosure in accordance with
PAS/PFRS.
DISCUSSION:
272
C. Rights and Obligations: Inventory warehousing transactions are for goods that belong to
the entity
6. Goods received on consignment are 6. Inquire about and observe the procedure.
labeled and separated from goods and
entity owns.
D. Valuation or Allocation: Inventory warehousing transactions are recorded for the proper
amounts.
7. Costs assign to work in process and 7. Inquire about and observe evidence of
finished goods are set by procedures that standards setting, review of standards,
are reviewed and periodically evaluated. and testing of standards.
Mathematical accuracy is tested.
273
Absence of or inadequate controls over inventory warehousing transactions could result into
the following misstatements and/or irregularities:
274
Discussion of Audit Procedures
The audit procedures described in the preceding schedule are designed primarily to test the
quantities of goods recorded and the prices assigned to goods in the perpetual inventory
records.
Testing Quantities
Inventory records usually include a description of goods, the warehouse location and the
quantity on hand. The auditor may select items from the inventory records, goes to the
warehouse and counts the goods on hand, and determines the accuracy of the inventory records.
The auditor may also examine the related receiving reports and requisitions.
Testing Prices
The prices assigned to inventory should be in accordance with the client's method [e.g., first in,
first out (FIFO), weighted average or specific identification]. To test the accuracy of prices, an
auditor may trade amounts to vendor's invoices, prior year's schedules listing the inventory
value, a standard cost sheet, or a cost of production report.
When the auditor verifies acquisitions as part of the tests of the acquisition and payment cycle,
evidence is being obtained about the accuracy of raw materials acquired and all manufacturing
overhead costs except labor. These acquisition costs either flow directly into cost of goods sold
or become the most significant part of the ending inventory of raw material, work in process,
and finished. goods. In audits involving perpetual inventory master files, it is common to test
these as part of tests of controls and substantive tests of transactions procedures in the
acquisition and payment cycle. Similarly, if manufacturing costs are assigned to individual jobs
or processes, they are usually tested as a part of the same cycle.
When the auditor verified labor costs, the same comments apply as for acquisitions. In most
cases, the cost accounting records for direct and indirect labor costs can be tested as part of the
audit of the payroll and personnel cycle if there is adequate advance planning.
275
Tests of the Sales and Collection Cycle
Although the relationship is less close between the sales and collection cycle and the inventory
and warehousing cycle than between the two previously discussed, it is still important. Most of
the audit testing in the storage of finished goods as well as the shipment and recording of sales
takes place when the sales and collection cycle is tested. In addition, if standard cost records are
used, it may be possible to test the standard cost of goods sold at the same time that sales tests
are performed.
Tests of cost accounting are meant to verify the controls affecting inventory that were not
verified as part of the three previously discussed cycles. Tests are made of the physical controls,
transfers of raw material costs to work-in process, transfers of costs of completed goods to
finished goods, perpetual inventory master files, and unit cost records.
In most audits, the underlying assumption testing the inventory and warehousing cycle is that
cost of goods sold is a residual of beginning inventory plus acquisitions of; raw materials, direct
labor, and other manufacturing costs minus ending inventory. When the audit of inventory and
costs of goods sold is approached with this idea in mind, the importance of ending inventory
becomes obvious. Physical inventory, pricing, and compilation are each equally important in
the audit because a misstatement in any one results in misstated inventory and cost of goods
sold.
In testing the physical inventory, it is possible to rely heavily on the perpetual inventory master
files if they have been tested as a part of one or more of the previously discussed tests. In fact,
if the perpetual inventory master files are considered reliable, the auditor can observe and test
the physical count at some time during the year and rely on the perpetual to keep adequate
records of the quantities.
When testing the unit costs, it is also possible to rely, to some degree, on the tests of the cost
records made during the substantive tests of transactions. The existence of standard cost records
is also useful for the purpose of comparison with the actual unit costs. If the standard costs are
used to represent historical cost, they must be tested for reliability.
AUDIT OF PAYROLL TRANSACTIONS
Payroll transactions involve the events and activities relative to executive and employee
compensation. This class of transactions includes salaries of personnel, wage earners
(factory workers), sales persons' commission, bonuses to executives, payroll taxes,
pensions and profit sharing plans and other employees' fringe benefits. The primary errors
or irregularities that may occur are a padded payroll and misappropriation of unclaimed
paychecks. The auditor should therefore adopt procedures that will enable him enable him
to detect such occurrences.
Documents Used in the Payroll and Personal Cycle and their Audit Signature
Deduction Authorization
A form that employee sign to authorize their Indicates that the employee authorized an
employer to withhold taxes and various amount to be withheld from a paycheck for a
optional payments from their paychecks. specific purpose.
Payroll Register
Includes a list of each payroll check, along with gross pay, amounts withheld, and net pay. The
payroll register, sometimes called a payroll journal, is a book of original entry. Totals for each
payroll are posted to general ledger accounts.
Includes for each employee for each pay period the date, check number, gross amount,
deductions, and net pay. The record includes the gross earnings and deductions for the year to
date and may include other data, such as the number of hours worked during each payroll
period.
278
Labor Distribution Journal
Report in which, based on an account code, salaries and wages are allocated to particular
accounts, such as direct or indirect labor or other functions within the entity.
The methodology to be used by the auditor in evaluating internal control for payroll
transactions will include inquiry, observation and review or documentation.
Questionnaires may be accomplished to document the results of his evaluation. Figure 8-4
shows the questionnaire applicable to Payroll Transactions.
Auditors are interest in internal controls because of their effect on financial statement
assertions. The following financial statement assertions apply to payroll transactions.
General Specific
1. Existence or occurrence 1. Recorded payroll transactions occurred.
2. Completeness 2. All payroll earned by employees is
recorded.
3. Rights and obligations 3. Recorded payroll transactions are for
services received.
4. Valuation or allocation 4. Payroll transactions are recorded for the
proper amounts.
5. Presentation and disclosure 5. Payroll transactions are recorded to result
in presentation and disclosure in
accordance with PAS / PFRS.
279
Figure 8-4:
4: Payroll Flowchart
Figure 8-5: Internal Control Questionnaire for Payroll Transactions
Recording
1. Are personnel who journalize payroll
transactions independent of those who
prepare and pay the payroll?
2. Are changes in employee earnings records
reconciled?
281
DISCUSSION:
The following sections present the controls and entity should have to ensure the propriety of
each assertion and tests an auditor might perform to determine the effectiveness of the controls
on payroll transactions.
4. Use prenumbered checks accounted for 4. To test this control, an auditor would
in the bank reconciliation. Require an observe whether reconciliations are
employee not involved in the preparation routinely prepared by a person not
of payroll to reconcile the payroll bank involved with payroll activities.
account.
282
C. Rights and Obligations: Recorded payroll transactions are for services received.
5. Employees are required to record the 5. The auditor should observe whether the
time they work, using a time clock. procedure is being followed. The auditor
Employees are not allowed to time in for should examine signature on card.
each other.
6. Supervisors should review and approve 6. The auditor should observe the
each employee’s time card, functioning of this control.
D. Valuation or Allocation: Payroll transactions are recorded for the proper amount.
9. An employee should use a chart of 9. The auditor should examine the payroll
accounts in assigning codes for labor summary for the signature indicating that
charges. Another employee would this procedure is being followed.
checks the work of the employee who
assigned the codes and then signs or
initials the work.
283
IV. AUDIT PROGRAM FOR TESTS OF CONTROLS OVER PAYROLL
TRANSACTIONS
Done
Audit Procedures WP
Ref By Date
1. Review the payroll journal, general ledger, and payroll earnings
records for large or unusual amounts.
2. Compare cancelled checks with payroll journal for name,
amount, and date.
3. Examine cancelled checks for proper endorsement.
4. Compare cancelled checks with personnel records.
5. Reconcile the disbursements in the payroll journal with the
disbursements on the payroll bank statement.
6. Prove the bank reconciliation.
7. Recomputed hours worked from time cards.
8. Compare pay rates with union contract, approval by board of
directors, or other source.
9. Recomputed gross pay.
10. Checks with holdings by reference to tax tables and
authorization forms in personnel file.
11. Recomputed net pay.
12. Compare cancelled check with payroll journal for amount.
13. Compare classification with charts of accounts or procedures
manual.
14. Review time card for employee department and job ticket for
job assignment, and trace through to labor distribution.
15. Compare date of recorded check in the payroll journal with date
on cancelled checks and time cards.
16. Compare date on check with date the check cleared the bank.
17. Tests clerical accuracy by footing the payroll journal and
tracing postings on the general ledger and the payroll master
file.
284
The test of controls over payroll transactions may reveal the following weaknesses and possible
errors.
285
III. Rights and Obligations C. To determine that 5. Examine the canceled
recorded payroll employee payroll checks
transactions are for for propriety. If
services received. employees are paid in
cash, examine receipts
signed by them to
determine that payments
have, in fact, been, made
to the proper party.
IV. Valuation or Allocation D. To determine that 6. Checks the recorded pay
payroll transactions are against the original
recorded for the proper record of hours worked
amounts. or units produced.
7. Compare the rates paid
with authorization
forms, union contracts or
other pertinent source
data.
8. Check the computation
of payroll and
deductions from gross
pay.
V. Presentation and E. To determine that 9. Compare the total of the
Disclosure payroll transactions are payroll tested with the
recorded to result in appropriate recorded
presentation and disbursements from the
disclosure in accordance general bank account.
with PAS / PFRS.
1. Check the personnel records to ascertain whether the persons paid were actually
employed during the pay period tested.
This procedure will enable the auditor to ascertain whether there are fictitious names or
names of terminated employees included in the payroll sheet. Inclusion of such names is
one of the most common techniques used by employees to obtain funds by fraudulent
means.
This procedure is followed to ascertain whether the proper employees did receive their pay
as authorized. The auditor checks the identification of the employees being paid, compare
the amount paid with the payroll journal, and observes the employee signing the receipt.
This should done in the presence of a responsible official from the company in case any
disputes arise. When checks are issued, the auditor compares the paychecks to the payroll
journal.
286
3. Investigate the company 's method handling of unclaimed pay.
The client's procedures for handling unclaimed pay must be designed effectively and
followed closely to reduce the possibility of misappropriation of funds. The auditor should
list unclaimed wages for the period under investigation and determine the disposition that
has been made of the items.
4. Trace the payroll tested to summaries, trace posting of summary total to the general
ledger and to subsidiary ledgers, and check the propriety of the accounting distribution.
The procedure will satisfy the auditor that the details of the payroll have been summarized
properly and that the totals have been recorded properly both the general and subsidiary
ledgers.
5. Examine the canceled employee payroll checks for propriety. If employees are paid in
cash, examine receipts signed by them to determine that payments have, in fact, been
made to the proper party.
The purpose of this procedure is to enable the auditor to ascertain whether the proper
employees received their pay and whether the amounts paid are in agreement with the
payroll journal.
6. Check the recorded pay against the original record of hours worked or units produced.
The auditor compares the employee's name, clock number, department number and
recorded pay as shown on the original records (time card, time sheets and so on) with the
information included in the payroll journal. Through this procedures, the auditor will be
able to satisfy himself also for the approval of hours worked, units produced and related
overtime pays.
287
7. Compare the rates paid with authorization forms, union contracts or other pertinent
source data.
This procedure is done to determine whether employees are being paid at the proper and
authorized rate.
The auditor verifies the calculations of the pay of the individuals selected for testing. The
arithmetic accuracy if the payroll journal is likewise tested to ascertain whether the client's
internal control structure is functioning properly and tend to detect any errors in footings
that could misstate payroll expense or conceal defalcations.
9. Compare the total of the payroll tested with the appropriate recorded disbursements
from the general bank account.
If the company maintains imprest bank accounts for payrolls, the auditor should reconcile
the amount transferred from the general account to the imprest fund with the applicable
payroll. The auditor should check carefully reconciling items such as checks issued in
advance, correction of previous reimbursements or changes in the imprest balance to
establish their propriety.
288
REVIEW QUESTIONS AND PROBLEMS
Questions
2. Describe the controls a firm should establish to ensure that all payroll paid are
recorded.
3. Describe the audit procedures to test payroll account balances and the errors they may
uncover.
4. What is the role of the following documents in the audit of production costs?
a. Production order
b. Bill of materials
c. Materials requisition
d. Cost accumulation report
e. Materials requisition summary
f. Labor ticket
g. Labor ticket summary
h. Completed production report.
5. Identify controls an entity should have to ensure that all production transactions that
occur are recorded.
289
2. Mary Corp. has changed from a system in which time worked is recorded on cards to
computerized payroll system in which employees record time in and out with
magnetic cards. The system automatically updates all payroll records because of this
change,
a. the auditor must use a generalized computer audit program.
b. part of the audit trail is altered.
c. the potential for payroll-related fraud is diminished.
d. Transactions must be processed in batches.
3. In a manufacturing company which one of the following audit procedures would give
the least assurance of the valuation of inventory at the audit date?
a. Testing the computation of standard overhead rates
b. Examining paid vendors' invoices
c. Reviewing direct labor rates
d. Obtaining information of inventories pledged under loan agreements
4. When auditing merchandise inventory at year end, the auditor performs a purchase
cutoff test to obtain evidence concerning whether
a. all goods purchased before year-end are received before the physical inventory
unit.
b. All goods held on consignment for customers are included in the inventory
balance.
c. Any goods observed during the physical count are pledged or sold.
d. all goods owned at year-end are included in the inventory balances.
5. An auditor has accounted for a sequence of inventory tags and is now going to trace
information on a representative number of tags to the physical inventory sheets. The
purpose of this procedure is to obtain assurance that
a. the final inventory is valued at cost.
b. all inventory represented by an inventory tag is listed on the inventory sheets.
c. all inventory represented by an inventory tag is bonafide.
d. inventory sheets do not include untagged inventory items
290
6. The physical count of a retailer’s inventory was higher than that shown by the
perpetual records. Which of the following could explain the difference?
a. Inventory items had been counted, but the tags placed on the items had not been
taken off items and added to the inventory accumulation sheets.
b. Credit memos for several items returns by customers had not been recorded.
c. No journal entry had been made on the retailer's books for several items returned
to suppliers.
d. An item purchased FOB shipping point had not arrived at the date of inventory
count and not had been reflected in the perpetual records.
7. An auditor’s tests of controls over the issuance of raw materials to production would
probably include
a. Reconciling raw materials and work-in-process perpetual inventory.
b. Inquiring of the inventory custodian about the procedures followed when
defective materials are received from vendors.
c. Observing that raw materials are stored in secure areas and that storeroom
security is supervised by a responsible person.
d. Examining materials requisitions and reperforming client controls designed to
process and record issuances.
8. Which of the following is a question that the auditor would expect to find on the
production cycle section of an internal control questionnaire?
a. A vendors' invoices for raw materials approve for payment by an employee who
is independent of the cash disbursements function?
b. Are signed checks for the purchase of raw materials mailed directly after signing
without being returned to the person who authorized the invoice processing?
c. Are all releases by custodians of raw materials from storage based on approved
requisition documents?
d. Are details of individual disbursements for raw materials balanced with the total
to be posted to the appropriate general ledger account?
291
9. The auditor examining inventory out on consignment is faced with the following
situation. Goods are located in small quantities at a variety of location throughout the
country and cannot be observed. An attempt at obtaining positive confirmations from
consignees drew an 80 percent nonresponse rate; the other 20 percent confirmed the
statement balance. Given these constraints, what is the best evidence the auditor can
use to support the balance sheet value for inventory out on consignment?
a. Bills of lading adjusted for payments received
b. Analytical evidence comparing previous years' figures with those for the current
year
c. Copies of memorandum invoices sent to consignees
d. Analytical evidence comparing consignments-out to consignments-in
10. Which of the following is the most important internal control relating to the raw
materials inventory of a manufacturing company?
a. The physical inventory count should be made by personnel independent of the
inventory custodians.
b. Materials from vendors should be received directly by the production department
that will be using the materials.
c. Shortages in shipments from vendors should immediately be reported to the
production department that will be using the materials.
d. Issues from inventory should be supported by sales invoices.
11. An audit of the payroll function showed that on several occasions a payroll clerk had
added bogus employees to the payroll and deposited the checks in accounts of friends
and relatives. What controls should have prevented the occurrence of such
irregularities?
a. Using time cards and attendance records in the computation of employee gross
earnings
b. Requiring the preparation of a voucher for the payment of payroll
c. Having the treasurer’s office sign and distribute payroll checks
d. Allowing changes to the payroll to be authorized only by the personnel
department
14. Management is concerned with the potential for unauthorized changes to the payroll.
Which of the following is the proper organizational structure to prevent such
unauthorized changes?
a. The payroll department maintains and authorizes all changes to the personnel
records.
b. The payroll department is supervised by the management of the human resources
division.
c. The payroll department’s functions are limited to maintaining the payroll
records, distributing paychecks, and posting the payroll entries to the general
ledger.
d. The personnel department authorizes the hiring and pay levels of all employees.
15. Which of the following controls would be the most appropriate means to ensure that
terminated employees have been removed from the payroll?
a. Mailing checks to employees' residences
b. Establishing direct-deposit procedures with employees' banks
c. Reconciling payroll and timekeeping records
d. Establishing computerized limit checks on payroll rates
16. A means of ensuring that payroll checks are drawn for properly authorized amounts is
to
a. conduct periodic floor verification of employees on the payroll.
b. require that undelivered checks be returned to the cashier.
c. require supervisory approval of employee time cards.
d. Witness the distribution payroll checks.
293
Exercises
Exercise 1
The following questions related to payroll are included on the internal control
questionnaire for Mama Company:
3. Does a supervisor approve time cards before they are sent to payroll?
4. Are payroll checks distributed by someone other than the people involved in
supervising employees, personnel, payroll preparation, and check signing?
Required:
For each or the six preceding questions, provide the following information about Mama
Company's internal control:
a. Identify the financial statement assertion related to the control addressed in each
question.
b. Identify a potential misstatement that could arise from the absence of the control you
identified in part a.
c. Identify the tests of controls an auditor might perform for the controls you identified
in part a.
d. Indicate the substantive tests of transactions an auditor might perform after the test of
controls if the control is ineffective.
Exercise 2
Match the audit objectives listed on the left with the best audit procedure from the list on
the right. Use the audit procedures only once.
1. The entity has legal rights to items a. Foot the client's inventory listing
included in inventory.
2. Recorded inventory represents assets that b. Determine that the responsibility for
actually exist at the balance sheet date. maintaining the perpetual inventory
records is segregated from the
responsibility for receiving inventory.
3. Inventory is properly valued at the c. Reconcile inventory tags gathered during
balance sheet date. inventory listing.
d. Perform cutoff tests to verify that
inventory purchases are recorded in the
proper period.
e. Determine that inventory is adequately
insured.
f. Compare receiving reports to packing
slips and invoices.
g. Compare the inventory turnover rate for
the current period to that of the industry.
Exercise 3
1. The production supervisor believes he has good judgment about what customers will
buy. He surprised the sales manager with a new product that was produced on
December 24.
2. Raw materials were transferred to production but were not transferred in the
accounting records.
295
4. The materials-usage variance is unusually large because materials issued to product
development were charged to production.
5. The work-in-process account is overstated because goods were not transferred out
when they were completed.
6. The labor cost on one job is high because an employee completed a duplicate labor
ticket.
Required:
a. What control would have prevented or detected each of the errors or irregularities?
Exercise 4
An auditor discovered the following errors and irregularities while performing tests of
controls:
1. Goods received on June 3 were never placed in the storeroom but instead were taken
to the receiving clerk's home.
2. Raw materials issued on July 15 were never recorded as issued from the storeroom.
4. While storeroom personnel are at lunch, production employees come into the
storeroom to get the materials they need. They always complete and sign the
requisition forms.
296
Required:
a. What control would have prevented or detected each of the errors or irregularities?
297
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
INVESTING CYCLE
1. Enumerate and describe the steps involved in auditing the investing cycle.
2. Describe the nature and the major classes of transactions in the investing cycle.
4. Apply the risk assessment and risk response phases of the audit process, i.e.,
test of controls and substantive tests of transactions in the investing cycle.
CHAPTER 9
INTRODUCTION
This chapter covers the explanation of the investing cycle, the types of transactions in this cycle
and the internal control environment and objective pertaining thereto. Consideration is then
given to compliance tests of controls over transactions in the investing cycle.
In the audit of the investing cycle, the following activities should be undertaken:
1. Identify the activities and types of transactions that occur in a company's investing
cycle;
3. Determine the essential features of. internal control over the above-mentioned
transactions;
Steps 1 to 5 are discussed in this Chapter while Step no. 6 is covered in Chapters 11, 14, 15 and
16.
299
NATURE OF THE INVESTING CYCLE
Basic Considerations
Investing cycle includes the processes, procedures and policies for authorizing, executing and
recording transactions involving acquisition and disposition of investments in securities (e.g.,
government securities, equity securities, corporate bonds) short-term and long-term, property
and equipment, natural resources, intangible assets, non-trade loans, and investment property.
Figure 9-1 shows the flow of the entries in the accounts affected by the transactions in the
investing cycle.
300
Figure 9-1: Interrelationship of Accounts (Partial) Affected by the Investing Cycle
DOCUMENTS AND RECORDS
The pertinent documents and records used in the Expenditure Cycle (Chapter 7) are also used in
the investing cycle. In addition, the following forms may also be encountered:
Share Certificate. An engraved form showing the number of shares of shares owned by a
shareholder in a corporation.
Bond Certificate. An engraved form showing the number of bonds owned by a bondholder.
Broker's Advice. A statement from a broker specifying the details of an investing transaction.
302
AUDITING THE INVESTING CYCLE
As part of performing risk assessment procedures, the auditor obtains information that is useful
in assessing the risk of material misstatement. This includes information about inherent risks at
the financial statement level (for example, the client's business and operational risks and
financial reporting risks) and at the account and assertion levels, fraud risks including feedback
from audit team brainstorming sessions, strengths and weaknesses in internal control, and
results from preliminary analytical procedures. Once the risks of material misstatement have
been identified, the auditor then determines how best to respond to them as part of the audit
opinion formulation process.
Much of the inherent risk associated with long-lived assets is due to the importance of
management estimates, such as estimating useful lives and residual values and determining
whether asset impairment has occurred. Inherent risk related to asset impairment stems from
the following factors:
Other inherent risks associated with long-lived assets and related expenses include:
303
The auditor will become aware of these risks through:
Natural resources present unique risks. First, it is often difficult to identify the costs associated
with discovery of the natural resource. Second, once the natural resource has been discovered,
it is often difficult to estimate the amount of commercially available resources to be used in
determining a rate. Third, the client may be responsible for restoring the property to its original
condition (reclamation) after the resources. are removed. Reclamation costs may be difficult to
estimate.
Intangible assets should be recorded at cost. However, the determination of cost for intangible
assets is not as straightforward as it is for intangible assets, such as equipment.
One of the more common techniques used to fraudulently misstate financial statements
involves the overstatement of assets through overvaluing existing assets, including fictitious
assets, or capitalizing expenses.
304
Amortization of intangible assets is miscalculated.
Costs that should have been expensed are improperly capitalized.
Impairment losses on long-lived assets are recognized.
Fair value estimates are unreasonable or unsupportable.
Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement related to long-lived assets, the auditor needs to understand the controls that the
client has designed and implemented to address those risks.
In an integrated audit, the auditor uses this understanding to identify important controls that
need to be tested.
Typical controls that effect multiple assertions for long-lived assets include:
To provide reasonable assurance that the existence and valuation assertions for fixed assets are
materially correct, controls should be in place to:
Identify existing assets, inventory them, and reconcile the physical asset inventory
with the property ledger on a periodic basis (existence)
Provide reasonable assurance that all purchases are authorized and properly valued
(valuation)
Appropriately classify new equipment according to its expected use and estimate of
useful life (valuation)
Periodically reassess the appropriateness of depreciation categories (valuation)
305
Identify obsolete or scrapped equipment and write the equipment down to scrap value
(valuation)
Review management strategy and systematically assess the impairment of assets
(valuation)
Many organizations face a challenge in tracking the location, quantity, condition, maintenance,
and depreciation status of their fixed assets. One approach to dealing with this challenge is to
use serial numbered asset tags, often with bar codes. Then periodically, the organization takes
inventory, utilizing a barcode include:
Given the challenges related to asset impairment, the auditor needs to understand
management's controls related to asset impairment judgments. Such controls should include:
Most established natural resource companies have developed procedures and associated
internal controls for identifying costs, and such organizations use geologists to establish an
estimate of the reserves contained in a new discovery. These organizations periodically reassess
the amount of reserves as more information becomes available during the course of mining,
harvesting, or extracting resources.
306
Performing Preliminary Analytical Procedures
When planning the audit, the auditor is required to perform preliminary analytical procedures.
These procedures can help auditors identify areas of potential misstatements.
Techniques that auditors can use when performing preliminary analytical procedures include
the following:
Ratios that the auditor should plan review, after developing independent expectations, include:
Ratio of repairs and maintenance expense total depreciable long-lived tangible assets
— This ratio may fluctuate because of changes in management's policies (for
example, maintenance expenses can be postponed without immediate breakdowns or
loss of productivity). The auditor should plan to analyze any unexpected deviation
with this consideration in mind.
307
If preliminary analytical procedures do not identify any unexpected relationships, the auditor
would conclude that there is not a heightened risk of material misstatements in these accounts.
If unusual or unexpected relationships exist, the planned audit procedures (tests of controls,
substantive procedures) would be adjusted to address the potential material misstatements.
Basic Considerations
Once the auditor has developed an understanding of the risks of material misstatement, the
auditor can determine the appropriate audit procedures to perform. Audit procedures should be
proportional to the assessed risks, with areas of higher risk receiving more audit attention and
effort. Responding to identified risks typically involves developing an audit approach that
contains substantive procedures (such as tests of details and, when appropriate, substantive
analytical procedures) and tests of controls, when applicable.
Audit .risk for investing cycle transactions and balances can generally be kept at a very low
level because in most commercial enterprises (l) these transactions occur infrequently and (2)
effectively controls can be maintained at relatively little cost. Furthermore, the auditor can
obtain evidential matter from independent sources outside the enterprise and acquire direct
personal knowledge concerning the balances.
308
I. Evaluation and Obtaining Evidence About Internal Control Effectiveness in the
Investing Cycle Transactions
The three operative objectives of internal accounting control are applicable to the investing
cycle. These objectives consist of proper
1) Executing of transactions
2) Recording of transactions
3) Custody of assets
The specific control objectives for each function in this cycle are as follows:
1) Purchases of property and equipment, securities and intangibles are made in accordance
with management's authorizations.
2) Sales of property and equipment, securities and intangibles are made in accordance with
management's authorizations.
3) Dividend and interest checks from investments are promptly deposited intact.
4) Access to property and equipment, securities and intangibles are restricted to authorized
personnel.
1) Transactions and events are correctly recorded as to amount, classification, and accounting
period.
309
Internal control over investments
c) Custodianship of investment securities and the accounting for the securities should be
separated.
d) Securities must be physically controlled in order to prevent unauthorized usage and they
must be registered in the name of the owner.
e) Revenues received from investments periodically should be reconciled with the amounts
that should be received.
The following illustrates the typical errors and fraud that the auditors might identify and assess
in the audit of financial investments.
Internal Control
Weaknesses or Factors Description of
That Increase the Risk of Possible Errors or
the Misstatement Examples of Fraud / Error Misstatement
310
3. Inadequate segregation 3. An employee with 3. Unauthorized
of duties of record access to securities investment transactions.
keeping for and custody converts them for
of securities. personal use.
The following are considered good internal control measures over property and equipment
a) Additions and dispositions of property and equipment should be properly authorized and
approved by the board of directors or executive committee or person to whom authority
has been delegated.
b) A clearly defined and sound policy for differentiation of capital and revenue expenditures
should be established.
d) Property and equipment controlling account should be supported by detailed plant records.
f) Periodic review of adequacy of insurance for fire, theft, etc. on fixed assets should be
performed.
311
The following illustrates the typical errors and fraud that the auditors might identify and assess
in the audit of property, plant and equipment.
Internal Control
Weaknesses or Factors Description of
That Increase the Risk of Possible Errors or
the Misstatement Examples of Fraud / Error Misstatement
312
II. Tests Of Controls And Substantive Tests of Transactions
Because the number of transactions that involve fixed tangible assets, securities and intangibles
is usually relatively small, the auditor's testing of controls in this area is rather limited. When
there are few investment transactions, the auditor may decide to proceed directly to substantive
tests of property and equipment and investment balances after a preliminary review of the flow
of transactions through the accounting system. This decision may be based on cost-benefit
considerations, rather than on the absence of effective controls. When a client has an extensive
investment portfolio and numerous transactions, the auditor may decide to complete his review
of internal control and perform compliance tests on the controls expected to be relied on.
The auditor's assessment of control risk would also be influenced by the results of tests of
transactions for the expenditure and cash disbursements cycle.
III. Illustrative Audit Program for the Test of Controls and Substantive Tests of
Transactions
The following are procedures typically performed by auditors to determine that adequate
internal control exists over property and equipment, securities and intangibles and the related
expenses and revenue from these investments:
1. Trace transactions for purchases and sales of property and equipment, securities and
intangibles through the system.
Selected transactions for purchase or sale of property and equipment, securities and
intangibles will be traced through the system to verify that the controls are being followed
in actual practice. For example, a purchase of securities should be approved in minutes of
the meetings of the investment committee, and documents from the share brokerage firm
should show receipt of the order and its execution. Other evidence will be the broker's
month-end statement, the share certificate acquired, the entry in the subsidiary ledger for
securities and the monthly report of the treasurer showing all purchases, sales, current
holdings and revenue received from investments.
313
2. Review reports by internal auditors, on their periodic inspections to property and
equipment, securities and intangibles.
In large companies, the internal auditors may make inspection of property and equipment,
and securities. The independent auditor may reconcile the listing of property and
equipment, securities at a given date as prepared by the internal auditors with the
subsidiary ledger for securities and with the CPA firm's own working papers from the
preceding years' audit.
3. Review monthly reports by officer of client company on securities owned, purchased, and
sold, and revenue earned.
In many companies, the treasurer will submit to the investment committee of the board of
directors a monthly report showing securities owned at the beginning of the month, all
purchases, sales, gains and losses during the month the dividends and interest received and
month-end holdings.
4. Review significant changes in the composition of property and equipment and related liens
and mortgages.
5. Review rental revenue from land, buildings, and equipment owned by the client but leased
to others.
The auditors should determine that the client is applying the appropriate accounting
standards depending on whether the lease terms indicate a sales-type, direct financing, or
operating lease. When the lease involves variable payments, the auditors must carefully
evaluate when the variable payments should be recognized.
6. Examine lease agreements on property, plant, and equipment leased to and from others.
The auditors should carefully examine lease agreements to determine whether the
accounting for the assets involved is proper. For example the auditors should be alert for
the client's possible use of improper accounting techniques, such as the following:
Assets under a lease that are being improperly accounted for (e.g., failure to record
asset and liability for leases with terms of more than 12 months).
Leasehold improvements to buildings under leases that are being depreciated over the
estimated useful life of the improvements rather than the shorter term of the lease,
when renewal of the lease is not reasonably assured.
Improper accounting for items such as initial costs, lease incentives, and variable
payments.
If the client has a large number of lease agreements, the auditors may use software to identify
lease provisions that may affect accounting or disclosure related to the agreements.
314
REVIEW QUESTIONS AND EXERCISES
Questions
1. Identify the transactions involved in investing and explain their relationship to other
cycles.
3. Describe the important investment-related duties that must be separated if controls are
to be effective.
4. What is asset impairment, and what inherent risk factors are associated with asset
impairment?
5. What are some inherent risks of material misstatement associated with natural
resources?
6. What are some inherent risks of material misstatement associated with intangible
assets?
7. What audit procedures might an auditor use to identify fully depreciated equipment?
How might the auditor determine that such equipment is properly valued?
315
Multiple Choice Questions
1. The audit procedure of analyzing the repairs and maintenance accounts is designed
primarily to provide evidence in support of the audit proposition that all
a. expenditures for fixed assets have been recorded in the proper period.
b. capital expenditures have been properly authorized.
c. noncapitalizable expenditures have been properly expensed.
d. expenditures for fixed assets have been capitalized.
2. When an entity has few property and equipment transactions during the year, the
continuing auditor usually carries out
a. a complete review of the related internal controls and performs tests of the
controls on which the entity relies.
b. a complete review of the related internal controls and performs analytical review
tests to verify current-year additions to property and equipment.
c. a preliminary review of the related internal controls and performs a thorough
examination of the balances at the beginning of the year.
d. a preliminary review of the related internal controls and performs extensive tests
of current-year property and equipment transactions.
4. A company has temporarily excess funds to invest. The board of directors decided to
purchase marketable securities, and it assigned the future purchase and sale decisions
to a responsible financial executive. The best person(s) to make periodic reviews of
the investment activity
a. investment committee of the board of directors.
b. treasurer
c. corporate controller
d. chief operating officer
316
5. if an auditor is unable to inspect and count a client's investment securities until after
the balance sheet date, the bank in which the securities are held in a safe deposit box
should be asked to
a. verify any differences between the contents of the box and the balances in the
client's subsidiary ledger.
b. provide a list of securities added to and removed from the box between the
balance sheet date and the security count date.
c. Confirm that there has been no access to the box between the balance sheet date
and the security count date.
d. Count the securities in the box so the auditor will have an independent direct
verification.
6. Which of the following would provide the best for of evidence pertaining to the
annual valuation of a long-term investment in which the independent auditor's client
owns a 30 percent voting interest?
a. Market quotations of the investee company's shares
b. Current fair value of the investee company's assets
c. Historical cost of the investee company's assets
d. Audited financial statements of the investee company
7. Which of the following controls is most likely to prevent the improper disposition of
equipment?
a. Separating duties between those authorized to dispose of equipment and those
authorized to approve removal work orders
b. Using serial numbers to identify equipment that could be sold
c. Periodically comparing removal work orders with authorizing documentation
d. Periodically analyzing scrap sales and the repairs and maintenance accounts
317
9. A company makes a practice of investing excess short-term cash in marketable
securities. A reliable test of the valuation of those securities is
a. Comparing cost data with current market quotations.
b. Confirming securities held by the broker.
c. Recalculating investment carrying value using the equity method.
d. Calculating premium or discount amortizations.
10. A company invests material amounts of idle cash in marketable securities. The auditor
has reason to believe that sub optimal use is being made of the idle cash. Which of the
following procedures would provide the most reliable evidence relative to this
concern?
a. Computing rate of return earned on investments and comparing it with alternative
investments
b. Reviewing minutes of the meetings of the company's investment committee
c. Confirming the security transactions and income received by contacting the
company's independent share brokers
d. Comparing actual with budgeted investment income earned
11. No employee should be able to visit the corporate safe deposit box containing
investment securities without being accompanied by another corporate employee.
What consequence might follow if this rule were not enforced?
a. An employee could pledge corporate investments as security for a short-term
personal bank loan.
b. An employee could still securities and the theft would never be discovered.
c. It would be impossible to get a fidelity bond on the employee.
d. There would be no record of when company personnel visited the safe deposit
box.
12. In establishing the existence and ownership of a long-term investment in the form of
publicly traded shares, an auditor should inspect the securities or
a. correspond with the investee company to verify the number of shares owned.
b. inspect the audited financial statements of the investee company.
c. confirm the number of shares owned that are held by an independent custodian.
d. determine that the investment is carried at the lower of costs or market.
13. Long-lived assets include which of the following?
a. Tangible assets such as equipment
b. Intangible assets such as patents
c. Natural resources
d. All of the above
15. Which of the following is not an inherent risk related to long-lived asset accounts?
a. Failing to record asset disposals.
b. Capitalizing repairs and maintenance expense.
c. Changing depreciation estimates to manage earnings.
d. All of the above.
16. Which of the following risks is an inherent risk related to asset impairment?
a. Determining asset impairment is based on management judgement.
b. It is difficult to identify the costs associated with the discovery of natural
resources.
c. Management might have incentives to not record all asset disposals.
d. All of the above are inherent risks related to asset impairment.
319
17. Which of the following statements is false regarding fraud risk factors related to
long-lived assets, tangible and intangible?
a. A potential fraud scheme involves not removing sold assets from the books.
b. Because long-lived assets are typically an audit area of law risk, auditors do not
need to perform brainstorming activities related to long-lived assets.
c. Management might use unreasonably long depreciable lives in an effort to reduce
expenses.
d. None of the above statements is false.
18. Which of the following controls would be most useful in providing reasonable
assurance about the valuation of tangible assets?
a. A policy requiring the reconciliation of the physical asset count with the property
ledger.
b. A policy requiring that depreciation categories and lives be periodically assessed.
c. A formal budgeting process.
d. Written policies requiring authorization for the acquisition of long-lived assets.
19. Which of the following controls should management have in place to provide
reasonable assurance about asset impairment judgments?
a. A policy requiring the reconciliation of the physical asset count with the property
ledger.
b. Limits to physical access of long-lived assets.
c. A systematic process to identify assets that are not currently in use.
d. A formal budgeting process.
20. An auditor performing preliminary analytical procedures scans the repairs and
maintenance accounts. Which of the following statements is consistent with the
auditor is most likely focused on?
a. Expenditures for long-lived assets have not been changed to expense.
b. Expenditures for long-lived assets have been properly approved.
c. Expenditures for long-lived assets have been recorded in the correct period.
d. The auditor would not be performing scanning as a preliminary analytical
procedure.
320
Exercises
Exercise 1
A 20X0 study on fraudulent financial reporting noted ways in which long-lived assets can
be fraudulently overstated, including:
Fictitious assets on the books
Improper and incomplete depreciation
Failure to record impairment of assets, especially goodwill
Expired or worthless assets left on a company’s books
Assets overvalued upon acquisition, especially in the purchase of a company
Required:
Exercise 2
Explain how skeptical auditor might come to understand management’s potential for
adjusting earnings through manipulation of fixed-asset accounts.
Exercise 3
Exercise 4
Consider the risks typically associated with intangible long-lived assets and identify the
internal controls over these assets that you would expect a client to have in place.
Exercise 5
Consider the risks typically associated with intangible long-lived assets and identify the
internal controls over these assets that you would expect a client to have in place.
321
Exercise 6
Required:
1. Does the client periodically take a physical inventory of property and reconcile tothe
property ledger?
2. Does the client have a policy manual to classify property and assign an estimated life
for depreciation purposes to the class of assets?
3. Does the client have a policy on minimum expenditures before an item is capitalized?
If yes, what is the minimum amount?
4. Does the client have a mechanism to identify pieces of equipment that have been
designated for scrap? If yes, is it effective?
5. Does the client have an acceptable mechanism to differentiate major renovations from
repair and maintenance? If yes, is it effective?
6. Does the client regularly self-construct its own assets? If yes, does the client have an
effective procedure to appropriately identify and classify all construction costs?
7. Does the client systematically review major classes of assets for potential
impairment?
322
Exercise 7
The audit senior has asked out to perform analytical procedures to obtain substantive
evidence on the reasonableness of recorded depreciation expense of the delivery vehicles
of a client. Changes in the account occurred pretty much evenly during the year. The
estimated useful life in six years. Estimated salvage value is 10% of original cost.
Straight-line depreciation is used.
Additional information:
Based on this information, estimate the amount of depreciation expense for the year using
analytical procedures. Does the recorded depreciation expense seem acceptable? Explain.
What is the impact of this analytical procedure on other substantive procedures that the
auditor may perform?
323
Chapter
PHASE II -
RISK RESPONSE:
AUDIT OF THE
FINANCING CYCLE
1. Enumerate and describe the steps involved in auditing the financing cycle.
2. Describe the nature and the major classes of transactions in the financing
cycle.
4. Apply the risk assessment and risk response phases of the audit process i.e.,
test of controls and substantive tests of transactions in the financing cycle.
CHAPTER 10
INTRODUCTION
This chapter covers the explanation of the financing cycle, the types of transactions in this cycle
and the internal control environment and objectives pertaining thereto. Consideration is then
given to compliance tests of controls and substantive tests of transactions in the financing cycle.
In the audit of the financing cycle, the following activities should be undertaken:
1. Identify the activities and types of transactions that occur in a company's financing cycle;
3. Determine the essential features of internal control over the above-mentioned transactions;
5. After evaluating the effectiveness of internal control, perform substantive audit procedures
to determine whether financial statement assertions are materially correct on accounts
affected by the financing cycle.
Steps 1 to 5 are discussed in this chapter while Step 6 is covered in Chapters 17 and 18.
Financing cycle includes the processes, procedures and policies for authorizing, executing and
recording transactions involving bank loans, leases, bonds payable and equity share capital.
This cycle involves the responsibilities of planning the cash needs and raising capital. Every
business must receive money to finance the acquisition of productive assets used to produce
revenue. Manager of the business may obtain funds from investors who become owners or from
lenders who become creditors, thus creating owners' equity and long-term debts.
325
Activities Related to Financing Cycle
Figure 10-1 and Figure 10-2 show the overview of the accounts and entries to record the
transactions in the Financing Cycle.
Notes payable
Contracts payable
Mortgages payable
Bonds payable
Interest expense
Accrued interest
Cash in the bank
Capital stock — common
Capital stock — preferred
Paid-in capital in excess of par
Donated capital
Retained earnings
Appropriations of retained earnings
Treasury stock
Dividends declared
Dividends payable
Proprietorship — capital account
Partnership — capital account
The pertinent documents and records used in the Expenditure Cycle (Chapter 7) are also used in
the financing cycle. In addition, the following forms may also be encountered:
Share Certificate. An engraved form showing the number of shares of shares owned by a
shareholder In a corporation.
Bond Certificate. An engraved form showing the number of bonds owned by a bondholder.
Bond Indenture. A contract stating the terms of the bond issue between the bondholder and the
issuing entity.
Broker's Advice. A statement from a broker specifying the details of an investing transaction.
Promissory Note. A financial instrument evidencing the promise to pay a loan granted to the
enterprise.
328
AUDITING THE FINANCING CYCLE
Basic Considerations
An entity's financing cycle consists of transactions pertaining to the acquisition of capital funds
through borrowings from and others, the subsequent short-term and long-term excluding trade
credit, and share capital and the subsequent redemption and reacquisition of these securities.
This cycle includes the sequence of procedures for authorizing, executing and recording
transactions that involve bank loans, mortgages, bonds payable and share capital. The
payments of interest and dividends are also an integral part of the financing cycle.
Audit risk is similar to the risk for investing cycle transactions and balances. Ordinarily, control
risk is low and the auditor can also keep detection risk at a low level. Possible errors related to
financing activities include the following:
As part of performing risk assessment procedures, the auditor obtains information that is
useful in assessing the risk of material misstatement. This includes information about
inherent risks at the financial statement level (for example, the client's business and
operational risks, financial reporting risks) and at the account and assertion levels, fraud
risks including feedback from audit team brainstorming sessions, strengths and
weaknesses in internal control, and results from preliminary analytical procedures. Once
the risks of material misstatement have been identified, the auditor then determines how
best to respond to them as part of the audit opinion formulation process.
329
Identifying Inherent Risks
Inherent risks related to debt obligations primarily concern the authorization of debt, receipt of
funds, recording of debt transactions, and compliance with any debt covenants. For
authorization, inherent risks include incurring debt that is not properly authorized or reviewed.
Similarly, there are risks that new debt, debt extinguishments, or debt payment transactions are
not properly authorized. In terms of recording debt transactions, risks include interest expense
not being properly recorded or accrued and debt not being classified or recorded in accordance
with PFRS. Regarding debt covenant compliance issues, inherent risks relate to whether debt
covenants are calculated accurately and whether compliance with debt covenants is
appropriately reviewed and disclosed.
Standards of auditing require the auditor to identify and assess the risks of material
misstatement due to fraud at the financial statement level and at the assertion level. As part of
brainstorming activities, the auditor should identify possible frauds that could occur such as
violation of debt covenants.
Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement associated with debt obligations, the auditor needs to understand the controls that
the client has designed and implemented to address those risks. Remember, the auditor is
required to gain an overall understanding of internal controls for both integrated audits and
financial statement only audits. Such understanding is normally gained by means of a
walkthrough of the process, inquiry, observation, and review of the client's documentation. The
auditor considers both entity-wide controls and transaction controls at the account and assertion
levels. This understanding provides the auditor with a basis for making an initial control risk
assessment.
330
Performing Preliminary Analytical Procedures
When planning the audit, the auditor is required to perform preliminary analytical procedures.
These procedures can help auditors identify areas of potential misstatements.
The following are examples of typical analytical procedures related to debt obligations:
Perform a trend analysis of the balances in notes payable, interest expense, and accrued
interest with prior periods, considering known client activities related to debt.
Estimate interest expense based on average interest rates and average debt outstanding.
Calculate debt-to-equity ratios and perform a trend analysis with prior periods.
Calculate the times interest earned ratio and perform a trend analysis with prior periods.
Inherent risks relate to shareholder's equity transactions vary across the specific activities.
Figure 10-3 outlines some of the common inherent risks associated with typical
shareholders' equity activities.
331
Figure 10-3: Inherent Risks Associated with Shareholders' Equity Activities
Inherent Risk
Sales and Issuances of Equity Shares Issuances / sales are not authorized in
accordance with organization's bylaws.
Stock issuances / sales are recorded in wrong
period.
Stock issued in exchange for goods / services
is not properly valued.
Equity activities are not properly disclosed in
accordance with FRS.
Purchase of Treasury Shares All shares repurchased is not recorded as
treasury shares.
Treasury share transactions are recorded in
wrong period.
The cost of treasury shares that is
subsequently retired is not allocated among
the appropriate accounts.
Dividend Dividends may be recorded and paid before
being declared.
Dividends may not be properly approved
before being declared.
Dividends are recorded in the wrong period.
Share Options and Warrants Options / warrants are granted without being
properly approved.
Inadequate records as to options / warrants
issued but not exercised.
Options exercised or expired remain on the
organization's books.
Option / warrant grants are not properly
valued due to inappropriate assumptions or
models.
Inappropriate amortization methods are used.
Inaccurate period of service is used.
Other potential frauds related to shareholders' equity accounts include the following:
332
Share options exercised are not authorized or are not in accordance with the terms of
options granted.
Once the auditor has obtained an understanding of the inherent and fraud risks of material
misstatement associated with shareholders' equity transactions, the auditor needs to understand
the controls that the client has designed and implemented to address those risks. Remember, the
auditor is required to gain an overall understanding of internal controls for both .integrated
audits and financial statement only audits. Such understanding is normally gained by means of
a walkthrough of the process, inquiry, observation, and review of the client's documentation.
The auditor considers both entity-wide controls and transaction controls at the account and
assertion levels. This understanding provides the auditor with a basis for making an initial
control risk assessment.
When planning the audit, the auditor is required to perform preliminary analytical procedures.
These procedures can help auditors identify areas of potential misstatements.
The primary preliminary analytical procedure for shareholders' equity account is a comparison
of current year account balances with prior-year account balances. The auditor should have an
expectation as to the nature And magnitude of any account balance changes.
If preliminary analytical procedures do not identify any unexpected relationships, the auditor
would conclude that a heightened risk of material misstatement does not exist in these accounts.
333
PHASE II - RISK RESPONSE
Some effective internal control measures over financing cycle transactions that may be adopted
by the client and assessed by the auditor are as follows:
1. Current liabilities (other those arising from trade credit and operating expenses)
2. Long-term liabilities
b) There should be proper control over issued and unissued obligations as in bonds, by
an independent bond trustee or transfer agent.
c) Redeemed bonds should be canceled, properly mutilated and retained for auditor in
order to prevent the authorized issuance.
d) Bond ledger should be used in which details of bonds issued, canceled and
outstanding are shown. A subsidiary bondholders' ledger should also be maintained
by the issuing corporation or the bond trustee for bonds registered, as to principal and
payment.
334
3. Equity share capital
a) Internal control measures regarding the issuance of share certificates and proper
accounting for transfer and registration of shares should be established. One of these
measures is the appointment of share and transfer agent or an independent register.
b) Share certificates should be serially prenumbered by the printer and that the authority
for signing and issuing the certificates be designated by the board of directors.
e) Entries for share issuances and transfers should be made by a person who does not
have authority to sign and issue certificate.
The audits of debt obligation and shareholder's equity transactions typically involve only
substantive procedures. Debt obligation accounts are tested with both substantive
analytical procedures and tests of details. In contrast, only tests of details are typically used
to audit shareholders' equity accounts. Further the transactions in the shareholders' equity
accounts are typically tested 100% because they are usually so few, and yet they are highly
material.
Determining what changes, if any, have been made to prior loan agreements
Confirming with relevant outside parties the significant factors and transactions that have
occurred
335
As a starting point for these procedures, the auditor will have the client provide a schedule of
debt obligations and interest. The client should also have a bond premium / discount
amortization schedule that the auditor can review in assessing whether bonds are appropriately
valued and disclosed in the financial statements. For additions to debt, the auditor traces the
proceeds into the cash receipts records and the bank statement. The auditor might also examine
the debt instrument and obtain assurance regarding board approval of the debt through review
of board meeting minutes. For debt reductions, the auditor examines payments through the cash
disbursements records, possibly including canceled checks. Also, for notes or mortgages that
have been paid in full, the auditor should examine the canceled notes.
The auditor should obtain an understanding of the procedures the client uses to determine
whether they are in compliance with their debt covenants. The auditor should then
independently determine if the client is in compliance.
a. As a starting point for testing capital stock and equity transactions, the auditor should
review a copy of the client's article of incorporation. This document provides relevant
information with respect to each class of stock. The auditor can agree that information to
the disclosures included in the client's financial statements. The auditor will also prepare,
or ask the client to prepare, an analysis of all capital stock transactions.
b. The auditor will inspect documentation related to the client's record keeping of capital
stock and contributed capital. This documentation may be maintained by the client or held
by a transfer agent. Review of this documentation provides the auditor with evidence
related tot the existence and completeness of capital.
c. To obtain evidence related to the valuation of capital stock, the auditor should review the
minutes of the board of directors meetings and examine the stock records books (or
confirm with the registrar and transfer agent) to determine issuance and repurchase of
capital stock.
d. For those clients with treasury stock, the auditor will examine documentation supporting
changes in the number of shares since the prior year. This documentation might include
obtaining confirmation from the stock transfer agent and tracing the transaction through
the cash receipts or cash disbursements journal.
336
e. Dividends
1. The auditor examines the minutes of the board of directors meetings for authorization
of the dividends per share amount and the dividend record date.
2. The auditor will also want to obtain evidence as to whether the payment was made to
the stockholders who owned the stock as of the dividend record date. The auditor can
trace the payee’s name on the canceled check to the dividend records to make sure the
payee was to have received the dividend.
3. The auditor also needs to be aware of restrictions related to dividend payments and
determine that the restrictions are adequately disclosed in the financial statements.
f. Retained earnings— The auditor typically examines all transactions recorded in the
retained earnings account during the audit period. The common entries include net income
or loss. These amounts would be tested through substantive audit procedures related to
revenues and expenses. The other common entry includes dividends. If there are additional
entries, the auditor examines documentation supporting that the entries should be
included. For example, if there is correction of an error from a prior period, the auditor
determines that the correction is made in accordance with relevant accounting standards.
337
REVIEW QUESTIONS AND EXERCISES
Questions
1. Identify the transactions involved in financing activities and explain their relationship
to other cycles.
2. It is common practice to audit and the balance in notes payable in conjunction with the
audit of interest expense and interest payable. Explain the advantages of this
approach.
3. Which internal controls should the auditor be most concerned about in the audit of
notes payable? Explain the importance of each.
4. List four types of restrictions long-term creditors often put on companies when
granting them a loan. How can the auditor find out about each of these restrictions?
6. Evaluate the following statement: "The most important audit procedure to verify
dividends for the year is a comparison of a random sample of canceled dividend
checks with a dividend list that has been prepared by management as of the dividend
record date."
8. What: are the relevant accounts and related to shareholders' equity transactions?
13. Given typical inherent and fraud risks related to material misstatement of debt
obligations, identify controls that an auditor would expect a client to have
implemented.
14. Given typical inherent and fraud risks related to material misstatement of
shareholders' equity accounts, identify would expect a client to have implemented.
338
Multiple Choice Questions
1. One control objective of the investing and financing cycle is the proper authorization
of company transactions dealing with debt and equity instruments. Which of the
following controls would best meet this objective?
a. Separating responsibility for custody of funds from responsibility for recording
the transactions
b. Maintaining written company policies that require the board of directors to
review major funding or repayment proposals
c. Using an underwriter in all cases of new issue of debt or equity instrument
d. Requiring two signatures on all organization checks of a material amount
2. During the year under audit, a company has completed a private placement of
substantial amount of bonds. Which of the following is the most important step in the
auditor's program for the examination of bonds payable?
a. Confirming the amount issued with the bond trustee.
b. Tracing the cash received from the issue to the accounting records.
c. Examining the bond records maintained by the transfer agent.
d. Recomputing the annual interest cost and the effective yield.
3. Several years ago, Conway Inc., secured a conventional real estate mortgage loan.
Which of the following audit procedures would be least likely to be performed by an
auditor examining the mortgage balance?
a. Examine the current years' canceled checks.
b. Review the mortgage amortization schedule.
c. Inspect public records of lien balances.
d. Recomputed mortgage interest expense.
339
5. Which of the following accounts would not typically be included in the audit of debt
obligations?
a. Interest income
b. Interest expense
c. Bonds payable
d. Notes payable
6. Inherent risks related to debt obligations primarily include which of the following?
a. Debt is not properly authorized
b. Interest expense is not properly accrued
c. Debt covenants are not properly disclosed
d. All of the above are inherent risks related to debt obligations
7. Which of the following is not an inherent risk typically associated with the existence
of dividends?
a. Dividends are recorded before being declared
b. Dividends are not properly amortized
c. Dividends have not been approved before being declared
d. Dividends are recorded in the wrong period
8. Which of the following would an auditor typically not perform as part of gaining an
understanding of the client's controls related to debt obligations?
a. Review the client's documentation of controls
b. Recalculate interest expense
c. Inquire of management about the process of reviewing compliance with debt
covenants
d. Review policies related to approval required for new debt
9. Which of the following is a control the auditor would expect a client to have related to
shareholders' equity transactions?
a. A policy requiring approval by the board of directors for all stock transactions
b. Reconciliation of equity accounts to the general ledger
c. CFO and CEO authorization of all stock transaction approved by the board of
directors
d. The auditor would typically expect all of the above controls to be in place
340
10. Which of the following statements is true regarding preliminary analytical procedures
for debt obligations and shareholders' equity transactions?
a. Because there are typically only a few shareholders’ equity transactions, the
auditor is not required to perform preliminary analytical procedures for
shareholders' equity accounts
b. Trend analysis would not typically be performed for debt obligations
c. The long-term debt to equity ratio could be considered by the auditor as part o the
preliminary analytical procedures
d. All of the above statements are true
Exercises
Exercise 1
Items 1 through 6 are questions typically found in a standard internal control questionnaire
used by auditors to obtain an understanding of internal control structure for notes payable.
In using the questionnaire for a particular client, a "yes" response indicates a possible
internal control, whereas a "no" indicates a potential weakness.
1) Are liabilities for notes payable incurred only after written by a proper company
official?
2) Is a notes payable master file maintained?
3) Is the individual who maintains the notes payable master file someone other than the
person who approves the issue of new notes or handles cash?
4) Are paid notes canceled and retained in the company files?
5) Is a periodic reconciliation made of the notes payable master file with the actual notes
outstanding by an individual who does not maintain the master file?
6) Are interest expense and accrued interest recomputed periodically by an individual
who does not record interest transactions?
Required:
a. For each of the preceding questions, state the purpose of the control.
b. For each of the preceding questions, identify the type financial statement error that
could occur if the control were not in effect.
c. For each of the potential errors in part b, list an audit procedure that can be used to
determine whether a material error exists.
341
Exercise 2
The auditor should review the bond indenture at the time a bond is issued and anytime
subsequent changes are made to it.
a. Briefly identify the information the auditor would expect to obtain from a bond
indenture. List at least five specific pieces of information that would be relevant to the
conduct of the audit.
c. A company issued bonds at a discount. Explain how the amount of the discount is
computed and how the auditor could determine whether the amount is properly
amortized each year.
d. Explain how the auditor could verify that semiannual interest payments are made on
the bond each year.
e. The company has a 15-year, P20 million loan that is due on September 30 of next
year. It is the company's intent to refinance the bond before it is due, but it is waiting
for the best time to issue new debt. Because its intent is to issue the bond next year,
the company believes that the existing $20 million bond need not be classified as a
current liability. What evidence should the auditor gather to determine the appropriate
classification of the bond?
Exercise 3
The following covenants are extracted from a bond indenture. The indenture provides that
failure to comply with its terms in any respect automatically advances the due date of the
loan to the date of noncompliance (the maturity date is 20 years hence). Identify the audit
steps that should be taken or reporting requirements necessary in connection with each one
of the following scenarios:
a. The debtor company shall endeavor to maintain a working capital ratio of 2 to 1 at all
times, and, in any fiscal year following a failure to maintain the said ratio, the
company shall restrict compensation of the CEO and executive officers to a total of no
more than P500,000. Executive officers for this purpose shall include the chairman of
the board of directors, president, all vice presidents, the secretary, and the treasurer.
342
b. The debtor company shall insure all property that is security for this debt against loss
by fire to the extent of 100% of its value. Insurance policies securing this protection
shall be filed with the trustee.
c. The debtor company shall pay all taxes legally assessed against the property that
serves as security for this debt within the time provided by law for payment without
penalty and shall receipted tax bills or equally acceptable evidence of payment of the
same with the trustee.
343
UNIT IV
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE II - RISK RESPONSE:
SUBSTANTIVE TESTS OF
DETAILS OF BALANCES
Chapter
11 Audit of Cash Balances
344
14 Audit of Investments
345
Chapter
AUDIT OF
CASH BALANCES
1. Describe the auditors' objectives for the substantive audit of cash in bank and
on hand.
INTRODUCTION
Since cash generally has a higher degree of inherent risk, more audit time is devoted to the audit
of the account than is indicated by its peso amount. The amount of cash flowing in and out of
the cash account is frequently larger than for any other account in the financial statement.
Furthermore, the susceptibility of cash to defalcation is greater than for other types of assets
because most other assets must be converted to cash to make them usable.
As discussed in the preceding chapters, the following misstatements which result in the
improper payment of or failure to receive cash may be uncovered through the tests of controls
and substantive tests of transactions.
1. Failure to bill a customer
2. Billing a customer at a price lower than called for by company policy
3. Abstraction of cash receipts from customers before they are recorded
4. Duplicate payment of a vendor’s invoice
5. Improper payments of officers' personal expenses
6. Payment for merchandise or goods that were not received
7. Payment to an employee for more hours than he or she has worked
8. Payment of interest to a related party for an amount far exceeding the going rate
The first three misstatements could be uncovered as part of the audit of the revenue and cash
receipts cycle, the next three in the audit of the acquisition and payment cycle, and the last two
in the tests of the payroll and personnel cycle and the financing and investing cycle,
respectively.
Entirely different types of misstatements are normally discovered in applying substantive test
of details of balances. Examples are
a. Cash received by the client subsequent to the statement of financial position date but
recorded as cash receipts in the current year
b. Deposits recorded as cash receipts near the end of the year, deposited in the bank in the
same month but still reported as a deposit in transit in the bank reconciliation
c. Understatement of the outstanding checks in the bank reconciliation
d. Payments on notes payable debited directly to bank balance by the banks but not entered in
the client's records
347
The appropriate methods for discovering the preceding misstatements by testing the client's
bank reconciliation will become clearer as we proceed. At this point, it is important only that
the reader distinguish between tests of controls and substantive tests of transactions that are
related to the cash account and tests that determine whether the book balance reconciles to the
bank balance.
To blend the conceptual and procedural aspects of substantive tests for cash balances as well as
for other accounts, the audit program presented is keyed to and discussed in the context of the
financial statement assertions discussed later.
This schedule will typically list the bank, the account number, account type (current,
savings, time deposit) and the year-end balance per books. This balance will then be
traced and reconciled to the general ledger as necessary.
349
Figure 11-2: Confirmation Form
3. Perform cash count procedures for cash on hand
Existence of undeposited collections, petty cash funds and other funds may be verified
by conducting a surprise count of these funds. Figure 11-3 illustrates a cash count
sheet that the auditor may use.
In conducting the cash count the auditor should follow these procedures:
1) Control all cash and negotiable instruments held by the client until all funds have
been counted.
2) Insist that the custodian of the cash be present throughout the count.
3) Obtain a signed receipt from the custodian on return of the funds to the client.
4) Ascertain that all undeposited checks are payable to the order of the client either
directly or through endorsement. Figure 11-4 illustrates the working papers to
determine the adjusted balance of Petty Cash Fund.
If client provides the auditor with the reconciliation of the balance per the bank
statement at the statement of financial position date with the balance per the company’s
accounting records, he should examine such in detail to satisfy himself that is has been
properly prepared. A careful review of the client's reconciliation is important because a
cash shortage may be concealed by omitting a check from the outstanding checks list or
by purposely making an error in addition on the reconciliation. The examination of the
client-prepared bank reconciliation should also include:
Figures 11-5, 11-6, and 11-7 illustrate the forms of bank reconciliation. The forms most
frequently used by auditors are those shown in Figure 11-5 (Bank to Books) and Figure 11-7
(Adjusted balances).
351
Figure 11-3: Cash Count Sheet
Company
Name of Fund
Cash Count Date
(Signature of Cashier)
352
Figure 11-5: Bank Reconciliation Statement
(Bank Balance to Book Balance Method)
X Company
Bank Reconciliation Statement
December 31, 20X7
X Company
Bank Reconciliation Statement
December 31, 20X7
353
Figure 11-7: Bank Reconciliation Statement
(Adjusted Balances Method)
X Company
Bank Reconciliation Statement
December 31, 20X7
Unadjusted balance per bank Pxx
Add: Book debits not yet credited by the bank
(e.g., undeposited collections) xx
Less: Book credits not yet debited by the bank
(e.g., outstanding checks) (xx)
Adjusted bank balance Pxx
Unadjusted balance per books Pxx
Add: Bank credits not yet debited by the company
(e.g, proceeds of note collected by the bank) xx
Less: Bank debits not yet credited by the company
(e.g., bank charges) (xx)
Adjusted book balance Pxx
20X7
354
6. Obtain a cutoff bank statement containing transactions several days subsequent to
the statement of financial position date.
This statement should be sent directly by the bank to the auditor. Upon receipt of the
statement, the auditor should
(a) Trace all prior year dated checks to the outstanding checks listed on the bank
reconciliation.
(b) Trace deposits in transit on the bank reconciliation to deposits on the cutoff
statement.
(c) Scan the cutoff statement and enclosed data for unusual items.
7. Prepare proof of cash and reconcile cash transactions occurring during a specified
period as they are recorded by the bank and the client.
Figures 11-9, 11-10, and 11-11 illustrate the Proof of Cash working papers.
355
Figures 11-9: Proof of Cash or Reconciliation of Receipts and Disbursements
(Bank Balance to Book Balance Method)
X Company
Proof of Cash
For the month ended December 31, 20X7
356
Figures 11-10: Proof of Cash
(Book Balance to Bank Balance Method)
X Company
Proof of Cash
For the month ended December 31, 20X7
357
Figure 11-11: Proof of Cash (Adjusted Balances Method)
X Company
Proof of Cash
For the month ended December 31, 20X7
Nov. 30 December Dec. 31
Balance Receipts Disbursements Balance
Unadjusted book balance Pxx Pxx Pxx Pxx
Add (Deduct) Adjustments
Proceeds of note collected by bank
(recorded by the company in the
succeeding month)
November 30 xx (xx)
December 31 xx xx
Bank charges (recorded by the
company in the succeeding
month)
November (xx) (xx)
December xx (xx)
Adjusted book balance Pxx Pxx Pxx Pxx
358
8. Verify the client's cutoff of cash receipts and cash disbursements.
If a cash count can not be done on the statement of financial position date to verify the
accuracy of the client's cutoff of cash receipts, the auditor can trace the deposits in transit
on the year-end bank reconciliation to the credits on the bank statement on the first
business day of the new year.
To ensure an accurate cutoff of cash disbursement, the auditor should determine the
number of the last check prepared on each bank account on the statement of financial
position date and verify whether all checks up to this number have actually been mailed.
For cash receipts, the auditor should verify the number of the last official receipt and cash
sales invoice used on the statement of financial position date.
The auditor should review any bank overdrafts and note the existence of any funds that
may be subject to withdrawal restrictions in order to determine the effect(s) (if any) on
financial statement presentation.
10. Verify existence of cash in bank under receivership, cash in foreign banks or in foreign
currency.
This can be done through examination of minutes, loan agreements and confirmations.
11. Investigate any checks representing large or unusual payments to related parties.
359
Illustrative Audit Case 11-1: Petty Cash Fund and Undeposited Collections
Lina Reyes is the cashier of the Luzon Glass Company. As representative of the Santos, Tan
and Associate, CPAs, you were assigned to verify her cash on and in the morning of January 4,
20X8. You began to count at 9:00 A.M. in the presence of Miss Reyes. In the course of your
counting, you found currencies in paper bills and coins together wit checks, vouchers and other
items, which are mentioned below:
Bills
9 one hundreds, 25 fifties, 50 twenties, 120 tens
Coins
P5.00 - 4 rolls and 5 loose (50 pieces to a roll)
1.00 - 8 rolls and 15 loose (100 pieces to a roll)
0.25 - 2 rolls and 2 loose (500 pieces to a roll)
0.10 - 3 rolls and 40 loose (500 pieces to a roll)
0.05 - 2 rolls (400 pieces to a roll)
Checks
Maker Date Payee Amount
Rose Manalo,
12/23/X7 Luzon Glass Co. P600
Asst. Manager
Miss L. Reyes,
12/26/X7 Luzon Glass Co. 400
Cashier
I.O.U.s
A. David, Janitor 12/20/X7 P350
R. Tirao, Clerk 12/22/X7 250
Pedro Munar,
12/24/X7 150
Bookkeeper
360
Your investigation also disclosed the following:
Required:
1. Prepare working papers showing your cash count.
2. Prepare necessary adjusting journal entries without explanation as of December 31, 20X7.
3. Determine the amount at which the Petty Cash Fund will be stated in the statement of
financial position as of December 31, 20X7.
EXHIBIT 11-1
Requirement (1)
Luzon Glass Company
Cash Count Sheet
January 4, 20X8
361
Unreplenished vouchers
Date Payee Particulars
12/18/X7 Rosario & Co. Supplies P145.00
12/18/X7 Victory Liner Freight-in 182.50
12/18/X7 Bureau of Posts Supplies 300.00
12/20/X7 A. Vallo Repairs 450.00
12/21/X7 B. Tello Miscellaneous 154.00
1,231.50
Advances or IOUs
Date Payee
12/16/X7 L. Cruz P100.00
12/23/X7 A. David 350.00
12/22/X7 R. Tirao 250.00
12/24/X7 P. Munar 150.00 850.00
I certify that the above fund of P9,716.00 was counted in my presence by (name of auditor) of Santos, Tan
and Associate, CPAs on January 4, 20X8 at 9:00 AM and was returned to me intact.
Lina Reyes
LINA REYES
Cashier
Prepared by: Reviewed by:
Initial Date Initial Date
Requirement (2)
362
Requirement (3)
Luzon Glass Company
Petty Cash Fund
December 31, 20X7
Balance per ledger P9,000.00
Add (Deduct) Adjustments
AJE (1) To take up unreplenished expenses (1,231.50)
(2) To take up advances to
(850.00)
employees
(3) To take up shortage per cash
(864.00)
count
Net adjustment (2,945.50)
Balance as adjusted P6,054.50
Proof:
Bills and coins P6,634.50
Checks for deposit 1,000.00
Total cash counted P7,634.50
Less: Non-fund items
Unclaimed wages P580.00
Undeposited collections 1,000.00 1,580.00
Balance for Petty Cash Fund P6,054.50
Illustrative Case 11-2: Audit of Cash and elate Accounts using the Bank Reconciliation
Statement
The following example illustrates the preparation of a bank reconciliation and the required
adjusting entries for the Bulacan Corporation for the month ended June 30, 20X7. The
unadjusted cash balances are as follows:
1. A customer note P24,000 plus P240 interest was collected on June 30,20X7.
2. A customer check for P2,762.80 was returned because of insufficient funds (NSF
check).
3. The month service charge was P300.
363
A review of the company records discussed the following:
1. A deposit for P22,857.40 mailed to the bank on June 29, 20X7 did not appear on the bank
statement.
2. Customer checks totaling P6,548.00 were on hand at the end of June awaiting deposit.
3. The following company checks were outstanding at the end of June:
#862 P1,923.80
#864 2,943.60
#865 5,265.00
4. Check #843 written for P1,824.00 in payment of a creditor account and included with the
canceled checks in the bank statement has been erroneously recorded as P384.00 in the
company records.
BULACAN CORPORATION
Bank Reconciliation
June 30, 20X7
364
1. Cash 24,240.00
Notes Receivable (note collected) 24,240.00
The entries adjust the cash account to P268,496.00, the amount that would appear as the Cash
balance (along with any petty cash) on the June 30, 20X7 statement of financial position.
The independent certified public accountant responsible for auditing the company records
normally will prepare more comprehensive bank reconciliation. This type of reconciliation,
termed a proof of cash, incorporates the monthly cash receipts and payments to test the internal
control over cash and provides additional evidence of the accuracy of the cash balance.
Therefore, the proof of cash identifies the sources of differences between the company records
and the bank statement (such as receipts and disbursements). There are several forms of a proof
of cash (sometimes called a four-column reconciliation); again, our discussion focuses on the
form that arrives at adjusted balances. This form of the proof of cash begins with the
reconciliation made the previous month and accounts, in summary form, for all of the receipts
and payments that have transpired during the current month. In essence, the proof of cash
provides four separate reconciliations:
1. The reconciliation of the bank and book balance for the previous month.
2. The reconciliation of the receipts recorded by the bank for the current month with the
receipts recorded on the books.
3. The reconciliation of the payments recorded by the bank for the current month with
the payments recorded on the books.
4. The reconciliation of the bank and book balances for the current month.
The proof of cash for the Bulacan Corporation (Illustrative Audit Case 11-2)
requires the following in addition to that given in the preceding case:
The proof of cash for the Bulacan Corporation is shown in Exhibit 11-1.
BULACAN CORPORATION
Proof of Cash
June 30, 20X7
Reconciliation June June Reconciliation
May 31, 20X7 Receipts Payments June 30, 20X7
Balance per bank P272,348.40 P528,423.40 P551,548.80 P249,223.00
Deposit in transit:
May 24,803.00 (24,803.00)
June 22,857.40 22,857.40
Undeposited cash 6,548.00 6,548.00
Outstanding checks:
May 31, 20X7
#781 (3,263.00) (3,263.00)
#782 (4,258.00) (4,258.00)
June 30, 20X7
#862 1,923.80 (1,923.80)
#864 2,943.60 (2,943.60)
#865 5,265.00 (5,265.00)
Adjusted Balance P289,630.40 P533,025.80 P554,160.20 P268,496.00
366
Illustrative Case 11-4: Cash and Other Items
The following information has been extracted from the accounting records of the Oracle,
Corporation:
Required:
Determine the balance in Oracle’s Cash account, and discuss the statement of financial position
treatment of any items not included as cash.
367
Illustrative Audit Case 11-5: Reconciliation of Bank and
Company Cash Amounts
The December 31, 20X7 bank statement for Miguel Corporation showed a P2,049.25 balance.
On this date the company’s Cash account reflected a P325.60 overdraft. In reconciling these
amounts, the following information is discovered:
1. Cash on hand for undeposited sales receipts, December 31, 20X7, P130.25.
2. Customer NSF check returned with bank statement, P420.40.
3. Cash sales of P640.25 for the week ended December 18, 20X7 were recorded on the
books. The cashier reports this amounts missing, and it was not deposited in the bank.
4. Note receivable of P2,500 and interest of P25 collected by the bank and not recorded
on the books.
5. Deposit in transit December 31, 20X7, P350.00.
6. A customer check for P290.40 in payment of its account was recorded on the books at
P940.20.
7. Outstanding checks, P2,040.55. Includes a duplicate check of P70.85 to G. Violet,
who notified Miguel that the original was lost. Miguel stopped payment on the
original check and has already adjusted the cash account in the accounting records for
this amount.
Required:
1. Prepare a December 31, 20X7 bank reconciliation for Miguel Corporation.
2. Prepare any journal entries necessary by Miguel Corporation to record the information
from Requirement 1.
Requirement 1
MIGUEL CORPORATION
Bank Reconciliation
December 31, 20X7
368
Balance from company records P(325.60)
Add: Note collected by bank P2,500.00
Interest on note 25.00 2,525.00
P2,199.40
Deduct: Missing deposit P640.25
Error in recording collection (P940.20-P290.40) 649.80
NSF check
420.40 (1,710.45)
returned
Adjusted cash balance P488.95
*Since the cash account has been adjusted for the original P70.85 check to G. Violet and
payment has been stopped, the outstanding checks do not include the original check and no
adjustment needs to be made.
Requirement 2
20X7
31 Cash 2,525.00
Notes
P2,500.00
Receivable
Interest
25.00
Revenue
369
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
1. "When auditors are, verifying a client's bank reconciliation they are particularly
concerned with the possibility that the list of outstanding checks may include a
nonexistent or fictitious check, and also are concerned with the possibility of omission
from the reconciliation of a deposit in transit." Criticize the above quotation and
revise it into an accurate statement. (AICPA adapted)
2. During the first few months of the year Olano, the cashier in a small company, was
engaged in lapping operations. However, she was able to restore the amount of cash
"borrowed" by March 31, and she refrained from any fraudulent acts after that date.
Will the year-end audit probably lead to the discovery of her lapping activities?
Explain.
3. Although the primary objective of an independent audit is not the discovery of fraud,
the auditors in their work on cash take into consideration the high relative associated
with this asset. One evidence of this attitude is evidenced by the CPA's alertness of
signs of lapping.
Required:
a. Define lapping.
b. Explain the audit procedures that CPAs might utilize to uncover lapping.
(AICPA adapted)
4. Describe the following types of cash accounts: (a) general checking accounts, (b)
cash management accounts, (c) imprest payroll accounts, and (d) petty cash accounts.
5. Match the following assertions with their associated description: (a) existence or
occurrence, (b) completeness, (c) rights and obligations, (d) valuation or allocation,
(e) presentation and disclosure.
i. Cash accounts are properly classified on the balance sheet and disclosed in the
notes to the financial statements.
ii. Cash balances exist at the balance sheet date.
iii. The recorded balances reflect the true underlying economic value of those assets.
iv. The company has title to the cash accounts as of the balance sheet date.
v. Cash balances include all cash transactions that have taken place during the
period.
6. Evaluate the following statement made by a third year auditor: "In comparison with other
accounts, such as accounts receivable or property, plant and equipment, it is my
assessment that cash contains less inherent risk. There are no significant valuation
problems with cash." Do you agree or disagree with the auditor's assessment of inherent
risk? Explain.
7. Give two reasons audit work on cash is likely to be more extensive than might appear to be
adjustified by the relative amount of the balance sheet figure for cash.
8. "If the auditors discover any evidence of employee fraud during their work on cash, they
should extend their investigation as far as necessary to develop a complete set of facts,
regardless of whether the amounts involved are or not material." Do you agree with the
quoted statement? Explain.
9. During the audit of a small manufacturing firm, you find numerous checks for large
amounts drawn payable to the treasurer and charged to the Miscellaneous Expense
account. Does this require any action by the auditor? Explain.
10. What action should be taken by the auditors when the count of cash on hand discloses a
shortage?
371
Exercises
Exercise 1
During the audit of Evolution Building Supply, you are given the following year-end bank
reconciliation prepared by the client:
According to the client's accounting records, checks totaling P62,964 were issued between
January 1 and January 14 of the following year. You have obtained a cutoff bank statement
dated January 14 containing paid checks amounting to P100,880. Of the checks outstanding at
December 31, checks totaling P7,200 were not returned in the cutoff statement, and of those
issued per the accounting records in January, checks totaling P 16,400 were not returned.
Required:
a. Prepare a working paper comparing (l ) the total of all checks returned by the bank or still
outstanding with (2) the total per client's records of checks outstanding at December 31
plus checks issued from January 1-14.
b. Suggest four possible explanations for the situation disclosed in your working paper. State
what action you would take in each case, including any adjusting entry you would
propose.
Exercise 2
Listed below are eight interbank cash transfers for SPF Co., indicated by the letters a through h,
for late December 20X8 and early January 20X9.
For each of transfers a through h (l) indicate whether cash is understated, overstated, or correct
as a result; and (2) provide a brief example of what could cause the situation. Answer in a form
such as the one illustrated here.
Understated,
Transfer Overstated, or Example
Correct
a. Correct Book entries: The transfer was recorded in the accounting
records as a check written on the disbursing bank on
December 29 and a corresponding cash receipt recorded to
receiving bank on that date.
h.
Exercise 3
Items a through f represent the items that an auditor ordinarily would find on a client-prepared
bank reconciliation. The accompanying List of Auditing Procedures represents substantive
auditing procedure. For each item, select one or more procedures, as indicated, that the auditor
most likely would perform to gather evidence in support of that item. The procedures on the list
may be selected once, more than once, or not at all.
373
Assume
GENERAL COMPANY
Bank Reconciliation
st
1 National Bank of US Bank Account
September 30, 20X5
a. Select 2 procedures Balance per bank P28,375
b. Select 5 procedures Deposits in transit
9/29/X5 P4,500
9/30/X5 1,525 6,025
34,400
c. Select 5 procedures Outstanding checks
#988 8/31/X5 2,200
#1281 9/26/X5 675
#1285 9/27/X5 850
#1289 9/29/X5 2,500
#1292 9/30/X5 7,225 (13,450)
20,950
d. Select 1 procedure Customer note collected by bank (3,000)
e. Select 2 procedures Error: Check #1282; written on 9/26/X5
374
Exercise 4
Auditors perform a number of procedures relating to cash - some unique, some not unique. For
each substantive procedure below, identify its primary objective or indicate that the procedure
serves no purpose.
Substantive Procedures:
Exercise 5
You are the senior auditor-in-charge of the July 31, 20X0, audit of Reliable Auto Part, Inc.
Your newly hired staff assistant reports to you that she is unable to complete the four-column
proof of cash for the month of April 20X0, which you instructed her to do as part of the
consideration of internal control over cash.
You assistant shows you the working paper that she has prepared. Your review of your
assistant's work reveals that the dollar amounts of all items in her working paper are correct.
You learn that the accountant for Reliable Auto Parts, Inc., makes no journal entries for bank
service charges or note collections until the month following the bank’s recording of the item.
In addition, Reliable’s account makes no journal entries what soever for NSF check that are
redeposited and cleared. Your assistant’s working paper appears below.
RELIABLE AUTO PARTS, INC.
Proof of Cash for April 20X0
July 31, 20X0
Balance Balance
Deposits Checks
3/31/X0 4/30/X0
Per bank statement P71,682.84 P61,688.19 P68,119.40 P65,051.63
Deposit in transit:
At 3/31/X0 2,118.18 (2,118.18)
At 4/30/X0 4,918.16 4,918.16
Outstanding checks:
At 3/31/X0 (14,888.16) 14,888.16
At 4/30/X0 (22,914.70) 22,914.70
Bank service charges:
March 20X0 (22.18) 22.18
April 20X0 (19.14) 19.14
Note receivable collected by bank 4/30/X0 18,180.00 18,180.00
NSF check of customer L. G. Wang,
charged back by bank 3/31/X0,
redeposited and cleared 4/3/X0 (418.19) 418.19
Balance as computed 58,472.49 85,004.54 60,095.90 108,964.45
Balances per book 59,353.23 45,689.98 76,148.98 28,294.23
Unlocated difference P(880.74) P39,314.56 P(16,053.08) P80,071.22
Required:
Prepare a corrected four-column proof of cash in good form for Reliable Auto Parts, Inc., for
the month of April 20X0.
376
Problems
Problem 1
The following client-prepared bank reconciliation is being examined by Karen, CPA, during an
examination of the financial statements of Concrete Products, Inc.:
Required:
Identify one or more substantive audit procedures that should be performed by Karen by
gathering evidence in support of each of the items (a) through (f) in this bank reconciliation.
377
Problem 2
Toyco, a retail toy chain, honors two bank credit cards and makes daily deposits of credit card
sales in two credit card bank accounts (Bank A and Bank B). Each day, Toyco batches its credit
card sales slips, bank deposit slips, and authorized sales return documents, and send them to
data processing for data entry. Each week, detailed computer printouts of the general ledger
credit card cash accounts are prepared. Credit card banks have been instructed to make an
automatic weekly transfer of cash to Toyco’s general bank account. The credit card banks
charge back deposits that include sales to holders of stolen or expired cards. The auditor
examining the Toyco financial statements has obtained copies of the detailed general ledger
cash account printouts, a summary of the bank statements, and the manually prepared bank
reconciliations, all for the week ended December 31, as shown here.
Review the December 31 bank reconciliation and the related information contained in the
following schedule and describe what actions the auditor should take to obtain evidence for
each item on the bank reconciliation. Assume that all amounts are material and that all
computations are accurate. Organize your answer sheet as follows, using the code contained on
the bank reconciliation.
Toyco
Bank Reconciliation
for December 31, 20X3
Bank A Bank B
Code No. Add or (Deduct)
1. Balance per bank statement, December 31 P8,600 P 0
2. Deposits in transit, December 31 2,200 6,000
3. Redeposit of invalid deposits (Deposited in wrong account) 1,000 1,400
4. Difference in deposits of December 29 (2,000) (100)
5. Unexplained bank charge 400
6. Bank cash transfer not yet recorded -0- 22,600
7. Bank service charges -0- 500
8. Chargebacks not recorded - stolen cards 100 -0-
9. Sales returns recorded but not reported to the bank (600) (1,200)
10. Balance per general ledger, December 31 P9,700 P29,200
378
Toyco
Detailed General Ledger Credit Card Accounts Printouts
for the Week Ended December 31, 20X3
Bank A Bank B
Dr. or (Cr.)
Beginning balance, December 24 P12,100 P4,200
Deposits: December 27 2,500 5,000
December 28 3,000 7,000
December 29 -0- 5,400
December 30 1,900 4,000
December 31 2,200 6,000
Cash transfer, December 17 (10,700) -0-
Chargebacks - expired cards (300) (1,600)
Invalid deposits (deposited in wrong account) (1,400) (1,000)
Redeposited of invalid deposits 1,000 1,400
Sales returns for week ended December 31 (600) (1,200)
Ending balance P 9,700 P29,200
Toyco
Summary of the Bank Statements
for the Week Ended December 31, 20X3
Bank A Bank B
(Charges) or Credits
Beginning balance, December 24 P10,000 0
Deposits dated: December 2 2,100 P4,200
December 27 2,500 5,000
December 28 3,000 7,000
December 29 2,000 5,500
December 30 1,900 4,000
Cash transfers to general bank account:
December 27 (10,700) -0-
December 31 -0- (22,600)
Invalid deposits (deposited in wrong account) (1,400) (1,000)
Bank service charges -0- (500)
Bank charge (unexplained) (400) (-0-)
Ending balance P8,600 P -0-
379
Chapter
AUDIT OF TRADE
RECEIVABLES,
ALLOWANCE FOR
DOUBTFUL ACCOUNTS
AND SALES
1. Describe the auditors’ objectives for the substantive tests of details of balances
of the trade accounts and notes receivable, allowance for doubtful accounts
and sales.
INTRODUCTION
Because sales transactions and receivables from customers are so closely related, the two can
best be considered jointly in a discussion of auditing objectives and audit procedures.
Tests of controls and substantive tests of transactions of the revenue and collection cycle are
covered in Chapter 6. Tests of details of balances for the revenue and collection cycle are
studied in this Chapter.
Our discussion of substantive tests of details of balances focuses on accounts and notes
receivable trade, sales, and allowances for doubtful accounts.
The audit program and relative audit objectives for year-end substantive tests applicable to
accounts and notes receivable is presented below:
381
III. Completeness B. To determine that all 5. Test cutoff of sales and
transactions relative to sales returns to
receivables have been determine whether
recorded in the proper receivables are recorded
accounting period. in the proper accounting
period.
IV. Valuation or Allocation C. To determine that 6. Review collectability of
receivables are recorded receivables and
and presented at proper determine the adequacy
amounts in accordance of allowance for
with PFRS. doubtful accounts.
7. Recalculate the interest
income from the notes
receivable.
V. Presented and Disclosure D. To determine that the 8. Evaluate financial
receivables are properly statement presentation
presented and classified and disclosure of
in the statement of receivables.
financial position. 9. Obtain written client
representations
regarding pledge,
discount or assignment
of receivable, and about
receivables from
officers, directors,
affiliates or other related
parties.
1. Obtain a schedule of aged accounts receivable and notes receivable and reconcile to
ledgers.
An aged schedule of trade accounts receivable at the audit date is commonly prepared for the
auditors by employees of the client. If may be designed for (1) the aging of customers’
accounts, (2) the estimating of probable credit losses and (3) the controlling of confirmation
request. The auditor should test footings, cross footings and aging especially those accounts
classified as current, as well as those shown as past due. These selected accounts should be
traced to the subsidiary ledgers. The totals of schedules prepared by client personnel should
also be compared with related controlling accounts. Also, the balance of the subsidiary ledger
records should be verified by footing the debit and credit columns on a test basis. Figure 12-1
illustrates the working papers for accounts receivable while Figure 12-2 shows the working
papers for notes receivable.
382
Figure 12-1: Accounts Receivable Aging Schedule
XYZCorporation
Accounts Receivable - Aging Schedule
December 31, 20X7
Aging Distribution
Balance Past Due Subsequent
Collection
up to
Name of Customer Dr Cr Current 1 - 60 61 - 90 Over 90
2/15/X8
M Corporation Pxx ✓✓ Pxx ^ Pxx /
N Company (xx) ✓✓
O Enterprises xx ✓✓ Xx ^ xx /
P Incorporated xx ✓✓ xx ^
383
Figure 12-2: Working Paper for Notes Receivable
XYZ Corporation
Notes Receivable
December 31, 20X7
C Confirmed by maker
Confirmation replies on separate file
✓ Traced to the general ledger
| Inspected promissory note
^ Computations verified
384
2. Confirm receivables with debtors.
Direct communication with debt is the most essential and conclusive step in the verification of
the existence of accounts receivable. The following steps may be followed:
i). Determine the Method, Timing and the Number of Confirmation to be Requested.
a) Methods of confirmation
Accounts receivable may be confirmed by either the positive request method, the
negative method or by a combination of the two methods.
In many situations, a combination of two forms may be appropriate with the positive
form used for large balances and the negative form for small balances.
Figure 12-3 and 12-4 illustrate the positive and negative forms of confirmation
requests, respectively.
b) Timing of confirmation
385
Figure 12-3: Positive Form of Accounts Receivable Confirmation Request
XYZ Corporation
1997 Star Avenue
Makati City
January 10, 20X8
MNO Company
222 Aquino Avenue
Paranaque, Metro Manila
Dear Sirs:
the correctness of the balance of your account payable to us as shown below and on the
enclosed statement at December 31, 20X7. If the amount is not in agreement with your
records at that date, please provide any information which will aid our auditors in
reconciling the difference.
Your prompt return of this form in the enclosed stamped envelope is essential to the
completion of the auditors' examination of our financial statements and will be appreciated.
XYZ Company
THIS NOT A REQUEST FOR PAYMENT, BUT MERELY FOR CONFIRMATION OF YOUR ACCOUNT
This statement of our account showing a balance of P40,000 due XYZ Corporation at
December 31, 20X7 is correct except as noted below:
MNO Company
By Allan Santos
Date: January 16. 20X8
Exceptions: None
386
Figure 12-4: Negative Form of Accounts Receivable Confirmation Request
Please examine this statement carefully. It does not agree with your records, please report any
differences to our auditors.
c) Extent of confirmation
In the audit of companies with reasonably adequate systems of internal control, the
confirmation process is limited to a sample of the accounts receivable. The sample
should be sufficiently large to account for most of the peso amount of the receivables
or it should be sufficiently representative to dater the drawing of invalid inferences
about the entire population of receivables. The size of the sample will depend upon
(1) the materiality of account receivable in comparison with total assets. The size
of the sample should be relatively large if accounts receivable are a relatively
large asset;
(2) the auditor's evaluation of the system of internal control. Weaknesses in
internal control call for larger samples than when internal control is strong.
(3) the results of confirmation tests in prior year. Significant exceptions in prior
year's confirmations signals the need for extensive confirmation of this year's
receivables; and
(4) the choice between the positive and negative form of confirmation request.
The number of confirmations is usually increased when the negative form is
used.
387
ii) Second confirmation letters to the debtors
After a lapse of reasonable time and no replies received, a second request for confirmation
of accounts and notes receivable may be mailed in envelopes bearing the CPA firm's return
address. A stamped business reply envelope addressed to the office of the auditors should
be enclosed with the request. The auditors should try to include in the confirmation from
the details of the transactions such as statement of account or customer's purchase order
number.
The auditor should resolve unusual or significant differences reported by customers. Other
exception may be turned over to employee of the client with the request that investigation
be made and explanation furnished to the auditors. When replies are not received on
accounts with substantial balances, the auditors should verify the existence, location and
credit standing of the debtor by reference to credit agencies or other sources independent
of the client as well as establish the authenticity of the underlying transactions by
examination of supporting document such as contract, customer purchase orders and
copies of sales invoices and shipping advices. The auditor should likewise investigate
thoroughly if an excessive number of confirmation request to individual debtors are
returned by post office as they may represent fictitious names included by employees of
the company engaged in accounts receivable fraud.
Summary of results of confirmation may be prepared (Figure 12-5) and all pertinent
information and conclusions of the investigation should be included in the working paper.
v) Perform alternative procedures for any confirmation which are not returned
To substantiate the balance of any customers who fail to respond to positive confirmation
requests, the auditor may perform the following procedures.
388
1. Examine collections made subsequent to the confirmation date by inspection of
incoming checks or remittance advices.
2. Trace invoice number and amounts collected to the individual customer's account and
to the record of cash receipts and to the bank deposit.
3. Examine the customer's purchase order; the client's shipping records, and the sales
invoice.
4. Perform analytical procedures for accounts receivable.
XYZ Corporation
Summary of Results of Positive Confirmation
Accounts Receivable
December 31, 20X7
Number of Per Cent
Accounts Amount This Year Last Year
Confirming balances (CB) xx Pxx xx xx
Reporting differences (RD) xx
Portion confirmed xx xx xx
Portion excepted to xx xx xx
Returned by post office (RPO) xx xx xx xx
No replies (NR) xx xx xx xx
Total confirmation sent xx Pxx 100% 100%
Total of accounts xx Pxx
Per Cent of Confirmation Sent to total of accounts xx% xx%
The audit should generally inspect all of the actual notes and any collateral for the notes,
preferably simultaneous, with the counting of cash and examination of securities.
However, if there are great numbers of notes receivable, the auditor might consider
examining only a sample of the notes. Also, if some. of the notes are held by some other
party, the auditor should send a confirmation to the holder of the note.
389
4. Perform analytical procedures to determine whether the receivables, sales, and interest
revenue balances appear reasonable.
The auditor should compare significant statistics related to accounts and notes receivable
with those of the prior year. This procedure can highlight potential weakness in the client's
collection efforts that may affect the overall collectability of accounts receivable. This
procedure may be used also to evaluate the overall reasonableness of accounts receivable.
These statistics include
5. Test sales and sales returns cutoff to determine whether receivables are recorded in the
proper accounting period.
The auditor usually tests the sales cutoff by examining invoices and shipping documents
for several days both before and after the year-end and by tracing such documents to the
sales and account receivable records for the appropriate. period. This test of sales cutoff
may occasionally be made at an interim date to check the adequacy of the company's
procedures. All substantial sales returns after the statement of financial position date
should also be reviewed carefully as they may represent fictitious sales recorded at
year-end.
In reviewing the collectability of accounts receivable, and evaluating the adequacy of the
allowance for doubtful accounts, the auditors may take the following steps:
(1) Verify the past-due accounts receivable listed in the aging schedule that have not been
paid subsequent to the statement of financial position date.
390
(2) Determine credit ratings for delinquent and unusually large accounts.
The most effective verification of the Interest Earned account consists of an independent
computation by the auditors of the interest earned during the year on notes receivable. The
interest section of working paper consists of four columns showing for ach note receivable
owned during the year the following information:
In addition to the foregoing audit procedures mentioned, the auditor should also review of
the minutes of directors' meeting and confirm with banks of any selling or assigning of
accounts receivable.
391
Illustrative Audit Case 12-1
During the annual audit of Cookie Corporation, you encountered the following account,
entitled receivables and payables:
Required:
1. Give the journal entry to eliminate the above account and to set up appropriate
accounts to replace it.
2. Show how the various items should be reported on a current statement of financial
position.
Requirement (1)
Accounts receivable 156,000
Note receivable - long-term 80,000
Receivables arising from loans to employees 2,200
Receivables arising from dishonored note 22,000
Prepaid insurance 1,200
Accounts payable - trade 62,000
Allowance for doubtful accounts 4,000
Cash dividends payable 24,000
Wages payable 2,400
Rent revenue collected in advance 1,600
Mortgage payable - long-term 40,000
Receivables and payables 127,400
392
Requirement (2)
Current assets:
Accounts receivable - trade 156,000
Less Allowance for doubtful accounts 4,000 152,000
Receivables from employees 2,200
Prepaid insurance 1,200
Investment in funds:
Notes receivable - long-term 80,000
Other assets:
Receivables arising from dishonored note 22,000
Current liabilities:
Accounts payable - trade 62,000
Cash dividends payable 24,000
Wages payable 2,400
Rent revenue collected in advance 1,600
Long-term liabilities:
Mortgage payable 40,000
You have been asked to audit the records of XYZ Manufacturing Company, a small
manufacturer of precision tools and machines, for the year-ended December 31, 20X7. Your
examination of sales transactions revealed among others the following:
1. Some machines have been shipped on consignment to XYZ's regular dealers. These
transactions have been recorded as ordinary sales and billed as such. As of December 31,
20X7 the machines billed and in the hands of consignees amounted to P130,000. Sales
price was determined by adding 30% to cost.
2. On December 30, 20X7, two machines were shipped to a customer on FOB shipping point
basis. The sales was entered in the records on January 5, 20X8 when cash was received in
the amount of PI3,000.
3. The inventory as of December 31, 20X7 included goods sold during November, 20X5 for
P6,500 but returned on December 15, 20X7. No entry has been made to adjust the
customer's account for the goods returned. The goods were included at selling price which
was 103% of cost.
As auditor of XYZ Manufacturing Company, what adjusting journal entries would you
recommend relative to the above findings?
393
Solution: Illustrative Audit Case 12-2
The following are the recommended adjusting entries to correct the accounts of XYZ
Manufacturing Company as of December 31 20X7.
394
Illustrative Audit Case 12-3: Application of Analytical Procedures in Auditing
Doubtful Accounts
Excerpts from Titanic 20X7 Annual Report follow. Titanic is the parent company of five
Pharmaceutical companies in the Southeast Asia Region.
(P million)
Income Statement 20X7 20X6
Revenues P17,154 P15,998
Net income 3,606 2,296
Footnotes
Provision for uncollectibles P385 P355
Required:
Answer the following questions assuming that (a) Titanic uses the allowance account to record
bad debts (provision for uncollectibles) and (b) all revenues are credit sales.
395
Solution: Illustrative Audit Case 12-3
Requirement (1)
(Amount in P millions)
20X6 20X7
Estimated bad debts:
P355 / P15,998 = 2.2%
P385 / P17,154 = 2.0%
Requirement (2)
(Amount in P millions)
Requirement (3)
(Amount in P millions)
Allowance receivable:
Beginning balance
Accounts receivable P3,078
Allowance for doubtful accounts 308 P3,386
Add Revenues 17,154
Total P20,540
Less Ending balance
Accounts receivable P3,052
Allowance for doubtful accounts 338 P3,390
Add Net write-offs 355 3,745
Cash collections P16,795
396
Illustrative Audit Case 12-4: Audit of Allowance for Doubtful Accounts
You have been appointed external auditor of Orange Corporation. Orange Corporation operates
in an industry that has a high rate of bad debts. On December 31, 20X7, before any year-end
adjustments, Orange’s Accounts Receivable balance was P600,000 and its Allowance for
Doubtful Accounts balance was P25,000. The year-end balance reported in the statement of
financial position for the Allowance for Doubtful Accounts will be based on the aging schedule
shown as follows:
Required:
a) The allowance for Doubtful Accounts should have a balance of P48,500 on December 31,
20X7.
The supporting calculations are shown below:
The accounts which have been outstanding over 75 days (P10,000) and have zero probability of
collection would be written off immediately and not be considered when determining the
proper amount for the Allowance for Doubtful Accounts.
397
b)
Accounts receivable P590,000
Less: Allowance for doubtful accounts 48,500
Net accounts receivable P541,500
c) The year-end bad debt adjustment would decrease pretax income P33,500 for 20X5 as
shown below:
Estimated amount required in the Allowance for Doubtful Accounts P48,500
Balance in the account after write-off of bad accounts but before
adjustment (25,000 - 10,000) 15000
Required charge expense P33,500
Illustrative Audit Case 12-5: Audit of Notes Receivable and Related Accounts
During the course of the audit of the financial statements of Crome, Inc., for the year ended
December 31, 20X7, you examined the notes receivable presented by the following items:
1) A four-month note dated November 30, 20X7, from the Aeon Company, P10,00; interest
rate, 16 percent; discounted on November 30, 20X7, at 16 percent.
2) A draft drawn payable 30 days after due for P45,000 by the Benton Company on the
Dodge Company in favor of the Gerrad Company, endorsed to Crome, Inc., on
December 2, 20X7, and accepted on December 4, 20X7.
3) A 90-day note dated November 1, 20X7, from J.C Cruz of P25,000; interest at 16 percent;
the note is for subscriptions to 250 preference shares of Crome Inc., at P100 per share.
4) A 60-day note dated May 3, 20X7, from the National Investment Company, P30,000;
interest rate 16 percent; dishonored and maturity; judgment obtained on October 10,
20X7. Collection doubtful. (No interest after maturity).
5) A 90-day note dated January 4, 20X7, from Romeo Paz, president of Crome, P8,000; no
interest; not renewed; president confirmed.
6) A 120-day note dated September 14, 20X7, from the Samson Company, P6,000; interest
rate, 16 percent; note is held by bank as collateral.
When the company discounted a note, Interest Expense was debited for the discount cost and
Interest Income was credited for the revenue.
398
Required:
Requirement (a)
CROME, INC.
Notes Receivable
12/31/X7
Date Int. Interest
Remarks
Maker of Note Due Rate Amount Received Accrued Earned
Discounted on
Aeon Company 11/30/X7 3/30/X8 16% P10,000 C P533 r P133
11/30/X0 at 16%
Accepted by
Benton
12/2/X7 1/2/X8 - 45,000 C Dodge
Company
Co. on 12/14/X0
Subscription
J.C. Cruz 11/1/X7 1/30/X8 16% 25,000 C P667 ^ 667 Receivable on
preference shares
Dishonored at
National maturity;
5/13/X7 7/2/X7 16% 30,000 C 800 ^ 800
Investment Co. collection
doubtful
Maker is President
of Crome; not paid
Romeo Paz 1/4/X7 4/4/X7 - 8,000 C at maturity nor
reviewed;
confirmed
Samson Note held by bank
9/14/X7 1/12/X8 16% 6,000 C 280 ^ 280
Company as collateral
Balance per
P124,000 ✓
ledger
399
Requirement (b)
Requirement(c)
Current Assets
Notes receivable - trade (net of note discounted amounting to P10,000;
Note for P6,000 is held by bank as collateral for a loan) P51,000
Subscription receivable 25,000
Advances to officers 8,000
400
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
1. Distinguish between tests of details of balances and test of transactions for the sales
and collection cycle. Explain how the tests of transactions affect the tests of details.
4. During the audit of South Technologies, Inc., the auditors sent confirmation request to
customers whose accounts had been written off as collectible during the year under
audit. An executive of South protested, saying: “You people should be verifying that
the receivables on the books are collectible. We know the ones we wrote off are no
good.”
Required:
a. What purpose, if any, is served by this audit procedure?
b. Does the South executive’s statement suggest some misunderstanding of audit
objectives? Explain.
5. During the preliminary conversations with a new staff assistant you instruct her to
send out confirmation requests for both accounts receivable and notes receivable. She
asks whether the confirmation requests should go to the makers of the notes or to the
holders of the notes in the case of notes that have been discounted. Provide an answer
to her question and give reasons for your answer.
6. What are the implications to the auditors if, during their examination of accounts
receivable, some of the client’s customers do not respond to the auditors’ request for
positive confirmation of their accounts receivable.
401
7. Your regular annual audit of North, Inc., included the confirmation of accounts
receivable. You decided to use the positive form of confirmation request. Satisfactory
replies were received from all but one of the large accounts. You sent a second and
third request to this customer, but received no reply. At this point an employee of the
client company informed you that a check had been received for the full amount of the
receivable. Would you regard this as a satisfactory disposition of the matter? Explain.
Exercises
Exercise 1
When examining the accounts of Tripoli Company, you ascertain that balances relating to both
receivables and payables are included in a single controlling account (called receivables),
which has a P23,050 debit balance. An analysis of the details of this account revealed the
following:
Required:
1. Give the journal entry to eliminate the above account and to set up the appropriate
accounts to replace it.
2. How should the items be reported on Tripoli Company’s statement of financial position?
402
Exercise 2
The following are the balances of selected accounts taken from the December 31, 20X4
statement of financial position of Visayas Company:
The following transactions (in summary) affecting the Accounts Receivable account occurred
during the year ended December 31, 20X5.
Required:
a. Current balance of Accounts Receivable as of December 31, 20X5.
b. Adjusting journal entry for estimated bad debts on December 31, 20X5. The corporation
adjusts its allowance account to a percentage of outstanding receivable. The credit
experience of the corporation indicates that the percentage rate to be used on December 31,
20X4.
Exercise 3
An examination of the accounting records for the Amy Corporation indicates that all
receivables are being recorded in a single account entitled Receivables. An analysis of the
account reveals the following:
403
Required:
1. Prepare a journal entry to separate the preceding items into their proper accounts.
2. How could each of the preceding items normally be reflected on Amy’s statement of
financial position?
The Gabe Company requires additional cash for its business. Gabe has decided to use its
accounts receivable to raise the additional cash as follows:
1. On June 30, 20X6, Gabe assigned P200,000 of accounts receivable to the Belle Finance
Company. Gabe received an advance from Belle of 85% of the assigned accounts
receivable, less the commission on the advance of 3%. Prior to December 31, 20X6, Gabe
collected P150,000 on the assigned accounts receivable and remitted P160,000 to Belle,
P10,000 of which represented interest on the advance from Belle.
2. On December 1, 20X6, Gabe sold P300,000 of net accounts receivable to the Factoring
Company for P260,000. The receivables were sold outright on a non recourse basis.
3. On December 29, 20X6, Gabe received an advance of P100,000 from the Domestic Bank
by pledging P120,000 of Gabe’s accounts receivable. Gabe’s first payment to Domestic is
due on January 29, 20X7.
Required:
Prepare a schedule showing the income statement effect for the year ended December 31,
20X6, as a result of the preceding facts. Show supporting computations in good form.
404
Problems
The following information's are available from the records of Stardust Corporation:
Data from the allowance account of the company as it appeared on December 31, 20X7 are
presented below:
Allowance for doubtful account
5/6 125 1/1 566
8/11 401
12/20 80
Required:
1. Prepare an aging working paper as of December 31, 20X7 making use of the following
categories: not due; past due, less than 2 months; past due, more than 2 months. Accounts
are considered past due 60 days after date of sale.
The company establishes an allowance accounts for uncollectible receivables equal to:
10% of accounts less than 2 months past due
30% of accounts more than 2 months past due
405
The rates are based on historical bad debts adjusted for current observable data on collectibility
of Accounts Receivable.
2. Determine the adjusted balance of Accounts receivable and Allowance for Doubtful
Accounts as of December 31, 20X7.
As the manager of the accounts receivable department for Katrin Leather Goods, Ltd., you
recently noticed that Simmy Santos, your accounts receivable clerk who is paid P12,000 per
month, has been wearing usually tasteful and expensive clothing (this is Katrin's first year in
business). This morning, Santos drove up to work in a brand new Vios.
Naturally suspicious by nature, you decide to test the accuracy of the accounts receivable
balance of P1,320,000 as shown in the ledger. The following information is available for your
first year (precisely 9 months ended September 30, 20X7 ) in business.
Required:
Assuming all sales were made; on account, compute the ending accounts receivable balance
that should appear in the ledger, noting any apparent shortage. Then, draft a memo dated on
October 3, 20X7, to Jay Corales, the branch manager, explaining the facts in this situation.
Remember that this problem is serious, and you do not want to make hasty accusations.
Problem 3
406
You have sent confirmations to 40 customers of Von-Sanchez Express, a long-time audit client
experiencing some financial difficulty. The company sells specialized high-technology goods.
You have received confirmations from 32 of the 40 positive confirmations sent. A few minor
errors were noted on these accounts, but the projected amount of errors on the confirmations
returned is just below tolerable error.
Required:
a. Indicate the audit procedures (and be specific as to what those procedures will accomplish)
to complete the work on accounts receivable related to the confirmation process. In other
words, identify the specific alternative audit procedures that should be performed.
b. Assuming that all items could not be cleared to the auditor's satisfaction, identify the audit
procedures that should be implemented to finish auditing the valuation and existence
assertions for accounts receivable.
Problem 4
Read the following scenario about String identify the substantive procedures that the CPA
(Stanley) perform to determine whether lapping exists. Do not discuss deficiencies in the
system of internal control.
During the year, String Corporation began to encounter cash flow difficulties, and a cursory
review by management revealed receivable collection problems. String's management engaged
Elaine Stanley, CPA, to perform a special investigation. Stanley studied the billing and
collection cycle and noted the following:
The accounting department employs one bookkeeper who received and opens all incoming
mail. This bookkeeper is also responsible for depositing receipts, filing daily remittance
advices, recording receipts in the cash receipts journal, and posting receipts in the individual
customer accounts and the general ledger accounts. There are no cash sales. The bookkeeper
prepares and controls the mailing of monthly statements to customers.
The concentration of functions and the receivable collection problems caused Stanley to
suspect that a systematic defalcation of customers' payments through a delayed posting of
remittances (lapping of accounts receivable) is present. Stanley was surprised to find that no
customers complained about receiving erroneous monthly statements.
409
Chapter
AUDIT OF
INVENTORIES,
COST OF SALES AND
TRADE PAYABLES
1. Describe the auditors' objectives for the substantive audit of details of balances
of inventories, cost of sales and trade payables.
INTRODUCTION
It is logical to consider the topics inventories and cost of goods sold together because of their
interrelationship. For instance, the internal controls that assure the fair valuation of inventories
are found in the purchase (or origination) cycle. In a manufacturing concern, the valuation of
inventories is also affected by the production (or conversion) cycle, in which various
manufacturing costs are assigned to inventories, and the cost of inventories is then transferred
to the cost of goods sold. The determination of inventory value therefore affects the cost of
goods sold and has a major impact on net income for the year. This is one of the reasons why
special significance is attached to inventories in both the accounting and auditing literature.
The following audit objectives and procedures for the verification of inventories and cost of
goods sold are presented below and discussed in detail in the succeeding pages. The audit
program is appropriate not only for a trading concern but also for a manufacturing company
that takes a complete physical inventory to verify the perpetual inventories at the close of each
fiscal year.
Balance-Related Common Test of Details of
Assertions Audit Objectives Balances Audit Procedures
I. Existence or A. To determine whether 1. Obtain listings of
Occurrence inventories exist at year-end inventory and reconcile
and represent items held for to ledgers.
sale in the ordinary course of 2. Observe the taking of
business. physical inventory and
conduct test counts.
3. Confirm inventories in
public warehouse and
with consignees.
II. Completeness B. 1. To determine whether all 4. Obtain a final inventory
transactions related to listing from the client.
inventory are recorded in the A. Trace test counts
proper accounting period. made during the
inventory
observation into
inventory listing.
2. To determine that B. Test the clerical
inventory listings are accuracy of the
accurately compiled and final inventory
inventory quantities listing.
include all items on hand 5. Review the year-end
and in transit. cutoff of purchases and
sales transactions.
6. Test numerical sequence
of inventory purchase
III. Rights and requisition.
Obligations 7. Review entries to cost of
goods sold.
8. Perform analytical
review related to
inventories and cost of
goods sold.
9. Make inquiries of
C. To determine whether the management regarding
company has legal title or inventory ownershipand
ownership rights to inventory examine consignment
items and inventories exclude agreements.
items billed to customers or
owned by others.
IV. Valuation or D. To determine whether the 10. Evaluate the bases and
Allocation inventories are properly methods of inventory
stated with respect to pricing.
Cost determined by an 11. Vouch and test
acceptable method inventory pricing.
consistently applied. 12. Check inventory for
Slow-moving, excess, quality and/or
defective, and obsolete obsolescence.
items identified and
reduced to replacement
cost or net realizable
value if lower than cost.
V. Presentation and E. To determine that the 13. Determine the existence
Disclosure inventories and cost of goods of pledged inventory.
sold are presented and 14. Evaluate financial
classified in the financial statement presentation
statements in accordance of inventories and cost
with PAS/PFRS. of goods sold, including
the adequacy of
disclosure.
Discussion of Audit Procedures
For goods in the hands of consignees, the auditor may start their verification by obtaining
from the client a list of all consignees and copies of the consignment contracts. Direct
written confirmation should also be obtained from the consignee as to the consigned
inventory, receivables, unremitted proceeds and accrued expenses and commissions as of
the statement of financial position date.
Extensions and footings on the final inventory listing should be tested to prove clerical
accuracy of the list and discover any misstatements of physical inventories. The auditor
should also trace their test counts made during the observation of physical inventory to the
completed physical inventory list. The auditor should be alert for any indications that the
inventory tags have been altered or that fictitious tags have been included.
A purchase cutoff test is performed to obtain evidence that all goods owned by the client at
the statement of financial position date are included in inventory and that the related
liability is recorded. Purchase cutoff test involves tracing of receiving reports to voucher
register entries and vouching recorded entries to receiving reports and vendors' invoices.
Sales cutoff examination aims to determine whether goods sold as of year-end are
excluded from the inventory and that the related receivable or cash is recorded. This
examination involves tracing of delivery receipts to sales journal entries and verifying
recorded entries to delivery receipts and sales invoices.
The auditor must give particular attention to inventory in transit. He should note receiving
and shipping cutoff date during the taking of the physical inventory. The numerical
sequence of inventory purchase requisition should also be tested.
Substantial evidence on the propriety, accuracy and consistency of costs assigned to cost
of goods sold is obtained from tests of sales, purchases and manufacturing transactions and
by substantive tests of inventory balances.
The following financial relationships are frequently drawn when performing analytical
review procedures to inventories:
The auditor should inquire of management as to any goods held as well as shipped on
consignment. He should further ascertain that the consigned stock has been properly
included in the inventory if it is a consignment out or excluded if it is a consignment from
other firm.
10 & 11. Evaluate the bases and methods of inventory pricing. Vouch and test inventory
pricing.
The auditor must determine whether the basis of pricing used by the client conforms to
generally accepted accounting principles and whether it has been applied consistently.
Because inventory pricing methods and cost system vary widely, so do the related audit
procedures.
The audit of a job-order cost system will involve a review of the categories flowing
through the control accounts (materials, labor; and overhead) and tests of these costs in the
jobs in progress at year-end. The audit of a process cost system concentrate on the flow and
accumulation of costs by cost center for the major products. In a standard cost system the
audit emphasis is on testing the standard cost buildups for major inventory items and
reviewing variances for an approximation of actual costs.
Cost, however, is only one aspect of inventory pricing. The lower of current replacement
cost or net realizable value is generally the proper accounting principle for inventory
pricing.
Test of pricing of merchandise and purchased parts and materials involves the following
steps:
1. Prepare a list of items for testing. This will include a description of the inventory
items selected, the stock number, the tag or sheet number and the inventory quantity,
unit price and extended amount. The working papers should provide sufficient space
to accommodate several invoices making up the total of the inventory quantity.
416
2. After selection of items for testing, the compan
companyy personnel could be asked to locate
supporting purchase invoices.
3. To determine market value review the price paid for recent purchases. Other sources
include suppliers' price lists and published quotations included in financial and trade
publications.
Figure 13-2:
2: Raw Materials Price Test
X Company
Raw Materials Price Test
1/27/X7
1. The auditor should determine whether the costs included in the final inventory lists are in
agreement with those in the supporting cost records as compiled in accordance with the
company's cost system. The following procedure may be followed:
a) For Work in Process, the market price or net realizable value may be determined as
follows:
Selling price P xx
Less: Estimated cost to sell xx
Net realizable value P xx
Selling price of the items may be obtained from the company's price list, from contracts, from
catalogs or from recent sales invoices. Estimated cost to sell may be determined by dividing
selling expenses by sales.
As previously mentioned, the auditor should determine whether provision for losses for
damaged, slow-moving and obsolete inventories has been made.
The auditor should determine whether the inventory appears to be in condition for sale,
use, or consumption and whether there are any obsolete, slow-moving or damaged goods.
He obtains evidence of general condition or obsolescence by
418
(a) Observing the client's inventory taking
(b) Scanning perpetual records for slow moving items
(c) Reviewing quality control production reports
(d) Making inquiries of client when the evidence suggests a decline in the utility of the
goods. Such items should be reduced to their net realizable value.
Assistance of an outside expert may be required by the auditor when client assertions
about the nature of the inventory pertain to highly technical matters. The auditor may use
the work of a specialist as an audit procedure to obtain competent evidential matter,
providing he is satisfied about the qualifications and independence of the expert.
13. Determine the existence of pledged inventory and examine purchases and sales
commitments.
The inventory audit procedure designed to detect liens and pledges of inventories include
review of minutes of board of directors' meeting, debt instrument (promissory note),
confirmation with financial institution with which the client does business, and inquiry of
management.
The auditor should also discuss with company officials the existence of any binding
contracts for future purchases of goods for quantities in excess of normal requirements or
prices in excess of current market. Likewise, sales contracts for future deliveries should be
examined to determine whether provision for losses from such commitments is required.
14. Evaluate financial statement presentation of inventories and cost of goods sold
including adequacy of disclosure.
420
AUDIT OF TRADE ACCOUNTS / NOTES PAYABLE
If tests of controls and related substantive tests of transactions show that controls are operating
effectively, the auditor may be able to reduce analytical procedures and tests of details of
balances for accounts / notes payable. However, because accounts payable tend to be material
for many companies, auditors almost always perform extensive analytical procedures and some
tests of details of balances of these accounts.
Figure 13-3 shows the balance-related audit objectives and common tests of details of balances
procedures for trade accounts / notes payable. The actual audit procedures will vary
considerably depending on the nature of the entity, the materiality of accounts payable, the
nature and effectiveness of internal controls, and inherent risk.
Figure 13-3: Balance-Related Audit Objectives and Tests of Details of Balances for
Accounts Payable
1 & 2. Obtain from the client a listing of accounts and notes payable as of year-end.
Vouch recorded liabilities to vendors' statements.
For a sample of items from the listing, examine supporting documentary evidence
(supplies invoice, receiving report, etc.) nothing that the item is a proper account payable
as of year-end and that the account distribution (i.e., the account to be debited) is
appropriate. Trace the posting of the entry recording the account payable at year-end to the
general ledger. Figure 13-4 illustrates the working papers for Accounts Payable.
3 & 4. Confirm recorded liabilities directly with suppliers / creditors. Examine bank
confirmations for loans.
Confirmation of accounts payable is optional but recommended (l) when control risk is
high, (2) when there are individual creditors with relatively large balances and (3) the
client is experiencing difficulties in meeting its obligations.
When confirmation is undertaken, confirmation should be sent to
1) accounts with zero or small balances because they may be understand than accounts
with large balances,
2) major vendors who do not send monthly statement, and the must control the
preparation and mailing of the requests and should receive the responses directly from
13 illustrates the positive form of confirmation requested
the respondent. Figure 13-5
Figure 13-6 illustrates another positive form of confirmation request.
Figure 13-4:
4: Accounts Payable
XYZ Corporation
Accounts Payable
12/31/X7
Subsequent
Payment
Supplies Address Amount up to 2/15/X8
Yalung Trading 301 U
UN Ave., Manila P5,000 C 5,000
000 ~
Union Trading Port Are
Area, Manila 15,000 C -
Sunlight Express 400 Rizal Ave., Manila 10,000 C 10,000
000 ~
Champion Enterprises 211 CM Recto, Manila 5,000 C 5,000
000 ~
January 7, 20X7
Sunset Company
305 Kalayaan Avenue
Makati City
Our auditors, Flores, Cruz and Cabrera, CPAs, are auditing our financial statements for
20X6. Will you please furnish them with the following information as of December 31,
20X6.
Please reply directly to our auditors. An envelope addressed to our auditors is enclosed.
Efren Santos
Controller
Bulacan Trading Company
For notes payable, the auditor can have the client prepare an analysis for the year. The schedule
should reflect:
The analysis should also reflect the payee of the note, the date of the note, the interest rate, and
the details of any security or collateral arrangement. Figure 13-7 presents a sample working
paper for Notes payable.
425
Figure 13-7: Notes Payable
5. Perform purchases cutoff examination.
The auditor tests purchases cutoff to determine whether purchases and corresponding
payables are recorded in the appropriate period. Cutoff tests of purchase transactions
involve examining a sample of purchase entries on or at year-end, the corresponding
receiving reports and purchase invoices.
Cutoff Tests
Cutoff tests for accounts payable are intended to determine whether transactions
recorded a few days before and after the balance sheet date are included in the correct
period.
At this time, the auditor should review the procedures in the receiving department to
determine that all inventory received was counted, and the auditor should record in his
or her working papers the last receiving report number of inventory included in the
physical count. During the year-end field work, the auditor should then test the
accounting records for cutoff. The auditor should trace receiving report numbers to the
accounts payable records to verify that they are correctly included or excluded.
Inventory in transit
427
6. Test for unrecorded liabilities.
The auditor’s search for unrecorded liabilities will normally include the following
steps:
By comparing these ratios and amounts to those from prior years, the auditor might
discover significant differences caused by errors or irregularities in the recording of
accounts payable and notes payable.
The client’s files should contain documents that support the validity of creditor
claims-against assets. These include documentation required number under a voucher
system (i.e., purchase order, receiving report, and vendor’s invoice), copies of notes
and loan agreements. The auditor can also examine creditor’s monthly statement
received by the client and vouch payments made to them.
428
9. Examine Subsequent payments to creditors.
The auditor can schedule this procedure toward the end of the field work to further
substantiate the validity of the payables. This test consists of tracing vouchers or
checks issued after the statement date to the list of payables at the statement of financial
position date. The comparison will also enable the auditor to identify:
a) Large disbursements pertaining to the prior period not included in the list of
payables.
b) Large disbursements that clearly relate to the list of payables or to liabilities
incurred subsequent to the statement date.
c) Significant listed balances that remain unpaid.
To determine proper valuation of the obligations, the auditor should vouch amounts
owed to creditors shown in the schedule of accounts payable to supporting
documentation.
The auditor should prove the mathematical accuracy of interest computations, accrued
as well as prepaid.
12. Scan list of payables to determine that each type of obligation is properly
described and classified. Determine that contingent liabilities are properly
disclosed.
Each major type of obligation, such as accounts payable, accrued expenses payable, etc.
should be identified in the current liabilities section. For short-term notes payable,
there should be disclosure of interest rates and the existence of any assets pledged as
collateral. Evidence pertaining to this objective may be obtained through inquiries of
management of any contingencies.
The auditor then compares the statement presentation and disclosures with PAS/PFRS.
429
Illustrative Audit Case 13-1: Goods to Include in Inventory
Ball Company’s inventory at December 31, 20x7, was P1,500,000 based on a physical
count of goods priced at cost, and before any necessary year-end adjustment relating to
the following:
(1) Included in the physical count were goods billed to a customer F.O.B.
shipping point on December 31, 20x7. These goods has a cost of P30,000
and were picked up by the carrier on January 10, 20x8.
(2) Goods shipped F.O.B. shipping point on December 28, 20x7, from a
vendor to Ball were received on January 4, 20x8. The invoice cost was
P50,000.
Required: What amount should Ball report as inventory on its December 31, 20x7
statement of financial position?
Mindoro Auto Parts sells new parts for foreign automobiles to auto dealers. Company
policy requires that a prenumbered shipping document be issued for each sale. At the
time of pickup or shipment, the shipping clerk writes the date on the shipping
document. The last shipment made in the fiscal year ended August 31, 20X7, was
recorded on document 2167. Shipments are billed in the order the billing clerk receives
the shipping documents.
For late August and early September, shipping documents are billed on sales invoices
as follows:
Shipping Document No. Sales Invoice No.
August 2163 4332
August 2164 4326
August 2165 4327
August 2166 4330
August 2167 4331
September 2168 4328
September 2169 4329
September 2170 4333
September 2171 4335
September 2172 4334
430
The August and September sales journals have the following information included:
Required:
431
Shipping Document Error in Sales Overstatement or Understatement
Invoice No.
No. Cutoff of August 31 Sales
Adjusting Entry
Accounts Receivable 213.18
Sales 213.18
c. After making the type of cutoff adjustments shown in part b, current year sales
would be overstated by:
Amount of Sales
2168 P 620.22
2169 1,914.30
2170 852.06
2171 1,250.50
2172 646.58
P 5,283.66
The best way to discover the error is to be on hand on the statement of financial position date
and record in the audit working papers the last shipping document issued in the current period.
Later, the auditors can examine shipping documents before and after the statement of financial
position date to determine if they were correctly dated.
432
d. The following procedures are usually desirable for sales cutoff.
1. Be present during the physical count on the last day of the accounting period
to determine the shipping document number for the last shipment made in
the current year. Record that number in the working papers.
2. During the year-ended field work, select a sample of shipping documents
preceding and succeeding those selected in procedure 1. Shipping
documents with the same or with a smaller number than the one
determined in procedure 1 should be included in current sales. Those with
document number larger than that number should have been excluded
from current sales.
3. During year-end field work, select a sample of sales recorded in the last few
days of the sales journal and a sample of those recorded for the first few
days in the subsequent period. Trace sale recorded in the current period to
related shipping documents to make sure each one has a number equal to
or smaller than the one in procedure 1. Similarly, trace sales recorded in
the subsequent period to make sure each sale has a related shipping
document number greater than the one in procedure 1.
e. The following are effective controls to prevent cutoff errors and related tests of
controls.
(2) Policy requiring the issuance of shipping Observe issuance of documents, examine
documents sequentially. document numbers and inquiry.
(3) Policy requiring recording sales invoices in the Observe recording of documents,
same sequence as shipping documents are issued. examine document numbers and inquiry.
(4) Policy requiring dating of shipping documents, Observe dating of shipping documents
immediate recording of sales, and dating sales on and sales invoices, and timing of
the same date as the shipment. recording.
433
Illustrative Audit Case 13-3: Purchases Cutoff Examination
The management of Maligaya Company has engaged you to assist in the preparation of
year-end (December 31, 20X7) financial statements. You are told that on November 30,
the correct inventory level was 150,000 units. During the month of December, sales
totaled 50,000 units including 25,000 units shipped on consignment to Tower
Company. A letter received from Tower indicates that as of December 31, it had sold
12,000 units and was still trying to sell the remainder. A review of the December
purchase orders, to various suppliers, shows the following:
Maligaya Company uses the “passing of legal title” for inventory recognition.
Required:
434
Illustrative Audit Case 13-4: Sales and Purchases Cutoff Examination
1) Included in the physical count were tools billed to a customer FOB shipping point
on December 31, 20X7. These tools had a cost of P28,000 and had been billed at
P35,000. The shipment was on MABES’s loading dock waiting to be picked up by
the common carrier.
2) Goods were in transit from a vendor to MABES on December 31, 20X7. The
invoice cost was P50,000, and the goods were shipped FOB shipping point on
December 29, 20X7.
3) Work-in-process inventory costing P20,000 was sent to an outside processor for
plating on December 30, 20X7.
4) Tools returned by customers and held pending inspection in the returned goods
area on December 31, 20X7, were not included in the physical count. On January 8,
20X8, the tools costing P26,000 were inspected and returned to inventory. Credit
memos totaling P40,000 were issued to the customers on the same date.
5) Tools shipped to a customer FOB destination on December 26, 20X7, were in
transit at December 31, 20X7, and had cost of P25,000. Upon notification of
receipt by the customer on January 2, 20X6, MABES issued a sales invoice for
P42,000.
6) Goods, with an invoice cost of P30,000 received from a vendor at 5:00 p.m. on
December 31, 20X7, were recorded on a receiving report dated January 2, 20X8.
The goods were not included in the physical count, but the invoice was included in
accounts payable at December 31, 20X7.
7) Goods received from a vendor on December 26, 20X7, were included in the
physical count. However, the related P60,000 vendor invoice was not included in
accounts payable at December 31, 20X7, because the accounts payable copy of the
receiving report was lost.
8) On January 3, 20X8, a monthly freight bill in the amount of P4,000 was received.
The bill specifically related to merchandise purchased in December, 20X7,
one-half of which was still in the inventory at December 31, 20X7. The freight
charges were not included in either the inventory or in accounts payable at
December 31, 20X7.
435
Required:
Using the format below, prepare a schedule of adjustments as of December 31, 20X7,
to the initial amounts per MABES’s accounting records. Show separately the effect, if
any, of each of the eight transactions on December 31, 20X7, amounts. If the
transactions would have no effect on the initial amount shown, state NONE.
436
Illustrative Audit Case 13-5: Errors
A company that uses the periodic inventory system makes the following errors:
1. It omits a purchase on account from the Purchases account and the ending
inventory.
2. It omits a purchase on account from the Purchases account, but the ending is
correct.
3. It overstates the ending inventory, but purchases are correct.
Required:
Indicate the effect of the preceding errors on the statement of comprehensive income
and the statement of financial position of the current and succeeding years.
1. Current year:
Succeeding year:
2. Current year:
437
Statement of financial position: Liabilities (Accounts Payable) are understated
because a purchase has not been recorded. Retained Earnings are overstated
because net income is overstated.
Succeeding year:
Statement of financial position: If the error is not corrected, Accounts Payable will
continue to be understated. It will be doubly understated if a debit is made to
Accounts Payable when the purchase is actually paid for. Retained Earnings will
also be overstated if the error from the previous year is not corrected.
3. Current year:
Succeeding year:
438
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
1. Many auditors consider the substantiation of the figure for inventory to be a more
difficult and challenging task than the verification of most other items on the statement
of financial position. List several specific factors that support this view.
2. The client’s cost accounting system is often the focal point in the auditors’ examination
of the financial statements of a manufacturing company. For what purposes do the
auditors review the cost accounting system?
3. For what purposes do the auditors make and record test counts of inventory quantities
during their observation of the taking of the physical inventory? Discuss.
4. “If the auditors can determine that all goods in the physical inventory have been
accurately counted and properly priced, they will have discharged fully their
responsibility with respect to inventory.” Evaluate this statement.
5. How do the independent auditors use the client’s backlog of unfilled sales orders in the
examination of inventories?
6. You are engaged in the audit of Beed Company, a new client, at the end of its first fiscal
year, June 30, 20X7. During your work on inventories, you discover that all of the
merchandise remaining in stock on June 30, 20X7, had been acquired July 1, 20X6,
from Anne Beed, the sole shareholder and president of Beed Company, for an original
selling price of P10,000 cash and a note payable due July 1, 20X9, with interest at 15
percent, in the amount of P90,000. The merchandise had been used by the president
when she operated a similar business as a single proprietor.
How can you verify the pricing of the June 30, 20X7 inventory of Beed Company?
Explain.
439
7. The auditor is always concerned whether slow-moving or potentially obsolete
inventory is included in inventory, and whether inventory should be reduced to a lower
market value. Identify five substantive audit procedures the auditor might use to
determine the existence of obsolete goods or goods whose market value is less than
cost.
8. Explain the purpose of test counts and other inventory observations that the auditor
notes while a physical inventory is being taken.
9. What charges and credits may be disclosed in the auditors’ analysis of the Cost of
Goods Sold account of a manufacturing concern?
10. As a part of the investigation of accounts payable, auditors sometimes vouch entries in
the selected creditors’ accounts back through the journals to original documents, such
as purchase orders, receiving reports, invoices, and paid checks. What is the principal
purpose of this procedure?
Exercises
Exercise 1
Required:
Normal inventory and notes payable auditing procedures have been satisfactorily
completed. Describe the specific additional auditing procedures that Roldan should
undertake with respect to –
a. Consignments out.
b. Finished merchandise in public warehouses pledged as collateral for outstanding
debt.
440
Exercise 2
The company maintains separate perpetual ledgers at the plant office for both stock
owned and stock being held for customers. The cost department also maintains a
perpetual record of stock owned. The above perpetual records reflect quantities only.
The company does not take a complete physical inventory at any time during the year,
since the temperature in the cold storage facilities is too low to allow one to spend more
than 15 minutes inside at a time. It is not considered practical to move items outside or
to defreeze the cold storage facilities for the purpose of taking a physical inventory.
Due to these circumstances, it is impractical to test count quantities to the extent of
completely verifying specific items. The company considers as its inventory valuation
at year-end the aggregate of the quantities reflected by the perpetual record of stock
owned that is maintained at the plant office, price at the lower of cost of market.
Required:
a. What are the two principal problems facing the auditor in the audit of the inventory?
Discuss briefly.
b. Outline the audit steps that you would take to enable you to render an unqualified
opinion with respect to the inventory. (You may omit consideration of a
verification of unit prices and clerical accuracy.)
Exercise 3
441
6. Determine whether inventory has been valued at the lower of cost or market.
7. Tour the inventory area to determine that all inventory items have been tagged.
8. Obtain the receiving report for the last goods received.
9. Test perpetual records for inventory, using records-to-floor and floor-to-records
tests.
10. Review the client’s written inventory procedures.
Required: Identify the assertion that each audit procedure would test.
Exercise 4
While observing inventory at Remote Inc. a staff auditor determined that the client has
removed P4.2 million of inventories from the books during the year. The adjustment
was material to the financial statements and was made because the auditor had
expressed concern about the client’s ability to sell inventory, a hazardous chemical
compound.
A warehouse attendant explain that the chemical had begun to eat through the metal
drums in which it was stored, and that the company had placed it in a ravine and
covered it with dirt. Recently the municipal government concluded that disposal of the
chemical compound met its standards. However, the agent performing the
investigation explained that he would not drink water from the well on the property. He
indicated that cows kept on nearby property have recently been tested, and the tests had
shown traces of this hazardous chemical. Since that time, Remote has used only bottled
drinking water. The warehouse attendant expressed concern the pollution might reach
the surrounding takes.
Required:
442
Exercise 5: Items to Include in Inventory: Classification, Correction
Required:
1. The auditor did not agree with the “corrected” inventory amount of P271,500.
Compute the correct ending inventory amount
(show computations) by modifying the corrected balance of P271,500.
2. List the items on the statement of comprehensive income and statement of financial
position for 20X6 that should be corrected for the above errors; give the amount of
the error in the balance of each item affected.
3. The accounts have been closed for 20X6. Therefore, a correcting entry in January
20X6 is needed. Give the required correcting entry.
Exercise 6
Paul Marcos, CPA, is the auditor of Red Corporation. Marcos is considering the audit
work to be performed in the accounts payable are for the current-year engagement. The
prior-year documentation shows that the confirmation requests were mailed to 100 of
Red’s 1,000 suppliers. The selected suppliers were based on Marcos’ sample that was
designed to select accounts with large pesos balances. Marcos and Red staff spent a
substantial number of hours resolving relatively minor differences between the
confirmation replies and
443
Red’s accounting records. Alternative audit procedures were used for those suppliers
who did not respond to the confirmation requests.
a. Identify the accounts payable management assertions that Marcos must consider in
determining the audit procedures to be followed.
b. Identify situations in which Marcos should use accounts payable confirmation, and
discuss whether he is required to use them.
c. Discuss why using large peso balances as the basis for selecting accounts payable
for confirmation might not be the most effective approach and indicate what more
effective procedures could be followed when selecting accounts payable for
confirmation.
Exercise 7
Exercise 8
Explain how the auditors coordinate the year-end cutoff of accounts payable with their
observation of the year-end physical inventory.
Exercise 9
Most auditors are interested in the performing as many phases of an audit as possible in
advance of the balance sheet date. The verification of accounts payable, however,
generally is regarded as something to be done after the balance sheet date. What
specific factors can you suggest that make the verification of accounts payable less
suitable than many other accounts for interim work?
444
Exercise 10
Early in your first audit of Star Corporation, you notice that sale and year-end
inventory are almost unchanged from the prior year. However, cost of goods sold is
less than in the preceding year, and accounts payable also are down substantially.
Gross profit has increased, but this increase has not carried through to net income
because of increased executive salaries. Management informs you that sales prices and
purchase prices have not changed significantly during the past year, and there have
been no charges in the product line. Star Corporation relies on the periodic inventory
system. Your initial impression of internal control is that several weaknesses may exist.
Suggest a possible explanation for the trends described, especially the decrease in
accounts payable while sales and inventory were constant and gross profit increased.
Explain fully the relationships involved.
Problems
You have been engaged for the audit of the Y Company for the year ended December 31,
20X7. The Y Company is engaged in the wholesale chemical business and makes all sales
at 25 percent over cost.
Following are portions of the client’s sales and purchases accounts for the calendar year
20X7.
SALES
Balance Forward
Date Reference Amount Date Reference Amount
12-31 Closing entry P699,860 P658,320
12-17 *SI#965 5,195
12-28 SI#966 19,720
12-28 SI#967 1,302
12-31 SI#969 5,841
12-31 SI#970 7,922
12-31 SI#971 2,010
P699,860 P699,860
445
PURCHASES
Balance Forward
Date Reference Amount Date Reference Amount
P360,000 12-31 Closing entry P385,346
12-28 *RR#1059 3,100
12-30 RR#1061 19,720
12-31 RR#1062 8,965
12-31 RR#1063 4,861
8,120
P385,346 P385,346
When performing a sales and purchases cutoff test, you found that at December 31,
20X7, the last receiving report that had been used was no. 1063 and that no
shipments have been made on any sales invoices with numbers larger than no. 968.
You also obtained the following additional information.
446
5. En route to the Y Company on December 31, 20X7, was a truckload of material
that was received on receiving report no. 166. The material was shipped FOB
destination and freight of P75 was paid by the Y Company. However, the
freight was deducted from the purchase price of P975.
6. Included in the physical inventory were chemical exposed to rain in transit and
deemed unsalable. Their invoice cost was P1,250, and freight charges of P350
had been paid on the chemicals.
Required:
a. Compute the adjustments that should be made to the client’s physical inventory
at December 31, 20X7.
b. Prepare the auditor’s worksheet adjusting entries that are required as of
December 31, 20X7.
You are observing inventory as part of the August 31 year-end audit of Engine Warehouse
Supply Company, a wholesale and retail engine parts company. Inventory includes a large
number of diverse parts varying from small bolts to large engines for earth-moving
equipment.
The company has ceased operation during the physical count except for receiving goods
from suppliers and making shipments to essential wholesale customers. On the morning of
the physical count, which is Saturday, September 2, you record in your working papers the
last shipping document and receiving report number issued the previous day. They are 314
and 682, respectively.
You observe the client’s counting procedures and test count selected inventory yourself.
You conclude the counts and description are accurate. Before you leave the warehouse at
the end of the day after all counting is completed, you do several things:
1. Examine the receiving report book. The last number used was 685. The receiving
clerk informs you all goods received on September 2 were kept in the receiving
department with other goods received during the past two or three days.
2. Examine the shipping document book. The last number used was 317. The
shipping department informs you that three shipments were made before noon, two
were made after noon, and one was still in the shipping department.
447
3. Ask the receiving department to identify all goods received September 1. He
identifies receiving reports 680 through 682 as having been received September 1.
4. Ask the shipping department to identify all goods shipped or sold over the counter
September 1. He informs you goods on shipping document 311 to 313 were
shipped September 1. He shows you approximately 300 duplicate sales slips for
September 1 over-the-counter sales. September 1 retail sales totaled P12,690, but
they were not included in August sales.
5. Examine the client’s inventory counts in the receiving department. Inventory had
been counted only for receiving reports 674 to 684.
6. Examine the client’s inventory counts in the shipping department. Inventory had
been counted only for shipping documents 316 to 317. Further examination shows
that inventory for all shipments made September were included in the counts in the
department from which the inventory was taken.
During the year-end audit work you obtain selling prices, costs, terms, and recording
data for each receipt and shipment. They are as shown below.
ACQUISITIONS OF INVENTORY
Included in or
Receiving Excluded FOB
Peso Amount
Report Date Shipped Date Received from August Origin or
of Acquisition
No. Acquisitions Destination
Journal
679 8-29 8-30 P 860 I Destination
680 8-27 9-01 1,211 I Origin
681 8-20 9-01 193 I Origin
682 8-27 9-01 4,674 I Destination
683 8-30 9-02 450 E Destination
684 8-30 9-02 106 E Origin
685 9-02 9-02 2,800 E Origin
686 8-30 9-02 686 E Destination
SHIPMENTS OF INVENTORY
Shipping
Pesos Amount of Included in or Excluded from August
Document Date Shipped
Sales Acquisitions Journal
No.
310 8-31 P 780 I
311 9-01 56 I
312 9-01 3,194 I
313 9-01 635 I
314 9-01 193 I
315 9-02 1,621 E
316 9-02 945 E
317 9-02 78 E
318 9-02 3,611 E
448
Required:
Assume that the information you have obtained about the September 1 receipts and
shipments is accurate:
449
The physical count of goods in Isabela’s warehouse on December 31, 20X7,
because the parts were on the loading dock waiting to be picked up by customers.
3) Parts in transit December 31, 20X7, to customers, shipped F.O.B. shipping point,
on December 28, 20X7, amounted to P34,000. The customers received the parts on
January 6, 20X8. Sales of P40,000 to the customers for the parts were recorded by
Isabela on January 2, 20X8.
4) Retailers were holding P210,000 at cost (P250,000 at retail) of goods on
consignment from Isabela, the consigner, at their stores on December 31, 20X7.
5) Goods were in transit from G Company to Isabela on December 31, 20X7. The cost
of goods was P25,000 and they were shipped F.O.B. shipping point on December
29, 20X7.
6) A quarterly bill in the amount of P2,000 specifically relating to merchandise
purchases in December 20X7, all of which was still in the inventory at December
31, 20X7, was received on January 3, 20X6. The freight bill was not included in
either the inventory or in accounts payable at December 31, 20X7.
7) All of the purchases from B Company occurred during the last seven days of the
year. These items have been recorded in accounts payable and accounted for in the
physical inventory at cost before discount. Isabela’s policy is to pay invoices in
time to take advantage of all cash discounts, adjust inventory accordingly, and
record accounts payable, net of cash discount.
450
Required:
Prepare a schedule of adjustments to the initial amounts using the form as shown below.
Show the effect, if any, of each of the transactions separately and if the transactions would
have no effect on the amount shown state NONE.
Bers Company has completed the statement of comprehensive income and statement of
financial position (summarized and uncorrected, shown below) at December 31, 20X6.
Subsequently, during an audit, the following items were discovered.
Required:
Set up a schedule similar to the one shown in the next page, make the corrections, and
derive the corrected amounts. Include increases and decreases for each transaction.
Explain any assumptions made with respect to the doubtful items. Disregard income taxes.
451
Items for Correction
Uncorrected (a) (b) (c) (d) (e) Corrected
Amounts Amounts
Statement of
comprehensive income:
Sales revenue…………. P90,000
Cost of goods sold…….. 50,000
Gross margin………….. 40,000
Expenses…………...…. 30,000
Income……………...… P10,000
Statement of financial
position:
Accounts receivable...… P42,000
Inventory…………..….. 20,000
Remaining assets..….…. 30,000
Accounts payable…….. 11,000
Remaining liabilities…… 6,000
Share capital, ordinary.... 60,000
Retained earnings…..…. 15,000
Problem 5
You are audit manager of the rapidly growing CPA firm of Raye and Coye. You have been
placed in charge of three new audit clients, which have the following inventory features:
1. Canyon Cattle Co., which maintains 15,000 head of cattle on a 100 hectares, mostly
unfenced, near the south rim of the Canyon Grove in Butuan City.
2. Rhoads Mfg. Co., which has raw materials inventories consisting principally of iron
ores loaded on freight cars on a siding at the company's plant.
3. Strawser Company, which is in production around the clock on three shifts, and which
cannot shut down production during the physical inventory.
452
Problem 6
The auditors of the SSC Company, a nonpublic company, are working on both audit
objectives for the various accounts and documentation requirements. Parts (a) through (d)
of this question relate to objectives, while part (e) addresses documentation.
The auditors have established the objectives listed below as a part of the audit. For each
objective, select a substantive procedure (from the list of substantive procedures) that will
help achieve that objective. Each of the procedures may be used once, more than once, or
not at all.
Audit Objectives
a. Determine the existence of year-end recorded accounts payable and that the client has
obligations to pay these liabilities.
b. Establish the completeness of recorded accounts payable.
c. Determine that the presentation and disclosure of accounts payable are appropriate.
d. Determine that the valuation of warranty loss reserves is measured in accordance with
PFRS.
Substantive Procedures
1. Obtain a trial balance of payables and reconcile with the accounts payable
subsidiary ledger.
2. Vouch sales from throughout the year.
3. Vouch purchases recorded after year-end.
4. Vouch sales recorded shortly before year-end.
5. Vouch major warranty expenses paid during 20X8.
6. Inquire of management concerning the existence the existence of related
party transactions.
7. Test the computations made by the client to set up the accrual.
8. Test the reasonableness of general and administrative labor rates.
9. Confirm outstanding year-end balances of payables.
10. Confirm warranty expenses payable as of year-end.
453
Problem 7
Nancy Diaz, your staff assistant on the April 30, 20X7, audit of Will Company, was
transferred to another audit engagement before she could complete the audit of unrecorded
accounts payable. Her working paper, which you have reviewed and are satisfied is
complete, appears below.
WIL COMPANY
Unrecorded Accounts Payable
April 30, 20X7
M-1-1
Invoice
Date Vendor and Description Amount
Hill & Harper - unpaid legal fees at Apr. 30, X7 (See
1,000 ✓
lawyer's letter at M-4)
Drew Insurance Agency - unpaid premium at year-end on
fire insurance for period Apr. 1, X7 - Mar. 31, X8 (See
Apr. 1, 20X7 1,800 ✓
insurance broker letter at J-1-1) Payment made on May 7,
20X7.
Required: Prepare a proposed adjusting journal entry for the unrecorded accounts payable
of Will Company at April 30, 20X7. The amounts are material. (Do not deal with income
taxes.)
454
Problem 8: Inventory Valuation
MAR Company's records of transactions concerning part S for the month of April was as
follows:
Purchases Sales
April 1 (balance on hand) 100 @ P5.10 April 5 300
4 400 @ 5.10 12 200
11 300 @ 5.30 27 800
18 200 @ 5.35 28 100
26 500 @ 5.60
30 200 @ 5.80
Required:
(a) Compute the inventory at April 30 on each of the following bases. Assume that
perpetual inventory records are kept in units only. Carry unit costs to the nearest cent.
1) First-in, first-out (FIFO)
2) Average cost.
(b) If the perpetual inventory record is kept in pesos, and costs are computed at the time of
each withdrawal, what amount would be shown as ending inventory in 1 and 2 above?
Carry average unit costs to four decimal places.
Cosmo and Wanda Company lost most of its inventory in a fire in December just before
the year-end physical inventory was taken. The corporation's books disclosed the
following:
Merchandise with a selling price of P21,000 remained undamaged after the fire. Damaged
merchandise with an original selling price of P15,000 had a net realizable value of P5,300.
Required:
Compute the amount of the loss as a result of the fire, assuming that the corporation had no
insurance coverage.
455
Chapter
AUDIT OF
INVESTMENTS
1. Describe the auditors' objectives for the substantive tests of details of balances
of investments in debt and equity securities as well as non-trade loans
receivable.
3. Understand and prepare audit working papers to document audit procedures for
investments in debt and equity securities and non-trade loans receivable.
CHAPTER 14
AUDIT OF INVESTMENTS
INTRODUCTION
The form of investments can vary considerably. The investments may be in debt (T-bills,
commercial paper, bonds) or equity (ordinary shares, preference shares) securities. The
securities may be marketable or long term, as investment in shares of subsidiary or affiliated
companies. Also, the investment may be in pension funds, cash surrender value of life
insurance, real estate, or loan or advance rather than a security. However, the primary
distinction between long-term investment and investment classified as current assets is
management’s intention and ability to hold the investment for longer than one year. Thus, the
following discussion of the substantive audit objectives and procedures will apply in general to
most investments.
Figure 14-1 summarizes the financial statement assertions, specific audit objectives and the
common audit procedures traditionally used to audit investments.
457
B. To determine that 4. In addition audit procedures 2
investments are all included in and 3, vouch selected purchases
II. Completeness
the statement of financial and sales transactions of
position. securities during the year.
5. In addition to audit
procedures 2 and 3, verify the
C. To determine that the
clients' cutoff of securities
company owns or has
III. Rights and transactions.
ownership rights to all
Obligations 6. Perform analytical
investments included in the
procedures.
statement of financial position.
7. Compute independently
revenue from securities.
D. To determine that 8. Determine market value of
investments are valued securities at statement of
IV. Valuation properly in accordance with financial position date.
generally accepted accounting 9. Evaluate the method of
principles. accounting for securities.
1. Obtain or prepare analysis of the securities, other investments and related revenue
account and reconcile to the general ledger.
458
2. Inspect securities on hand.
The auditor should account for the securities owned by the company by inspecting the
securities on hand in the presence of the company's official and a signed receipt in ink
for their return to the custodian. The information mentioned in audit procedures
number 1 will be shown in the securities count sheet. If securities are held in more than
one location, an arrangement should be made to have a simultaneous count at all
locations. This will avoid the possibility of client personnel attempting to cover up theft
of authorized used by transferring the securities from one location to another.
Figure 14-2 shows the pro-forma working papers for securities count sheet.
The auditors should verify a sample of transactions by reference to the brokers' advices
and cash records. Entries to record the purchases and sales transactions should be
checked as to authorization, proprietary and accuracy.
The auditors should review transactions pertaining to securities a few weeks before and
after the statement of financial position date to determine whether they are recorded in
the correct accounting period. Sometimes sales occurring at the statement of financial
position date are not recorded because the delivery of the certificates by the broker are
made after the statement of financial position date. Hence, an error in cutoff of
transactions will occur.
To test the reasonableness of the amounts of dividend and interest income recorded,
they may be related to their sources namely, the securities. Dividends that should have
been received and recorded can also be verified by referring to the investment advisory
services by the Philippine Stock Exchange and other international publications. Interest
income earned on notes, bonds can also be verified independently by the auditors and
compared with recorded amounts in the books of the client.
Generally, the audit procedures in the verification of "valuation" are largely determined
by the method of valuation that is appropriate under PFRS.
Cost is substantiated by vouching the acquisition price in the accounting records and
market price is substantiated by comparison to publication of market quotation of
security prices. When securities are not listed at the Stock Exchange pr not actively
traded, it may be necessary to obtain market quotations from brokers.
If the investment is closely held with no active market, the auditors may obtain an
appraisal value from a securities appraiser.
460
The investment account is increased to reflect a proportionate share of investee income
and decreased to reflect investee losses and dividends received from the investee.
When auditing an investment accounted for by the equity method, the auditors must
verify that the investment was properly recorded initially. The auditors must also
obtain evidence regarding additions to or deductions from the account by referring to
the "audited financial statements of the investee." If these statements are not available,
the auditors should perform a sufficient investigation of the investee's financial
statements to determine the fairness of the amounts recorded by the investor. In certain
cases, this might involve performing audit procedures at the investee's place.
PAS 32 and PFRS 9 require the proper categorization of the investment portfolio in the
financial statements. They also require the disclosure of the method of accounting for
the securities, aggregate market values of the various portfolio, amount of realized and
unrealized gains and losses, proceeds from sales of securities, lien on the securities and
other related matters.
The following are data on Investment in MES (@FVOCI) for the auditor's scrutiny:
Required:
1. What entries relative to the Investment in MES (@FVOCI) should have been made
by the company
a) On January 1, 20X7?
b) On December 31, 20X7?
c) On December 31, 20X8?
d) On July 1, 20X9?
461
2. At what balance should the following accounts be shown on the Statement of
Financial Position
Accounts Balance as of
Investment in MES (@FVOCI) 12.31.X7 ?
12.31.X8 ?
07.31.X9 ?
Requirement 1
January 1, 20X7
Investment in MES @ FVOCI 2,200,000
Cash (P2,000,000 + P200,000) 2,200,000
July 1, 20X9
Cash 4,000,000
Investment in MES @ FVOCI 3,200,000
Retained Earnings 800,000
462
Requirement 2
Accounts Balance as of
Investment in MES (@FVOCI) 12.31.X7 P2,600,000
12.31.X8 3,200,000
07.31.X9 0
Unrealized gain - OCI 12.31.X7 P400,000
12.31.X8 1,000,000
07.31.X9 0
Summary:
Selling price of Investment in MES - @FVOCI P4,000,000
Original Cost 2,200,000
Realized gain on 7.31.X9
credited to retained earnings P1,800,000
As auditor for the Laurel Company, you are to prepare the following:
Working papers for the securities and for security transactions for the year ended December 31,
20X7, including columns for the following:
(1) Securities inventory at December 31, 20X6, divided into security name, number of shares,
cost, and average cost per share.
(2) Security purchases in 20X7, divided into date, shares, and amount.
(3) Security sales in 20X7, divided into date, shares, amount, and average cost of shares sold,
and profit or loss on sales.
(4) Securities inventory at December 31, 20X7, divided into name of security, shares, cost, and
market value.
(6) Adjusting journal entry required (if any) as of December 31, 20X7.
463
Marketable securities (@FVOCI) purchased by the Laurel Company at December
31, 20X6.
Security transactions for 20X7 are as shown in the two tables following:
A P100,000
C 70,000
D 135,000
E 40,000
F 12,000
G 133,000
P490,000
464
Solution: Illustrative Audit Case 14-2 - Working Papers for Investments in Securities
@FVOCI
Illustrative Audit Case 14-3: Valuation of Current and Non-Current Investments
The following asset side of the statement of financial position was provided by the MB
Corporation on December 31, 20X7.
MB Corporation
December 31, 20X7
Assets
Cash P20,000
Temporary marketable equity securities (@FVPL) (market: P16,000) 22,000
Inventory 30,000
Current assets 72,000
Noncurrent investment in 8%, 10-year bonds (at face value;
cost: P87,711 100,000
Noncurrent marketable equity securities @FVOCI
(at market; cost: P62,000) 75,000
Plant assets 100,000
Less: Accumulated depreciation (25,000)
Total assets P322,000
The long-term investment in bonds (held-to-maturity) was purchased on January 1, 20X7. The
difference between cost and face value was recognized on the 20X7 income statement as an
unrealized gain on the acquisition date. The interest on the bond is payable annually on January
1. The noncurrent marketable equity securities (@FVOCI) include a 30% interest in the
Alomar Company. This investment (with a P45,000 market value on December 31, 20X7) was
purchased on January 2, 20X7, for P40,000 and represents a significant influence. Alomar had
net income of P50,000 and dividends of P20,000 in 20X5. MB reported 20X7 net income of
P57,000. The books for MB Corporation have not been closed for 20X7. Assume that all items
are material.
Required:
a. Provide correcting and adjusting entries for MB Corporation in light of the information given.
Any discount or premium on the bond investment is to be carried in a separate account from the
face value.
b. What is MB's correct net income for 20X7? Show your computations.
c. Recast the asset side of the December 31, 20X7, Statement of Financial Position MB
Corporation according to applicable Financial Reporting Standards.
466
Solution: Illustrative Audit Case 14-3
Requirement (a)
Adjusting journal entries for MB Corporation are as follows:
AJE (1)
Loss on Valuation of Current Marketable
Equity Securities (@FVPL) 6,000
Allowance to reduce Current Marketable
Equity Securities to Fair Value or
Market Adjustment - Trading Securities (@FVPL) 6,000
To adjust FVPL to fair value valuation.
AJE (2)
Unrealized gain on Bond Investment 12,289
(P100,000 -
P87,711)
Discount on Bond Investment 12,289
To properly record discount on bond investment.
AJE (3)
Interest Receivable (8% x P100,000) 8,000
Discount on Bond Investment 771
Interest Revenue (P87,711 x 10%) 8,711
The effective rate of the bond investment must be determined. The effective rate must be
greater than 8% because the bonds were acquired at a discount; try 10%.
P100,000 x pvf10¬ 10% P38,554
(0.38554)
(P100,000 x 8%) x
pvf10¬ 10% 49,157
(.614457) P87,771
This calculation indicates that 10% is the effective rate on the investment. Therefore, the
above journal entry has to be made.
AJE (4)
Gain on Valuation Noncurrent Marketable Equity 13,000
Securities
(NCMES)*
Investment in Equity Securities - Alomar 40,000
Noncurrent Marketable Equity Securities (@FVOCI) 45,000
Unrealized Gain on Noncurrent Marketable Equity Securities
(@FVOCI) (Equity) 8,000
To reclassify investment in Alomar and correct entry to record
gain on valuation of non-current marketable equity securities.
467
The noncurrent marketable equity securities are carried at market value, which exceeds cost.
The company uses “fair value” basis of valuation in consonance with PFRS 9. They include,
however, the investment in Alomar Company which should be reclassified and accounted for
by the equity method.
Cost Market
Noncurrent Marketable Equity Securities P62,000 P75,000
Investment in Alomar (40,000) (45,000)
Balance of noncurrent marketable equity securities
(@FVOCI) P22,000 P30,000
*Because the securities are included in the statement of financial position at P75,000, the
assumption is made that an unrealized gain of P13,000 to the asset account was recorded.
AJE (5)
Investment in Equity Securities (P50,000 x 30%) 15,000
Equity in Investee
15,000
Income
To take up share in investee income.
AJE (6)
Dividend Revenue (P20,000 x 30%) 6,000
Investment in Equity Securities 6,000
To correct entry recording receipts of dividends.
Requirement (b)
468
Requirement (c)
MB Corporation
December 31, 20X7
Assets
Cash P20,000
Current marketable equity securities P22,000
Less: Allowance to reduce current marketable
equity securities to fair value (6,000) 16,000
Interest receivable 8,000
Inventory 30,000
Total current assets P74,000
Non-current investment in bonds (held-to-maturity) 88,482*
Non-current marketable equity securities (cost:
P22,000) 30,000
Investment in Alomar 49,000**
Plant assets 100,000
Less: Accumulated depreciation (25,000) 75,000
Total assets P308,482
The Unrealized Gain on NCMES (FVOCI) balance of P8,000 will be reflected in the Equity
section of the Statement of Financial Position.
469
Illustrative Case 14-4: Audit of Cash Surrender Value of Life Insurance Policy
Case facts
On January 1, 20X5 Gordon Manufacturing Corporation took a like insurance policy on the life
of its president for P20,000,000 with the entity designated as the lone beneficiary.
Data relative to the life insurance policy follow.
20X5 P300,000 -
20X6 300,000 -
20X7 300,000 P300,000
20X8 300,000 420,000
20X9 300,000 580,000
The president died on June 30, 20X9 and the face value of the policy collected on July 31,
20X9.
Premiums paid were correctly recorded as expense from January 1, 20X5 to January 1, 20X9.
The accountant, however, failed to recognize the cash surrender value of the policy in 20X7 to
20X9.
Required:
What adjusting entry should be made on July 1, 20X9 to correct the accounts of the entity?
470
2. Gain on life insurance settlement 500,000
Cash insurance value 500,000
To correct overstatement of gain on insurance settlement and close the cash
surrender value account.
OR
471
REVIEW QUESTIONS AND PROBLEMS
Questions
1. A client that has never before invested in securities recently acquired more than a
million peso in cash from the sale of real estate no longer used in operations. The
president intends to invest this money in marketable securities until such time as the
opportunity arises for advantageous acquisition of a new plant site. He asks you to
enumerate the principal factors you would recommend to create strong internal control
over marketable securities.
3. During your audit of a small manufacturing firm, you find numerous checks for a large
amounts drawn payable to the treasurer and charged to the Miscellaneous Expense
account. Does this require any action by the auditor? Explain.
4. What information should be noted by the auditors during their inspection of securities
on hand?
6. In what ways can the audit of financial investments present special risks requiring
specialized skill and knowledge?
7. How can the auditors determine that all dividends applicable to investment in securities
owned by the client have been received and recorded?
472
Exercises
Exercise 1
During the current year, the management of Circle Inc., entered into a futures contract
to hedge the price of silver that will be needed for the next year’s production. The
contract, which is held by Circle’s commodity broker, is marketable and exchanged on
the Philippine Stock Exchange.
Required:
Exercise 2
Following are typical questions that might appear on an internal control questionnaire
for investments in marketable securities.
Required:
Exercise 3
In the audit of a client with a fiscal year ending December 31, the CPAs obtain a
January 10 bank statement directly from the bank. Explain how this cutoff bank
statement will be used.
473
Exercise 4: Journal Entries for Fair Value and Equity Methods
Situation 1
Charming Cosmetics acquired 10% of the 200,000 ordinary shares of Monday Fashion
at a total cost of P13 per share on March 18, 20X7. On June 30, Monday declared and
paid a P75,000 cash dividend. On December 31, Monday reported net income of
P122,000 for the year. At December 31, the market price of Monday Fashion was P15
per share. The securities are classified as FA @ FVOCI but the accountant used the
equity method. The balance of the Investment in Securities account is P264,700.
Situation 2
Monsters, Inc. obtained significant influence over Nemo Corporation by buying 30%
of Nemo’s 30,000 outstanding ordinary shares at a total cost of P9 per share on January
1, 20X7. On June 15, Nemo declared and paid a cash dividend of P36,000. On
December 31, Nemo reported net income of P85,000 for the year. The accountant used
the fair value method of accounting and considered the shares as FA @ FVOCI. The
market value per share on December 31, 20X7 is P10.
Required: Prepare all necessary adjusting journal entries in 20X7 for both situations.
Problems
The information on the following page is available for BYDG Company at December 31,
20X7, regarding its investments.
474
Required:
(a) Prepare the adjusting entry (if any) for 20X7, assuming the securities are classified
as trading (@FVPL).
(b) Prepare the adjusting entry (if any) for 20X7, assuming the securities are classified
as FA @FVOCI.
(c) Discuss how the amounts reported in the financial statements are affected by the
entries in (a) and (b).
Problem 2
During the first quarter of 20X6 the Canada Corporation entered into the following
transactions:
Jan. 1 Acquired 150 ordinary shares of Tan Corporation for P20 per share, 200
ordinary shares of Argante Corporation for P30 per share, and 100
ordinary shares of Francisco Corporation for P25 per share. These are
the only shares the company owns and all are classified as securities
@FVOCI.
Feb. 1 Purchased 12% Josefina Company bonds with a face value of P20,000 at
par, plus accrued interest. Interest on the bonds is payable February 28
and August 31 each year, and the bonds are due August 31, 20X8. Also
purchased 10% Jayce Company bonds with a face value of P12,000 at
par, plus accrued interest. Interest on the bonds is payable March 31 and
September 30, and the bonds are due September 30, 20X8. These are
the only bonds the company owns and all are classified as securities
@FVOCI.
Feb. 1 Established a petty cash fund for incidental expenditures at P500.
Feb. 28 Received the semiannual interest on the Josefina Company bonds.
Feb. 28 A count of cash on hand indicated that P125.50 remained in the petty
cash fund. A sorting of petty cash vouchers disclosed that P110.00 was
spent for postage, P170.65 was spent for office supplies, P45.00 was
spent for transportation, and P43.50 was spent for miscellaneous items.
The fund was replenished.
Mar. 31 Received first quarter dividends of P1,500 and the semiannual interest on
the Jayce Company bonds. On this date, the aggregate fair value of
Canada's securities at FVOCI is P42,600.
Mar. 31 A count of cash on hand indicated that P230.50 remained in the petty
cash fund. A sorting of petty cash vouchers disclosed that P140.00 was
spent for postage, P75.30 was spent for office supplies, P54.20 was
spent for miscellaneous items. The fund was replenished.
475
The bank statement and the accounting records of the Canada Corporation for the
month of March 20X6 indicated that the cash collected from the dividends and the
Jayce Company bond interest was deposited on March 31 but did not appear on the
March bank statement. There were no other deposits in transit. The bank statement
showed a balance on March 31 of P13,459.75, which included collection of a P1,500
note and P100 of interest by the bank for the Canada Corporation. Also listed was a P20
bank service charge and a P75.60 NSF check returned by the bank. The cash balance
per the accounting records on March 31 was P11,689.95, which included checks
totaling P2,365.40 that had not yet cleared the bank.
Required:
Problem 3
On January 1, 20X6 Patrick Company paid P600,000 for 10,000 shares of Lede
Company’s voting ordinary shares, which was a 10% interest in Lede. Patrick does not
have the ability to exercise significant influence over the operating and financial
policies of Lede. The company made an irrevocable election to present the investment
@FVOCI.
Patrick received dividends of P1.00 per share from Lede on October 2, 20X6. Lede
reported net income of P400,000 for the year ended December 31, 20X6. Lede reported
net income of P400,000 for the year ended December 31, 20X6 and the ending market
price of its share was P63.
On July 2, 20X7 Patrick paid P1,950,000 for 30,000 additional shares of Lede
Company’s voting ordinary shares, which represents a 30% investment in Lede. The
fair values of all of Lede’s assets, net of liabilities, were equal to their book values of
P6,500,000. As a result of this transaction, Patrick has the ability to exercise significant
influence over the operating and financial policies of Lede. Patrick received dividends
of P1.00 per share from Lede on April 2, 20X7 and P1.35 per share on October 31,
20X7, and P200,000 for the 6 months ended December 31, 20X7.
476
Required:
1. For the Patrick Company show the dividend revenue for 20X6, as well as the
December 31, 20X6 unrealized increase in the value of securities @ FVOCI and
carrying value of the investment account.
2. Assuming that Patrick Company issues comparative financial statements for 20X6
and 20X7, show the investment income for 20X6 and 20X7, as well as the
December 31, 20X6 and 20X7 carrying value of the investment account.
Problem 4
May Flores, of Castro & Horario, CPAs, is in charge of the Belle Manufacturing
Company audit for the year ended December 31, 20X8. The firm also audited Belle last
year. Belle manufactures earth-moving equipment and owns 25% of the voting shares
of Laribee Industries, a leasing company. At December 31, 20X7, the end of the
preceding year, Belle held 10% of the shares and reported the investment at cost, which
equaled the market value of the shares at that date. During 20X8, Belle acquired an
additional 15% of the voting shares, 12/31/20X7 balances and 20X8 transactions
related to this investment are as follows:
12/31/20X7: Balance in "Investment in Laribee," 1,000 shares at cost of P50 per share.
01/02/20X8: Purchased 1,500 shares of Laribee at a cost of P50 per share.
04/01/20X8: Laribee declared a first-quarter dividend of of P50,000.
07/01/20X8: Laribee declared a second-quarter dividend of of P50,000.
10/01/20X8: Laribee declared a third-quarter dividend of of P60,000.
At December 31, the investment account appeared as follows in Belle’s general ledger.
477
Laribee’s income statement for 20X7 reflected the following revenue and expense
components:
Required:
a. What specific audit objectives should Flores have in examining the Laribee
account? What audit procedures should she apply?
b. What level of satisfaction does Flores require with respect to Laribee’s income
statement components?
c. Prepare an audit workpaper, in good form, for the Laribee investments. Be sure to
include any necessary audit adjustments.
d. Does the Laribee investment raise any “warning signs” that the auditors should
pursue?
*These are amounts added back (subtracted from) net income to obtain cash flow from
operations
478
Assume that there are no adjustments required for differences between book value and
fair value at the date of acquisition, or any goodwill, associated with the equity-based
companies.
Required:
1. On the income statement, equity income is combined with “other income”. From
the information presented, what is the maximum amount that Del could have
received in dividends from its equity-basis companies in 20X7? Now suppose Del
received no dividend from its equity-basis companies in 20X7. In this case, how
much of the P74 million is other income?
3. What rate of return on average assets did Del earn on its investment in equity-basis
companies in 20X7? Assume that other income in 20X7 is zero.
479
Chapter AUDIT OF PROPERTY,
PLANT AND EQUIPMENT,
AND THE RELATED
DEPRECIATION AND
DEPLETION
INTRODUCTION
The term property, plant and equipment include all tangible assets with a service life of more
than one year that are used in the operation of the business and are not acquired for the purpose
of resale. Three major subgroups of such assets are generally recognized:
1. Land, such as property used in the operation of the business, has the significant
characteristics of not being subject to depreciation.
2. Buildings, machinery, equipment, and land improvements, such as fences and parking
lots, have limited service lives and are subject to depreciation.
3. Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber,
are subject to depletion as the natural resources are extracted or removed.
Acquisitions and disposals of property, plant and equipment are usually large in peso amount,
but concentrated in only a few transactions, individual items of plant and equipment may
remain unchanged in the accounts for many years.
Even when the assets are classified separately, the audit approach is generally the same as for
property and equipment.
The essential features of substantive tests of balances for property, plant and equipment are
emphasis on specific audit objectives related to existence, ownership and valuation achieved
primarily by substantiating additions and identifying retirements during the period and
verification of depreciation and depletion (if any) expense.
481
AUDIT OBJECTIVES AND PROCEDURES
The financial statement assertions, specific audit objectives and the commonly applied audit
procedures used for property, plant and equipment are summarized below:
Assertions Audit Objectives Audit Procedures
482
Discussion of Audit Procedures
To provide a focal point for applying substantive tests, the auditor should prepare or
obtain a schedule of plant assets and accumulated depreciation showing balances at
the beginning of the year additions and disposals during the year and balance at the
end of the year. Figure 15-1 illustrates a Lead Schedule for Property and Equipment
and Related Accumulated Depreciation.
Beginning balance of plant and equipment assets may be verified by reference to the
prior year's audit working papers. While additions and disposals/retirements may be
verified as the audit progresses.
Before making a detailed analysis of change is property accounts, the auditor should
be sure that the amounts in the working paper agree with the ledger balances, both
subsidiary and general. Although, the audit testing will be performed on the
subsidiary ledger, any audit adjustment will be posted by the client to the
controlling account.
A physical inspection of major units of plant and equipment acquired during the year
under audit is usually performed by the auditor to determine that these assets do, in fact,
exist. This step is also helpful in maintaining a good working knowledge of the client's
operations, and in interpreting the validity of the5accounting entries for both additions
and retirements.
3 & 4. Vouch additions to property during the year. Investigate disposals and retirements.
The auditor should examine on a test basis documentation supporting plant asset additions and
disposals. Vendors' invoices and freight bills provide evidence supporting proper valuation and
ownership of purchased assets. While for constructed plant assets, work orders provide the
information covering materials, labor and overhead applied to them. Materials, labor and direct
overhead charges should be traced to requisitions and time tickets on a test basis. Fixed
overhead should be recalculated to support the reasonableness of the application rates. The
auditor should also determine whether interest should be capitalized as part of the project.
For plant asset disposals, the auditor should examine remittance advices, validated deposit slips
and bank statements to verify whether material amounts of receipts from sale were properly
recorded and deposited intact.
The auditor should also examine the minutes of directors' meetings for proper authorization of
major acquisitions and disposals. Purchase and sale agreements should be examined for proper
recording and for the existence of indebtedness, contingent liabilities or other restrictions
arising from the transactions.
To verify legal ownership of the asset, the auditor must examine evidence such as deeds,
transfer certificate of title (TCT), insurance policy and property tax bills. Assets owned by the
client but held by third parties under operating lease agreements may be confirmed with the
third parties. While assets held by client under capital lease agreement should be verified
against the lease contract to determine whether correct accounting entries were made. For
capital or financing leases, the auditor should recalculate minimum lease payments and
evaluate the appropriateness of the discount used in capitalizing the leases. The ownership of
machinery and equipment can be verified by examining the purchase invoices and contract of
sale. While ownership of cars, trucks and other delivery equipment can be ascertained by
reference to certificates of titles and registration documents.
7. Review rental revenue from land, buildings and equipment owned by the client and leased
to others.
In testing revenue from rental of land, buildings and equipment, the auditor should account for
all available rental space and determine the premises actually occupied by lessees and those
which are vacant. The auditor can obtain the floor plan of the building as well as copies of all
lease contracts.
Rental revenue account should be analyzed in all cases and the amount compared with lease
agreements and cash records.
485
8. Analyze repairs and maintenance account.
Repairs and maintenance account should be analyzed to discover items that should have been
capitalized. The auditor should examine and evaluate company policy regarding capitalization
of extraordinary repairs and consistency in its application. The accuracy of the client's
accounting for the expenditures may be verified by reference to vendors' invoices, to material
requisitions and to labor time records. A comparison of the current repairs and maintenance
charges with those of the prior year and with budgeted amounts could indicate errors in
classifying repairs as capital expenditures. A material increase in repairs expense, alternately,
suggests possible expense overstatement.
Property and equipment not in current use should be investigated thoroughly to determine the
properties for their future use in operations. Equipment and other property that have been
dismantled or appear unsuitable for operating use in the future should be written down to their
estimated net realizable value and excluded from the property and equipment classification. If
plant assets are temporarily idle, they need not be reclassified and depreciation may continue at
normal rates.
The auditor should evaluate the appropriateness of depreciation methods used by the client and
then recalculate the depreciation charges on a test basis. Depreciation recorded on additions and
disposals should be examined for consistency with company policy and the prior year.
In the audit of companies operating properties subject to depletion (mines, timberlands, oil and
gas deposits, and other natural resources), the auditors follow a pattern similar to that used in
evaluating the provisions for depreciation expense and accumulated depreciation. They
determine whether depletion has been recorded consistently and in accordance with generally
accepted accounting principles.
486
11. Perform analytical procedures for property and equipment.
Some specific ratios and trends may be used in judging the overall reasonableness of the
recorded amounts for property and equipment. These are
1. Total cost of plant assets divided by annual output in pesos, or in units.
2. Total cost of plant assets divided by cost of goods sold.
3. Comparison of repairs and maintenance expense on a month-to-month basis or from
year-to-year.
4. Comparison of additions and retirements for the current year with prior years.
5. Compare the ratio of depreciation expenses to total cost of property and equipment in
the current year and compare with prior year.
6. Compare the percentage relationships of accumulated depreciation and related
property account in the current year and compare with prior year.
12. Evaluate financial statements presentation and disclosure for property and equipment,
accumulated depreciation and related revenue and expense accounts.
Balances of major classes of depreciable assets should be disclosed in the statement of financial
position or accompanying notes. Accumulated depreciation may be shown by major class or in
total, and the method(s) of computing depreciation should be .stated. The total amount of
depreciation should be disclosed in the statement of comprehensive income or supporting notes.
Disclosure is also required for the following:
a) Basis of valuation
b) Property pledged to secure loans
c) Property not in current use
The auditor should examine loan agreements for possible pledging of property and equipment
as collateral. He should also inquire or legal counsel and examine bank confirmations for
evidence of pledging. To the extent to which property and equipment have been pledged as
security, statement of financial position disclosure is required.
487
AUDIT OF NATURAL RESOURCES
In the audit of companies' operating properties subject to depletion (mines. oil and gas deposits,
timberlands, and other natural resources), the auditors follow pattern similar to that used in
evaluating the provision for depreciation expense and accumulated depreciation. They
determine whether depletion has been recorded consistently and in accordance with generally
accepted accounting principles and they test the mathematical accuracy of the client's
computations.
For instance, the depletion of timberlands is usually based on physical quantities established by
cruising. (The term cruising means the inspection of tract of forestland for the purpose of
estimating the total lumber yield.) For areas that are difficult to access the client or the auditors
might use drones to assess the yield.
The determination of physical quantities to use as a basis for depletion is more difficult in many
mining ventures and for oil and gas deposits. The auditors often rely upon the opinions of such
specialists as mining engineers and geologists about the reasonableness of the depletion rates
being used for such resources. Under these circumstances, the auditors must comply with
requirements of the professional standards on the use of specialists.
• If the number of tons of ore in a mining property could be accurately determined in advance,
an exact depletion cost per ton could be computed by dividing the cost of the mine by the
number of tons available for extraction. In reality, the contents of the mine can only be
estimated, and the estimated may require significant revision as mining operations progress.
• The auditors investigate the ownership and the cost of mining properties by examining deed,
leases, tax bills, vouchers, paid checks and other records in the same manner that they verify the
plant and equipment of a manufacturing or trading concern. The costs of exploration and
development work in a mine customarily are capitalized until such time as commercial
production begins. After that date, additional development work generally is treated as an
expense. The large oil companies capitalize the costs of drilling oil wells only if they are found
to be productive. Under this "successful efforts" policy, the costs of drilling wells that prove not
to be productive are immediately written off. However, some smaller companies follow an
alternative "full-cost" policy, under which all drilling costs are capitalized and amortized over
future years.
488
Illustrative Audit Case 15-1: Audit of Property, Equipment and Related Depreciation
and Accumulated Depreciation Accounts
You are engaged in the examination of the financial statement of the Haven Corporation for the
year ended December 31, 20X9. The accompanying analyses of the Property, Plant and
Equipment, and related accumulated depreciation accounts, have been prepared by the chief
accountant of the client. You have traced beginning balance to your prior year’s audit working
papers.
HAVEN CORPORATION
Analysis of Property, Plant and Equipment, and
Related Accumulated Depreciation Account
Year Ended December 31, 20X9 (P000's)
Description Final Assets Per Ledger
12/31/X8 Additions Retirements 12/31/X9
Land P422,500 P5,000 P427,500
Buildings 120,000 17,500 137,500
Machinery and equipment 385,000 40,400 P26,000 399,400
P927,500 P62,900 P26,000 P964,400
Accumulated
Description Final Per Ledger
Depreciation
12/31/X8 Additions* Retirements 12/31/X9
Buildings P60,000 P5,150 P65,150
Machinery and equipment 173,250 39,220 212,470
P233,250 P44,370 P277,620
All plant assets are depreciated on the straight-line basis (no residual value taken into
consideration) based on the following estimated service lives: building, 25 years, and all other
items, 10 years. The company’s policy is to take one half year’s depreciation on all asset
additions and disposals during the year.
1. On April 1, the company entered into a 10-year lease contract for a die casting machine,
with annual rentals of P5,000 payable in advance every April 1. The lease is
cancellable by either party (60 days’ written notice is required), and there is no option
to renew the lease or buy the equipment at the end of the lease. The estimated service
life of the machine is 25 years with no residual value. The company recorded the die
casting
489
Machine in the Machinery and Equipment account at P40,400, the present value at the
date of the lease, and P2,020 applicable to the machine has been included in
depreciation expense for the year.
2. The company completed the construction of a wing on the plant building on June 30.
The service life of the building was not extended by this addition. The lowest
construction bid received was PI 7,500, the amount recorded in the Buildings account.
Company personnel constructed the addition at a cost of PI 6,000 (materials, P7,500;
labor, P5,500; and overhead, P3,000).
3. On August 18, P5,000 was paid for paving and fencing a portion of land owned by the
company and used as a parking lot for employees. The expenditure was charged to the
Land account.
4. The amount shown in the machinery and equipment asset retirement column represents
cash received on September 5 upon disposal of a machine purchased in July 20X0 for
P48,000. The chief accountant recorded depreciation expense-of P3,500 on this
machine in 20X9.
5. Cebu City donated land and building appraised at PI 00,000 and P400,000, respectively,
to Haven Corporation for a plant. On September l , the company began operating the
plant. Since no costs were involved, the chief accountant made no entry for the above
transaction.
Required:
Prepare the adjusting journal entries that you would propose at December 31, 20X8, to
adjust the accounts for the above transactions. Disregard income tax implications. The
accounts have not been closed. Computations should be rounded off to the nearest peso.
Use a separate adjusting journal entry for each of the above five paragraphs.
490
2) Accumulated depreciation: Machinery and equipment 2,020
Depreciation expense 2,020
To reverse provision for depreciation on leased machine.
3) Gain on construction of building addition 1,500
Buildings 1,500
To correct June 30, 20X9 entry for addition
4) Depreciation expense 317
Accumulated depreciation - building 317
To correct depreciation on addition.
Per audit [(16,000/12)] x 1/2] P667
Per client 350
Additional provision P317
5) Land improvement 5,000
Land 5,000
To correct August 13, 20X9 entry for paving and fencing parking lot.
6) Depreciation expense 250
Accumulated depreciation - Land improvement 250
7) Accumulated depreciation: Machinery and equipment 20,300
Loss on sale of machinery and equipment 2,800
Machinery and equipment 22,000
Depreciation expense 1,100
To correct Sept. 5, 20X9 entry for sale of machinery and
depreciation thereon, and to take up loss on disposal as follows:
P48,00
Cost
0
Accumulated Depreciation
Through 20X8 P16,800
For 20X9 2,400 19,200
Net Book P28,80
Value 0
Proceeds of Sale 26,000
Loss on Sale 2,800
100,00
8) Land
0
400,00
Buildings
0
Depreciation expense 8,000
500,00
Paid-in capital from donated assets
0
Accumulated Depreciation: Buildings 8,000
To record at appraised value land and building donated to the client and to take up
depreciation on building as follows: (1/25 x 1/2 x P400,000).
491
Illustrative Case 15-2: Audit of Machinery
The following account appears in the records of the Kart Company:
MACHINERY
Date Explanation Debit Credit Balance
20X1
Jan. 2 Purchased Machine No. 1 P50,000 P50,000
Dec. 31 Depreciation P5,000 P45,000
20X2
Jan. 2 Purchased Machine No. 2 40,000 85,000
Dec. 31 Depreciation 9,000 76,000
20X3
Jan. 2 Purchased Machine No. 3 60,000 136,000
Aug. 2 Machine no. 1 ordinary repairs 2,000 138,000
Aug. 2 Machine no. 2 major repairs
originally estimated life is not
extended 4,000 142,000
Dec. 31 Depreciation 15,000 127,000
20X4
Jan. 2 Purchased Machine No. 4 44,000 171,000
Jan. 2 Machine No. 1 Sold 24,000 147,000
Dec. 31 Depreciation 21,000 126,000
20X5
Jan. 2 Machine No. 2, major repairs;
originally estimated life is
extended 10,000 136,000
Dec. 31 Depreciation 18,000 118,000
The accounts have not been closed for the year 20X5.
Required:
Prepare work papers showing the correct accounts, and prepare all necessary audit adjustment.
Straight-line depreciation at 10 percent per year is to be used. For purpose of this problem,
ignore salvage values.
492
Solution: Illustrative Audit Case 15-2
KART COMPANY
Machinery
12.31.X5
Per Ledger Adjustments As Adjusted
Date Particulars Dr Cr Dr Cr Dr (Cr)
20X1
Jan. 2 Purchased Machine No. 1 P50,000 P50,000
Dec. 31 Depreciation P5,000 (1) P5,000
20X2
Jan. 2 Purchased Machine No. 2 40,000 40,000
Dec. 31 Depreciation 9,000 (1) 9,000
20X3
Jan. 2 Purchased Machine No. 3 60,000 60,000
Aug. 2 Mach 1, ordinary repairs 2,000 (2) 2,000
Aug. 2 Mach 2, major repairs no
life extension 4,000 (3) 4,000
Dec. 31 Depreciation 15,000 (1) 15,000
20X4
Jan. 2 Purchased Machine No. 4 44,000 44,000
Jan. 2 Machine No. 1 Sold 24,000 (5) 26,000 (50,000)
Dec. 31 Depreciation 21,000 (1) 21,000
20X5
Jan. 2 Machine No. 2, major
repairs original life 10,000 (4) 10,000
extended
Dec. 31 Depreciation 18,000 (1) 18,000
P210,000 P92,000 P68,000 P42,000
118,000 26,000
P210,000 P210,000 P68,000 P68,000 P144,000
KART COMPANY
Accumulated Depreciation - Machinery
12.31.X5
Balance per ledger P 0
Add (Deduct) Adjustments
AJE (1) 68,000
(4) (10,000)
(5) (15,000)
(6) (10,200)
Net 32,800
Balance as Adjusted P32,800
493
Adjusting Journal Entries
Depreciation Schedule:
Date
Description Cost 20X1 20X2 20X3 20X4 20X5
Acquired
1.2.X1 Machine 1 P50,000 P5,000 P5,000 P5,000 P 0 P 0
1.2.X2 Machine 2 40,000 0 4,000 4,000 4,000 4,000
1.2.X3 Machine 3 60,000 0 0 6,000 6,000 6,000
1.2.X4 Machine 4 44,000 0 0 0 4,400 4,400
Total depreciation per audit P5,000 P9,000 P15,000 P14,400 P14,400
Depreciation per client 5,000 9,000 15,000 21,000 18,000
(Over) Under provision P 0 P 0 P 0 P (6,600) P(3,600)
Summary:
Total correct depreciation - 20X1 to 20X5 P57,000
Less: A/D of Mach#1 (sold) P15,000
Repairs capitalized 10,000 25,000
Total accumulated depreciation as of 12.31.X5 P32,800
494
Illustrative Audit Case 15-3: Acquisition Costs
The Maven Company bought land and built a warehouse during 20X7. It debited the following
related costs to an account titled Land and Buildings:
In addition, you discover that compensation for the worker’s injury was necessary because it
was not covered by the particular insurance policy purchased by the company. Accident
insurance that would have covered the injury would have cost an additional P3,500. The
modifications ordered by the building inspectors resulted from poor planning by the company.
Required:
Prepare adjusting entries on December 31, 20X7 to properly reclassify the preceding items.
495
Solution: Illustrative Audit Case 15-3
Adjusting entries at December 31, 20X7 to correct the books. All original must be reversed out
of the Land and Building accounts and recorded in correct accounts.
1. Land 265,000
Land and buildings 265,000
To record purchase, demolition of old building, and legal fees in separate Land
account. (P220,000 + P30,000 + P15,000)
2. Buildings 29,000
Land and buildings 29,000
Interest on loan for construction.
3. Buildings 530,000
Land and buildings 530,000
To record cost of construction in separate Building account.
4. Land Improvements 12,000
Land and buildings 12,000
Sewer assessment.
5. Land Improvements 35,000
Land and buildings 35,000
Cost of landscaping.
6. Equipment 180,000
Land and buildings 180,000
Excavation equipment purchase.
7. Buildings 150,000
Land and buildings 150,000
Fixed overhead charged to building construction (alternatively, this item could be
charged to regular production through Goods in Process.)
8. Buildings 10,000
Land and buildings 10,000
Cost of insurance during construction (alternatively, could be recorded as
Insurance Expense.)
496
9. Profit (Gain) on Construction 120,000
Land and buildings 120,000
Reversing of profit improperly recognized.
10. Loss Due to Worker's Injury 30,000
Land and buildings 30,000
To expense cost to compensate construction worker.
11. Loss Due to Modifications to Building 75,000
Land and buildings 75,000
To expense avoidable costs required by inspectors due to planning error.
12. Land 25,000
Land and buildings 25,000
20X6 property tax expense on land (alternatively, could be recorded
as Property Tax Expense.
13. Land and Buildings 7,000
Land 7,000
Credit to Land account for salvage value of demolished building.
14. Land and Buildings 140,000
Loss on Sale of Equipment 48,000
Equipment 188,000
To write off equipment sold and recognize loss on sale (note that Depreciation
should have been recorded; however, the total of the depreciation and the loss
would be P48,000.)
497
Illustrative Audit Case 15-4: Classification of Costs Associated with Assets
The following account balances were included in the statement of financial position of the
Brass Company on December 31, 20X4.
Land P100,000
Land improvements 20,000
Buildings 300,000
Machinery and equipment 500,000
Required:
Prepare journal entries to record all the preceding events. Unless otherwise indicated,
assume the company makes all payments in cash.
498
Solution: Illustrative Audit Case 15-4
1. Investment in Land 74,000
Cash 74,000
2. Land 50,000 a
Buildings 150,000 b
Ordinary Shares, P3 par 60,000
Additional Paid-in Capital on Ordinary Shares 140,000
a
(P60,000 ÷ P240,000) x P200,000
b
(P180,000 ÷ P240,000) x P200,000
a
P120,000 + P7,000 + P10,000 + P16,000
5. Cash 6,000
Accumulated Depreciation 16,000
Machinery and Equipment 20,000
Gain on Disposal 2,000
6. Land 60,000 a
Buildings 78,000 b
Investment in Land 37,000
Cash 101,000
a
P37,000 + P26,000 - P3,000
b
P60,000 + P18,000 (imputed interest is ignored)
8. Machinery 32,000
Cash 32,000
499
Illustrative Audit Case 15-5: Acquisition Cost
1. The company acquired a tract of land in exchange for 10,000 shares of P10 par value
ordinary shares. The shares were traded on the Philippine Stock Exchange at P24 on
the date of exchange. The land had a book value on the selling company's records of
P50,000, and it was believed to be worth "anything up to P300,000."
2. An engine on a truck was replaced. The truck originally cost P100,000 three years ago
and was being depreciated at P20,000 per year. The engine cost P10,000 to replace.
3. The company acquired a tract of land that was believed to have mineral deposits by
issuing 5,000 preference shares of P50 par value. The preference shares were rarely
traded. The last transaction was 2 months earlier, when 500 shares were sold at P75 per
share. The owner of the land was willing to accept cash of P550,000, and an appraisal
had shown a value of P600,000.
4. The company purchased a machine with a list price of P85,000 by issuing a 2-year
P100,000 non-interest bearing note when the market rate of interest was 10%.
Required:
Land 240,000
Ordinary Shares, P10 par 100,000
Additional Paid-in Capital on Ordinary Shares 140,000
500
3. Land is acquired:
Land 600,000
Preference Shares, P50 par 250,000
Additional Paid-in Capital on Preference Shares 350,000
4. The present value of the 2-year noninterest-bearing note, using the 10% imputed
interest rate, is: P100,000 x 0.826446* = P82,640
Machinery 82,640
Discount on Notes Payable 17,360
Notes Payable 100,000
Information for Mama Corporation’s property, plant and equipment for 20X7 is:
501
Transactions during 20X7 and other information were as follows:
1. On January 2, 20X7, Mama purchased a new car for P10,000 cash and a trade-in of a
2-year old car with a cost of P9,000 and a book value of P2,700. The new car has a cash
price of P12,000; the market value of the trade-in is not known.
2. On April l, 20X7, a machine purchased for P23,000 on April l, 20X2 was destroyed by
fire. Mama recovered PI 5,500 from its insurance company.
3. On May l, 20X7, costs of P168,000 were incurred to improve leased office premises.
The leasehold improvements have a useful life of 8 years. The related lease, which
terminates after 8 years, is renewable for an additional 6-year term. The decision to
renew will be made at the end of the 8th year based on office space needs at that time.
4. On July l, 20X7, machinery and equipment were purchased at a total invoice cost of
P280,000; additional costs of P5,000 for freight and P25,000 for installation were
incurred.
5. Mama determined that the automotive equipment comprising the P115,000 balance at
January l, 20X7 would have been depreciated at a total amount of P18,000 for the year
ended December 31, 20X7.
Required:
1. For each asset classification, prepare schedules showing depreciation and amortization
expense, and accumulated depreciation and amortization that would appear on Mama's
statement of comprehensive income for the year ended December 31, 20X7 and on the
statement of financial position at December 31, 20X7, respectively.
2. Prepare a schedule showing the gain or loss from disposal of assets that would appear
in Mama's statement of comprehensive income for the year ended December 31, 20X7.
3. Prepare the property, plant, and equipment section of Mama's December 31, 20X7
statement of financial position.
502
Solution: Illustrative Audit Case 15-6
Requirement 1
MAMA CORPORATION
Depreciation and Amortization Expense
For the Year Ended December 31, 20X7
Building:
Book value 1/1/X7
(P1,200,000 - P263,100) P936,900
150% declining balance rate
[(100% ÷ 25) x 1.5)] x 6%
Total depreciation on building P56,214
Automotive equipment:
Depreciation on P115,000
balance, 1/1/X7 P18,000
Deduct: Depreciation on car
traded in 1/2/X7
(SYD 3rd year 2/10 x P9,000) (1,800) 16,200
Car purchased, 1/2/X7 12,000
Depreciation SYD 1st year x 4/10 4,800
Total depreciation on
automotive equipment 21,000
503
Leasehold improvements:
MAMA CORPORATION
Accumulated Depreciation and Amortization
December 31, 20X7
504
Requirement 2
MAMA CORPORATION
Gain or Loss from Disposal of Assets
For the Year Ended December 31, 20X7
Requirement 3
MAMA CORPORATION
Property, Plant and Equipment Section of Statement of Financial Position
December 31, 20X7
Accumulated
Cost Depreciation and Book Value
Amortization
P
Land P150,000 P150,000
-
Building 1,200,000 319,314 880,686
Machinery and equipment 1,187,000 1 342,275 844,725
Automotive equipment 118,000 2 99,300 18,700
Leasehold improvements 168,000 16,800 151,200
Totals P2,823,000 P777,689 P2,045,311
Explanation of amounts:
1
Machinery and equipment at 12/31/X7
Balance, 1/1/X7 P900,000
Purchased, 7/1/X7 (P280,000 + P5,000 + P25,000) 310,000
P1,210,000
Deduct: Machine destroyed by fire 4/1/X7 (23,000)
Balance, 12/31/X7 P1,187,000
2
Automotive equipment at
Balance, 1/1/X7 P115,000
Car purchased,
12,000
1/2/X7
P127,000
Deduct: Car
(9,000)
traded-in
Balance, 12/31/X7 P118,000
505
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
1. The auditors' verification of plant and equipment is facilitated by several factors not
applicable to audit work on current assets. What are these factors?
2. Do the auditors question the service lives adopted by the client for plant assets, or do
they accept the service lives without investigation? Explain.
4. What documentary evidence is usually available to the auditors in the client's office to
substantiate the legal ownership of property, plant, and equipment?
5. Cite various substantive tests the auditors could employ that might detect unrecorded
retirements of property, plant, and equipment.
6. Kris Corporation, a small manufacturing company, did not use the services of
independent auditors during the first two years of its existence. Near the end of the third
year, Kris retained Ian and Ronna, CPAs to perform an audit for the year ended
December 31. Officials of the company requested that the CPA firm perform only the
audit work necessary to provide an audit report on the financial statements for the
current year.
During the first two years of its operation, Kris had erroneously treated some material
acquisitions of plant and equipment as revenue expenditures. No such errors occurred
in the third year.
a. Under these circumstances, would Ian and Ronna, CPAs, be likely to learn of the
transactions erroneously treated as revenue expenditures in Years I and 2? Explain.
b. Would the income statement and statement of financial position prepared at the end
of Year 3 be affected by the above accounting errors made in Years I and 2? If so,
identify the specific items. Explain fully.
506
Multiple Choice Questions
3. Which of the following is not an inherent risk related to long-lived asset accounts?
a. Failing to record asset disposals.
b. Capitalizing repairs and maintenance expense.
c. Changing depreciation estimates to manage earnings.
d. All of the above.
5. Which of the following statements is false regarding fraud risk factors related to
long-lived assets, tangible and intangible?
a. A potential fraud scheme involves not removing sold assets from the
b. Because long-lived assets are typically an audit area of low risk, auditors do not
need to perform brainstorming activities related to long-lived assets.
c. Management might use unreasonably long depreciable lives in an effort to reduce
expenses.
d. None of the above statements is false.
507
6. Which of the following techniques can be used by management to overstate long-lived
assets?
a. Overvalue existing assets.
b. Include fictitious assets on the financial statements.
c. Capitalize transactions that should be expensed.
d. All of the above.
8. Assume that the auditor decides to only perform substantive tests of details when
auditing the equipment account. Which of the following statements best describes the
circumstances associated with the client being audited?
a. The client does not have effective controls over equipment.
b. The equipment account involves only a few assets of relatively high value.
c. Either a or b could be descriptive of the circumstances associated with the client
being audited.
d. Neither a nor b would be descriptive of the circumstances associated with the client
being audited.
9. Assume that a client's controls over recording retirements of long-lived tangible assets
are not well designed. Which of the following procedures would the auditor plan to
perform as a way of responding to the heightened risk of material misstatement?
a. Select long-lived tangible assets recorded in the property ledger and locate them
for inspection.
b. Inspect long-lived tangible assets located at the client location and trace those
assets to the property ledger.
c. Review the tangible long-lived asset property ledger to see if depreciation was
recorded on each tangible long-lived asset.
d. The auditor would perform all of the above procedures to respond to the
heightened risk of material misstatement.
508
10. Which of the following situations would lead an auditor to test controls over long-lived
assets?
a. Substantive analytical procedures indicated that controls were effectively
designed.
b. Risk assessment procedures indicated that controls were effectively designed,
c. Tests of details have decided many errors in recording long-lived asset
transactions.
d. The auditor has decided that the additional effort to test controls would not exceed
the potential reduction in substantive procedures.
11. To test the effectiveness of controls over asset impairment, the auditor could perform
which of the following procedures?
a. Perform analytical procedures.
b. Send confirmations to the management specialist who performed work related to
the impairment.
c. Inquire of management as to its process for determining assessment impairment.
d. Inspect the asset for potential impairment.
12. When auditing intangible assets, the auditor would likely recomputed amortization and
determines whether management's recorded amount is reasonable. When performing
this procedure which assertion is the auditor primarily gathering evidence for?
a. Completeness
b. Existence
c. Valuation
d. Rights and obligations.
13. As part of auditing equipment, the auditor will inspect new equipment additions
selected from the client's property ledger. The procedure will provide evidence about
which of the following assertions?
a. Completeness
b. Existence
c. Valuation
d. Rights and obligations.
509
Exercises
During the course of your audit of the following financial statements of Briggs, Inc.,
which was organized in June, 20X7, the following accounts appeared in the general
ledger at the date of the audit, December 31, 20X7:
FIXED ASSETS
Date Item Debits
20X7
June 1 Organization fees paid P3,000
1 Bond discount on P1,000,000 of ten-year, 6 percent bonds 6,000
16 Land site and existing building: building value, P30,000 500,000
30 Corporate organization costs 5,000
30 Title clearance fees 4,000
July 31 Net cost of razing existing building 7,000
Dec.1 Bond interest, six months 30,000
15 Salaries of executives (no participation in construction) 50,000
15 Share bonus to corporate promoters; 4,000 shares at P10 par per share 40,000
15 Real estate tax for six months ended December 31, 20X7, on land only 7,000
15 Cost of new building, paid to Arcose, Inc. 2,000,000
Required:
Prepare audit adjustments without explanation to close out the Fixed Asset Account.
510
3. Machine C was purchased for P200,000 on January l , 20X6.
Double-declining-balance depreciation has been recorded for 1 year. The estimated
residual value Of the machine is P20,000 and the estimated service life is 5 years. The
computation of the depreciation erroneously included the estimated residual value.
Required:
Prepare any necessary correcting journal entries for each situation. Also prepare the
journal entry necessary for each situation to record the depreciation for 20X7. (Assume
that the debit is to Depreciation Expense.)
Equipment was acquired on January l, 20X2 for P5,000,000 and is expected to have a
10-year life. Straight-line depreciation will be used.
Exercise 4: Impairment
Presented below is information related to equipment owned by Sweetie Company at
December 3 1, 20X7.
Cost P9,000,000
Accumulated depreciation to date 1,000,000
Expected future net cash flows 7,000,000
Fair value 4,800,000
Assume that Sweetie will continue to use this asset in the future. As of December 31,
20X7, the equipment has a remaining useful life of 4 years.
Required:
(a) Prepare the journal entry (if any) to record the impairment of the asset at December
31, 20X7.
(b) Prepare the journal entry to record depreciation expense for 20X8.
(c) The fair value of the equipment at December 31, 20X8, is P5,000,000. Prepare the
journal entry (if any) necessary to record this increase in fair value.
511
Problems
On December 31, 20X7, the Aerospace Co. shows the following account for machinery
that it had assembled for its own use during 20X7:
b) Cash discounts received on the payments for materials used in construction totaled
P400 and these were reported in the purchases discount account.
c) The factory overhead account shows a balance of P52,000 for the year ended
December 31, 20X7; this balance exceeds normal overhead on regular plant
activities by approximately P2,900 and is attributable to machine construction.
d) A profit was recognized on construction for the difference between costs incurred
and the price at which the machine could have purchased.
e) Machine tools have an estimated life of 3 years; machinery has an estimated life of
10 years. The machinery was used for production beginning on September l, 20X7.
512
Required:
1) Set up machinery and machine tools accounts as they should appear the end of
20X7.
2) Give individual journal entries that are necessary to correct the accounts as of
December 31, 20X7, assuming that the nominal accounts are still open.
b) On June 30, 20X5, a machine was purchased for P80,000, 2/10, n/30, and recorded
at P80,000 when paid for on July 7, 20X5.
c) On June 30, 20X5, the machine acquired for P52,400 was traded for a larger one
having a list price of P93,000. Allowance of P43,000 was received on the old
machine, the balance of the list price being paid in cash and charged to the
machinery account.
d) On January l, 20X6, the machine which cost P44,000 was sold for P25,000, but
because the cost of removal and crating was PI ,250, the machinery account was
credited with only P23,750.
e) On October l, 20X7, the machine purchased for P40,000 was sold for cash and the
cash received amounting to P8,000 was credited to the account.
513
Required:
Prepare adjusting entries to correct the accounts as of December 31, 20X7. Assume a
5-year useful life for the machines purchased. Show supporting computations in good
form.
Problem 3
At December 31, 20X2, certain accounts included in the property, plant, and equipment
section of the Tatty Company's statement of financial position had the following
balances:
1. Land site number 621 was acquired for P 1,000,000. Additionally, to acquire the
land Tatty paid a P60,000 commission to a real estate agent. Costs of PI 5,000 were
incurred to clear the land. During the course of clearing the land, timber and gravel
were recovered and sold for P5,000.
2. A second tract of land (site number 622) with a building was acquired for P300,000.
The closing statement indicated that the land was P200,000 and the building value
was P 100,000. Shortly after acquisition, the building was demolished at a cost of
P30,000. A new building was constructed for PI 50,000 plus the following costs:
3. A third tract of land (site number 623) was acquired for P600,000 and was put on
the market for resale.
514
The lessor paid one-half of the costs incurred in connection with the extension to the
current working are.
5. During December costs Of P65,000 were incurred to improve leased office space.
The related lease will terminate on December 31, 20X4, and is not expected to be
renewed.
Required:
2. List the items in the fact situation which were not used to determine the answer to
Requirement l, and indicate where, or if, these should be included in fatty's
financial statements.
(AICPA Adapted)
Problem 4
The Nikko Company's December 31, 20X6 statement of financial position follows:
Assets
Cash P540,000
Inventory 450,000
Prepaid rent 60,000
Machine P500,000
Less: Accumulated depreciation (135,000) 365,000
P1,415,000
515
Liabilities and Equities
Accounts payable P400,000
Ordinary shares, P10 par 300,000
Additional paid-in capital 515,000
Retained earnings 200,000
P1,415,000
1. To avoid paying monthly rent of P5,000 on existing plant facilities, the company
decided to buy a tract of land and construct a building of its own on it. On January
2, 20X7, Nikko exchanged 7,000 shares of its ordinary shares to acquire the land;
the share was selling for P25 per share. Construction of the building also began on
January 2, 20X7. At the time, Nikko borrowed funds by issuing a one-year,
P500,000 note at 12% to help finance the project. The principal and interest on the
note are due January 2, 20X8. Construction costs (paid in cash) that occurred
evenly throughout the year totaled P700,000. The building was completed on
December 30, 20X7 and the move-in to the new building was to occur during the
next week.
2. On January 2, 20X7, Nikko exchanged its one existing machine plus P60,000 for a
newer, similar machine with a fair value of P430,000. The exchange was with
another company in the same industry. The new machine is to be depreciated using
straight-line depreciation based on an economic life of 5 years and a residual value
of P55,000.
3. Nikko uses a FIFO perpetual inventory system. Nikko sold P350,000 of its
inventory for P800,000 cash, paid for its beginning accounts payable, and
purchased P480,000 of inventory on account during the year.
4. On July 31, 20X7, Nikko declared and paid a P2.50 per share cash dividend to its
shareholders.
5. Nikko is subject to a 30% income tax rate, and income taxes are accrued at
year-end.
Required:
Prepare Nikko's income statement and statement of retained earnings for the fiscal year
ended December 31, 20X7 and a statement of financial position as Of December 3 1,
20X7. Show all supporting journal entries and computations made during 20X7.
516
Problem 5: Depletion
On July 1, 20X6, the Apple Company purchased a coal mine for P2 million. The
estimated capacity of the mine was 700,000 tons. During 20X6, the company mines
10,000 -tons of coal per month and sells 9,000 tons per month. The selling price isP30
per ton and production costs (excluding depletion and depreciation) are P8 per ton. At
the end of the mine's life, it is expected that it will cost P200,000 to restore the land;
after which it can be sold for P 100,000. The company also purchased some temporary
housing for the miners at a cost of P 150,000. The -housing has an expected life of 10
years but is expected to be sold for P10,000 at the end of the miners life. The company
uses the FIFO cost flow assumption.
Required:
3. In January 20X7, a new estimate indicated that the capacity of the mine was only
500,000 tons at that time. Compute the company's expenses included on the
20X7 income statement if the company mines and sells 10,000 tons per month.
517
Chapter
AUDIT OF
INTANGIBLES ASSETS
INTRODUCTION
A variety of items fall in this asset category. Intangibles include patents, leaseholds, copyrights,
formulas, organizational costs, franchise fees and goodwill acquired m a business combination.
Since intangible assets are lacking in physical substance, their value lies in the rights and
economic advantages afforded in their ownership. And because of their intangible nature, these
assets are more difficult to identify than units of property and equipment.
The essential features or direct tests of balances for intangibles are emphasis on specific audit
related to existence and valuation achieved primarily by vouching, inspection of legal
document and recomputation or analytical tests. Whenever the client treats expenditure as
creating an intangible asset, the auditor must look for objective evidence that a genuine asset
has come into existence.
The financial statement assertions, specific audit objectives, and the common audit procedures
traditionally used to achieve the objectives for intangibles are summarized below:
519
5. In addition to audit procedure
III. Rights and C. To determine that the intangibles
no. 2, perform analytical
obligations are owned by the company.
procedures.
6. In addition to audit procedures
IV. Valuation or D. To determine that intangibles are nos. 3&4, evaluate amortization
allocation stated at cost less amortization. policy and verify computation of
amortization.
The auditor may begin with the substantiation of intangible assets with the analysis of
the ledger accounts for these assets. The balance should be traced to the general ledger.
2. Examine documentation.
3&4. Vouch additions to or acquisitions during the year. Evaluate dispositions and
write offs during the year.
520
Credits to the accounts representing amortization should be independently calculated
and reconciled with the client's program of amortization while credits representing
write-off of the asset should be traced to appropriate authorization or minutes of
directors' meetings. Also, the auditor should inquire if there is any change in the
estimated period to be benefited.
The auditor should apply analytical procedures to Research and Development expense
by company with those of prior year and budgeted amounts. Material changes and/or
variances should be investigated.
The auditor should evaluate future economic benefit by relating assets to revenues
produced by them. He should also inquire of management and legal counsel as to
possible contingencies relating to intangible assets (e.g. patent infringement suits).
Finally, PAS/PFRS require that the intangibles be shown at their amortized cost and
disclosure of the amortization policy should be made.
521
Illustrative Audit Case 16-1: Audit of Various Intangible Assets
Akian Inc., has accumulated a number of costs in a single Intangibles account. As external
auditor of the company, you have been asked to analyze the account and recommend any
corrections you think should be made for 20X7 is presented to you as follows:
Intangibles
Balanc
Date Transaction Description Dr. Cr.
e
10,00
Jan. 2 Legal fees related to organization of business 10,500
0
18,00
Jan. 2 Prepayment of lease of building for one year 28,500
0
Feb. 1 Prepayment of insurance for two year 1,800 30,300
Advertising expenses (radio, television, and
Feb. 28 8,000 38,300
newspaper)
10,50
Apr. 7 Premium on bonds issued 27,800
0
Apr.
Interest paid on short-term notes 2,500 30,300
25
May 5 Legal fees in filing for trade name (Akian, Inc.) 7,200 37,500
June
Cash discount on merchandise purchased 175 37,325
30
The company plans to present financial statements as of June 30, 20X7, to a local bank to
support a request for additional financing. Company policy is to amortize intangible asset costs
over a 10-year period, computed to the nearest full month. The president suggests an
amortization on June 30, 20X7, of P1,866, computed as follows:
Required:
a. Prepare an analysis of the entries in the Intangibles account and indicate corrections
you would propose in the account, including reclassifications of items.
b. Based on your response to [a] above, prepare the entries to properly record
amortization of intangible assets on June 30, 20X7. Assume all amounts are material
and that straight-line amortization is to be used.
522
Solution: Illustrative Audit Case 16-1
Requirement (a): Working Papers to Correct Intangible Assets
Adjustments
Intangib
Other Accounts
les
Dr.
Date Dr. (Cr.) Explanation
(Cr.)
P(10,50 P10,5 Organization
Jan. 2 To reclassify legal costs associated
0) 00 Expenses
with organization.
Jan. 2 (18,000) 9,000 Lease Expenses To reclassify lease payment,
Prepaid Lease
9,000 recognizing 1/2 year as expense.
Expenses
Feb. Insurance
(1,800) 375* To reclassify insurance payment,
1 Expenses
recognizing 5 months as
1,425 Prepaid Insurance
expense.
Feb. Advertising
(8,000) 8,000 To reclassify advertising expense.
28 Expense
Apr. (10,50 Premium on Bonds To reclassify premium on bonds
10,500
7 0) Payable payable.
Apr.
(2,500) 2,500 Interest Expense To reclassify interest expense.
25
May
(7,200) 7,200 Trade Name To establish specific intangible asset.
5
June
175 (175) Purchase Discount To reclassify purchase discounts.
30
P(37,32 P37,3
5) 25
*Insurance Expense: 5/24 x P1,800 =
P375
Prepaid insurance: 19/24 x P1,800
= P1,425
Adjusting Journal Entry:
Organization Expenses 10,500
Lease Expenses 9,000
Prepaid Lease Expenses 9,000
Insurance Expenses 375
Prepaid Insurance 1,425
Advertising Expense 8,000
Interest Expense 2,500
Trade Name 7,200
Premium on Bonds Payable 10,500
Purchase Discounts 175
Intangibles 37,325
Requirement (b)
Amortization of Intangibles 120
Trade name* 120
523
Illustrative Audit Case 16-2: Miscellaneous Intangible Assets
Required:
b. Prepare a schedule showing all expenses resulting from the transactions that would
appear on Evan's statement of comprehensive income for the year ended December 31,
20X7. Show supporting computations in good form
524
Solution: Illustrative Audit Case 16-2
Requirement (a)
Evan Corporation
Intangibles Section of Statement of Financial Position
December 31, 20X7
Schedule 1
Computation of Franchise from
Rapid Copy Services, Inc.
Schedule 2
Computation of Patent
525
Schedule 3
Computation of Trademark
Accumulated
Cost Amortization
Cost of trademark at July 1, 20X4 P40,000
Amortization through December 31, 20X7
(P40,000 ÷ 20 years = P2,000 x 3/12 years) P7,000
Balance, December 31, 20X7 40,000 P7,000
Deduct accumulated amortization 7,000
Trademark balance, December 31, 20X7 P33,000
Evan Company
Expenses Resulting from Intangibles Transactions
For the Year Ended December 31, 20X7
526
Illustrative Audit Case 16-3: Audit of Intangible Assets Account
As the recently appointed auditor for Walt de Castro Corporation, you have been asked to
examine selected accounts before the 6-month financial statements of June 30, 20X7, are
prepared. The controller for Walt de Castro Corporation mentions that only one account is kept
for Intangible Assets. The account is shown below:
Intangible Assets
Date Particulars Dr. Cr. Balance
20X7
940,00
Jan. 4 Research and development costs 940,000
0
Jan. 5 Legal costs to obtain patent 75,000 1,015,00
Payment of 7 months' rent on property leased by de 1,106,00
Jan. 31 91,000
Castro 0
Feb. 250,00
Premium on ordinary shares 856,000
11 0
Mar. Unamortized bond discount on bonds due March 31,
84,000 940,000
31 2028
Apr. 207,00 1,147,00
Promotional expenses related to start-up of business
30 0 0
June 241,00 1,388,00
Operating losses for first 6 months
30 0 0
Required:
Prepare the entry or entries necessary to correct this account. Assume that the patent has a
useful life of 10 years.
527
Illustrative Audit Case 16-4: Audit of R & D Costs
Tom Mendiola Company incurred the following costs during 20X7 in connection with its
research and development activities:
Required:
Compute the amount to be reported as research and development expense by Mendiola on its
statement of comprehensive income for 20X7. Assume equipment is purchased at beginning of
year.
528
Illustrative Audit Case 16-5: Audit of Computer Software Costs
During 20X7, Del Enterprises Inc. spent P5,000,000 developing its new "Dover" software
package. Of this amount, P2,200,000 was spent before technological feasibility was
established for the product, which is to be marketed to third parties. The package was
completed at December 31, 20X7. Del expects a useful life of 8 years for this product with
total revenues of P16,000,000. During the first year (20X8), Del realizes revenues
of P3,200,000.
Required:
(a) What journal entries should have been prepared by the accountant in 20X7 for the foregoing
facts?
(c) At what amount should the computer software costs be reported in the December 31, 20X8,
statement of financial position? Could the net realizable value of this asset affect your answer?
(d) What disclosures are required in the December 31, 20X8, financial statements for the
computer software costs?
Requirement (a)
Requirement (b)
529
Requirement (c)
The computer software costs should be reported in the 12/31/X8 statement of financial position
at unamortized cost (P2,800,000 P560,000 = P2,240,000) unless net realizable value is lower.
Requirement (d)
Del Enterprises should disclose in its December 31, 20X8, financial statements the unamortized
computer software costs included in the statement of financial position presented, and the total
amount charged to expense in the statement of comprehensive income presented for
amortization of capitalized computer software costs, and for amounts written down to net
realizable value.
1. How does the auditor ascertain the future economic benefit of recorded intangibles?
3. Audit of Leaseholds
Menfro Inc., purchased a 20-year lease, paying P450,000 for it at the time of
purchase. Menfro amortized the lease on the straight-line basis and charged
expenses for P27,500 each year for 12 years. During the 13th year, an operating loss
was incurred to the extent of P20,000 by including P27,500 as lease amortization
expense. If the P20,000 loss was closed to retained earnings, that account would be
almost depleted after the regular dividend was declared. Menfro therefore decided
to charge nothing off the lease for the current year, thereby showing a P7,500 net
income. Management called upon you to approve the plan. What do you suggest in
view of the past amortization policy of the company?
530
Exercises
A company leased a land site for 20 years, at an annual rental of P25,000. The lease does
not contain a renewal clause. Immediately after negotiating for the lease the company
erected a building costing P50,000 with an estimated life of 25 years. The building was
depreciated at the rate of 5 percent per year on cost. At the end of the tenth years the
original lease was canceled and a new one was negotiated for 20 more years.
Required:
a. What is the annual depreciation for years 1l through 40?
b. If the original lease had contained renewal clause for an additional 20 years, what
original depreciation rate would you have used?
During the current year, the accountant for the Cartwright Corporation recorded
numerous transactions in account-labeled Intangibles as follows:
531
Required:
Prepare adjusting journal entries to eliminate the intangibles account and correctly
record all the items. Organization costs are amortized over 5 years and any other
intangibles are amortized over their legal lives.
The data in the following table are presented for Bayer, Inc. and Lead, Inc., as of
November 1, 20X7, in connection with a proposed merger of the two companies:
It is agreed that the values of the respective assets contributed are to be determined on
the following basis:
1) Equipment of Bayer, Inc., is estimated to be worth P40,000 more than book value.
The equipment has a remaining life of five years.
2) Lead, Inc., wrote off all of its organization costs of P20,000 against operating
revenue in 20X6.
Required:
Prepare an audit work paper, supported by calculations, to show for each party to
the merger the determination of the amounts to be paid for the (a) net tangible
assets and (b) goodwill.
532
Exercise 4: Audit of Patents
Phoenix Supply Company acquired two patents, several items of equipment, and a
parcel of land for a total of P1,375,000. Appraisal values of the assets on the date of
acquisition are as follows:
By acquiring the assets in a group, the company was able to get a favorable price. The
acquisition took place on April 27, 20X5. Patent A has a five-year remaining life and
Patent B, a 12-year remaining life. Amortization of intangible assets is determined on a
straight-line basis, computed in whole pesos to the nearest full month.
During 20X6, the company became involved in two lawsuits resulting in the
successful defense of Patent B but the unsuccessful defense of Patent A. Total legal
fees of P176,000 were incurred. Management estimates that approximately equal
effort went into defending each patent. The established date of these settlements was
March 7, 20X6.
No further transactions affecting the patents occurred through October 31, 20X7.
Required:
a. Prepare journal entries for the year 20X5, 20X6 and 20X7, related to the intangible
asset accounts. The company's reporting year ends on October 31.
b. Briefly explain any difference in your treatment of the legal costs of the defenses of
Patents A and B.
533
Exercise 5: Audit of Various Intangible Assets
Required:
2. Prepare a schedule showing all expenses resulting from the transactions that would
appear on Broadway's income statement for the year ended December 3 1, 20X7.
Show supporting computations in good form.
(AICPA Adapted)
534
Exercise 6: Audit of Intangible Assets
Español Co., organized in 20X7, has set up a single account for all intangible assets.
The following summary discloses the debit entries that have been recorded during
20X7 and 20X8.
Intangible Assets
7/1/20X7 8-year franchise P42,000
Advance payment on laboratory space (2-year
10/1/20X7 28,000
lease)
Net loss for 20X7 including incorporation fee,
12/31/20X7 P1,000, and related legal fees of organizing, 16,000
P5,000 (all fees incurred in 20X7)
1/2/20X8 Patent purchased (10-year life) 74,000
3/1/20X8 Cost of developing a secret formula (indefinite life) 75,000
4/1/20X8 Goodwill purchased (indefinite life) 278,400
Legal fee for successful defense of patent
6/1/20X8 12,650
purchased above
9/1/20X8 Research and development costs 160,000
Required:
Prepare the necessary entries to clear the Intangible Assets account and to set up separate
accounts for distinct types of intangibles. Make the entries as of December 31, 20X8,
recording any necessary amortization and reflecting all balances accurately as of that
date. (Ignore income tax effects.)
Problems
The president of Balagtas Company, Jose P. Balagtas, has engaged you to assist in the
preparation of financial statements to be used in connection with a proposed bank loan.
Officials of the bank have requested financial statements which are "based on good
accounting."
Balagtas Company was organized during 20X7. The company has been raising capital,
acquiring assets, developing personnel, and developing products which it plans to market
in the future. Only insignificant amounts of revenue have been generated to date.
Mr. Balagtas has prepared the following statement of financial position which he
considers adequate for purposes of the proposed bank loan. He also offers the information
which accompanies the statement of financial position as an explanation of some of the
activities of the enterprise to date.
535
BALAGTAS COMPANY
STATEMENT OF FINANCIAL POSITION
October 31, 20X7
Assets
Cash P17,650
Machinery (at cost) 59,350
Land (at cost) 15,000
Intangibles 41,400
P133,400
Liabilities
Accrued expenses P11,975
Notes payable (90-day) 21,425
P33,400
Shareholders' Equity
Ordinary shares 100,000
P133,400
Notes:
a. Jose P. Balagtas, President, acquired 8,000 shares at the P10 par value.
b. Mario P. Balagtas, brother of Jose, received 2,000 shares in exchange for land
which he had purchased five years earlier for P15,000.
c. One thousand shares were issued to Pedro X. Balagtas, a cousin of both Jose
and Mario, for managerial services rendered in operating the enterprise to date.
Pedro will become the general manager at some future date when he quits his
current position with another company.
536
Mr. Balagtas asks you to verify the authenticity of his statement of financial position
and give it to the bank as soon as possible so that he may proceed with his application
for the much needed bank loan.
Required:
Problem 2
After securing lease commitments from several major stores, Golden Springs Shopping
Center, Inc., was organized and built a shopping center in a growing suburb. The
shopping center would have opened on schedule on January 2, 20X6 if it had not been
struck by a severe typhoon in December; it opened for business on October 2, 20X6.
All the additional construction costs incurred as a result of the typhoon were covered
by insurance.
In July 20X5 in anticipation of the scheduled January opening, a permanent staff was
hired to promote the shopping center, obtain tenants for the uncommitted space, and
manage the property. A summary of some of the costs incurred in 20X5 and the first 9
months of 20X6 follows:
The promotional advertising campaign was designed to familiarize shoppers with the
center. Had the company known in time that the center would not open until October
20X6, it would not have made the 20X5 expenditure for promotional advertising. The
company had to repeat the advertising in 20X6.
All the tenants who had leased space in the shopping center at the time of the typhoon
accepted the October occupancy date on condition that the monthly rental charges for
the first 9 months of 20X6 are canceled.
537
Required:
Explain how the company should treat each of the costs for 20X5 and the first 9 months
of20X6. Give the reasons for each treatment.
(AICPA Adapted)
Debit Credit
Cash P61,000
Accounts receivable 92,500
Allowance for doubtful accounts P500
Inventories 38,500
Machinery 75,000
Equipment 29,000
Accumulated depreciation 10,000
Patents 85,000
Leasehold improvements 26,000
Prepaid expenses 10,500
Organization costs 29,000
Goodwill 24,000
Licensing Agreement No. 1 50,000
Licensing Agreement No. 2 49,000
Accounts payable 147,500
Unearned revenue 12,500
Share capital 300,000
Retained earnings, January 1, 20X7 27,000
Sales 768,500
Cost of goods sold 454,000
Selling and general expenses 173,000
Interest expense 3,500
Extraordinary losses 12,000
Total P1,239,000 P1,239,000
538
The following information relates to accounts that may yet require adjustment:
1. Patents for Lee's manufacturing process were acquired January 2, 20X7 at a cost of
P68,000. An additional P17,000 was spent in December 20X7 to improve machinery
covered by the patents and charged to the Patents account. Depreciation on fixed assets
has been properly recorded for 20X7 in accordance with Lee's practice, which provides
a full year's depreciation for property on hand June 30 and no depreciation otherwise.
Lee uses the straight-line method for all depreciation and amortization and amortizes
its patents over their legal life.
2. On January 3, 20X6, Lee purchased Licensing Agreement No. l, which was believed to
have an unlimited useful life. The balance in the Licensing Agreement No. 1 account
includes its purchase price of P48,000 and expenses of P2,000 related to the
acquisition. On January 1, 20X6 Lee purchased Licensing Agreement No. 2, which has
a life expectancy of 10 years. The balance in the Licensing Agreement No. 2 account
includes its P48,000 purchase price and in acquisition expenses, but it has been reduced
by a credit of PI ,000 for the advance collection of 20X8 revenue from the agreement.
In late December 20X6 an explosion caused a permanent 60% reduction in the
expected revenue producing value of Licensing Agreement No. l, and in January 20X8
a flood caused additional damage that rendered the agreement worthless. (Use 40-year
life in amortizing Licensing Agreement No. 1.)
3. The balance in the Goodwill account includes (a) P8,000 paid on December 30, 20X6
for an advertising program it is estimated will assist in increasing Lee's sales over a
period of 4 years following the disbursement, and (b) legal expenses of P16,000
incurred for Lee's incorporation on January 3, 20X6.
4. The Leasehold Improvements account includes (a) the P15,000 cost Of improvements
with a total estimated useful life of 12 years which Lee, as tenant, made to leased
premises in January 20X6, (b) movable assembly line equipment costing P 8,500 that
was installed in the leased premises in December 20X79 and (c) real estate taxes of
P2,500 paid by Lee in 2017, which under the terms of the lease should have been paid
by the landlord' Lee paid its rent in full during 20X7. A 10-year nonrenewable lease
was signed January 3, 20X6 for the leased building that Lee used in manufacturing
operations.
539
5. The balance in the Organization Costs account includes costs incurred during the
organizational period.
Required:
Prepare a worksheet to adjust accounts that require adjustment and prepare financial
statements. A separate account should be used for the accumulation of each type of
amortization and for each prior period adjustment. Formal adjusting journal entries and
financial statements are not required. Ignore income taxes.
(AICPA Adapted)
A patent was purchased from Francis Argante Company for on January l, 20X5. Tan
estimates the remaining useful life of the patent to be 10 years. The patent was carried in
Argante's accounting records at a net book value of P2,000,000 when Argante sold it to
Tan.
During 20X6, a franchise was purchased from JC Company for P480,000. In addition, 5%
of revenue from the franchise must be paid to JC. Revenue from the franchise for 20X6 was
P2,500,000. Tan estimates the useful life of the franchise to be 10 years and takes a full
year's amortization in the year of purchase.
Tan estimates that these costs will be recouped by December 31, 20X9. The materials and
equipment purchased have no alternative uses.
On January l, 20X6, because of recent events in the field, Tan estimates that the
remaining life of the patent purchased on January 1, is only 5 years from January l, 20X6.
540
Required:
(a) Prepare a schedule showing the intangibles section of Tan's statement of financial
position at December 31, 20X6. Show supporting computations in good form.
(b) Prepare a schedule showing the income statement effect for the year ended
December 31, 20X6, as a result of the facts above. Show supporting computations in
good form.
(AICPA Adapted)
541
Chapter AUDIT OF PREPAID
EXPENSES,
DEFERRED CHARGES
AND OTHER CURRENT
LIABILITIES
INTRODUCTION
Among the most common prepaid expenses that auditors encounter are insurance, advertising
services, office supplies, rent, interest, taxes and royalties and they are usually classified as
current assets. Deferred charges such as bond issue costs, plant rearrangement costs or
relocation charges are prepayments that are chargeable to the operations of several years and
are separately classified as noncurrent assets.
Audit Objectives
1. To determine that the prepaid expenses or deferred charges carried forward at the
beginning of the period are actually chargeable to the operations of future periods and
that definite benefits will be received in the future periods from these expenses carried
forward as assets.
2. To ascertain the correctness of the prepaid or deferred amount at the end of the period
as well as the amount consumed or had expired, if any, during the period under review.
3. To ascertain the propriety of the amount charged as prepaid expenses or as deferred
charges.
4. To determine the reasonableness and consistency in amortizing prepaid expenses and
deferred charges to expenses.
5. To determine proper presentation and classification of prepaid expenses and deferred
charges on the statement of financial position.
The auditor's primary objective in examining prepaid expenses and deferred charges is to
determine that those items represent proper charges to future operations, and that the
amounts, their allocation to costs and expenses' reported in accordance with generally
accepted accounting principle applied on a consistent basis. To determine propriety, validity
and accuracy of these prepayments and deferred charges the following general audit
procedures may be followed:
543
A. Audit of Prepaid Expenses
1. Prepaid insurance
a. Inspect insurance policies on a test basis.
b. Review coverage premiums.
c. Vouch premium paid and amounts charged to expense during the year and amounts
prepaid at year-end.
2. Prepaid advertising
a. Examine advertising contracts with advertising agencies and note effective dates
covered by the agreement. Determine propriety of charges in the current year.
b. Test-count undated advertising and sales promotion materials.
3. Prepaid rent
a. Examine signed rental agreement noting the effective dates covered by the
agreement.
b. Vouch total amount paid and compare with provision in the rental agreement.
c. Verify distribution of the prepaid amount to prepaid rent and rental expense by
recalculating the amounts.
4. Prepaid interest
a. Examine loan agreement and vouch interest payments.
b. Verify mathematical accuracy of the computation of interest expense and prepaid
interest.
5. Office supplies
a. Vouch purchases of office supplies on a test basis.
b. Conduct physical count of supplies inventory on a test basis.
6. Other prepayments
a. Review existence of adequate records and documentation.
b. Evaluate allocation of prepaid expenses be seen asset and expense accounts.
544
Figure 17-1: Schedule of Prepaid Insurance
B. Audit of Deferred Charges
546
Discussion of Audit Procedures
The management assertion, audit objectives and audit procedures enumerated in Figure 17-2
would also generally apply to the above-mentioned current liabilities. In addition, specific
audit procedures should be applied to these items as follows:
Income taxes withheld from employees' pay and not remitted to the BIR as of the
statement of financial position date constitute a liability to be verified by the auditor.
VAT on receipts constitutes current liabilities of the business until they are remitted to
the BIR. The auditor's responsibility includes verification of the client's periodic tax
returns and remittance. The auditor should also test the reasonableness of the liability
by a computation applying the tax rate to total taxable receipts. Debits to the liability
account for remittances to the BIR should be traced to copies of the tax return and
should be vouched to the paid checks. Verify remittance of tax subsequent to the
statement of financial position date to the BIR.
The auditor should analyze this account to determine that the credits represent all
unclaimed wages after each payroll distribution, and the debits represent only
authorized payments to employees or transfer back to general cash funds through
approved procedures. Verify disposition of the account subsequent to the statement of
financial position date.
547
d&e. Customers ' Deposits; Liabilities under Trust Receipts
The auditor should obtain a list of the individual deposits and liabilities under trust receipts and
reconcile to the general ledger balance. If amounts are substantial, or internal control
procedures are considered deficient, they should be confirmed by direct communication with
customers and appropriate financial institutions.
The approaches to auditing accrued liabilities ore as varied as the types of accrued liability
accounts. Many can be tested by reference to the subsequent payment of the liability (accrued
rent, utilities, property taxes) while others must be estimated or calculated on the basis of
transactions in other accounts (accrued interest on the basis of interest-bearing debt outstanding
and accrued royalties on the basis of sales). The basic auditing steps for accrued liabilities
1. Examine any contracts or other documents on hand that provide the basis for the
accrual (e.g., pension plan agreement, warranty agreement).
2. Evaluate the accuracy of the detailed accounting records maintained for this category
of liability.
3. Test mathematical accuracy of the amounts of accrual set up by the client.
4. Determine consistency in the treatment of accrued liabilities at the beginning and end
of the period.
5. Follow up actual payment or settlement subsequent to the statement of financial
position date.
Auditing procedures for the accrued liability for pension costs may begin with a review
of the copy of the pension plan in the auditor's, permanent file. The auditors should
determine that the client's accrued pension liability is presented in accordance with PFRS
715, including consideration of service cost, interest cost, amortization of transaction
and service costs, and gains and losses on pension plan assets. In auditing these amounts,
the auditors will obtain representations from an actuary and confirm the activity in the
plan with the trustee.
548
h. Income Tax Payable
The auditor should analyze the Income Tax Payable account and vouch all amounts to income
tax returns, paid checks, or other supporting documents. He should also verify the
reasonableness of the tax liability by reviewing the tax returns prepared by the client. The final
balance in the Income Taxes Payable account will equal the taxes on the current year's income
tax returns, less any payments thereon. Deferred Income Taxes resulting from tax allocation
should be classified as current liabilities if they relate to current assets. Otherwise, deferred
income taxes are classified as long-term. Follow up remittance to the BIR subsequent to the
statement of financial position date.
Review warranty agreements with buyers of goods and services and determine whether
expected warranty expense or liability is recognized in the records of the entity. The provision
for estimated liability is usually based on historical experience of the level of volumes, product
mix and repair, and replacement cost.
Inspect the copy of the installment note payable taking special attention to the terms of
payment. Determine the portion of the long-term debt that is due within twelve months after
the reporting period and ensure that the client reclassifies such portion as current liability.
549
Illustrative Audit Case 17-1: Audit of Various Prepayments
You are examining the financial statements of the Atlas Retail Company for the year ended
December 31, 20X7. The client’s accounting department presented you with an analysis of the
Prepaid Expenses account at December 31, 20X7, as shown below.
2) The postage meter was delivered in November and the balance due was paid January.
Unused postage of P700 in the machine at Dec. 31, 20X7, was recorded as expense at time of
purchase.
3) Bond discount represents the unamortized portion applicable to bonds maturing in 20X8.
550
4) The P9,600 paid and recorded for advertising was for the cost of an advertisement to
be run in a monthly magazine for six-months, beginning in December, 20X7. You
examined an invoice received from the advertising agency and extracted the following
description: "Advertising services rendered for store opened in November 20X7,
P6,900."
5) Atlas has contracted to purchase New Stores and has been required to accompany its
offer with a check for P1,000 to be held in escrow as an indication of good faith. An
examination of paid checks revealed the check has not been returned from the bank
through January 20X8.
Required:
Assuming that you have examined acceptable underlying audit evidence, prepare a
worksheet to show the necessary adjustment, corrections, and reclassification of the
items in the Prepaid Expense account.
(AICPA Adapted)
Solution: Illustrative Audit Case 17-1
Illustrative Audit Case 17-2: Audit of Current Liabilities
From the following information, prepare the current liabilities section of the statement of
financial position for the Drummand Company as of December 31, 20X7.
5) Cash balance with First Bank, P26,000; cash overdraft with College Station Bank, P35,000.
9) Installment notes on equipment purchased, P40,000 of which P20,000 is due in 20X8 and the
balance in 20X6.
11) Estimated costs of meeting service requirement guarantees on products produced and sold,
P14,400.
12) One of the company's products exploded causing injury to a customer's employee. The
estimated claim is P4,800. The company has no insurance to cover a loss of this nature.
13) Drummand borrowed P20,000 on the cash surrender value of its officer's life insurance.
Cash surrender value amounts to P80,000. Interest on this loan has been paid to the statement of
financial position date.
552
Solution: Illustrative Audit Case 17-2
DRUMMAND COMPANY
Partial Statement of Financial Position
December 31, 20X7
Current Liabilities
Accounts payable P88,000
Bank overdraft (or Loan payable - bank) 35,000
Notes payable
- Trade P114,000
- Bank (secured by marketable securities valued at
60,000
P80,000)
- Officers 40,000 214,000
Customers' accounts with credit balances 3,600
Advances from customers 6,000
Withholding taxes payable 2,600
Estimated liability on product warranties 14,400
Estimated liability arising from product malfunction 4,800
Current portion of installment notes payable 20,000
Total current liabilities P388,400
Note: The policy loan of P20,000 will be shown as a deduction from Cash
Surrender Value Life Insurance account in the "Long-term Investments"
section.
Friday Factory provides a 2-year warranty with one of its products which was first sold in 20X7.
In that year, Friday spent P70,000 servicing warranty claims. At year-end, Friday estimates that
an additional P500,000 will be spent in the future service warranty claims related to 20X7 sales.
Prepare Friday’s journal entry to record the P70,000 expenditure, and the December 31
adjusting entry.
553
Illustrative Audit Case 17-4: Audit of Estimated Liability for Premiums
Summer Company offers a set of building blocks to customers who send in 3 UPC codes from
Summer cereal, along with P50.00. The blocks set cost Summer P110 each to purchase and
P60.00 each to mail to customers. During 20X7, summer sold 1,000,000 boxes of cereal. The
company expects 30% of the UPC codes to be sent in. During 20X7, 120,000 UPC codes are
redeemed Prepare Summer's December 31, 20X7, adjusting entry.
Melody Music Emporium carries a wide variety of musical instruments, sound reproduction
equipment, recorded music, and sheet music. Melody uses two sales promotion techniques
warranties and premiums — to attract customers.
Musical instruments and sound equipment are sold with one-year warranty for replacement of
parts and labor. The estimated warranty cost, based on past experience, is 2% of sales.
The premium is offered on the recorded and sheet music. Customers receive a coupon for each
peso spent on recorded music or sheet music. Customers may exchange 200 coupons and P20
for a CD player. Melody pays P34 for each CD player and estimates that 60% of the coupons
given to customers will be redeemed.
Melody's total sales for 20X7 were P7,200,000 P5,400,000 from musical instruments and sound
reproduction equipment and P1,800,000 from recorded music and sheet music. Replacement
parts and labor for warranty work totaled P164,000 during 2017. A total of 6,500 CD players
used in the premium program were purchased during the year and there were 1,200,000
coupons redeemed in 20X7.
554
The accrual method is used by Melody to account for the warranty and premium costs for
financial reporting purposes. The balances in the accounts related to warranties and premiums
on January 1, 20X7, were as shown below:
Melody Music Emporium is preparing its financial statements for the year ended December 31,
20X7. Determine the amounts that will be shown on the 20X7 financial statements for the
following:
(1) Warranty Expense.
(2) Estimated Liability from Warranties.
(3) Premium Expense.
(4) Inventory of Premium CD Players.
(5) Estimated Premium Claims Outstanding.
555
(4) Inventory of premium cassette players - 1/1/X7 P39,950
Premium cassette players purchased during 20X7
(6,500 x P34) 221,000
Premium cassette players available 260,950
Premium cassette players exchanged for coupons
during the 2015 (1,200,000 / 200 x P34) P204,000
Inventory of premium cassette players - 12/31/X7 P56,950
556
EXERCISES AND PROBLEMS
Exercises
On December 1, 20X7, Rhan Corporation leased office space for five years at a monthly
rental of P10,000. On that date, Rhan paid the lessor the following amounts:
The entire amount of P105,000 was charged to rent expense in 20X7. What portion of the
payments should Rhan have deferred to years subsequent to 20X7?
557
Exercise 3: Discount on Bonds Payable
On January l, 20X1, Hansen, Inc., issued for P939,000, one thousand units of its 9%,
P1,000 bonds. The bonds were issued to yield 10%. The bonds are dated January 1, 20X1,
and mature on December 31, 20X6. Hansen uses the interest method of amortizing bond
discount. In its December 31, 20X6 statement of financial positions Hansen should report,
unamortized bond discount of
On July l, 20X7, Walton Company leased office premises for a three-year period at an
annual rental of P36,000 payable on July 1 each year. The first rent payment was made
July l, 2017. Additionally on July l, 20X7, Walton paid P24,000 as a lease bonus to obtain
a three-year lease instead of the lessor's usual lease term of six years. In its December 31,
20X7, statement of financial position, Walton should report prepaid rent of
Prepare the audit adjustments for the following situations you find in the records of
Mabini, Inc. which closes its accounts December 31, 20X7.
a) December 1, 20X7:
Advertising Expense P12,000
Cash P12,000
Records payment of 20X8 advertising contract.
c) June 1, 20X7:
Prepaid Insurance P1,800
Cash P1,800
Records payment of 36-month policy
for fire loss on inventory
558
d) Balance of Factory Supplies Expense Account
at 12/31/20X7 P3,300
Physical inventory of factory supplies at 12/31/20X7 P1,100
f) On September l, 20X7, paid 36 months premium of P3,600 on fire and extended coverage on
building. No amortization of this premium has been recorded to date and the full amount
remains in the Prepaid Insurance account.
g) Signed a 10-year lease for a new warehouse; the closing costs of P 12,000 paid on July l,
20X7, effective date of lease, was charged to Rent Expense.
h) Paid annual dues of P1,200 on September l, 20X7, to the Chamber of Commerce and
charged Dues and Subscription Expense.
j) Vacation advances were made in the amount on December 15, 20X7, and charged to
Vacation Expense. Of this amount P3,000 applies to vacations starting January 1, 20X8.
559
Problems
The audit for the year ending December 31, 20X3, of the Raven Construction Company
revealed that the present balance of Prepaid Insurance account consisted of the following
policies. All insurance premiums were charged to this account.
Required:
2) Prepare journal entries to record the proper amount of expense for 20X3 and create
the correct balance of Prepaid Insurance.
560
Problem 2
As of December 31, 20X5, the Insurance Expense account on the records of the Queen
Company has a debit balance of P46,220. A Prepaid Insurance account is not carried;
all premiums are charged to expense as they are paid.
Based on the examination of the policies listed in the table below, prepare (a) an
insurance schedule and (b) the adjusting entry or entries to set up the prepaid insurance
properly.
561
Chapter
AUDIT OF LONG-TERM
LIABILITIES
INTRODUCTION
In determining the tests of details of balances for long-term debts such as bonds payable,
mortgage payable, notes payable, the auditor considers tolerable misstatement, inherent
risk, control risk, the results of tests of controls and substantive tests of transactions, and
the results of analytical procedures. Tolerable misstatement if often set at a low level
because it is often possible to completely audit the account balance transactions affecting
the account balance. Inherent risk is also typically set at a low level because it is usually
easy to determine the correct account value. Auditors are normally about the adequacy of
disclosures, such as collateral and covenant restrictions for notes payable.
Because there are usually few transactions in the cycle, control risk and the results of
substantive tests of transactions are normally less important for designing tests of details of
balances of accounts such as notes payable - bonds payable. For most transactions in the cycle,
an important consideration is that they are properly authorized.
563
4. Trace authorization for
issuance of debt to credits to
B. To determine that all the long-term debt account.
transactions relating to 5. Vouch borrowing and
II. Completeness
long-term debts are repayment transactions and
properly recorded. review transactions to
supporting documents
occurring near year-end.
8. Recalculate interest
D. To determine that the expense and amortization of
IV. Valuation or long-term debts are premium or discount if any.
Allocation recorded at the proper 9. Ascertain the amount of
amount. long-term debt maturing
within one year.
564
Discussion of Audit Procedures
1. Obtain analyses of long-term debt accounts and related interest, premium and
discount accounts.
The long-term debt accounts may include Bonds Payable, Mortgage Payable and
Long-term Notes Payable. The analyses of these accounts will show the following
1) Beginning balance
2) Additional notes/bonds issued
3) Payments during the year
4) Ending balance
2. Review debt agreements and confirm with payees or appropriate third party the
principal, interest rates, maturity date, etc.
The auditor should examine the client's copies of notes payable, bond indenture
instruments and supporting documents such as mortgages and trust deeds.
Physical inspection of these bonds may be conducted if they are in the custody of
company officials. If, however, the bonds are handled by a trustee, the trustees to the
confirmation should include information about bonds redeemed, retired or purchased
for the treasury.
565
4&5. Trace authorization for issuance of debt to credits to the long-term debt account.
Review minutes of board of directors' meetings.
The auditor should read the minutes of the board of directors' and shareholders' meetings
concerning the issuance of debt.
Proceeds from borrowing should be traced to remittance advices, validated bank deposit slip
and to the bank statement by the auditor to obtain evidence as to the validity of the transaction.
Likewise, checks used to pay the principal and interests should be examined.
7. Review payments of principals and renewals after the statement of financial position
date.
This procedure is performed by the auditors so that they may be aware of any unusual
transactions with company officers, directors and affiliates. It would also afford them
additional evidence on the proper classification of their liabilities.
9. Ascertain the amount of long-term debt maturing within one year requiring current
assets.
Long-term liabilities which will not mature within the operating cycle and any debt that will
mature but will not be liquidated from current assets will be classified long-term obligations.
Any debt maturing currently and payable from current assets will be a current liability.
Maturity date of the debt is traceable to the debt instrument itself. Verify the source of
repayment.
566
10. Send confirmation letters to financial institutions to obtain information about financing
arrangements.
Financing arrangements and transactions can be very complex, and the details of these
arrangements and transactions must be adequately disclosed in the notes to the financial
statement. If the auditors determine that additional evidence is needed to verify these details,
they will send a separate confirmation letter to the financial institution.
For example, confirmation letters may be used to obtain information about lines of credit,
contingent liabilities, compensating balance arrangements, letters of credit, or futures
contracts. These letters are signed by the client and specifically addressed to the client's loan
officer or another official to the financial institution who is knowledgeable about the
information. This expedites a response to the confirmation and enhances the quality of the
evidence received. Figure 18-1 provides an example of a letter to confirm information about
line of credit.
11. Evaluate financial statement presentation and adequacy of disclosure of long-term debt.
567
Figure 18-1: Illustrative Letter for Confirmation of Lines of Credit
In connection with an audit of the financial Statements of WXY Manufacturing., as of December 31,
20X4, and for the year then ended, we have advised our independent auditors of the information
listed below, which We believe is a complete and accurate description of our line of credit from your
financial institution as of the close of business on December 31, Although we do not request or
expect you to conduct a comprehensive, detailed search of your records, if during the process of
completing this confirmation additional information about other lines of credit from your financial
institution comes to your attention, please include such information below.
1. The company has available at your financial institution a line of credit totaling P47 million.
2. The current terms of the line of credit are contained in the letter dated May 11, 20X2.
3. The amount of unused line of credit, subject to the terms of the related letter, at December
31, 20X4, was P19 million.
4. The interest rate at the close of business on December 31, 20X4, was 9.2%
5. There are no requirements for compensating balances in connection with this line of credit.
Please confirm whether the information about the line of credit presented above is correct by signing
below and returning this letter directly to our independent auditors, Cruz & Lim, CPAs, 256 Ayala
Ave., Makati City.
Sincerely,
WXY Manufacturing, Inc.
Bank of PI
By: Ricardo Santos, Senior Loan Officer 2/20/X5
(Officer and Title) (Date)
568
ANALYTICAL PROCEDURES FOR LONG-TERM DEBTS
Analytical procedures are essential for long-term debts because tests of details for interest
expense and accrued interest can often be eliminated when results are favorable. Figure 18-2
illustrates typical analytical procedures for notes payable and related interest accounts.
The auditor's independent estimate of interest expense, using average notes payable
outstanding and average interest rates, tests the reasonableness of interest expense, but also
tests for omitted notes payable.
The normal starting point for the audit of long-term debts such as notes payable is a schedule of
notes payable and accrued interest obtained from the client.
A typical schedule is shown in Figure 18-3. The usual schedule includes detailed information
of all transactions that took place during the entire year for principal and interest, the beginning
and ending balances for notes and interest payable, and descriptive information about the notes,
such as the due date, the interest rate, and the assets pledged as collateral.
569
Figure 18-3: Schedule of Loan Payable and Accrued Interest
In addition to the enumerated audit procedures for long-term debts enumerated on page 545, the
auditor should also do the following:
1. Obtain evidence about interest expense, interest payable and bond discount.
2. Determine whether the company has met all requirements and restrictions imported
upon it by debt (bond) agreement.
3. A copy of the indenture agreement relating to a bond issue should be placed in the
auditor’s permit file. A listing of restrictions placed on the company is extracted from
these documents to facilitate the auditors' test of compliance with the debt provisions,
In connection with your firm's annual examination of the December 31 financial statements of
the Milco Corp., you have been assigned the duty of auditing long-term liabilities for the year
ended December 31, 20X7. In the course of performing your work, you obtained the following
evidence and information related to a new bond issue sold during 20X7:
1) Milco floated a new issue of P8,000,000 par value, 15 year, 10 percent bonds during the
latter half of the second quarter of the year.
2) The new bond issue was dated July l, 20X7 and it was sold to an underwriting syndicate on
that date for P6,898,720. This price provided an effective interest rate on the bond issue of
12 percent.
3) Interest on a new bond issue was payable semiannually on January 1 and July 1.
4) Milco paid P120,000 cash for printing, legal and other fees in connection with the issuance
of the bonds.
5) The Milco Corp. accounts related to this new bond reflect these bond transactions as
follows:
571
Bond Interest Expense, 20X7 Bond Issue
J-V-2, 12/31/X7 40,709.30
V-R-4, 12/30/X7 400,000.00
Required:
Prepared audit adjusting entries that you would propose to correct the bond-related accounts. In
drafting your entries, assume that all amounts are material and that recommended accounting
methods are to be employed.
(P120,000 x 1/2)
15
572
Illustrative Audit Case 18-2: Audit of Capital Lease
Roehl Wholesale Foods, Inc., leases its single warehouse from Belle Leasing Company. The
terms of the lease provide for minimum lease payments of P150,000 per quarter, payable at the
beginning of the quarter. The initial lease term runs for ten years with no renewal or purchase
options. Roehl is responsible for paying property taxes and also for any needed repairs to the
warehouse. The cost of the warehouse to Belle was P3,000,000 and the market value at date of
completion was P4,185,388. The explicit interest rate stated in the lease agreement is 8%. The
lease was signed and the warehouse occupied on January 2, 20X7.
Ty and Reyes, CPAs, have audited the accounts of Roehl since 20X3. The company closes its
books on December 31. Myra Luntok is in charge of the 20X7 audit. She has asked you to
audit the Belle warehouse lease.
Required:
a. Assuming that this is a capital lease, prepare an amortization schedule for the period
1/2/20X7 through 12/31/20X9.
d. Draft an audit workpaper, in good form, analyzing the account "Obligation under
Long-Term Lease." Incorporate all of the objectives that you identified in (c) above,
and assume that Roehl has accounted for the obligation as follows:
573
Solution: Illustrative Audit Case 18-2
Requirement (a)
*Calculated as follows:
Net present value of an annuity due of P150,000
per period for 40 periods at 2% equals P4,185,388.
Requirement (b)
This is a capital lease in as much as the present value of the minimum lease payments exceeds
90% of the fair value of the property at the date of lease signing.
574
Requirement (c)
In auditing the Belle lease, the student should identify the following objectives:
1) Determine that the warehouse exists and that the transaction was completed in 20X7.
2) Establish proper classification of the lease as to capital or operating.
3) Verify proper recording of the lease.
4) Ascertain validity of the quarterly payments and determine that they have been
correctly classified as to interest expense and principal reduction.
5) Determine proper authorization of the lease transaction.
6) Verify terms of the lease, i.e., initial lease term, explicit interest rate, quarterly lease
payments and dates of payment, responsibility for executory costs, and absence of
contingent rentals.
Requirement (d)
AJE 1
Interest expense 314,405
Interest payable 76,467
Obligation under long-term lease 237,938
To adjust obligation for interest not recognized in lease payments.
576
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
2. Palmer Company has issued a number of notes payable during the year, and several of
these notes are outstanding at the balance sheet date. What sources of information
should the auditors use in preparing a working paper analysis of the notes payable?
3. Is the confirmation of notes payable usually correlated with any other specific phase of
the audit? Explain.
4. What is the principal reason for testing the reasonableness of the Interest Expense
account in conjunction with the verification of notes payable?
5. What does the trust indenture used by a corporation in creating long-term bonded
indebtedness have to do with the payment of dividends on common stock?
6. Long-term creditors often insist upon placing certain restrictions upon the borrowing
company for the term of the loan. Give the three examples of such restrictions, and
indicate how each restriction protects the long-term creditor.
7. Most corporations with bonds payable outstanding utilize the services of a trustee.
What relation, if any, does this practice have to the maintenance of adequate internal
control?
8. What information should be requested by the auditors from the trustee responsible for
an issue of debentures payable?
9. "Auditors are not qualified to pass on the legality of a bond issue; this is a question for
the company's attorneys. It is therefore unnecessary for the auditors this bond issue be
classified as a current liability?
577
10. Kingsfield Corporation has outstanding an issue of 30-year bonds payable. There is no
sinking fund for these bonds. Under what circumstance, if any, should this bond issue
be classified as a current liability?
Exercises
Exercise 1
Aila Esteva, a CPA, has been engaged to examine the financial statements of
Broadwall Corporation for the year ended December 31, 20X7. During the year,
Broadwall obtained a long-term loan from a local bank pursuant to a financing
agreement that provided that the
3) Company was not to pay dividends without permission from the bank.
In addition, during the year the company also borrowed amounts, on a short-term basis,
from the president of the company, including substantial amounts just prior to
year-end.
Required:
b. What financial statement disclosures should Esteva expect to find with respect to
the loans from the president?
578
Exercise 2
Pine, Inc., a developer and producer of personal computers, printers, and other
computer hardware, leases factory and office space at its only location in the Sto.
Tomas area of Laguna. Quarterly lease payments of P150,000 are charged to rent
expense as paid or accrued. The lease is noncancellable and was signed on January
1, 20X7. The present value of the future lease payments at 1/1/20X7 is P3,467,215.
This amount is based on the 12% interest rate stated in the lease agreement.
Required:
a. As in-charge auditor examining the Pine financial statements for the year ended
12/31/20X7, what additional information do you need in order to determine
whether the lease is a financing or operating lease?
b. What audit procedures would you apply in gathering the information needed in
(a)?
c. Assuming that the lease is considered a financing lease, and the estimated useful
life and salvage value of the property are 10 years and P600,000 respectively,
prepare an audit workpaper for the lease liability. Assume that the quarterly
payments are due on April l, July l, October l, and January l. Include all necessary
audit legends as evidence of procedures performed.
579
The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2,
20X5, Boogie called P900,000 face amount of the bonds and retired them.
Required:
Required:
Ignoring interest, compute the gain or loss and record this refunding transaction.
Grease Products Company purchases an oil tanker depot on January l, 20Xl, at a cost of
P600,000. Grease Products expects to operate the depot for 10 years, at which time it is
legally required to dismantle the depot and remove the underground storage tanks. It is
estimated that it will cost P75,000 to dismantle the depot and remove the tanks at the
end of the depot's useful life.
Required:
(a) Prepare the journal entries to record the depot and the asset retirement obligation
for the depot on January l, 20Xl. Based on an effective interest rate of 6%, the
present value of the asset retirement obligation on January l , 20X1, is P41,879.
580
(b) Prepare any journal entries required for the depot and the asset retirement
obligation, at December 31, 20Xl. Grease Products uses straight-line depreciation;
the estimated residual value for the depot is zero.
(c) On December 31, 20X6, Grease Products pays a demolition firm to dismantle the
depot and remove the tanks at a price of P80,000. Prepare the journal entry for the
settlement of the asset retirement obligation.
Required:
(a) Prepare journal entries for Miguel Company and Prime National Bank to record
this debt settlement.
(b) How should Miguel report the gain or loss on the disposition of machine and on
restructuring of debt in its 20X7 statement of comprehensive income?
(c) Assume that, instead of transferring the machine, Miguel decides to grant 15,000
shares of its ordinary shares (P10 par) which has a fair market value of P190,000 in
full settlement of the loan obligation. If Prime National Bank treats Miguel's shares
as a trading investment, prepare the entries to record the transaction for both
parties.
581
Problems
b) Smooth Co. sold P2,000,000 of 10%, 10-year bonds at 104 on January l , 20X7.
The bonds were dated January l, 20X7, and pay interest on July 1 and January l . If
Smooth uses the straight-line method to amortize bond premium or discount,
determine the amount of interest expense to be reported on July l , 20X7, and
December 3 1, 20X7.
c) Jelly Inc. issued P600,000 of 9%, 10-year bonds on June 30, 20X7, for P562,500.
This price provides a yield of 10% on the bonds. Interest is payable semiannually
on December 31 and June 30. If Jelly uses the effective interest method, determine
the amount of interest expense to record if financial statements are issued on
October 31, 20X7.
Problem 2
Your client, Sunflower, Inc., has a debt agreement with Valley City Bank that includes
a number- of restrictions and covenants. Violation of any restriction or covenant results
in the entire amount of the debt becoming due immediately. For each of the following,
provide audit procedures that will address whether Sunflower has met the restriction or
covenant.
582
Problem 3: Audit of Liabilities: Current and Non-current
Rose People, Inc., has produced quality children's apparel for over 25, years. The
company's fiscal year is from April 1 to March 31. The following information relates to
the obligations of Rose People as of March 31, 20X3:
Bonds Payable. The company issued P4,000,000 of 7% bonds on July l, 20X3, at 98,
which yielded proceeds of P3,920,000. The bonds will mature on July 1, 20X7. Interest
is paid semi-annually on July 1 and January l. Rose People uses the straight-line
method to amortize the bond discount.
Notes Payable. Rose People has signed several long-term notes with financial
institutions and insurance companies. The maturities of these notes are given below.
The total unpaid interest for all of these notes amounts to P90,000 on March 31, 20X3.
Estimated Warranties. Rose People has a one-year product warranty on selected items.
The estimated warranty liability on sales made during the 20X1-20X2 fiscal year and
still outstanding as of March 31, 20X2, amounted to P55,000. The warranty costs on
sales made from April l, 20X2, through March 31, 20X3, are estimated at P145,000.
The actual warranty costs incurred during the current 20X2-20X3 fiscal year are as
follows:
583
Additional Information:
1. Trade payables. Accounts payable for supplies, goods, and services purchased on
open account amount to P325,000 as of March 31, 20X3.
3. Taxes. The following taxes are incurred but not due until the next fiscal year:
5. Dividends. On March 15, 20X3, the company's board of directors declared a cash
dividend of P0.40 per common share and a 10% ordinary share dividend. Both
dividends were to be distributed on April 12, 20X3, to the ordinary shareholders of
record at the close of business on March 31, 20X3. Data regarding Cute People's
ordinary shares are as follows:
Required:
a. Prepare the current liability section of the statement of financial position for Rose
People, Inc., as of March 31, 20X3, as it should appear in the annual report to
shareholders.
b. If you have excluded any items from the presentation of current liabilities, explain
why you have done so.
(CMA adapted)
584
Problem 4
Match the following definitions (or partial definitions) to the appropriate term. Each
term may be used once or not at all.
585
Chapter
AUDIT OF
OWNER(S)' EQUITY
ACCOUNTS
1. Describe the general procedures in auditing the partnership and the sole
proprietorship accounts.
2. Describe the auditor's objectives for the substantive audit of owners' equity
in a corporate setting.
INTRODUCTION
In general, the examination of the capital accounts and drawing accounts for a sole
proprietorship and partnership will involve application of the same principles.
Analyses are made for all proprietorship accounts from the beginning of' the business; the initial
capital investment and any additions are traced to the cash asset records and the net income or
loss for the period and any withdrawals are verified. One common source of difficulty,
however, in auditing a sole proprietorship is the practice of intermingling business and personal
transactions making it necessary for the auditors to segregate personal net worth from business
capital. Corrections may also be required to transfer from expense drawing account any
personal expenditures paid with company funds.
In the audit of the Partners' accounts, the auditors are particularly interested in determining that
the distribution of net income has been carried in accordance with the profit-sharing provisions
of the partnership contract. In a situation where a partnership operates without any written
agreement of partnership, the auditor may wish to obtain from each partner a written statement
confirming the balance in his or her capital account and approval of the method used in dividing
the year's earnings. They may also suggest that the firm develop a written
partnership agreement.
In examining shareholders' equity accounts, the auditor aims to determine (a) the propriety of
the charges and credits to the accounts, (b) the propriety of presentation of the accounts on the
statement of financial position, and (c) client’s compliance with relevant legal requirement. A
summary of the management assertions, audit objectives and audit procedures for the
shareholders' equity accounts are presented in Figure 19-1.
587
AUDIT OBJECTIVES AND PROCEDURES
588
DICUSSION OF AUDIT PROCEDURES
1. Obtain schedule of shareholders' equity accounts and reconcile to the general ledger
balances.
The auditor establishes the accuracy of the supporting schedule by footing the
schedules and reconciling the date on the schedules to the ledger balances.
The auditor should review the minutes of the directors' meetings to obtain evidence of
authorization of shareholders' equity transactions such as share issues, share
reacquisition's and dividend declarations. The auditor should also examine whether
restriction provisions are observed by the client in the issuance of shares, dividend
declaration and liquidation.
The auditor should confirm with the registrar or share and transfer agent the total shares
authorized, issued and outstanding at the statement of financial position date. The
shares held by each shareholder may also be confirmed with the transfer agent.
This is done when the client serves as its own transfer agent. The following steps are
followed in this test:
a) Examine the share certificate book to determine that (l) stubs for shares issued and
outstanding have been properly filled out, (2) canceled certificates are attached to
the original stubs, and (3) all unissued certificates are accounted for.
b) Ascertain that the changes during the year have been correctly recorded in the
shareholders' subsidiary ledger.
c) Reconcile the shares issued and outstanding as shown in the share certificate book
with total shares reported in the shareholders' ledger and share capital accounts.
589
5. Inspect certificates of shares held in treasury.
If there are shares held in treasury, the auditor should inspect the certificates at the
same time other securities are counted. He should note in paper the number of shares
acquired during the year for subsequent tracing to the cash records.
Figure 19-2 shows a Share Book Examination Schedule.
These ratios may be compared with both internal data (prior year's figures) and external
data (industry averages) and unusual fluctuations and questionable items should be
investigated by the auditor.
7&8. Review articles of incorporation and by laws. Make inquires of legal counsel.
The auditor should review the articles of incorporation and by laws to determine that the
corporation is authorized to do business and that shares of all classes of shares outstanding
have been authorized as required by the corporate charter. Evidence of legality of any
changes in capitalization may be obtained through inquiry of the client's legal counsel
whose response should preferably be in writing.
590
Figure 19-2: Share Book Examination Schedule
9. Vouch entries in the shareholders' equity accounts.
1) For new issue of shares and sale of treasury shares: Examine remittance advices
of the cash proceeds from the issue and trace the proceeds to the cash receipt
records and share capital and other paid-in capital.
2) For purchase of treasury shares and payment of dividends: Examine
authorizations in the minutes, trace to disbursement vouchers, canceled checks and
cash disbursement books.
The auditor should also obtain evidence supporting the other shareholders' equity
accounts such as:
a. Appropriation of retained earnings which should be traced to the minute’s book.
b. Prior-period adjustment.
Figure 19-3 shows the working papers for Test of Dividend Payments.
Disclosures related to the equity section include details of par or stated value, share
option plans, dividends in arrears, and dividend and liquidation preferences. To meet
this objective, the auditor should review the evidences obtained in the foregoing tests
and from the review of the corporate minutes for provisions and agreements affecting
the shareholders' equity accounts. Additional evidence may also be obtained from
discussions and communication with legal counsel.
592
Figure 19-3: Test of Dividend Payments
Illustrative Audit Case 19-1: Analysis of Shareholders' Equity Accounts
During May 20X6, Glenn, Inc., was organized with 3,000,000 authorized shares of P10 par
value ordinary shares, and 300,000 of its ordinary shares were issued for P3,300,000. Net
income through December 31, 20X6, was P125,000.
On July 3, 20X7, Glenn issued 500,000 of its ordinary shares for P6,250,000. A 5% share
dividend was declared on October 2, 20X7, and issued on November 6, 2018, to shareholders
of record on October 23, 20X7. The market value of the ordinary shares was P11 per share on
the declaration date. Glenn's net income for the year ended December 31, 20X7, was
P350,000.
1. In February, Glenn reacquired 30,000 of its ordinary shares for P9 per share. Glenn
uses the cost method to account for treasury shares.
2. In June, Glenn sold 15,000 of its treasury shares for P12 per share.
3. In September, each shareholder was issued (for each share held) one right to purchase
two additional ordinary shares for P13 per share. The rights expire on December 31,
20X8.
4. In October, 250,000 rights issues were exercised when the market value of the
ordinary shares was P14 per share.
5. In November, 400,000 rights issues were exercised when the market value of the
ordinary share was P15 per share.
6. On December 15, Glenn declared its first cash dividend to shareholders of P0.30 per
share, payable on January 10, 20X9, to shareholders of record on December 31, 20X8.
7. On December 21, in accordance with the applicable law, Glenn formally retired
10,000 of its treasury shares and had them revert to an unissued basis. The market
value of the ordinary share was P16 per share on this date.
8. Net income for 20X8 was P800,000.
Required:
Prepare a schedule of all transactions affecting the share capital (share and peso amounts),
additional paid-in capital, retained earnings, and the treasury shares (shares and peso amounts)
and the amounts that would be included in Glenn's statement of financial position at December
31, 20X6, 20X7, and 20X8, as a result of the above transactions. Show supporting
computations in good form.
594
Solution: Illustrative Audit Case 19-1
Glenn, Inc.
Computation of Shareholders' Equity Accounts Balance
December 31, 20X6
Glenn, Inc.
Computation of Shareholders' Equity Accounts Balance
December 31, 20X6
Schedule 1
Share Dividend
595
Glenn, Inc.
Computation of Shareholders' Equity Accounts Balance
December 31, 20X8
Schedule 2
Cash Dividend
596
Illustrative Audit Case 19-2: Audit of Retained Earnings and Shareholders' Equity
Detdet, Inc., is a public enterprise whose shares are traded in the over-the-counter market. At
December 31, 20X7, Detdet had 6,000,000 authorized shares of P10 par value ordinary shares,
of which 2,000,000 shares were issued and outstanding. The shareholders' equity accounts at
December 31, 20X7 had the balances.
Transactions during 20X8 and other information relating to the shareholders' equity accounts
were as follows:
1. On January 5, 20X8, Detdet issued at P54 per share, 100,000 shares of par value, 9%
cumulative convertible preference shares. Each share of preference is convertible, at the
option of the holder, into two ordinary shares. Detdet had 600,000 authorized preference
shares.
2. On February l, 20X8, Detdet reacquired 20,000 of its ordinary shares for P16 per share.
Detdet uses the cost method to account for treasury shares.
3. On April 30, 20X8, Detdet sold 500,000 shares (previously unissued) of P10 par value
ordinary shares to the public at P17 per share.
4. On June 18, 20X8, Detdet declared a cash dividend of P1 per ordinary share, payable on
July 12, 20X8, to shareholders of record on July l, 20X8.
5. On November 10, 20X8, Detdet sold 10,000 treasury shares for P21 per share.
6. On December 14, 20X8, Detdet declared the yearly cash dividend on preference shares,
payable on January 14, 20X9, to shareholders of record on December 31, 20X8.
7. On January 20, 20X9, before the books were closed for 20X8, Detdet became aware that
the ending inventories at December 31, 20X7, were understated by P300,000 (the
after-tax effect on 20X6 net income was P210,000). The appropriate correcting entry was
recorded the same day.
8. After correcting the beginning inventory, net income for 20X8 was P4,500,000.
Required:
Prepare a statement of retained earnings for Detdet for the year ended December 31, 20X8.
Assume that only single-period financial statements for 20X8 are presented.
Prepare the shareholders’ equity section of Detdet's statement of financial position at December
31, 20X8.
597
Solution: Illustrative Audit Case 19-2
Requirement (1)
Requirement (2)
Illustrative Audit Case: 19-3: Correcting Entries for Equity Transactions
Pastel, Inc. recently hired new accountant with extensive experience in accounting for
partnerships. Because of the pressure of the new job, the accountant was unable to review what
he had learned earlier about corporation accounting. During the first month, he made the
following entries for the corporation’s share capital.
10 Cash 600,000
Share Capital 600,000
(Issued 10,000 shares of P30 par value preference share at P60 per share)
30 Cash 8,500
Share Capital 5,000
Gain on sale of shares 3,500
(Sold treasury shares at P17 per share)
Required:
On the basis of the explanation of each entry, prepare the entries that should have been made for
the share capital transactions.
599
Solution: Illustrative Audit Case: 19-3
Date Correct Entry Adjusting Journal Entry
May 2 Cash 192,000 AJE (1) Share capital -
Share Capital - ordinary 132,000
ordinary Paid in capital in
(12,000 x P5) 60,000 excess of par -
Paid in capital in ordinary shares 132,000
excess of par -
ordinary shares
(12,000 P11) 132000
May 10 Cash 600,000 AJE (2) Share capital 600,000
Preference shares Preference shares 300,000
(10,000 x P30) 300,000 Paid in capital 300,000
Paid in capital in
excess of par -
preference shares
(10,000 x P30) 300,000
May 15 Treasury shares 15,000 AJE (3) Treasury shares 15,000
Cash 15,000 Share capital 15,000
May 31 Cash 8,500 AJE (4)
Treasury shares Share capital 5,000
(500 x P15) 7,500 Gain on sale 3,500
Paid-in capital from Treasury shares 7,500
treasury shares Share capital 1,000
(500 x P2) 1,000
600
During 20X7, the company entered into the following transactions:
Jan. 2 Established a compensatory share option plan for its key executives. The
options vest after a 3-year service period. The estimated fair value of the
options expected to be exercised is P81,000.
Mar. 6 Received the remaining P40 per share on the subscribed preference shares
and issued the shares.
July 3 Received the remaining balance on subscribed ordinary shares and issued the
shares.
Sept. 22 Purchased building by paying P9,000 cash and issuing 800 ordinary shares
and 450 preference shares. Ordinary and preference shares are currently
selling for P19 and P57 per share, respectively.
Oct. 13 Reacquired 900 ordinary shares at P19.50 per share. The company uses the
cost method to account for treasury shares.
Nov. 14 Issued for P32,000 a combination of 700 ordinary shares and 12% bonds with
a face value of P20,000. The ordinary shares is currently selling for P18 per
share. No market value exists for the bonds.
Dec. 28 Distributed a P3.00 per share dividend to all outstanding preference shares
and a P1.50 per share dividend to all ordinary shares outstanding on this date
(debit Retained Earnings and credit Cash for each dividend).
Dec. 29 Declared a two-for-one share split on the ordinary shares, reducing the stated
value to P4 per share and increasing the authorized shares to 60,000.
Required:
Prepare the contributed capital section of the December 31, 20X7 statement of financial
position.
601
Solution: Illustrative Audit Case 19-4
Canada Company
Statement of Financial Position
Contributed Capital Section
December 31, 20X7
Contributed Capital
Preference shares (6%. P50 par, 8,000 shares authorized, 4,950
P247,500
shares issued and outstanding)
Ordinary shares (P4 stated value, 60,000 shares authorized,
120,800
30,200 shares issued and outstanding)
Ordinary share option warrants 27,000
Additional paid-in capital on preference shares* 17,450
Additional paid-in capital on ordinary shares* 96,000
Additional paid-in capital from treasury shares 900
Additional paid-in capital from share split 30,200
Contributed capital P539,850
The following entries for the transactions that occurred in year 20X7 support the above
schedule:
20X7
Jan. 3 Memo entry: On this date a compensatory share option plan was granted to key
executives. The options vest after a 3-year service period is completed. The
estimated fair value of the options expected to be exercised is P81,000.
Mar.
Cash (800 x P40) 32,000
6
Preference Shares Subscribed (800 x
40,000
P50)
Subscriptions
32,000
Receivable
Preference Shares, P50 par 40,000
Apr.
Cash (300 x P55) 16,500
24
Preference Shares, P50 par 15,000
Additional Paid-in Capital on
1,500
Preference Shares
May
Cash (1,000 x P6) 6,000
5
Subscription Receivable (1,000 x P11) 11,000
Ordinary Shares Subscribed 10,000
Additional Paid-in Capital on Ordinary
7,000
Shares
602
June 6 Cash (600 x P17) 10,200 6,000
Ordinary Shares, P10 stated value 4,200
Additional Paid-in Capital on Ordinary Shares
July 3 Cash (1,000 x P11) 11,000
Ordinary Shares, P10 stated value 10,000
Ordinary Shares, P10 stated value 11,000
Subscription Receivable 10,000
Sept. 10 Building 49,850
Cash 9,000
Ordinary Shares, P10 stated value 8,000
Additional Paid-in Capital on Ordinary Shares
(P9 x 800) 7,200
Preference Shares, P50 par 22,500
Additional Paid-in Capital on Preference Shares
(P7 x 450) 3,150
Oct. 13 Treasury Shares 17,550
Cash (P19.50 x 900) 17,550
Nov. 14 Cash 32,000
Discount on Bonds Payable 600
Bonds Payable, 12% 20,000
Ordinary Shares, P10 stated value 7,000
Additional Paid-in Capital on Ordinary Shares
(P8 x 700) 5,600
Dec. 15 Cash (P20.50 x 900) 18,450
Treasury Shares 17,550
Additional Paid-in Capital from Treasury Shares 900
28 Retained Earnings* 14,850
Cash 14,850
* Preference dividends: (3,400 + 800 + 300 + 450) x (0.06 x P50) = P14,850
Dec. 28 Retained Earnings* 22,650
Cash 22,650
* Ordinary dividends: (12,000 + 600 + 1,000 + 800 + 700) x P1.50 = P22,650
603
Dec. 29 Ordinary Shares, P10 stated value (P10 x P15,100) 151,000
Ordinary Shares, P4 stated value (P4 x 30,000) 120,800
Additional Paid-in Capital from Share Split 30,200
Memo entry: The authorized ordinary share is increased from
30,000 to 60,000 shares.
31 Compensation Expense (P81,000 ÷ 3) 27,000
Ordinary Shares Option Warrants 27,000
ETC Company adopted a share option plan on November 30, 20X6 that provided that 70,000
shares of P5 par value share are designated as available for the granting of options to officers
of the corporation at a price of P8 a share. The market value was P12 a share on November 30,
20X6.
On January 2, 20X7, options to purchase 28,000 shares were granted to president Dee
Posadas— 15,000 for service to be rendered in 20X7 and 13,000 for service to be rendered in
20X8. Also on that date, options to purchase 14,000 shares were granted to vice president
Bobbie Leandro 7,000 for services to be rendered in 20X7 and 7,000 for services to be rendered
in 20X8. The market value of the share was P14 a share on January 2, 20X7. The options were
exercisable for a period of one year following the year in which the services were rendered.
In 20X8, neither the president nor the vice president exercised their options because the market
price of the share was below the exercise price. The market value of the share was P7 a share on
December 31, 20X8, when the options for 20X7 services lapsed.
On December 31, 20X9, both president Posadas and vice president Leandro exercised their
options for 13,000 and 7,000 shares, respectively, when the market price was P16 a share.
Required:
Prepare the necessary journal entries in 20X6 when the share option plan was adopted, in 20X7
when options were granted, in 20X8 when options lapsed, and in 20X9 when options were
exercised. The company elects to use the intrinsic value method.
604
Solution: Illustrative Audit Case 19-5
20X6
No journal entry would be recorded at the time the share option plan was adopted. However, a
memorandum entry in the journal might be made on November 30, 20X4, indicating that a
share option plan had authorized the future granting to officers of options to buy P70,000 shares
of P5 value ordinary shares at P8 a share.
20X7
January 2
No entry
December 31
Compensation Expense 132,000
Paid-in Capital - Share Options 132,000
(To record compensation expense attribute to
20X7 - 22,000 options at P6 (P14-P8)
20X8
December 31
Compensation Expense 120,000
Paid-in Capital - Share Options 120,000
(To record compensation expense attribute to
20X8 - 20,000 options at P6 (P14-P8)
605
REVIEW QUESTIONS, EXERCISES AND PROBLEMS
Questions
1. What audit procedures may be employed to establish the (a) existence or occurrence
and (b) rights and obligations of shareholders' equity balances?
Exercises
Exercise 1
The Earla Company was incorporated July 10, 20X7, with an authorized capital as
follows:
1. Ordinary shares, Class A, 20,000 shares, par value P25 per share.
2. Ordinary shares, Class B, 100,000 shares, par value P5 per share.
The share capital account in the general ledger is credited with only one item in the year
20X7. This represents share capital sold for cash, at par, as follows:
1. Class A, 12,000 shares.
2. Class B, 60,000 shares.
The sum of open certificate stubs in the share certificate books at December 31, 20X7
indicates that 82,000 shares were outstanding.
Required:
a. State possible explanations for this apparent discrepancy.
b. State the procedures you would perform to determine the cause of the discrepancy.
606
Exercise 2
You are engaged in doing the audit of a corporation whose records have not previously
been audited by you. The corporation has both an independent transfer agent and a
registrar for its share capital. The transfer agent maintains the record of shareholders and
the registrar checks that there is no over issue of shares. Signatures of both are required to
validate certificates.
It has been proposed that confirmations be obtained from both the transfer agent and the
registrar as to the shares outstanding at statement of financial position. If such
confirmations agree with the books, no additional work is to be performed as to share
capital.
Required:
If you agree that obtaining the confirmations as suggested would be sufficient in this case,
give the justification for your position. If you do not agree, state specifically all additional
steps you would take and explain your reason for taking them.
Talisay Corporation presented the following statement of financial position for December
31, 20X7:
Assets
Current Assets P30,000
Treasury shares (at market; cost = P15,000) 14,000
Fixed assets 56,000
Total assets P100,000
Shareholders' equity
Ordinary shares (4,000 shares issued) 18,000
10% Preference shares (1,000 shares issued) 12,000
Less: Share subscriptions receivable (4,000)
Reserve for depreciation 16,000
Earned surplus 20,000
Total liabilities and shareholders' equity P100,000
607
Your investigation of Talisay Corporation's financial records indicates that all
authorized shares have been either issued or subscribed. In addition, the par values for
the ordinary and preference shares are P2 and P10, respectively. The treasury share was
originally purchased when the market price was P20 per share. During 20X7, 250
treasury shares were resold for P25 per share. A "gain on treasury share transactions"
was credited for the difference between the original cost and the selling price.
Furthermore, the excess of cost over market of the treasury shares at the end of the
period was recognized as an unrealized loss on the 20X7 income statement. You also
discovered that the City of Makati donated land with a market value of P9,000 to
Talisay during 20X7. Share subscriptions receivable are due six months from
December 31, 20X7.
Required:
Revise the December 31, 20X7, statement of financial position for Talisay
Corporation as it should be presented according to financial reporting standards.
608
4. On September 28, Hope contracted with Kathryn Reyes for the sale of 10,000
previously unissued shares at P25 per share to be issued when the purchase price is
fully paid. At September 30, only P195,000 had been paid. Reyes agreed to pay the
balance on or before November 3, 20X8.
5. On September 30, Hope redeemed 4,000 preference shares according to the issue
agreement. The shares were redeemed at P18 per share.
6. A cash dividend of P2 was declared on the preference shares on March 11, and paid
on March 30.
7. A cash dividend of P1.50 per share was declared on September 15, and payable
October 11.
8. Hope's net income for fiscal year 2018 was P250,000.
Required:
Prepare the shareholders' equity section of the statement of financial position for the
year ended September 30, 20X8. This statement should be supported by the following
schedules, presented in the order given:
a. Changes in preference shares account.
b. Changes in ordinary shares account.
c. Calculation of paid-in capital in excess of par.
d. Changes in retained earnings.
Adverse financial and operating circumstances warrant that Baguio Company undergo
a quasi reorganization at December 31, 20X8. The following information may be
relevant in accounting for the quasi reorganization.
609
6. The immediately before the events described above, the shareholders’ equity
section appears as follows:
Required:
The correct balance of Retained Earnings as at December 31, 20X8 should be:
a. P76,000 b. P106,000 c. P131,000 d. None of these
Exercise 7
The A4 Corporation has been operating successfully for several years. It is authorized to
issue 24,000 shares of no-par ordinary shares and 6,000 shares of 8%, P100 par preference
share. The Contributed Capital section of its January 1, 20X7 statement of financial
position is as follows:
610
Part a. A shareholder has raised the following questions:
Mar. 2 Received a subscription to 400 shares of the 8% preference share. The total
subscription price is P122 per share and the contract requires a P10 per
share down payment. The remaining balance must be paid within 60 days or
the share subscription is defaulted. In the case of default, 20% of the down
payment on the defaulted shares is forfeited, and the remainder is returned
to the defaulting subscribers.
Apr. 3 Sold 900 ordinary shares for P33 per share.
Apr. 13 Issued 400 ordinary shares in exchange for land. The share is currently
selling at P34 per share.
May 1 Received remaining subscription balance (from March 2) owed on 350
preference shares and issued the shares.
May 4 Returned 80% of their down payment to defaulting subscribers and canceled
the related account balances.
June 1 Reacquired 500 ordinary shares at P37 per share. The company uses the
cost method to account for treasury shares.
Oct. 19 Issued for P27,000 a combination of 500 ordinary shares and 100
preference shares. The ordinary and preference shares are currently selling
for P35 and P125 per share, respectively.
Nov. 16 Reissued the 500 treasury shares at P39 per share.
Dec. 31 Distributed an P8 per share dividend on all preference shares outstanding
and a P2 per share dividend on all ordinary shares outstanding on this date
(debit Retained Earnings and credit Cash for each dividend).
Required:
Prepare the contributed capital section of the December 31, 20X7 statement of financial
position.
611
Exercise 8
Partner Corporation’s post-closing trial balance at December 31, 20X7 was as follows:
Debit Credit
Accounts payable P290,000
Accounts receivable P550,000
Accumulated depreciation - building and equipment 200,000
Additional paid-in capital - ordinary shares
In excess of par value 1,560,000
From sale of treasury shares 250,000
Allowance for doubtful accounts 30,000
Bonds payable 400,000
Building and equipment 1,100,000
Cash 220,000
Ordinary shares (P1 par value) 150,000
Dividends payable on preference shares - cash 4,000
Inventories 620,000
Land 380,000
Investment in equity securities (at market) @ FVOCI 285,000
Trading equity securities (at market) 215,000
Preference shares (P50 par value) 500,000
Prepaid expenses 40,000
Retained earnings 231,000
Treasury shares - ordinary (at cost) 180,000
Unrealized decrease in value of investment in securities - OCI 25,000
Totals P3,165,000 P3,165,000
At December 31, 20X7 Partner had the following number of ordinary and preference
shares:
Ordinary Preference
Authorized 500,000 50,000
Issued 150,000 10,000
Outstanding 140,000 10,000
The dividends on preference shares are P4 cumulative. In addition, the preference share
has a preference in liquidation of P50 per share.
Required:
612
Problems
Problem 1
On January l, 20X7, Del-V Company had a retained earnings balance of P206,000. During
2017, the following events occurred:
1. Treasury shares (ordinary) was acquired at a cost of P14,000. The law requires a
restriction of retained earnings in an equal amount. The company reports its retained
earnings restrictions in a note to the financial statements.
2. Cash dividends totaling P9,000 share dividends totaling P6,000 were declared and
distributed.
3. Net income was P58,000.
4. Two thousand shares of callable preference shares were recalled and retired at a price
of P150 per share. This share had originally been issued at P130 per share.
5. A material error in net income for a previous period was corrected. This error
correction decreased retained earnings by P12,600 after a related income tax credit of
P5,400.
Required:
1. Prepare a statement of retained earnings for the year ended December 31, 20X7.
2. Prepare a note to disclose the restriction of retained earnings.
Problem 2
RICY Corporation has experienced a net loss for a number of years. On the advice of the
board of directors, a new management team was appointed. Furthermore, the corporation
has agreed to quasi-reorganization and to the revaluation of certain statement of financial
position account balances, subject to shareholder approval. The RICY statement of
financial position on December 31, 20X7 contained the following information prior to the
reorganization:
613
The following information is relevant to the quasi-reorganization as approved by the
shareholders:
Required:
1. Prepare journal entries to record the quasi-reorganization.
2. Prepare the statement of financial position of RICY Corporation immediately
following the quasi-reorganization. Include a note to accompany retained
earnings.
Problem 3
JTC Company has P80,000 available to pay dividends. It has 2,000 shares of 10%,
P100 par, preference shares and 30,000 shares of P10 par ordinary share outstanding.
The preference share is selling for P125 per share and the ordinary share is selling for
P20 per share.
Required:
2. For 1(a), compute the dividend yield on the preference share and the ordinary
share.
614
Problem 4
Trading on the Equity Analysis Presented below is information from the annual report
of Empire Plastics, Inc.
Required:
The following is a summary of all relevant transactions of MLA Corporation since it was
organized in 20X5.
In 20X5, 15,000 shares were authorized and 7,000 ordinary shares (P50 par value) were
issued at a price of P57. In 20X6, 1,000 shares were issued as share dividend when the
share was selling for P62. Three hundred ordinary shares were bought in 20X6 at a cost of
P66 per share. These 300 shares are still in the company treasury.
In 20X5, 10,000 preference shares were authorized and the company issued 4,000 of them
(P100 par value) at P113. Some of the preference share was reacquired by the company
and later reissued for P4,700 more than it cost the company.
The corporation has earned a total of P610,000 in net income after income taxes and paid
out a total of P312,600 in cash dividends since incorporation.
Required:
Prepare the shareholders' equity section of the statement of financial position in proper
form for MLA Corporation as of December 31, 20X6. Account for treasury shares using
the cost method.
615
Problem 6: Issuance of Bonds with Warrants
Odyssey, Inc. has decided to raise additional capital by issuing P170,000 face value of
bonds with a coupon rate of 10%. In discussions with investment bankers, it was
determined that to help the sale of the bonds, detachable share warrants should be issued at
the rate of one warrant for each P100 bond sold. The value of the bonds without the
warrants is considered and the value of the warrants in the market is The bonds sold in the
market at issuance for P152,000.
Required:
(a) What entry should be made at the time of the issuance of the bonds and warrants?
(b) If the warrants were nondetachable, would the entries be different? Discuss.
Required:
(a) Prepare a schedule to compute both basic and diluted earnings per share.
(b) Discuss how the schedule would differ if the security was convertible preference
share.
Problem 8
You are engaged in the audit of Phoenix Corp., a new client, at the close of its first fiscal
year, April 30, 20Xl. The accounts had been closed before the time you began your
year-end filed work.
You review the following stockholders' equity accounts in the general ledger:
Capital Stock
5/1/X0 CR1 500,000
4/28/X1 J12-5 50,000
616
Paid-in Capital in Excess of Stated Value
5/1/X0 CR1 250,000
2/2/X1 CR10 2,500
Retained Earnings
4/28/X1 J12-5 50,000 4/30/X1 J12-14 800,000
Treasury Stock
9/14/X0 CP5 80,000 2/2/X1 CR10 40,000
Income Summary
4/30/X1 J12-13 5,200,000 4/30/X1 J12-12 6,000,000
4/30/X1 J12-14 800,000
4/18/X0 Established P50 per share stated value for capital stock.
4/30/X0 Authorized issue of 10,000 shares to an underwriting syndicate for
P75 per share.
9/13/X0 Authorized acquisition of 1,000 shares from a dissident holder at
P80 per share.
2/01/X1 Authorized reissue of 500 treasury shares at P85 per share.
4/28/X1 Declared 10 percent stock dividend, payable May 18, 20X1, to
stockholders of record May 4, 20X1.
3. The following costs of the May 1, 20X0, and February 2, 20X1, stock issuances
were charged to the named expensed accounts: Printing Expense, P2,500. Legal
Fees, P17, 350; Accounting Fees, P12,000; and SEC Fees, P150.
4. Market values for Phoenix Corp. capital stock on various dates were:
Required:
a. Prepare the necessary journal entries at April 30, 20X1.
b. Prepare the stockholders’ equity section of Phoenix Corp.’s April 30, 20X1,
balance sheet.
617
Chapter AUDIT OF OTHER
ACCOUNTS IN THE
STATEMENT OF PROFIT
OR LOSS AND
COMPREHENSIVE
INCOME
1. Describe the auditor' objectives for the substantive audit of account in the
statement of profit or loss and comprehensive income.
3. Understand and prepare audit working papers to document audit procedures for
the accounts in the statement of profit or loss and comprehensive income.
CHAPTER 20
INTRODUCTION
Investors and other users of financial statements rely on the Statement of Income as an
indication of company's performance for a given period. They often use information from this
statement as a guide in projecting expected future performance. The auditor must therefore
have a reasonable basis for expressing an opinion on the fairness of management's statement of
profit or loss and comprehensive income, representations and disclosures.
This Chapter presents the approach and procedures that the auditors use in examining the
client's statement of profit or loss and comprehensive income accounts.
AUDIT OBJECTIVES
1. To determine whether all (completeness) revenues and expenses (rights and obligations)
applicable to the audit period (occurrence) have been recognized and are matched properly
(allocation) in accordance with generally accepted accounting principles.
2. To determine whether all material unusual and infrequent items are segregated properly in
the statement income (presentation).
3. To determine whether revenues and expenses are classified properly and consistently
(presentation).
4. To determine whether disclosures concerning revenue and expense are adequate and in
accordance with financial reporting standards (disclosure).
619
AUDITOR'S APPROACH IN THE EXAMINATION OF REVENUES AND
EXPENSES
Normally, very few explicit tests of balances in the revenue and expense accounts are
conducted at the end of an audit engagement. Instead, the auditor will have compliance tests of
the various segments of the information processing system (revenue and collection cycle,
expenditure cycle, financing and investing cycles) and will have also gathered substantive
evidence to support the propriety of revenue and expense information during the period.
Furthermore, the auditor may substantiate the balances in a number of these accounts as a
by-product of the substantive audit work for the related asset and liability accounts. Examples
are:
Prepaid Expenses; Deferred Rent Expense, Insurance Expenses and other related
Charges expenses
Intangibles Amortization, Royalties Expense
620
Although formal tests of the balances in the revenue and expense accounts are
frequently not necessary at year-end, the auditor however needs to supplement the
evidence obtained in the foregoing tests with the following procedures:
The above procedures are also appropriate for other expenses not verified in the audit
of statement of financial position accounts.
b. Determine the amount of difference from the expectation that can be accepted
without investigation.
The auditors use their estimates of materiality to arrive at which differences are
to be investigated and which might be expected to occur by chance. However,
the extent of the assurance desired from the analytical procedure also should be
considered.
621
d. Investigate significant deviations from the expected account balance.
2. Review journals and ledgers for unusual items that may be indicative of
misstatements.
Reviewing journals and ledgers for unusual entries, amounts, and other items is an
effective way of obtaining additional evidence about expense accounts. The
auditor will look for items such as unusually large entries, entries from unusual
sources, and entries with unusual timing.
Income tax returns generally require schedules for officers' salaries, directors' fees,
taxes, travel and entertainment, contributions, and casualty losses. In addition to
these, officers' expense account allowances are presented in the analysis of officers'
salaries. Accordingly, the auditors should obtain or prepare analyses of any of
these expenses that were not analyzed when performing other audit steps.
The auditor generally places heavy emphasis on analytical review procedures in the
revenue and expense area. In its simplest form, review of operations of profit or loss
and comprehensive income for the year being audited with the budget for the year and
the actual amounts for the prior year and determining the underlying reasons for
significant variations or the lack thereof.
622
Explanation for significant variations are obtained first from the client personnel
then verified by examination of supporting evidence. For example, the increase in
sales can be explained by the sales manager, whereas the significant change in
repairs and maintenance can best, be explained by the plant or maintenance
supervisor.
The auditor should also compare operating statistics such as the gross profit
percentage, inventory turnover, receivable turnover, operating ratio and other
significant relationships with statistics of the prior year and for other enterprises in
the same business. Such comparisons and review of operations may indicate
improper classification of extraordinary charges or credits as operating expenses or
erroneous recording of major repairs and maintenance expense.
The analytical review of operations will also include comparison of revenue and
expense account balances with budgeted amounts. Significant variations between
the actual and budgeted amounts may indicate that operations were not conducted in
accordance with the company's predetermined plans. The auditor can obtain the
explanations of such variances from the client's management.
ACCOUNT ANALYSIS
The auditor often will analyze certain selected operating accounts to supplement the
information already obtained elsewhere. Analysis is usually required for accounts that
(l) require special disclosure in the statement of profit or loss and comprehensive
income, (2) contain information needed in preparing tax returns and reports to SEC, and
(3) general account titles that suggest the likelihood of misclassifications and errors.
623
The auditor will usually follow the general guidelines listed below once a particular operating
account has been selected or detailed analysis:
1. Understand the purposes of the particular analysis and the number and kinds of items to
be checked.
For example: (l) salaries and wages are analyzed to countercheck proper withholding
of taxes, (2) repairs and maintenance — for verification of capital items charged to
expense, (3) rents — for identification of lease liabilities, (4) legal expenses — for
verification of contingent liabilities and (5) miscellaneous expense — because it is
often the repository of unusual charges and expenses.
The auditor must be alert to transactions involving revenue and expenses that will
require special classification or disclosure. Examples include the classification of
losses from discontinued operations, gains or losses, and affecting prior period. He
should also be satisfied with the level of summarization of the revenue and expense
accounts in the statement of profit or loss and comprehensive income; for example, that
all significant accounts are shown separately and all insignificant accounts are
aggregated.
1. All income items are subject to a 35% income tax rate except the loss on
disposal of a segment of the company's operations, which is subject to a 20%
income tax rate.
2. The company had 1,000,000 ordinary shares outstanding from January 1 to June
30, when an additional 200,000 shares were sold. There was no other share
activity during 20X7.
3. The following amounts related to the disposed segment are included in the
appropriate revenue and cost figures:
Sales P750,000
Cost of goods sold 600,000
Selling expenses 100,000
Administrative expenses 350,000
Interest expense 10,000
625
626
Required:
a. Prepare a statement of profit or loss and comprehensive income for Lawag Corporation
for the year ended December 31, 20X7
Sales
P7,900,000
Cost of Goods Sold 2,385,000
Gross Profit 5,515,000
Operating expenses
Administrative P950,000
Selling 1,243,000 2,193,000
Operating Income 3,322,000
Discontinued operations:
Operating loss of discontinued segment, P201,500
net of P108,500 income tax
Loss on disposal of discontinued segment,
net of P19,000 income tax 76,000 277,500
Net income P1,839,225
627
Computations:
Sales (P8,650,000 - P750,000) P7,900,000
Cost of goods sold (P2,985,000 - P600,000) P2,385,000
Administrative expenses (P1,300,000 - P350,000) P 950,000
Selling expenses (P1,343,000 - P100,000) P1,243,000
Interest expense (P65,000 - P10,000) P 55,000
Income tax expense (P3,099,500 x 35%) P1,084,825
Requirement (b)
Special items, such as discontinued operations, are presented on a net- of- tax basis in order to
isolate their full financial impact in a single income item. This permits the income subtotals to
be unaffected by the item that is specially classified. If the tax effect of the specially classified
item were included in the income tax expense figure, relationships within the statement of
profit or loss and comprehensive income would be distorted.
628
Illustrative Audit Case 20-2: Preparation of Audit Adjustments and Audited Financial
Statements
Jay Corporation was incorporated on December 1, 20X6, and began operations 1 week later.
Before closing the books for the fiscal year ended November 30, 20X7, Jay's controller
prepared the following financial statements:
JAY CORPORATION
Statement of Financial Position
November 30, 20X7
Assets
Current assets
Cash P 150,000
Marketable securities, at cost 60,000
Accounts Receivable 450,000
Less: Allowance for doubtful accounts (59,000)
Inventories 430,000
Prepaid insurance 15,000
Total current assets P 1,046,000
Property, plant and equipment 426,000
less: Accumulated depreciation (40,000)
Research and development costs 120,000
Total Assets P 1,552,000
629
JAY CORPORATION
Statement of Income
For Year Ended November 30, 20X7
Jay Corporation is in the process of negotiating a loan for expansion purposes, and the bank has
requested audited financial statements. During the course of the audit, the following additional
information was obtained:
3) Inventories at November 30, 20X7, did not include work-in-process inventory costing
P12,000 sent to an outside processor on November 29, 20X7.
4) A P3,000 insurance premium paid on November 30, 20X7, on policy expiring 1 year
later was charged to insurance expense.
5) Jay adopted a pension plan on June 1, 20X7, for eligible employees to be administered
by a trustee. Based upon actuarial computations, the first 12 months accrued pension
plan expense was estimated at P45,000.
6) On June 1, 20X7, a production machine purchased for P24,000 was charged to repairs
and maintenance. Jay depreciates machines of this type on the straight-line method
over a 5-year life, with no salvage value, for financial and tax purposes.
630
7) Research and development costs of P150,000 were incurred in the development of a
patent that Jay expects to be granted during the fiscal year ending November 30, 20X8.
Jay initiated a 5-year amortization of the P150,000 total cost during the fiscal year
ended November 30, 20X7.
8) During December 20X7 a competitor company filed suit against Jay for patent
infringement claiming P200,00 in damages. Jay's legal counsel believes that an
unfavorable outcome is probable. A reasonable accrual based on an estimate of the
court's award to the plaintiff is P 50,000.
9) The 30% effective tax rate was determined to be appropriate for calculating the
provision for the income taxes for the fiscal year ended November 30, 20X7. Ignore
computation of deferred portion of income taxes.
Required:
Requirements (1)
(1)
Unrealized Loss on Trading Securities 5,000
Allowance to Reduce Marketable Securities to Market 5,000
To reduce trading Securities investments to market
valuation (P60,000 - P55,000)
(2)
Allowance for Doubtful Accounts 23,000
Selling and Administrative Expenses (bad debts) 23,000
To reduce allowance account to balance determined by
aging of receivable (P59,000 - P36,000)
(3)
Inventories 12,000
Cost of sales 12,000
To adjust for work-in-process inventory held by outside
processor
631
(4)
Prepaid Insurance 3,000
Selling and Administrative Expenses (Insurance) 3,000
To adjust for nonrecognition of prepaid expense
(5)
Selling and Administrative Expenses (Pension) 22,500
Accounts Payable and accrued Expenses 22,500
To accrue pension expense (P45,000 x 6/12)
(6)
Property, Plant, and Equipment 24,000
Depreciation Expenses 2,400
Cost of sales (repairs & maintenance) 24,000
Accumulated Depreciation 2,400
To adjust for charge to repairs and maintenance of
machine purchased on 6/1/17, and to record depreciation to
11/30/17 (P24,000 x 20% x 6/12).
(7)
Research and Development Expense 120,000
Research and Development Costs 120,000
To write off research and development costs in accordance
with PAS/PFRS.
(8)
Estimated Loss From Lawsuit 50,000
Estimated Liability From Lawsuit 50,000
To record probable damages payable re: lawsuit for patent
infringement.
(9)
Income Taxes Payable 41,370
Income Taxes Expense 41,370
To adjust provision for year ended 11/30/17 (Schedule 1).
632
Schedule 1
Requirement (2)
JAY CORPORATION
Statement of Financial Position
November 30, 20X7
Assets
Current assets
Cash P 150,000
Marketable securities, at cost P 60,000
Less: Allowance for reduction to market (5,000) 55,000
Accounts Receivable 450,000
Less: Allowance for doubtful accounts (36,000) 414,000
Inventories 442,000
Prepaid insurance 18,000
Total current assets P 1,079,000
Property, plant and equipment P 450,000
less: Accumulated depreciation (42,400) 407,600
633
Liabilities and Shareholders' Equity
Current liabilities
Accounts payable and accrued expenses P 614,500
Estimated liability from lawsuit 50,000
Income tax payable 126,630
Total current liabilities P 791,130
Shareholders' Equity
Ordinary Share capital, P10 par value P 400,000
Retained earnings 295,470
Total shareholders' equity P 695,470
Total Liabilities and Shareholders' Equity P 1,486,600
JAY CORPORATION
Statement o Profit or Loss and Comprehensive Income
For the Year Ended November 30, 20X7
634
EXERCISES AND PROBLEMS
Exercises
Exercise 1
During 20X7, White Company determined that machinery previously depreciated over a
7- year life had a total estimated useful life of only 5 years. An accounting charge was
made in 20X7 to reflect the change in estimate. If the change has been made in 20X6,
accumulated depreciation would have been P1,600,000 at December 31, 20X6, instead of
P1,200,000. As a result of this change, the 20X7 depreciation expense was P100,000
greater. The income tax rate was 30% in both years. What should be reported in White's
statement of profit or loss and comprehensive income for the year ended December
31,20X7, as the cumulative effect on the prior years of changing the estimated useful life
of the machinery?
a. P0 c. P300,000
b. P280,000 d. P400,000
Exercise 2
635
Exercise 3
At the beginning of 20X8, Red Company discovered the following errors made in the
preceding 2 years:
2016 2017
Overstatement of ending inventory 5,000 2,000
Omission of wages payable 700 800
Omission of allowance for doubtful accounts 1,300 1,700
Prepayment of insurance recorded as expense 500 200
Reported net income was P27,000 in 20x6 and P35,000 in 20X7. The allowance for
doubtful accounts had a zero balance at the beginning of 20x6. No accounts were written
off during 20X6 or 20X7. Ignore income taxes.
Required:
1. What is the correct net income for 20X6 and 20X7?
2. Prepare the adjusting journal entry in 20X8 to correct the errors
Problems
Problem 1
Rita Cruz, your staff assistant on the April 30, 20X2, audit of Maxwell Company, was
transferred to another assignment before she could prepare a proposed adjusting journal
entry for Maxwell's Miscellaneous Revenue account, which she had analyzed per the
workings paper given on the next page. You have reviewed the workings paper and are
satisfied with Cruz' procedures. You are convinced that all the miscellaneous revenue
items should be transferred to other accounts.
Required:
Draft a proposed adjusting journal entry at April 30, 20X2, for Maxwell Company's
Miscellaneous Revenue account.
636
Maxwell Company
Miscellaneous Revenue
Year Ended April 30, 20X2
Acct. No. 430
Q-2
Date Description Reference Amount
637
Problem 2
The Orange Corporation is in the process of negotiating a loan for expansion purposes.
The books and records have never been audited, and the bank has requested that an audit
be performed. Orange has prepared the following comparative financial statements for the
years ended December 31, 20X7 and 20X6:
638
During the course of the audit, the following additional facts were determined:
1. An analysis of collection and losses on accounts receivable during the past 2 years
indicates a drop in anticipated losses due to bad debts. After consultation with
management, it was agreed that the loss experience rate on account receivable should
be reduced from the recorded 9.4% to 5%, beginning with the year ended December
31, 20X7.
3. The merchandise inventory at December 31, 20X6, was overstated by P4,000 and the
merchandise inventory at December 31, 20X7, was overstated by P6,100.
4. On January 2, 20X6, equipment costing P12,000 (estimated useful life of 10 years and
residual value of P1,000) was incorrectly charged to operating Expenses. Orange
records depreciation via straight-line method. In 20X7, fully depreciated equipment
(with no residual value) that originally cost P17,500 was sold as scrap for P2,500.
Orange credited the proceeds of P2,500 to Property and Equipment.
Required:
1. Prepare the journal entries to correct the books at December 31, 20X7. The books for
20X7 have not been closed. Ignore income taxes.
2. Prepare a schedule showing the computation of corrected net income for the years
ended December 31, 20X7 and 20X6, assuming that any adjustments are to be reported
on comparative statements for the 2 years. The first items on your schedule should be
the net income for each year. Ignore income taxes. (Do not prepare financial
statements.)
(AICPA adapted)
639
Problem 3: Corrections of Income and Related Accounts
You have been engaged to review the records and prepare corrected financial statements
for the XQR Corporation. The books of account are in agreement with the following
statement of financial position:
XOR Corporation
Statement of Financial Position
December 31, 20X7
(In thousands)
Assets
Cash P 5,000
Accounts Receivable 10,000
Notes Receivable 3,000
Inventories 25,000
P 43,000
A review of the books of the corporation indicates that the following errors and omissions
had not been corrected during the applicable years:
The profits per the books are: 20X5, P7,500; 20X6, P6,500; and 20X7, P5,500. No
dividends were declared during these years, and no adjustments were made to retained
earnings.
Required:
640
Prepare a worksheet to develop the correct profits for the years 20X5, 20X6, and 20X7 and
the adjusted statement of financial position accounts as of December 31, 20X7. (Ignore
possible income tax effects) (AICAPA adapted)
Problem 4
The Statement of financial position below is submitted to you for inspection and review.
Assets
Cash P 45,050
Accounts Receivable 112,500
Inventories 204,000
Prepaid insurance 8,800
Property, plant and equipment 376,800
P 747,150
In the course if the review, you find the data listed below:
c. The books show that Land, buildings, and equipment have a cost of P556,800 with
depreciation of P180,000 recognized in prior years. However, these balances include
fully depreciated equipment of P85,000 that has been scrapped and is no longer on
hand.
641
e. Loan payable represents a loan from the bank that is payable in regular quarterly
installments of P6,250.
g. Deferred income tax liability arising from temporary differences totals P44,550. This
liability was not included in the statement of financial position.
h. Share capital consists of 6,250 shares of preference 6% share, par P20 and 9,000
ordinary shares, stated value P10.
i. Share capital had been issued for a total consideration of P283,600, the amount
received in excess of the par and stated values of the Shares being reported as paid-in
capital.
Required:
Based on the above information, compute for the following:
3. Inventories:
a. P204,000 b. P198,000 c. P159,000 d. P195,000
6. Preference shares:
a. P215,000 b. P90,000 c. P125,000 d. P68,800
8. Retained earnings:
a. P180,000 b. P190,650 c. P180,650 d. P179,650
9. Total assets:
a. P703,250 b. P705,250 c. P710,250 d. P703,000
642
UNIT V
APPLICATION
OF THE RISK-BASED
AUDIT PROCESS
PHASE III - REPORTING
Chapter
21 Evaluation of Audit Evidence
and Completion of the Audit
24 Preparation of Financial
Statements
643
Chapter EVALUATION OF
AUDIT EVIDENCE AND
COMPLETION OF THE
AUDIT
3. Know the various issues that the auditor considers in completing the audit.
A. Evaluating the Audit Evidence to determine what additional audit work (if any) is
required (Chapter 21).
B. Forming an Opinion based on audit findings and preparing the auditor’s report
(Chapter 22).
Chapter 21, covers the procedures in evaluating audit evidence that will serve as the basis in
forming an opinion on the financial statements.
Each audit is unique, but the approach to all audits is essentially the same. Management makes
assertion in financial statements about the existence, completeness, rights or obligations,
valuation and presentation of financial data. Those assertions are examined during an audit.
The strength of an audit depends on the relevance and reliability of the evidence gathered.
Relevance is determined by the assertions tested; that is, some evidence will be relevant to an
existence assertion but only tangentially relevant to a valuation assertion. Reliability relates to
the quality of the evidence gathered and is affected by the independence of the evidence from
the influence of the client or by the quality of the client’s overall control structure. The auditor
uses the risk assessments to assist in determining the potential reliance on internally generated
audit evidence. An effective audit combines relevant and persuasive audit evidence to provide
reasonable assurance that the financial statements are free of material misstatement when the
auditor renders an opinion on the financial statements. It is also important to perform each audit
as efficiently as possible without jeopardizing quality. Determining the sufficiency and
appropriateness of evidence is a matter of professional judgment.
After the planned audit procedures have been performed an evaluation of the results will take
place. This will include a review of the audit documentation and discussion with the
engagement team and any changes to the audit plans as a result of the procedures performed.
645
The auditor should be satisfied that sufficient appropriate audit evidence has been obtained to
support the conclusions reached for the auditor’s report to be issued.
Auditors should evaluate with professional skepticism the evidence obtained in relation to their
accumulated knowledge of the client and the industries on which it operates. Professional
skepticism is especially important when management is pressured for results and is also called
for when the financial statements before they are audited show unusually favourable results.
The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion.
Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both
tests of control and substantive procedures. Sufficiency is the measure of the quantity of audit
evidence; appropriateness is the measure of the quality of the audit evidence and it's relevance
to a particular assertion and its reliability. Ordinarily, the auditor finds it necessary to rely on
audit evidence that is persuasive rather than conclusive and will often seek audit evidence from
different sources or of a different nature to support the same assertion.
In forming the audit opinion, the auditor does not ordinarily examine all of the information
available because conclusion can be reached about an account balance, class of transportation
or control by the way of using judgmental or statistical sampling procedures.
Auditor's assessment of the nature and level of inherent risk at both the financial statement
level and the account balance or class of transactions level.
Nature of the accounting and internal control systems and the assessment of the control
risk.
Materiality of the item being examined.
Experience gained during previous audits.
Results of audit procedures, including fraud or error which may have been found.
Source and reliability of information available.
646
When obtaining audit evidence from tests of control, the auditor should consider the sufficiency
and appropriateness of the audit evidence to support the assessed level of control risk. The
aspects of the accounting and internal control systems about which the auditor would obtain
audit evidence are:
a. Design: the accounting and internal control systems are suitably designed to prevent and/or
detect and correct material misstatement; and
b. Operation: the systems exist and have operated effectively throughout the relevant period.
When obtaining audit evidence from substantive procedures, the auditor should consider the
sufficiency and appropriateness of audit evidence from such procedures together with any
evidence from tests of control to support financial statement assertions.
Evidence must be relevant to the assertion being tested. For example, observing the taking of
inventory provides evidence concerning existence of the inventory, but it is not relevant to
determining ownership.
In general, the more objective the evidence, the more reliability and competent it is.
Conversely, the more subjective evidence is, the less reliable it is. The greater the judgment
required on the part of the provider of the information, the more subjective the information will
be. An example of the objective evidence is information obtained by physically counting cash
or footing the accounts receivable subsidiary ledger. Examples of subjective evidence are an
attorney's statement about a client's contingency and a credit manager's statement about the
collectively of an account. The more subjective the evidence, the more important the auditor's
experience in evaluating it.
647
3. Qualifications of the provider of the evidence
Evidence obtained from independent external sources has greater reliability than evidence
obtained within the entity. Evidence an auditor obtains directly through his or her own work is
more reliable than information obtained through the work of others. Confirmation responses
from a business are more reliable than confirmations from a -household. And accounting data
and financial statements developed in an entity in which internal control is satisfactory are more
reliable than data and statements developed in an entity with unsatisfactory internal control.
Timeless is particularly important with respect to accounts that change rapidly (either because
the total balance changes or because the peso value of the transactions that flow into and out of
the account is large). Evidence gathered about a year-end account balance provides more
evidence about a year-end balance than does evidence gathered about the balance at another
date.
The following hierarchy of evidential matter will help one understand the relative competence
and persuasive power of different kinds of evidence. The Hierarchy starts with the strongest
form of evidence and proceeds to the weakest.
1. An auditor’s direct, personal knowledge, obtained through physical observation and his or
her own mathematical computations, is generally considered the most competent evidence.
3. Documentary evidence gas originated outside the client’s data processing system but which
has been received and processed by the client (external - internal evidence) is generally
considered competent. However, the circumstances of internal control quality are important.
4. Internal evidence consisting of documents that are produced, circulated, and finally stored
within the client’s information system is generally considered low in competence. However,
internal evidence is used extensively when it is produced under satisfactory condition of
internal control. Sometimes, internal evidence is the only king available.
648
5. Verbal and written representations given by the client’s officers, directors, owners, and
employees are generally considered the least competent evidence. Such representations should
be corroborated with other types of evidence.
Sufficiency of Evidence
Sufficiency of audit evidence refers to the amount or quantity of evidence gathered. The concept
of sufficiency recognizes that the accumulation of evidence should be persuasive rather than
convincing.
This concept is consistent with the idea that the auditor is not free to collect unlimited amounts
of evidence since he must work within economic limits. Cost cannot, however be the sole basis
for the quantity or quality of audit procedures. Auditors use professional judgment to determine
the extent of tests necessary to obtain sufficient evidence. In exercising their professional
judgment, auditors consider both the (l) materiality (e.g., peso amount) of the item in question
as well as the (2) relative risk of the item (e.g., cash due to its liquidity, may have a higher
relative risk than certain property, plant and equipment do).
Since the competency of evidence depends upon the financial statement assertion under
consideration, the auditor should attempt to gather sufficient quantity of competent evidence at
a minimum cost.
An audit of financial statements is a cumulative and iterative process. As the auditor performs
planned audit procedures, the audit evidence obtained may cause the auditor to modify the
nature, timing, or extent of other planned audit procedures. Information may come to the
auditor's attention that differs significantly from the information on which the risk assessment
was based. For example:
The extent of misstatements that the auditor detects by performing substantive procedures
may alter the auditor's judgment about the risk assessments and may indicate a material
weakness in internal control.
The auditor may become aware of discrepancies in accounting records or conflicting or
missing evidence.
Analytical procedures performed at the overall review stage of the audit may indicate a
previously unrecognized risk of material misstatement.
649
In such circumstances, the auditor may need to reevaluate the planned audit procedures, based
on the revised consideration of assessed risks for all or some of the classes of transactions,
account balances, or disclosures and related assertions.
The auditor cannot assume that an instance of fraud or error is an isolated occurrence. Therefore,
the consideration of how the detection of a misstatement affects the assessed risks of material
misstatement is important in determining whether the assessment remains appropriate.
The auditor' judgment as to what constitutes sufficient appropriate audit evidence is influenced
by such factors as the following:
Significance of the potential misstatement in the assertion and the likelihood of its having
a Material effect, individually or aggregated with other potential misstatements, on the
financial statements.
Effectiveness of management’s responses and controls to address the risks.
Experience gained during previous audits with respect to similar potential misstatements.
Results of audit procedures performed, including whether such audit procedures identified
specific instances of fraud or error.
Source and reliability of the available information.
Persuasiveness of the audit evidence.
Understanding of the entity and its environment, including the entity’s internal control.
The evaluation of the audit evidence obtained would address the following matters.
1. Materiality
The auditor shall assess whether the amounts established for overall and performance
materiality are still appropriate in the context of the entity’s actual financial results. If a lower
materiality than that initially set is appropriate, the auditor is required to determine:
650
2. Risks
The auditor shall determine whether in the light of the audit findings the assessed risks of
material misstatement at the assertion level is still appropriate. If not, the risk assessments
would be revised and further planned audit procedures modified.
3. Misstatements
The auditor shall determine the effect on the audit of identified misstatements and whether
there is a need to perform additional audit procedures. Revisions to the audit strategy and
detailed audit plans may be required when:
4. Fraud
The auditor through the performance of analytical procedures shall assess whether previously
unrecognized risks of material misstatement due to fraud are present. Also, he/she shall
determine whether the identified misstatements are indicatives of fraud.
5. Evidence
The auditor shall determine whether sufficient appropriate evidence has been obtained to
reduce the risks of material misstatement in the financial statements to an acceptably low level.
He/she shall consider whether there is a need for further procedures to be performed.
6. Analytical
Procedures the auditor shall assess whether the analytical procedures performed at the final
review stage of the audit:
651
FACTORS TO CONSIDER
The following factors shall be considered in evaluating the sufficiency and appropriateness
audit evidence:
Is management responsive to audit findings, and how effective is the internal control in
addressing risk factors?
Are the sources of available information reliable and appropriate for supporting the
audit conclusions?
(d) Persuasiveness
What has been the previous experience in performing similar procedures, and were any
misstatements identified?
Do the results of performed audit procedures support the objectives, and is there any
indication of fraud or error?
Do the evidences obtained support or contradict the results of the risk assessment
procedures (which were performed to obtain an understanding of the entity and its
environment, including internal control)?
652
FINAL ANALYTICAL PROCEDURES
Analytical procedures help auditors assess the overall presentation of the financial statements.
Auditing standards require the use of analytical procedures in both the planning phase and the
final review phase of the audit to assist in identifying account relationships that are unusual. At
the conclusion of the audit, the audit team analyzes the data from an overall business
perspective. The reviewers are not only looking at the trends and ratios but are asking hard
questions about whether the company's results make sense in relationship to industry and
economic trends.
DOCUMENTATION
The final step in the evaluation process is to record all the significant findings or issues in an
engagement completion document. This document may include all information ,necessary to
understand the significant findings or issues, as well as cross-references, as appropriate to other
available supporting audit documentation.
This document would also include conclusions about information the auditor has identified
relating to significant matters that are inconsistent with or contradict the auditor's final
conclusions.
PSA 230"Audit Documentation" establishes standards and provides guidance regarding audit
documentation in the context of the audit of financial statements.
The standard on documentation requires that the auditor should prepare on a timely basis, audit
documentation that provides:
(a) A sufficient and appropriate record of the basis for the auditor's report; and
(b) Evidence that the audit was performed in accordance with PSAs and applicable legal
and regulatory requirements.
653
PSA 260 "Communication with Those Charged with Governance" requires that the auditor
shall communicate on a timely basis with those charged with governance the responsibilities of
the auditor in relation to the financial statement audit, including that:
(a) The auditor is responsible for forming and expressing an opinion o the financial
statements that have been prepared by management with the Oversight of those
charged with governance; and
(b) The audit of the financial statements does not relieve management or those charged
with governance of their responsibilities.
Audit working papers are the records kept by the auditor of the procedures applied, the tests
performed, the information obtained and the pertinent conclusions reached in the engagement.
They represent the documentation of audit evidences collected and evaluated.
The primary objective of audit documentation is preparing sufficient and appropriate audit
documentation on a timely basis to help enhance the quality of the audit and to facilitate .the
effective review and evaluation of the audit evidence obtained and conclusions reached before
the auditor's report is finalized. Documentation prepared at the time the work is performed is
likely to be more accurate than documentation prepared subsequently.
The auditor shall prepare audit documentation that is sufficient to enable an experienced
auditor, having no previous connection with the audit, to understand:
(a) The nature, timing, and extent of the audit procedures performed to comply with the PSAs
and applicable legal and regulatory requirements;
(b) The results of the audit procedures performed, and the audit evidence obtained; and
(c) Significant matters arising during the audit, the conclusions reached thereon, and
significant professional judgments made in reaching those conclusions.
The form, content and extent of audit documentation depend on factors such as:
654
The significance of the audit evidence obtained.
The significance of the audit evidence obtained.
The nature and extent of exceptions identified.
The need to document a conclusion or the basis for a conclusion not readily determinable
from the documentation Of the work performed or audit evidence obtained.
The audit methodology and tools used.
In documenting the nature, timing and extent of audit procedures performed, the auditor shall
record:
(a) The identifying characteristics of the specific items or matters tested;
(b) Who performed the audit work and the date such work was completed; and
(c) Who reviewed the audit work performed and the date and extent of such review.
The auditor shall the audit, documentation in an audit file and complete the administrative
process of assembling the final audit file on a timely basis after the date of the auditor's report.
After the assembly of the final audit file has been completed, the auditor shall not delete or
discard audit documentation of any nature before the end of its retention period.
In circumstances other than those mentioned in paragraph 13 of PSA 230 where the auditor
finds it necessary to modify existing audit documentation or add new audit documentation after
the assembly of the final audit file has been completed auditor shall, regardless of the nature of
the modifications or additions, document:
655
TYPES OF WORKING PAPERS
Finalization of Audit
Representation letter
4) Reviewer's checklist Quality control 10) Discussions with management and others
review ( if EQCR applicable)
Management letter
Notes and queries
Audit Acceptance
11) Audit engagement acceptance 12) Understanding the entity and its environment
checklist - New or continuing client -
Information from predecessor's files*
Client profile Documents to request
Engagement letter*
22) Determining materiality Evaluating 26) Determining whether the risks indicate the
misstatements need for an EQCR
23) Identifying risks using analytical 27) Audit budget - Time and Fees Schedule of
procedures documents to be prepared by client
656
Assessing Risks of Material Misstatement
36) Testing controls**:
Revenue, receivables, and receipts
Purchases, payables, and payments
31) Assessing the risks of material misstatement Payroll
checklist Inventory, cost of sales, and production
Financing and equity
32) Inquiries for management, for those responsible 37) Review of minutes of all meetings
for governance, for those responsible for internal Appointment of auditor (AGM
audit, and for others in the entity resolution)
657
Financial Statement Checklists, Analytical Procedures and Tests of Balances
658
Figure 21-1 shows an example of a letter sent to management and those charged with
governance.
The matters raised in this report arise from our financial statement audit and relate to matters
that we believe need to be brought to your attention.
Our audit performed to obtain reasonable assurance whether the financial statements are free
from material misstatements. Absolute assurance is not possible due to the inherent limitations
of an audit and of internal control, resulting in the unavoidable risk that some material
misstatements may not be detected.
In planning our audit, we consider internal control over financial reporting to determine the
nature, extent, and timing of audit procedures. However, a financial statement audit does not
provide assurance on the effective operation of internal control at Metro Express, Inc.
However, if in the course of our audit, certain deficiencies in internal control come to our
attention, these will be reported to you.
Because fraud is deliberate, there are always risks that material misstatements, fraud, and
other-illegal acts may exist and not be detected by our audit of the financial statements.
659
The following is a summary of findings resulting from the performance of the audit.
1. We did not identify any material matters (other than the identified misstatements already
discussed with you and have now been corrected) that need to brought to your attention.
2. We received good cooperation from management and employees during our audit. To the
best of our knowledge, we also had complete access to the accounting records and other
documents that we needed in order to carry out our audit. We did not have any disagreements
with management, and we have resolved all auditing, accounting, and disclosure issues to our
satisfaction.
Please note that the Philippine Auditing Standards do not require us to design procedures for
the purpose of identifying supplementary matters to communicate with those charged with
governance. Accordingly, an audit would not usually identify all such matters.
This communication is prepared solely for the information of management and is not intended
for any other purpose. We accept no responsibility to a third party who uses this
communication.
Yours truly,
________________
Alvin Monico
Valderama & Co., CPAs
660
COMPLETING THE AUDIT
Almost every audit engagement has deadline for issuance of audit report and release of audited
financial .statements. Thus, audit procedures need to be completed in time to allow for adequate
review and evaluation of working Papers and the financial statements before the opinion is
signed. The various issues that the auditor considers in completing his audit examination
include:
Transactions with related parties are important to auditors because they will be disclosed in the
financial statements if they are material. PAS/PFRS require disclosure of the nature of the
related-party relationship, a description of transactions, including peso amounts; and amounts
due to and from related parties. Management is responsible for the identification and disclosure
of related parties and transactions with such parties. This responsibility requires management to
implement adequate accounting and internal control systems to ensure that transactions with
related parties are appropriately identified in the accounting records and disclosed in the
financial statements.
Once related parties are identified, examination of related party transactions is pursued during
examination of relevant account balances or classes of transactions. The auditor should apply
procedures to give adequate consideration to the possibility that the other party to material
transactions is related. An example which might indicate the existence of a related party
transaction is borrowing or lending on an interest-free basis or at a rate significantly different
than prevailing market rates at the time of the transaction.
661
The auditor should perform audit procedures designed obtain sufficient appropriate audit
evidence regarding the identification and disclosure by management of related parties and the
effect of related transactions that are material to the financial statements. However, an audit
cannot be expected to detect all related party transactions.
The auditor has a responsibility to review transactions and events occurring after the statement
of financial position date to determine whether anything occurred that might affect the
valuation or disclosure of the statements being audited.
Two types of subsequent events require consideration by management and evaluation by the
auditor:
l) Those that provide further evidence of conditions that existed at period end; and
2) Those that are indicative of conditions that arose subsequent to period end.
When the auditor becomes aware of events which materially affect the financial statements, the
auditor should consider whether such events are properly accounted for and adequately
disclosed in the financial statements.
Figure 20-2 summarizes the auditors' responsibilities for subsequent event with respect to the
balance sheet date, the date of the audit report, and the date the auditors grant the client
permission to use the audit report — the report release date.
662
Figure 20-2: Subsequent Events
A contingent liability is a potential future obligation to an outside party for an unknown amount
resulting from activities that have already taken place. For a contingent liability to exist, the
following three (3) conditions must be present:
1. There is a potential future payment to an outside party that resulted from an existing
condition;
2. There is uncertainty about the amount of the future payment; and
3. The outcome will be resolved by some future event or events.
An audit inquiry letter (also called a lawyer's letter) is sent by the auditor to the client's lawyer
as a primary means of corroborating the information management provides about litigation,
claims, and assessments. The objective of the letter is to obtain information to facilitate the
auditor's understanding of a client's contingencies.
PSA 570 requires the auditor to evaluate whether there is a substantial doubt about a client's
ability to continue as a going concern for at least one year after statement of financial position
date. This assessment is initially made as a part of planning but is revised whenever significant
new information is obtained.
A final assessment is desirable after all evidence has been accumulated and proposed audit
adjustments have been incorporated into the financial statements.
Analytical procedures are one of the most important types of evidence to assess going concern.
Discussions with management and a review of future plans are important considerations in
evaluating the analytical procedures. The knowledge of the client's business gained throughout
the audit is important information used to assess the likelihood of financial failure within the
next year.
Management Representations
664
The auditor would ordinarily include in audit working papers evidence of management's
representations in the form of a summary of oral discussions with management or written
representations from management.
A written representation is better audit evidence than an oral representation and can take the
form of:
Analytical procedures are normally used as a part of planning the audit, during the
performance of detailed tests in each cycle, and at the completion of the audit.
Analytical procedures performed as part of the overall review assist the auditors in assessing
the validity of the conclusions reached, including the opinion to be issued. They are useful as a
final review for material misstatements or financial problems and to keep the auditor take a
final "objective look" at the financial statements. It is usual for a partner to do the analytical
procedures during the final review of working papers and financial statements. Knowledge of
the client's business combined with, effective analytical procedures help identify possible
oversights in "an audit."
The auditors should review the minutes of meetings of stockholders and directors, including
important subcommittees of directors such as the audit committee and the investment
committee. This review includes meetings held through the date of the audit report. In
completing the audit, the auditors should determine that they have considered all minutes,
including those for meetings subsequent to year-end. They also will obtain written
representation from management that all minutes have been made available.
665
Evaluating Findings, Formulating an Opinion and Drafting the Audit Report
The auditor's assessment of materiality and audit risk may be different at the time of initially
planning the engagement from at the time of evaluating the results of audit procedures. This
could be because of a change in circumstances or because of a change in the auditor's
knowledge as a result of the audit.
When completing the audit, the auditor must reconsider materiality and determine a material
amount to be used in evaluating the estimated misstatement in the financial statement. Audit
risk should also be reconsidered.
In evaluating whether the statements are presented fairly, an auditor should aggregate any
uncorrected misstatement to be able to consider them in relation to the financial statement as a
whole. The aggregation should include not only the known but also the likely misstatement.
Known misstatements are individual misstatements specifically identified by an auditor.
Likely misstatements are an auditor's best estimate of misstatement based on a projection of
the misstatements detected during sampling.
If audit risk increases due to numerous events and conditions while the audit is being
undertaken, the auditor should evaluate whether additional substantive procedures need to be
performed. The auditor then determines whether the accumulated evidence indicates that the
level of audit risk is appropriately low such that the auditor can render an opinion.
To evaluate whether the financial statement are fairly stated, errors uncovered in the audit are
summarized. Whenever the auditor uncovers errors that are in themselves material,
adjustments should be made on the trial balance to correct the statement. There may also be a
large' number of immaterial errors discovered that are not adjusted at the time they are found. It
is necessary to combine individually immaterial errors to evaluate whether the combined
amount is material that may require adjustment.
666
If the auditor believes that he or she has sufficient evidence, but it does not warrant a
conclusion of fairly presented financial statements, the auditor may either:
(a) Require the client to revise the statements to the auditor's satisfaction, or
(b) Issue either a qualified or an adverse opinion.
On the basis of these evaluations, the audit report is issued for the financial statements.
Questions
1. In the final stage of the risk-based audit process, how shall the engagement partner or
sole practitioner know that sufficient appropriate audit evidence has been obtained to
support the conclusions reached for the auditor's report to be issued.
2. Explain briefly the relevance of the following areas in connection with the final
evaluation of the audit evidence obtained:
(a) Materiality
(b) Risk
(c) Misstatements
(d) Fraud
(e) Evidence
(f) Analytical Procedures
3. In what instances will the auditor be required to revise the audit strategy and detailed
audit plans.
5. Give and explain at least 8 factors to consider in evaluating the sufficiency and
appropriateness of audit evidence.
6. Give examples of audit matters that should be communicated by the auditor to those
charged with governance.
667
Problems
Problem 1
The field work for the June 30, 20X7 audit of Tracy Brewing Company was finished
August 19, 20X7, and the completed financial statements, accompanied by the signed audit
reports, were mailed September 6, 20X7. In each of the highly material independent events
(a through i), state the appropriate action (l through 4) for the situation and justify your
response. The alternative actions are as follows:
a. On December 14, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on October 2, 20X7. The sale has taken place April 5, 20X7, but the amount
appeared collectible at June 30, 20X7 and August 19, 20X7.
b. On August 15, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on August l, 20X7. The most recent sale had taken place April 2, 20X6, and
no cash receipts had been received since that date.
c. On December 14, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 15, 20X7 due to declining financial health. The sale had taken place
January 15, 20X7.
d. On August 6, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 30, 20X7. The cause of the bankruptcy was an unexpected loss of a
major lawsuit on July 15, 20X7, resulting from a product deficiency suit by a different
customer.
e. On August 6, 20X7, the auditor discovered that a debtor of Tracy Brewing went
bankrupt on July 30, 20X7, for a sale that took place July 3, 20X7. The cause of the
bankruptcy was a major uninsured fire on July 20, 20X7.
668
f. On May 31, 20X7, the auditor discovered an uninsured lawsuit against Tracy Brewing
that had originated on February 28, 20X7.
g. On July 20, 20X7, Tracy Brewing settled a lawsuit out of that had originated in 2014
and is currently listed as a contingent liability.
h. On September 14, 20X7, Tracy Brewing lost a court case that had originated in 20X6
for an amount equal to the lawsuit. The June 30, 20X7, footnotes state that in the
opinion of legal counsel there will be a favorable settlement.
i. On July 20, 20X7, a lawsuit was filed against Tracy Brewing for a patent infringement
action that allegedly took place in early 20X7. In the opinion of legal counsel, there is
a danger of a significant loss to the client.
Problem 2
In connection with his examination of Flowmeter, Inc., for the year ended December 31,
20X6, Flores, CPA, is aware that certain events and transactions that took place after
December 31, 20X6, but before he issues his report dated February 28, 20X7, may affect
the company's financial statements. The following material events or transactions have
come to his attention:
669
Required
For each of the event or transactions just described, indicate the audit procedures that
should have brought the item to the attention of the auditor and the form of disclosure
required in the financial statements, including the reasons for such disclosures.
(AICPA Adapted)
Problem 3
In connection with your examination of the financial statements of Olars Mfg. Corporation
for the year ended December 31, 20X6, your review of subsequent events disclosed the
following items:
1) January 3, 20X7: The government approved a plan for the construction of an express
highway. The plan will result in the expropriation of a portion of the land owned by
Olars Mfg. Corporation. Construction will begin in late 20X7. No estimate of the
condemnation award is available.
2) January 4, 20X7: The funds for a P25,000 loan to the corporation made by Mr. Olars
on July 15, 20X6, were obtained by him by a loan on his personal life insurance policy.
The loan was recorded in the account "loan from officers." Mr. Olars' source of the
funds was not disclosed in the company records. The corporation pays the premiums
on the life insurance policy, and Mrs. Olars, wife of the president, is the beneficiary.
3) January 7, 20X7: The mineral content of a shipment of ore en route on December 31,
20X6, was determined to be 72 percent. The shipment was recorded at year-end at an
estimated content of 50 percent by a debit to raw material inventory and a credit to
accounts payable in the amount of P20,600. The final liability to the vendor is based on
the actual mineral content of the shipment.
4) January 15, 20X7: Culminating a series of personal disagreements between Mr. Olars,
the president, and his brother-in-law, the treasurer, the latter resigned, effective
immediately, under an agreement whereby the corporation would purchase his 10
percent share ownership at book value as of December 31, 20X6. Payment is to be
made in two equal amounts in cash on April l, 20X7 and October 1, 20X7. In
December, the treasurer has obtained a divorce from his wife, who was Mr. Olars
sister.
670
5) January 31, 20X7: As a result of reduced sales, production was curtailed in
mid-January and some workers were laid off. On February 5, 20X5 all the remaining
workers went on strike. To date the strike is Unsettled.
6) February 10, 20X7: A contract was signed whereby Lopez Enterprises purchased from
Olars Mfg. Corporation all of the latter's fixed assets (including rights to receive the
proceeds of any property condemnation), inventories, and the right to conduct business
under the name "Olars Mfg. Division." The effective date of the transfer will be March
l, 20X7. The sale price was P500,000 subject to adjustment following the taking of a
physical inventory. Important factors contributing to the decision to enter into the
contract were the policy of the board of directors of Lopez Enterprises to diversify the
firm's activities and the report of a survey conducted by an independent market
appraisal firm that revealed a declining market for Olars' products.
Required:
Assume that the items described above came to your attention prior to completion of your
audit work OIT February 15, 20X7. For each item:
a. Give the audit procedures, if any, that would have brought the item to your attention.
Indicate other sources of information that may have revealed the item.
b. Discuss the disclosure that you would recommend for the item, listing all details that
you would suggest should be disclosed. Indicate those items or details, if any, that
should not be disclosed. Give your reasons for recommending or not recommending
disclosure of the items or details.
(AICPA Adapted)
671
Problem 4
The following situations represent excerpts from the responses to audit inquiries of
external legal counsel of XYZ Co. during the annual audit of year I ("legal response"). For
each excerpt, select the •most appropriate financial statement effect and audit response.
Each excerpt is independent. Responses may be used once, more than once, or not at all.\
Financial
Audit
Situations Statement
Response
Effect
Letter dated February 14, year 2.
“I advice you that at and since December 31, year 1, I have not
been engaged to give substantive attention to, or represent, XYZ
Co. in connection with any pending or threatened litigation,
(a) (b)
claims, or assessment, nor am I aware of any loss contingencies.
No amounts were due to this office for services provided at
December 31, year 1.”
672
Financial Audit
Situations
Statement Effect Response
Letter dated January 21, year 2:
673
Problem 5
For each of the account balances and associated assertions below, select the audit
procedure from the list provided that provides the most appropriate audit evidence for the
account assertion.
674
4. Accounts Completeness a. Compare aging of accounts payable to prior
Payable periods.
b. Confirm accounts payable balance with
suppliers.
c. Examine invoices paid subsequent to year-end
and trace to subsidiary ledger.
d. Trace individual payable transaction to
purchase order.
e. Vouch invoices for the purchase of supplier to
receiving documents.
5. Cash Existence a. Agree bank statement to the subsidiary ledger.
b. Agree cash balance per the bank reconciliation
to the year-end bank statement.
c. Agree cash balance to online year-end bank
statement.
d. Recalculate bank statement balance including
interest receivable.
e. Trace deposit per bank statement to the cash
subsidiary ledger.
675
Chapter FORMING AN OPINION
AND REPORTING ON
FINANCIAL
STATEMENTS
3. Know how to deal with supplementary information presented with the financial
statements.
CHAPTER 22
INTRODUCTION
PSA 700 (Revised) "Forming an Opinion and Reporting on Financial Statements" establishes
the standards and provides guidance on the form and content of the auditor's report issued as a
result of an audit performed by an independent auditor of the financial statements of an entity.
Much of the guidance provided can be adapted to auditor reports on financial information other
than financial statements. PSA 700 (Revised) is effective for audits of financial statement for
periods ending on or after December 15, 2016.
In previous chapters, the purpose and nature of an audit have been described. In doing so, the
auditor's objectives, auditing standards, the gathering of evidence and the audit procedures
applicable to the various types of assets and other elements comprising a set of financial
statements have been considered. This entire audit process culminates in the preparation of the
auditor's report. The auditor's report is the primary product of the audit.
The auditor should review and assess the conclusions drawn from the audit evidence obtained
as the basis for the expression of an opinion on the financial statements.
This review and assessment involves considering whether the financial statements have been
prepared in accordance with an acceptable financial reporting framework. It may also be
necessary to consider whether the financial statements comply with statutory requirements.
The auditor's report should contain a clear written expression of opinion on the financial
statements taken as a whole.
677
FORMING AN OPINION ON THE FINANCIAL STATEMENTS
The auditor shall form an opinion on whether the financial statements are prepared, in all
material respects, in accordance with the applicable financial reporting framework.
In order to form that opinion, the auditor shall conclude as to whether the auditor has obtained
reasonable assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error. That conclusion shall take into account:
(a) The auditor's conclusion, in accordance with PSA 330, whether sufficient appropriate
audit evidence has been obtained;
(b) The auditor's conclusion, in accordance with PSA whether uncorrected misstatements
are material, individually or in aggregate, and
(c) The evaluation on the following:
(1) Whether the financial statements are prepared, in all material respects, in
accordance with the requirements of the applicable financial reporting framework.
This evaluation shall include consideration of the qualitative aspects of the entity's
accounting practices, including indicators of possible bias in management's
judgments.
(2) Whether, in view of the requirements of the applicable financial reporting
framework:
678
(3) Whether the financial statements achieve fair presentation which shall include
consideration of:
(i) The overall presentation, structure and content of the financial statements; and
(ii) Whether the financial statements, including the related notes, represent the
underlying transactions and events in a manner that achieves fair presentation.
(iii) Whether the financial statements adequately refer to or describe the
applicable financial reporting framework.
FORMS OF OPINION
Unmodified Opinion
The auditor shall express an unmodified opinion when the auditor concludes that the financial
statements are prepared, in all material respects, in accordance with the applicable financial
reporting framework.
Modified Opinion
If the auditor:
(a) concludes that, based on the audit evidence obtained, the financial statements as a
whole are not free from material misstatement; or
(b) is unable to obtain sufficient appropriate audit evidence to conclude that the financial
statements as a whole are free from material misstatement, the auditor shall modify the
opinion in the auditor's report in accordance with PSA 705 (Revised)
The types of modified opinion are (1) qualified, (2) adverse and (3) disclaimer.
679
When the financial statements are prepared in accordance with a compliance framework, the
auditor is not .required to evaluate whether the financial statements achieve fair presentation.
However, if in extremely rare circumstances the auditor concludes that such financial
statements are misleading, the auditor shall discuss the matter with management and,
depending on how it .is resolved, shall determine whether, and how, to communicate it in the
auditor's report.
Opinion
We have audited the financial statements of ABC Company (the Company), which comprise of financial
position as at December 31, 20c5, and the statement of income, statement of changes in equity and
statement of cash flows for the ended, and notes to the financial statements, including a summary of
significant policies.
In our opinion, the accompanying financial statements present fairly, in all material respects,(or give a
true and fair view of) the financial position of the Company as at December 31,20X5, and (of) its
financial performance and its cash flows for the year then ended in with Philippine Financial Reporting
Standards (PFRSs).
680
Key Audit Matters (if applicable)
Key audit matters are those matters that, in our professional judgment, were of most significance in our
audit of the financial statements of the current period. These matters were addressed in the context of our
audit of the financial statements as a whole, and in forming our opinion thereon, and we do not provide a
separate opinion on these matters.
[Description of each key audit matter in accordance with PSA 701.]
Responsibilities of Management and Those Charged with Governance for the Financial
Statements
Management is responsible for the preparation and fair presentation of the Financial statements in
accordance with PFRSs39, and for such internal control as management determines is necessary to enable
the preparation of financial statements that are free from material misstatement, whether due to fraud or
error.
In preparing the financial statements, management is responsible for assessing the Company's ability to
continue as a going concern, disclosing, as applicable, matters related to going concern and using the
going concern basis of accounting unless management either intends to liquidate the Company or to
cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Company’s Financial reporting
process.
681
Evaluate the appropriateness of accounting policies used and the reasonableness of accounting
estimates and related disclosures made by management.
Conclude on the appropriateness of management's use of the going concern basis of
accounting and, based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the Company's ability to
continue as a going concern. If we conclude that a material uncertainty exists, we are required
to draw attention in our auditors report to the related disclosures in the financial statements or,
if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the
audit evidence obtained up to the date of our audits report. However, future events or
conditions may cause the Company to cease to continue as a going concern.
Evaluate the overall presentation, structure and content of the financial statements, including
the disclosures, and whether the financial statements represent the underlying transactions and
events in a manner that achieves fair presentation.
We communicate with those charged with governance regarding, among other matters, the planned
scope and timing of the audit and significant audit findings, including any significant deficiencies in
internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with relevant
ethical requirements regarding independence, and to communicate with them all relationships and other
matters that may reasonably be thought to bear on our independence, and where applicable, related
safeguards.
From the matters communicated with those charged with governance, we determine those matters that
were of most significance in the audit of the financial statements of the current period and are therefore
the key audit matters. We describe these matters in our auditor's report unless law or regulation precludes
public disclosure about the matter or when, in extremely rare circumstances, we determine that a matter
should not be communicated in our report because the adverse consequences of doing so would
reasonably be expected to outweigh the public interest benefits of such communication.
The engagement partner on the audit resulting in this independent auditor's report is [name].
[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate
for the particular jurisdiction]
[Auditor Address]
[Date]
682
Illustration 22-2: Auditor's Report Expressing an Unmodified Opinion on Consolidated
Financial Statements of a Listed Entity Prepared in Accordance with a Fair Presentation
Framework
Opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries (the
Group), which comprise the consolidated statement of financial position as at December 31, 20X5, and
the consolidated statement of comprehensive income, consolidated statement of changes in equity and
consolidated statement of cash flows for the year then ended, and notes to the consolidated financial
statements, including a summary of significant accounting policies.
In our opinion, the accompanying consolidated financial statements present fairly, in all material
respects, (or give a true and fair view of) the consolidated financial position of the Group as at December
31, 20X5, and (of) its consolidated financial performance and its consolidated cash flows for the year
then ended in accordance with Philippine Financial Reporting Standards (PFRSs).
683
Responsibilities Of Management and Those Charged with Governance for the Consolidated
Financial Statements
Management is responsible for the preparation and fair presentation of the consolidated financial
statements in accordance with PFRSs43, and for such internal control as management determines is
necessary to enable the preparation of consolidated financial statements that are free from material
misstatement, whether due to fraud or error.
In preparing the consolidated financial statements, management is responsible for assessing the Group's
ability to continue as a going concern, disclosing, as applicable, matters related to going concern and
using the going concern basis of accounting unless management either intends to liquidate the Group or
to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Group's financial reporting process.
As part of an audit in accordance with PSAs, we exercise professional judgment and maintain
professional skepticism throughout the audit. We also:
Identify and assess the risks of material misstatement of the consolidated financial statements,
whether due to fraud or error, design and perform audit procedures responsive to those risks,
and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion.
The risk of not detecting a material misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
Obtain an understanding of internal control relevant to the audit in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Group's internal control44.
Evaluate the appropriateness of accounting policies used and the reasonableness of accounting
estimates and related disclosures made by management.
Conclude on the appropriateness of management's use of the going concern basis of
accounting and, based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the Group’s ability to
continue as a going concern. If we conclude that a material uncertainty exists, we are required
to draw attention in our auditors report to the related disclosures in the consolidated financial
statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are
684
based on the audit evidence obtained up to the date of our auditor's report. However, future
events or conditions may cause the Group to cease to continue as a going concern.
Evaluate the overall presentation, structure and content of the consolidated financial
statements, including the disclosures, and whether the consolidated financial statements
represent the underlying transactions and events in a manner that achieves fair presentation.
Obtain sufficient appropriate audit evidence regarding the financial information of the entities or
business activities within the Group to express an opinion on the consolidated financial statements. We
are responsible for the direction, supervision and performance of the group audit. We remain solely
responsible for our audit opinion.
We communicate with those charged with governance regarding, among other matters, the planned
scope and timing of the audit and significant audit findings, including any significant deficiencies in
internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with relevant
ethical requirements regarding independence, and to communicate with them all relationships and other
matters that may reasonably be thought to bear on our independence, and where applicable, related
safeguards.
From the matters communicated with those charged with governance, we determine those matters that
were of most significance in the audit of the consolidated financial statements of the current period and
are therefore the key audit matters. We describe these matters in our auditor's report unless law or
regulation precludes public disclosure about the matter or when, in extremely rare circumstances, we
determine that a matter should not be communicated in our report because the adverse consequences of
doing so would reasonably be expected to outweigh the public interest benefits of such communication.
The engagement partner on the audit resulting in this independent auditor's report is [name]
[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate
for the particular jurisdiction]
[Auditor Address]
[Date]
685
Preparation of the Auditor's Report for Audit conducted in accordance with Philippine
Standards on Auditing
Title
The auditor's report shall have a title that clearly indicates that it is the report of an independent
auditor.
A title indicating the report is the report of an independent auditor, for example,
"Independent Auditor's Report," distinguishes the independent auditor's report from
reports issued by others.
Addressee
The auditor's report shall be addressed, as appropriate, based on the circumstances of the
engagement.
Law, regulation or the terms of the engagement may specify to whom the auditor's
report is to be addressed in that particular jurisdiction. The auditor's report is normally
addressed to those for whom the report is prepared, often either to the shareholders or
to those charged with governance of the entity whose financial statements are being
audited.
Auditor's Opinion
The first section of the auditor's report shall include the auditor's opinion, and shall have the
heading "Opinion."
686
o The auditor's report states, for example, that the auditor has audited the financial
statements of' the entity, which comprise [state the title of each financial statement
comprising the complete set of financial statements required by the applicable
financial reporting framework specifying the date or period covered by each financial
Statement] and notes to the financial statements, including a summary of significant
accounting policies.
o When the auditor is aware that the audited financial statements will be included in a
document that contains other information, such as an annual report, the auditor may
consider, if the form of presentation allows, identifying the page number on which the
audited financial statements are presented. This helps users to identify the financial
statements to which the auditor's report relates.
(a) In our opinion, the accompanying financial statements present fairly, in all
material respects, [...] in accordance with [the applicable financial reporting
framework]; or
(b) In our opinion, the accompanying financial statements give a true and fair view of
[...J in accordance with [the applicable financial reporting framework]. (Ref: PSA 700
(Revised) Para. Al 9——A26)
If the reference to the applicable financial reporting framework in the auditor's opinion is
not to PFRSs issued by the International Accounting Standards Board or IPSASs issued by
the International Public Sector Accounting Standards Board, the auditor's opinion shall
identify the jurisdiction of origin of the framework.
687
Basis for Opinion
The auditor's report shall include a section, directly following the Opinion section, with the
heading "Basis for Opinion", that:
a. States that the audit was conducted in accordance with International Standards on
Auditing; The reference to the standards used conveys to the users of the auditor's report
that the audit has been conducted in accordance with established standards.
b. Refers to the section of the auditor's report that describes the auditor's responsibilities
under the PSAs;
c. Includes a statement that the auditor is independent of the entity in accordance with the
relevant ethical requirements relating to the audit, and has fulfilled the auditor's other
ethical responsibilities in accordance with these requirements. The statement shall identify
the jurisdiction of origin of the relevant ethical requirements or refer to the International
Ethics Standards Board for Accountants' Code of Ethics for Professional Accountants
(IESBA code); and (Ref: PSA 700 (Revised) Para: A29— A34)
d. States whether the auditor believes that the audit evidence the auditor has obtained is
sufficient and appropriate to provide a basis for the auditor's opinion.
Going Concern
Where applicable, the auditor shall report in accordance with PSA 570 (Revised).
For audits of complete sets of general purpose financial statements of listed entities, the
auditor shall communicate key audit matters in the auditor's report in accordance with PSA
701.
688
RESPONSIBILITIES FOR THE FINANCIAL STATEMENT
Responsibilities of Management and Those Charged with Governance for the Financial
Statements
This section of the auditor's report shall describe management's responsibility for: (Ref:
Para. A40—A43)
(a) Preparing the financial statements in accordance with the applicable financial
reporting framework, and for such internal control as management determines is
necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error; and
(b) Assessing the entity's ability to continue as a going concern 13 and whether the use of
the going concern basis of accounting is appropriate as well as disclosing, if applicable,
matters relating to going concern. The explanation of management's responsibility for
this assessment shall include a description of when the use of the going concern basis
of accounting is appropriate. (Ref: Para. A43)
This section of the auditor's report shall also identify those responsible for the oversight of
the financial reporting process, when those responsible for such oversight are different
from those who fulfill the responsibilities described in paragraph 33 above. In this case,
the heading of this section shall also refer to "Those Charged with Governance" or such
term that is appropriate in the context of the legal framework in the particular jurisdiction.
(Ref: Para. A44)
When the financial statements are prepared in accordance with a fair presentation
framework, the description of responsibilities for the financial statements In the auditor's
report shall refer to "the preparation and fair presentation of these financial statements" or
"the preparation of financial statements that give a true and fair view," as appropriate in the
circumstances.
689
Auditor's Responsibilities for the Audit of the Financial Statements
The auditor's report shall include a section with the heading "Auditor's Responsibilities for
the Audit of the Financial Statements."
i) Obtain reasonable assurance about whether the financial statements as a whole are
free from material misstatement, whether due to fraud or error; and
ii) Issue an auditor's report that includes the auditor's opinion. The auditor's report
explains that the objectives of the auditor are to obtain reasonable assurance about
whether the financial statements as a whole are free from material misstatement,
whether due to fraud or error, and to issue an auditor's report that includes the auditor's
opinion. These are in contrast to management's responsibilities for the preparation for
the financial statements.
(b) State that reasonable assurance is a high level of assurance, but is not a guarantee that
an audit conducted in accordance with PSAs will always detect a material misstatement
when it exists; and
(c) State that misstatements can arise from fraud or error, and either:
i) Describe that they are considered material if, individually or in the aggregate, they
could reasonably be expected to influence the economic decisions of users taken on
the basis of these financial statements; or
The Auditor's Responsibilities for the Audit of the Financial Statements section of the
auditor's report shall further:
(a) State that, as part of an audit in accordance with PSAs, the auditor exercises
professional judgment and maintains professional skepticism throughout the audit; and
i) To identify and assess the risks of material misstatement of the financial statements,
whether due to fraud or error; to design and perform audit procedures responsive to
those risks; and to obtain audit evidence that is sufficient and appropriate to provide a
basis for the auditor's opinion. The risk of not detecting a material misstatement
resulting from fraud is higher than for one resulting from error, as fraud may involve
collusion, forgery, intentional omissions, misrepresentations, or the override of
internal control.
690
ii) To obtain an understanding of internal control relevant to the audit in order to
design audit procedures that are appropriate in the circumstances, but not for the
purpose of expressing an opinion on the effectiveness of the entity's internal control.
In circumstances when the auditor also has a responsibility to express an opinion on
the effectiveness of internal control in conjunction with the audit of the financial
statements, the auditor shall omit the phrase that the auditor's consideration of internal
control is not for the purpose of expressing an opinion on the effectiveness of the
entity's internal control.
v) When the financial statements are prepared in accordance with a fair presentation
framework, to evaluate the overall presentation, structure and content of the financial
statements, including the disclosures, and whether the financial statements represent
the underlying transactions and events in a manner that achieves fair presentation.
691
(c) When PSA 60015 applies, further describe the auditor's responsibility in a group audit
engagement by stating that:
ii) The auditor is responsible for the direction, supervision and , performance of the
group audit; and
iii) The auditor remains solely responsible for the auditor's opinion.
The Auditor's Responsibilities for the Audit of the Financial Statements section of the auditor's
report also shall: (Ref: Para. A45)
(a) State that the auditor communicates with those charged with governance regarding,
among other matters, the planned scope and timing of the audit and significant audit
findings, including any significant deficiencies in internal control that the auditor identifies
during the audit;
(b) For audits of financial statements of listed entities, state that the auditor provides those
charged with governance with a statement that the auditor has complied with relevant
ethical requirements regarding independence and communicate with them all relationships
and other matters that may reasonably be thought to bear on the auditor's independence,
and where applicable, related safeguards; and
(c) For audits of financial statements of listed entities and any other entities for which key
audit matters are communicated in accordance with PSA 701, state that, from the matters
communicated with those charged with governance, the auditor determines those matters
that were of most significance in the audit of the financial statements of the current period
and are therefore the key audit matters. The auditor describes these matters in the auditor's
report unless law or regulation precludes public disclosure about the matter or when, in
extremely rare circumstances, the auditor determines that a matter should not be
communicated in the auditor's report because the adverse consequences of doing so would
reasonably be expected to outweigh the public interest benefits of such communication.
(Ref: Para. A48)
692
Location of the description of the auditor's responsibilities for the audit of the financial
statements
The description of the auditor's responsibilities for the audit of the financial
statements required by paragraphs 38-39 shall be included: (Ref: Para. A49)
If the auditor addresses other reporting responsibilities in the auditor's report on the
financial statements that are in addition to the auditor's responsibilities under the
PSAs, these other reporting responsibilities shall be addressed in a separate section in
the auditor's report with a heading titled "Report on Other Legal and Regulatory
Requirements" or otherwise as appropriate to the content of the section, unless these
other reporting responsibilities address the same topics as those presented under the
reporting responsibilities required by the PSAs in which case the other reporting
responsibilities may be presented in the same section as the related report elements
required by the PSAs. (Ref: Para. A53—A55)
If other reporting responsibilities are presented in the same section as the related
report elements required by the PSAs, the auditor's report shall clearly differentiate
the other reporting responsibilities from the reporting that is required by the PSAs.
(Ref: Para. A55)
If the auditor's report contains a separate section that addresses other reporting
responsibilities, the requirements of paragraphs 20-39 of this PSA shall be included
under a section with a heading "Report on the Audit of the Financial Statements." The
"Report on Other Legal and Regulatory Requirements", shall follow the "Report on
the Audit of the Financial Statements." (Ref: Para. A55)
693
Name of the Engagement Partner
The name of the engagement partner shall be included in the auditor’s report for audits
of complete sets of general purpose financial statements of listed entities unless, in
rare circumstances, such disclosure is reasonably expected to lead to a significant
personal security threat. In the rare circumstances that the auditor intends not to
include the name of the engagement partner in the auditor's report, the auditor shall
discuss this intention with those charged with governance to inform the auditor's
assessment of the likelihood and severity of a significant personal security threat. (Ref:
Para. A56—A58)
The auditor's signature is either in the name of the audit firm, the personal name of the
auditor or both, as appropriate for the particular jurisdiction. In addition to the
auditor's signature, in certain jurisdictions, the auditor may be required to declare in
the auditor's report the auditor's professional accountancy designation or the fact that
the auditor or firm, as appropriate, has been recognized by the appropriate licensing
authority in that jurisdiction.
In some cases, law or regulation may allow for the use of electronic signatures in the
auditor's report.
Auditor's Address
The auditor's report shall name the location in the jurisdiction where the auditor practices.
The auditor's report shall be dated no earlier than the date on which the auditor has obtained
sufficient appropriate audit evidence on which to base the auditor's opinion on the financial
statements, including evidence that: (Ref: Para. A61— A64)
694
(a) All the statements that comprise the financial statements, including the related notes,
have been prepared; and
(b) Those with the recognized authority have asserted that they have taken responsibility
for those financial statements.
The date of the auditor's report informs the user of the auditor's report that the auditor has
considered the effect of events and transactions of which the auditor became aware and that
occurred up to that date. The auditor's responsibility for events and transactions after the date of
the auditor's report is addressed in PSA 560.
Since the auditor's opinion is provided on the financial statements and the financial statements
are the responsibility of management, the auditor is not in a position to conclude that sufficient
appropriate audit evidence has been obtained until evidence is obtained that all the statements
that comprise the financial statements, including the related notes, have been prepared and
management has accepted responsibility for them.
695
REVIEW QUESTIONS AND PROBLEMS
Questions
2. What is the auditor's primary basis for the expression of an opinion on the financial
statements?
3. In forming an opinion on the financial statements, what factors should the auditor consider
in concluding whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error?
4. What should the auditor consider and evaluate in determining whether the financial
statements are prepared in all material respects in accordance with the applicable
financial reporting framework?
5. In evaluating whether the financial statements achieve fair presentation, what should the
auditor take into consideration?
6. When should the auditor express on unmodified opinion or the financial statements?
7. What course of action should the auditor take if it is found that financial statements
prepared are not fairly presented?
8. Describe the audit report to be issued by the auditor if the audit was conducted in
accordance with Philippine Standards on Auditing and the financial statements audited
were found to have been prepared in accordance with a fair presentation framework.
9. What specific information/data are contained in the first paragraph of the standard audit
report?
10. Why is "management's responsibility for the financial statements" paragraph in the audit
report important?
11. What is the significance of the section “auditor's responsibility” in the audit report?
696
Multiple Choice Questions
2. The existence of audit risk is recognized by the statement in the auditor's standard report
that the auditor
a. obtains reasonable assurance about whether the financial Statements are free of
material misstatement.
b. assesses the accounting principles used and also evaluates the overall financial
statement presentation.
c. realizes that some matters, either individually or in the aggregate, are important,
while other matters are not important.
d. is responsible for expressing an opinion on the financial statements, which are the
responsibility of management.
4. The introductory paragraph of the standard audit report states that the financial
statements and the opinion expressed about those statements are
a. the responsibility of the auditor.
b. the responsibility of management.
c. the joint responsibility of management and the auditor.
d. none of the above.
5. The scope paragraph of the standard unqualified report states that the audit is designed
to
a. discover all errors and/or irregularities.
b. discover material errors and/or irregularities.
c. obtain reasonable assurance whether the statements are free of material
misstatement.
d. conform to financial reporting standards.
697
6. In the scope paragraph of the audit report, the use of the term "reasonable assurance" is
intended to indicate that
a. no misstatements exist in the financial statements.
b. no material misstatements exist in the statements.
c. there is a possibility that material misstatements still exist in the financial
statements.
d. there is a possibility that immaterial misstatements still exist in the
financial statements.
7. In the scope paragraph of the audit report, the use of the term "material misstatements"
conveys that auditors are responsible to search for
a. minor misstatements
b. significant misstatements
c. fraudulent misstatements.
d. all misstatements.
9. Most auditors believe that financial statements are "presented fairly" when the
statements are in accordance with financial reporting standards, but that it is also necessary
to
a. determine that they are not in violation of PASs.
b. examine the substance of transactions and balances for possible
misinformation.
c. review the statements using the accounting principles promulgated by the
Securities and Exchange Commission.
d. assure investors that the net income reported this year will be equaled or
exceeded in the future.
698
Problems
Problem 1
CPA Lacsina and his associates audited the financial statements of West Company, a
computer equipment retailer. Lacsina conducted the audit in accordance with PSAs and
therefore wrote a standard audit description in his audit report. Then he received an
emergency call to fill in as a Substitute tenor in his barbershop quartet.
No one else was in the office that Saturday afternoon, so he handed you the completed
financial statements and footnotes and said: "Make sure it's OK to write an unqualified
opinion on these statements. The working papers are on the table. I'll check with you on
Monday morning."
Required: In general terms, what must you determine in order to write an unqualified
opinion paragraph for Lacsina's signature?
Problem 2
On the completion of all field work on September 23, 20x6, the following report was
written by Betty Rose to the directors of Continent Corporation.
The accompanying statement of financial position of Continent Corporation and the related
statements of income and retained earnings as of July 31, 20x6, are the responsibility of
management. In accordance with your instructions, we have conducted a complete audit. We
planned and performed the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In many respects this was an unusual year for the Continent Corporation. The weakening of the
economy in the early part of the year and the strike of plane employees in the summer led to a
decline in sales and net income. After making several tests of the sales records, nothing came to our
attention that would indicate sales have not been properly recorded.
In our opinion, with the explanation given above, and with the exception of some minor errors we
consider immaterial, the aforementioned financial statements present the financial position of
Continent Corporation at July 31 , 20X6, and the results of its operations, and its cash flows for the
year then ended in conformity with pronouncements of the Accounting Standards Council.
Required: List and explain the deficiencies and omissions in Rose's audit report.
699
Chapter MODIFICATIONS TO
THE OPINION IN THE
INDEPENDENT
AUDITOR'S REPORT
2. Understand with the form and content of the auditor's report when the opinion
is modified.
INTRODUCTION
PSA 705 (Revised) "Modifications to the Opinion in the Independent Auditor's Report," deals
with the auditor's responsibility to issue an appropriate report in circumstances when in forming
an opinion in accordance with PSA 700 (Revised) "Forming an Opinion and Reporting on
Financial Statements," the auditor concludes that a modification to the auditor's opinion on the
financial statements is necessary. Modified opinion is a qualified opinion, an adverse opinion or
a disclaimer of opinion.
a) a qualified opinion
b) an adverse opinion
c) a disclaimer of opinion
The decision regarding which type of modified opinion is appropriate depends upon
a) The nature of the matter giving rise to the modification, that is, whether the financial
statements are materially misstated or, in the case of an inability to obtain sufficient
appropriate audit evidence, may be materially misstated; and
b) The auditor's judgment about the pervasiveness of the effects or possible effects of the
matter on the financial statements.
Pervasiveness is the term used, in the context of misstatements, to describe the effects on the
financial statements of misstatements or the possible effects on the financial statements of
misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate
audit evidence.
701
Pervasive effects on the financial statements are those that, in the auditor’s judgment:
Are not confined to specific elements, accounts or items of the financial statements;
The auditor shall express clearly an appropriately modified opinion on the financial statements
that is necessary when:
a) The auditor concludes, based on the audit evidence obtained, that the financial
statements as a whole are not free from material misstatement; or
b) The auditor is unable to obtain sufficient appropriate audit evidence to conclude that
the financial statements as a whole are free from material misstatement.
PSA 700 (Revised) requires the auditor, in order to form an opinion on the financial statements,
to conclude as to whether reasonable assurance has been obtained about whether the financial
statements as a whole are free from material misstatement. This conclusion takes into account
the auditor's evaluation of uncorrected misstatements, if any, on the financial statements in
accordance with PSA 450.
702
Determining the Type of Modification to the Auditor's Opinion
Qualified Opinion
a) The auditor, having obtained sufficient appropriate audit evidence, concludes that
misstatements, individually or in the aggregate, are material, but not pervasive, to the
financial statements; or
b) The auditor is unable to obtain sufficient appropriate audit evidence on which to base
the opinion, but the auditor concludes that the possible effects on the financial statements
of undetected misstatements, if any, could be material but not pervasive.
Adverse Opinion
The auditor shall express an adverse opinion when the auditor, having obtained sufficient
appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are
both material and pervasive to the financial statements.
Disclaimer of Opinion
The auditor shall disclaim an opinion when the auditor is unable to obtain sufficient appropriate
audit evidence on which to base the opinion, and the auditor concludes that the possible effects
on the financial statements of undetected misstatements, if any, could be both material and
pervasive.
The auditor shall disclaim an opinion when, in extremely rare circumstances involving multiple
uncertainties, the auditor concludes that, notwithstanding having obtained sufficient
appropriate audit evidence regarding each of the individual uncertainties, it is not possible to
form an opinion on the financial statements due to the potential interaction of the uncertainties
and their possible cumulative effect on the financial statements.
703
The appropriate use of the three types of modifications is described below
704
Consequence of an Inability to Obtain Sufficient Appropriate Audit Evidence Due to a
Management-Imposed Limitation utter the Auditor Has Accepted the Engagement
If, after accepting the engagement, the auditor becomes aware that management has imposed a
limitation on the scope of the audit that the auditor considers likely to result in the need to
express a qualified opinion or to disclaim an opinion on the financial statements, the auditor
shall request that management remove the limitation.
If management refuses to remove the limitation referred to in paragraph 11 , the auditor shall
communicate the matter to those charged with governance and determine whether it is possible
to perform alternative procedures to obtain sufficient appropriate audit evidence.
If the auditor is unable to obtain sufficient appropriate audit evidence, the auditor shall
determine the implications as follows:
a) If the auditor concludes that the possible effects on the financial statements of
undetected misstatements, if any, could be material but not pervasive, the auditor shall
qualify the opinion; or
b) If the auditor concludes that the possible effects on the financial statements of
undetected misstatements, if any, could be both material and pervasive so that a
qualification of the opinion would be inadequate to communicate the gravity of the
situation, the auditor shall:
(i) Resign from the audit, where practicable and not prohibited by law or regulation; or
(ii) If resignation from the audit before issuing the auditor's report is not practicable or
possible, disclaim an opinion on the financial statements.
If the auditor withdraws as contemplated by paragraph 13(b)(i), before resigning the auditor
shall communicate to those charged with governance any matters regarding misstatements
identified during the audit that would have given rise to a modification of the audit opinion.
705
Other Considerations Relating to an Adverse Opinion or Disclaimer of Opinion
When the auditor considers it necessary to express an adverse opinion or disclaim an opinion on
the financial statements as a whole, the auditor's report shall not also include an unmodified
opinion with respect to the same financial reporting framework on a single financial statement
or one or more specific elements, accounts or items of a financial statement. To include such an
unmodified opinion in the same report in these circumstances would contradict the auditor's
adverse opinion or disclaimer of opinion on the financial statements as a whole.
Auditor's Opinion
When the auditor modifies the audit opinion, the auditor shall use the heading 'Qualified
Opinion,""Adverse Opinion," or "Disclaimer of Opinion," as appropriate, for the opinion
paragraph. (Ref: Para. Al 7—Al 9)
Opinion Paragraph
1. When the auditor modifies the audit opinion, the auditor shall use the heading
"Qualified Opinion,""Adverse Opinion," or "Disclaimer of Opinion, " as appropriate,
for the opinion paragraph.
2. When the auditor expresses a qualified opinion due to a material misstatement in the
financial statements, the auditor shall state in the opinion paragraph that, in the
auditor's opinion, except for the effects of the matter(s) described in the Basis for
Qualified Opinion paragraph:
a) The financial statements present fairly, in all material respects in accordance with
the applicable financial reporting framework when reporting in accordance with a
fair presentation framework; or
b) The financial statements have been prepared, in all material respects, in accordance
with the applicable financial framework when reporting. in accordance with a
compliance framework.
3. When the modification arises from an inability to obtain sufficient appropriate audit
evidence, the auditor shall use the corresponding for the modified phrase "except for
the possible effects of the matter(s)..." for the modified opinion.
706
4. When the auditor expresses an adverse opinion, the auditor shall state the opinion
paragraph that, in the auditor's opinion, because of the significance of the matter(s)
described in the Basis for Adverse Opinion paragraph:
a) The financial statements do not present fairly in accordance with the applicable
financial reporting framework when reporting in accordance with a fair
presentation framework; or
b) The financial statements have not been prepared, in all material respects, in
accordance with the applicable financial reporting framework when reporting in
accordance with a compliance framework.
a) Because of the significance of the matter(s) described in the Basis for Disclaimer
of Opinion paragraph, the auditor has not been able to obtain sufficient appropriate
audit evidence to provide a basis for an audit opinion; and, accordingly,
When the auditor expresses a qualified or adverse opinion, the auditor shall amend the
description of the auditor's responsibility to state that the auditor believes that the audit
evidence the auditor has obtained is sufficient and appropriate to provide a basis for the
auditor's modified audit opinion.
When the auditor disclaims an opinion due to an inability to obtain sufficient appropriate audit
evidence, the auditor shall amend the introductory paragraph of the auditor's report to state that
the auditor was engaged to audit the financial statements. The auditor shall also amend the
description of the auditor's responsibility and the description of the scope of the audit to state
only the following: "Our responsibility is express an opinion on the financial statements based
on conducting the audit in accordance with International Standards on Auditing. Because of
the matter(s) described in the Basis for Disclaimer of Opinion paragraph, however, we were
not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion."
707
Communication with Those Charged with Governance
When the auditor expects to modify the opinion in the auditor's report, the auditor shall
communicate with those charged with governance the circumstances that led to the expected
modification and the proposed wording of the modification.
Illustration 23-1: Auditor's report containing a qualified opinion due to a material misstatement
of the financial statements.
Illustration 23-2: Auditor's Report containing a qualified opinion due to the auditor's inability to
obtain sufficient appropriate audit evidence.
Illustration 23-3: Auditor's report containing an adverse opinion due to a material misstatement
of the consolidated financial statements.
Illustration 23-4: Auditor's report containing a disclaimer of opinion due to the auditor's
inability to obtain sufficient appropriate audit evidence about a single element of the
consolidated financial statements.
Illustration 23-5: Auditor's report containing a disclaimer of opinion due to the auditor's
inability to obtain sufficient appropriate audit evidence about multiple elements of the financial
statements.
708
Illustration 23-1: Auditor's Report Containing a Qualified Opinion Due to a Material
Misstatement of the Financial Statements
Qualified Opinion
We have audited the financial statements of the Company, which comprise the statement of
financial position as at December 31, 20x5, the statement of comprehensive income, statement
of changes in equity and statements of cash flows for the year then ended, and notes to the
financial accounting policies.
In our opinion, except for the effects of the matters described in the Basis for Qualified Opinion
section of our report, the accompanying financial statements present fairly, in all material
respects, (or give a true and fair view of ) the financial position of XYZ Company (the
Company) as at December 31, 20X5, and (of) it's financial performance and it's Cash flows for
the year then ended in accordance with Philippine Financial Reporting Standards (PFRSs).
The Company's inventories are carried in the statement of financial position at Pxxx.
Management has not stated the inventories at the lower of cost and net realizable but has stated
them solely at cost, which constitutes a departure from PFRSs. The Company's records indicate
that, had management stated the inventories at lower of cost and net realizable value, an amount
of xxx would have been required to write the inventories down to their net realizable value.
Accordingly, cost of sales would have been increased by xxx, and income tax, net income and
shareholder's equity would have been reduced by xxx, xxx and xxx, respectively.
We conducted our audit in accordance with Philippine Standards on Auditing (PSAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for
the Audit of the Financial Statements section of our report. We are independent of the Company
within the meaning of [indicate relevant ethical requirements or applicable law or regulation]
and have fulfilled our other responsibilities under those relevant ethical requirements. We
believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis
for our qualified opinion.
[The balance of the report would be in accordance with PSA 700 (Revised)]
709
Illustration 23-2. Auditor's Report Containing a Qualified Opinion Due to the Auditor's
Inability to Obtain Sufficient Appropriate Audit Evidence
Qualified Opinion
We have audited the consolidated financial statement of the Group, which comprise the
financial position as at December 31 , 20X5, and the consolidated comprehensive income,
consolidated statement of changes equity and consolidated statement of cash flows for the year
then ended, and notes to the consolidated financial statements, including a summary of
significant accounting policies.
In our opinion, except for the possible effects of the matter described in the Basis for Qualified
Opinion section of our report, the accompanying consolidated financial statements present
fairly, in all material respects, (or give a true and fair view of) the financial position of XYZ
Company and its subsidiaries (the Group) as at December 31, 20x5, and (of) their consolidated
financial performance and their consolidated cash flows for the year then ended in accordance
with Philippine Financial Reporting Standards (PFRSs).
The Group's investment in MNO Company, a foreign associate acquired during the year and
accounted for by the equity method, is carried at xxx on the consolidated statement of financial
position as at December 31, 20X5, and XYZs share of MNO's net income of xxx is included in
XYZ's income for the year then ended. We were unable to obtain sufficient appropriate audit
evidence about the carrying amount of XYZ's investment in MNO as at December 31, 20x5 and
XYZ'S share of MNO's net income for the year because we were denied access to the financial
information, management, and the auditors of MNO. Consequently, we are unable to determine
whether any adjustments to these amounts were necessary.
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibility under those standards are further described in the Auditor's Responsibilities for
the Audit of the consolidated Financial Statements section of our report. We are independent of
the Group within the meaning of [indicate relevant ethical requirements or applicable law or
regulation] and have fulfilled our other responsibilities under those ethical requirements. We
believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis
for our qualified opinion.
[The balance of the report would be in accordance with PSA 700 (Revised)]
710
Illustration 23-3: Auditor's Report Containing an Adverse Opinion due to a Material
Misstatement of The Financial Statements
Adverse Opinion
We have audited the consolidated financial statements of the Group, which comprise the
consolidated statement of financial position as at December 31, 20X5, and the consolidated
statement of comprehensive income, consolidated statement of changes in equity and
consolidated statement of cash flows for the year then ended, and notes to the consolidated
financial statements, including a summary of significant accounting policies.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse
Opinion section of our report, the accompanying consolidated financial statements do not
present fairly (or do not give a true and fair view of) the consolidated financial position of XYZ
Company and its subsidiaries (the Group) as at December 31, 20X5, and (of) their consolidated
financial performance and their consolidated cash flows for the year then ended in accordance
with Philippine Financial Reporting Standards (PFRSs).
As explained in Note X, the Group has not consolidated subsidiary MNO Company it acquired
during because it has not yet been able to determine the fair values of certain of the subsidiary's
material assets and liabilities at the acquisition date. This investment is therefore accounted for
on a cost basis. Under PFRSs, the Company should have consolidated this subsidiary and
accounted for the acquisition based on provisional amounts. Had MNO Company been
consolidated, many elements in the accompanying consolidated financial statements would
have been materially affected. The effects on the consolidated financial statements of the
failure to consolidate have not been determined.
We conducted our audit in accordance with Philippine Standards on Auditing (PSAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for
the Audit of the Consolidated Financial Statements section of our report. We are independent of
the Group within the meaning of [indicate relevant ethical requirements or applicable law or
regulation] and have fulfilled our other responsibilities under those ethical requirements. We
believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis
for our adverse opinion.
[The balance of the report would be in accordance with PSA 700 (Revised)]
711
Illustration 23-4: An Auditor's Report Containing a Disclaimer of Opinion Due to the
Auditor's Inability to Obtain Sufficient Appropriate Audit Evidence about a Single
Element of the Financial Statements.
Disclaimer of Opinion
We were engaged to audit the consolidated financial statements of the Group, which comprise the consolidated
statement of financial position as at December 31, 20X5, and the consolidated statement of comprehensive
income, consolidated statement of changes in equity and consolidated statement of cash flows for the year then
ended, and notes to the consolidated financial statements, including a summary of significant accounting
policies.
We do not express an opinion on the accompanying consolidated financial statements of XYZ Company and its
subsidiaries (the Group). Because of the significance of the matter described in the Basis for Disclaimer of
Opinion section of our report, we have not been able to obtain sufficient appropriate audit evidence to provide a
basis for an audit opinion on these consolidated financial statements.
The Group's investment in its joint venture MNO Company is carried at XXX on the Group's consolidated
statement of financial position, which represents over 90% of the Group's net assets as at December 31, 20x5. We
were not allowed access to the management and the Auditor's of MNO Company, including MNO Company's
auditors' audit documentation. As a results, we were unable to determine whether any adjustments were
necessary in respect of the Group's proportional share of MNO Company's assets that it controls jointly, its
proportional share of MNO Company's liabilities for which it is jointly responsible, its proportional share of
MNO's income and expenses for the year, and the elements making up the consolidated statement of changes in
equity and the consolidated cash flow statement.
Responsibilities of [Management and Those Charged with Governance or other appropriate terms] for
the Consolidated Financial Statements
Our responsibility is to conduct an audit of the Group's consolidated financial statements in accordance with
International Standards on Auditing and to issue an auditor's report. However, because of the matter described in
the Basis for Disclaimer Opinion section of our report, we were not able to obtain sufficient appropriate audit
evidence to provide a basis for an audit opinion on these consolidated financial statements.
We are independent of the Group within the meaning of [indicate relevant ethical requirements or applicable
law or regulation] and have fulfilled our other responsibilities under those ethical requirements.
[The balance of the report would be in accordance with PSA 700 (Revised)]
712
Illustration 23-5: Auditor's Report Containing a Disclaimer of Opinion Due to the
Auditor's Inability to Obtain Sufficient Appropriate Audit Evidence About Multiple
Elements Of The Financial Statements
Disclaimer of Opinion
We were engaged to audit the financial statements of the Company, which comprise the Statement of financial
position as at December 31, 20X5, and the statement of comprehensive income, statement of changes in equity
and statement of cash flows for the year then ended, and notes to the financial statements, including a summary
of significant accounting policies.
We do not express an opinion on the accompanying financial statements of XYZ Company (the Company).
Because of the significance of the matters described in the Basis for Disclaimer of Opinion section of our report,
we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on
these financial statements.
We were not appointed as auditors of the Company until after December 31, 20X5 and thus did not observe the
counting of physical inventories at the beginning and end of the year. We were unable to satisfy ourselves by
alternative means concerning the inventory quantities held at December 31, and 20X5, which are stated in the
statement of financial position at xxx and xxx, respectively. In addition, the introduction of a new computerized
accounts receivable system in September 20X5 resulted in numerous errors in accounts receivable. As of the
date of our audit report, management was Still in the process of rectifying the system deficiencies and correcting
the errors. We were unable to confirm or verify by alternative means accounts receivable included in the
statement of financial position at a total amount of xxx as at December 31, 20X5. As a result of these matters, we
were unable to determine whether any adjustments might have been found necessary in respect of recorded or
unrecorded inventories and accounts receivable, and the elements making up the statement of comprehensive
income, statement of changes in equity and statement of cash flows.
Responsibilities of [Management and Those Charged with Governance or other appropriate terms] for
the Financial Statements
Our responsibility is to conduct an audit of the Company's financial statements in accordance with International
Standards on Auditing and to issue an auditor's report. However, because of the matters described in the Basis
for Disclaimer Opinion section of our report, we were not able to obtain sufficient appropriate audit evidence to
provide a basis for an audit opinion on these financial statements.
We are independent of the Company within the meaning of [indicate relevant ethical requirements or applicable
law or regulation] and have fulfilled our other responsibilities under those ethical requirements.
[The balance of the report would be in accordance with PSA 700 (Revised)]
713
REVIEW QUESTIONS AND EXERCISES
Questions
1. What are the major reasons for changing the standard unmodified report?
2. What is the most important distinction between the auditor's opinion on financial
statements and an auditor's disclaimer of opinion?
3. Define material scope restriction. Must a material scope restriction always lead to a
modification of the audit opinion?
5. If an auditor is not independent with respect to a client, what type of opinion must be
issued? Why?
8. What steps should the auditor follow upon learning of a change in accounting
principle?
1. A CPA developed a system for clients to enter transaction data by remote terminal into
the CPA's computer. The CPA's system processes the data and prints monthly financial
statements. When delivered to clients, these financial statements should include:
a. a standard unmodified audit report.
b. an adverse audit report.
c. a report containing a description of the character of the auditor's examination and
the degree of responsibility he or she is taking.
d. a description of the remote terminal system and the controls for ensuring accurate
data processing.
714
2. Under which of the following conditions can a disclaimer of opinion never be given?
a. Going-concern problems are overwhelming the company.
b. The client does not let the auditor have access to evidence about important
accounts.
c. The auditor owns stock in the client corporation.
d. The auditor has found that the client has used the NIFO (next in, first out)
inventory costing method.
3. An auditor may reasonably issue an "except for" qualified opinion for a(an)
limitation change
a. Yes No
b. No Yes
c. Yes Yes
d. No No
5. Three of the following conditions would, by themselves, require the auditor to issue a
report other than an unmodified report. Which one would not require such a departure?
a. Client company's financial statements show a significant net loss for each of the
last three years, including the current fiscal period.
b. The financial statements have not been prepared in accordance with financial
reporting standards.
c. The auditor is not independent during the fiscal period under audit.
d. The scope of the auditor's examination has been restricted, although the cause of
the restriction was not the client's fault.
715
6. A report other than an unmodified report must be issued whenever any of the three
conditions requiring a departure from an unmodified report
a. exists.
b. exists and is material.
c. exists, is material, and is within management's control.
d. exists, is material, and is within either management's or the auditor's control.
9. The adverse opinion report will be issued by the independent auditor when he/she
a. suspects that client has not followed financial reporting standards (PFRS).
b. suspects that client's financial statements are not in conformity with financial
reporting standards (PFRS).
c. has knowledge that the financial statements are not in conformity with financial
reporting standards (PFRS).
d. Has knowledge that Philippine Standards on Auditing (ISAs) were not followed.
716
11. Which of the following statements is true?
a. The auditor is required to issue a disclaimer of opinion in the event of a material
uncertainty.
b. The auditor is required to issue a disclaimer of opinion in the event of a going
concern problem.
c. The auditor is required to issue a disclaimer of opinion for a material uncertainty
and for a going concern problem.
d. The auditor has the option, but it is not required, to issue a disclaimer of opinion
for a material uncertainty or r a going concern problem.
14. A qualified opinion report can be used only when the auditor believes that the overall
financial statements are
a. fairly stated.
b. not fairly stated.
c. materially misstated.
d. materially misleading.
15. The least severe type of report for disclosing departures from an unmodified report is
the
a. adverse opinion.
b. disclaimer of opinion.
c. qualified opinion.
d. report on unaudited financial statements.
16. A modified report can not take the form of a qualification of
a. the opinion alone.
b. both the scope and opinion.
c. the scope alone.
d. all of the above.
17. A scope and opinion qualification can be issued only when the auditor
a. is not independent.
b. has not been able to accumulate all the evidence required by Philippine Standards
on Auditing.
c. has accumulated all the evidence required by Philippine Standards on Auditing.
d. has been restricted by client from gathering the needed information to form an
opinion.
18. In which of the following situations would an auditor ordinarily express an opinion
without an explanatory paragraph?
a. The auditor wishes to emphasize that the entity had significant related-party
transactions.
b. The auditor decides to refer to the report of another auditor as a basis, in part, for
the auditor's opinion.
c. The entity issues financial statements that present financial position and results of
operations, but it omits the statement of cash flows.
d. The auditor has substantial doubt about the entity's ability to continue as a going
concern, but the circumstances are fully disclosed in the financial statements.
21. The management of a client company believes that the statement of cash flows is not a
useful document and refuses to include one in the annual report to stockholders. As a
result of this circumstance, the auditor's opinion should be
a. adverse.
b. unmodified.
c. qualified due to inadequate disclosure.
d. qualified due to a scope limitation.
23. An auditor was unable to obtain sufficient competent evidential matter concerning
certain transactions due to an inadequacy in the entity's accounting records. The auditor
would choose between issuing a(n)
a. qualified opinion and an unmodified opinion with an explanatory paragraph.
b. unmodified opinion with an explanatory paragraph and an adverse opinion.
c. adverse opinion and a disclaimer of opinion.
d. disclaimer of opinion and a qualified opinion.
24. In which of the following 'situations would a principal auditor be least likely to make
reference to another auditor who audited a subsidiary of entity?
a. The other auditor was retained by the principal auditor and the work was
performed under the principal auditor's guidance and control.
b. The principal auditor finds it impracticable to review the other auditor's work or
otherwise be satisfied as to the other auditor's work.
c. The financial statements audited by the other auditor are material to the
consolidated financial statements covered by the principal auditor's opinion.
d. The principal auditor is unable to be satisfied as to the independence and
'professional reputation of the other auditor.
25. Which of the following phrases should be included in the opinion paragraph when an
auditor expresses a qualified opinion?
a. Yes No
b. No Yes
c. Yes Yes
d. No No
26. When an auditor expresses an adverse opinion, the opinion paragraph should include
a. the principal effects of the departure from financial reporting standards.
b. a direct reference to a separate paragraph disclosing the basis for the opinion.
c. the substantive reasons for the financial statements being misleading.
d. a description of the uncertainty or scope limitation that prevents an unmodified
opinion.
720
Problems
Problem 1
Aya de Jesus, CPA, is the continuing auditor for Various Fabrics, Inc. The current year-end
is January 31, 20X5. Last year's' audit report contained an explanatory paragraph because
of uncertainty regarding the ability of Various Fabrics to continue as a going concern. The
company had defaulted on two major loan agreements, and appeared to be losing the race
to develop "space age" fabrics. Since the date of last year's audit report, however, company
management has changed. Significant new products, which already have proven
successful in the markets served by Various Fabrics, have been developed. Creditors have
agreed to major debt restructuring agreements, and the company appears to be "out of the
woods."
Required:
Assuming the company presents comparative financial statements for 20X5and 20X4,
present the audit report. Remember, you are updating not reproducing — last year's audit
report.
Problem 2
Items (l) through (7) present various independent factual situations an auditor might
encounter in conducting an audit. List A represents the types of opinions the auditor
ordinarily would issue, while List B represents the report modification (if any) that would
be necessary. For each situation, select one response form List A and one from List B.
Select as the best answer for each item the action the auditor would normally take. The
types of opinions in List A and the report modifications in List B may be selected once, or
not at all.
The auditor previously expressed an unmodified opinion on the prior year's financial
statements.
Only single-year (not comparative) statements are presented for the current year.
The conditions for an unmodified opinion exist, unless this contradicted in the
factual situations.
The following is an example of the manner in which the items should be answered.
Item: The financial statements present fairly, in all material respects, the financial
position, results of operations, and cash flows in conformity with financial reporting
standards.
Items to be Answered:
2. Due to recurring operating losses and working capital deficiencies, an auditor has
substantial doubt about an entity's ability to continue as a going concern for a
reasonable period of time. However, the financial statement disclosures concerning
these matters are adequate.
3. A principal auditor decides to take responsibility for the work of another CPA who
audited a wholly owned subsidiary of the entity and issued an unmodified opinion. The
total assets and revenues of the subsidiary represent 17% and 1 8%, respectively, of the
total assets and revenues of the entity being audited.
4. An entity issues financial statements that present financial position and results of
operations but omits the related statement of cash flows. Management discloses in the
notes to the financial statements that it does not believe the statement of cash flows to
be a useful financial statement.
5. An entity changes its depreciation method for production equipment from the
straight-line method to a units-of-production method based on hours of utilization. The
auditor concurs with the change, although it has a material effect on the comparability
of the entity's financial statements.
LIST A LIST B
Types of Opinions Report Modifications
a. An “except for" qualified h. Describe the circumstances in an explanatory
opinion paragraph preceding the opinion paragraph, without
modifying the three standard paragraphs.
b. An unmodified opinion i. Describe the circumstances in an explanatory
paragraph following the opinion paragraph, without
modifying the three standard paragraphs.
c. An adverse opinion j. Describe the circumstances in an explanatory
paragraph preceding the opinion paragraph, and
modify the opinion paragraph.
d. A disclaimer of opinion k. Describe the circumstances in an explanatory
paragraph following the opinion paragraph, and
modify the opinion paragraphs.
e. Either an "except for l. Describe the circumstances in an explanatory
qualified opinion or an paragraph, and modify the scope and opinion
adverse opinion paragraphs.
f. Either a disclaimer of m. Describe the circumstances in an explanatory
opinion or an "except for" paragraph following the opinion paragraph, and
qualified opinion modify the scope and opinion paragraphs.
g. Either an adverse opinion n. Describe the circumstances within the scope
or a disclaimer opinion paragraph without adding an explanatory
paragraphs.
o. Describe the circumstances within the opinion
paragraph without adding an explanatory
paragraphs.
p. Describe the circumstances within the scope and
opinion paragraphs without adding an explanatory
paragraphs.
q. Issue the standard auditor's report without
modifications.
723
Problem 3
Because the audit report reflects the degree of responsibility assumed, the independent
auditor must exercise caution in choosing the appropriate wording. The following report
alternatives are available:
1. Unmodified opinion;
2. Opinion qualified because of departure from PFRS;
3. Opinion qualified for lack of evidence (scope restriction);
4. Disclaimer of opinion - scope restriction;
5. Disclaimer of opinion- uncertainty;
6. Adverse opinion;
7. Explanatory paragraph following opinion paragraph:
a. Uncertainty;
b. Doubt as to ability to continue as a going concern;
c. Emphasis of a matter;
d. Agreed-upon departure from accounting principle;
e. Change in accounting principle.
Required:
For each of the situations described below, indicate by number and letter the appropriate
form of audit report. More than one choice may apply to a given situation. For example, an
unmodified opinion followed by an explanatory paragraph for emphasis of matter would
be answered as 17c.
A. The auditors were able to gather all of the evidence necessary to support an audit
opinion; the financial statements contain no material departures from PFRS; but oil
and gas reserve information required by ASC as supplemental information has been
omitted.
B. The client refused to capitalize certain leases meeting one or more of the criteria that
define financing leases. The auditors are also in doubts as to the recoverability of
purchased patents, the costs of which are material in relation to the company's net
assets.
C. The client refused the auditors' request to confirm trade accounts receivable. The
unaudited balance in this account is significant in relation to total assets, and the
auditors were unable to satisfy themselves by other means.
D. Certain subsidiary companies were audited by other independent CPAs. The principal
auditors decided to divide responsibility.
E. A land development company decided to write up all of its assets from Cost to current
market value and recognized the appreciation as part of current income. Management
believed that the increase in earnings would facilitate a public offering of the
company's stock.
F. Although Company A is virtually insolvent, its financial statements are based on the
going concern assumption. Given the gravity of the situation, the auditors do not
believe that adding an explanatory paragraph is adequate in the circumstances.
G. During the year, Company B changed its method of inventory costing from FIFO to
Average Costing. Although proper accounting treatment was accorded the change,
management refuses to include a footnote describing the change.
J. For many years, Company G followed the practice of recognizing revenue at the point
of sale. Given increasing uncertainty regarding collectibility, the company, with the
auditors' approval, decided to change to the installment method of accounting for sales.
Rather than recognizing the cumulative effect of the change as a component of current
income, however, the company decided to debit the amount to beginning retained
earnings and restate prior earnings to reflect the new method. The auditors agreed with
this departure on the basis that, given the magnitude of accounts receivable at the date
of change, the designated treatment would cause the financial statements to be
materially misleading.
725
Also, in conducting the current examination, the auditors were unable to obtain
sufficient evidence to evaluate the reasonableness of the company's provision for the
inventory obsolescence.
L. Company X changes its method of determining inventory cost from specific identity to
moving average. Footnote No. 6 fully described the change and its impact on current
earnings.
M. Company X changed its method of accounting for post retirement benefits to conform
to the PAS. In addition, the company has sustained significant losses over the past
three years, raising doubts concerning short-term debt-paying ability.
Problem 4
This caselette is designed to test your competence in the preparation of audit report.
You are the audit partner of five clients and will have to make a decision' as to the
appropriate type of audit opinion that should be issued relative to their financial statements.
The pertinent data for these clients follow:
DEF holds a note receivable consisting of principal and accrued interest payable in 20X7.
The note's maker recently filed a voluntary bankruptcy petition but DEF failed to reduce
the recorded value of the note to its net recoverable amount, which is approximately 20%
of the recorded amount.
You found an immaterial adjustment relating to inventory of QRS. It has refused to adjust
the financial statements to reflect this immaterial item.
HIJ's financial statements do not disclose certain long-term lease obligations. You
determined that the omitted disclosures were required by PhilippineFinancial Reporting
Standards (PFRS).
Client No. 4: WXY Company
WXY Company changed its method of accounting for the cost of inventories from FIFO to
weighted-average method. You concur with the change although it has a material effect on
the comparability of the financial statements.
Due to losses and adverse key financial ratios, you have substantial doubt about RST's
ability to continue as a going concern for a reasonable period of time. The client has
adequately disclosed its financial difficulties in a note to financial statements which do not
include any adjustments that might result from the outcome of this uncertainty. You have
also ruled out the use of a disclaimer of opinion.
Questions:
Problem 5
Items A to E are situations that Lucas Reyes, CPA has encountered during his audit of
Nordic Corporation. Select as the best answer for each item the auditor would normally
take.
A. Reyes decided not to take responsibility for the work for another CPA who audited a
wholly owned subsidiary of Nordic. The total assets and revenues of the subsidiary
represent 27% and 28%, respectively, of the related consolidated totals.
B. Due to losses and adverse key financial ratios, Reyes has substantial doubt about
Nordic's ability to continue as a going concern for a reasonable period of time. The
client has adequately disclosed its financial difficulties in a note to its financial
statements, which to not include any adjustments that might result from the outcome
of this uncertainty. Also, Reyes has ruled out the use of a disclaimer of opinion.
C. Nordic changed this method of accounting for the cost of inventories from FIFO to
Weighted Average. Reyes concurs with the change although it has a material effect on
the comparability of the financial statements.
D. Reyes concludes there is substantial doubt about Nordic's ability to continue as a going
concern for a reasonable period of time.
E. Reyes had substantial doubt about Nordic Co.'s ability to continue as a going concern
when reporting on Nordic's audited financial statements for the year ended June 30,
20X1. That doubt has been removed in 20X2.
Questions:
3. In Situation C, the type of opinion that the auditor would ordinary issue is
a. An unqualified opinion.
b. An "except for" opinion.
c. An adverse opinion.
d. Either an "except for" qualified opinion or an adverse opinion.
729
Chapter
PREPARATION OF
FINANCIAL
STATEMENTS
INTRODUCTION
In the world of business, accounting plays an important role to aid in making critical decisions.
The more complex the decision, the more detailed the information must be. Individuals and
companies need different kinds of information to make their business decisions.
The financial statements present the accounting information in formal reports that tell
interested groups, such as manager creditors, prospective in investors and governmental
agencies, how the business is doing. Those reports are prepared from information obtained
from the various business transactions that the business recorded. It should be remembered that
the responsibility to prepare the financial statements rests primarily with the entity's
management.
FINANCIAL STATEMENTS
Financial statements are a structured representation of the financial position and financial
performance of an entity. The objective of financial statements is to provide information about
the financial position, financial performance and cash flows of an entity that is useful to a wide
range of users in making economic decisions. Financial statements also show the results of the
management's stewardship of the resources entrusted to it.
To meet this objective, financial statements provide information about an entity's:
(a) assets;
(b) liabilities;
(c) equity;
(d) income and expenses, including gains and losses;
(e) contributions by and distributions to owners in their capacity as owners; and
(f) cash flows.
This information, along with other information in the notes, assists users of financial statements
in predicting the entity's future cash flows and, in particular, their timing and certainty.
(b) a statement of profit or loss and comprehensive income for the period;
(e) notes, comprising a summary of significant accounting policies and other explanatory
information; and
(f) a statement of financial position as at the beginning of the earliest comparative period
when an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements, or when it reclassifies items in its financial.
statements.
An entity may use titles for the statements other than those used in this Standard.
By downloading from the Philippine Stock Exchange (PSE) for listed companies.
By having an IView account with the Securities and Exchange Commission (SEC)
on-line facility to download the annual reports submitted by corporations to them.
Financial statements shall present fairly the financial position, financial performance and cash
flows of an entity. Fair presentation requires the faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the Framework. The application of
PFRSs, with additional disclosure when necessary, is presumed to result in financial statements
that achieve a fair presentation.
An entity whose financial statements comply with PFRSs shall make an explicit and unreserved
statement of such compliance in the notes. An entity shall not describe financial statements as
complying with PFRSs unless they comply with all the requirements of PFRSs.
In the extremely rare circumstances in which management concludes that compliance with a
requirement to a PFRS would be so misleading that it would conflict with the objective of
financial statements set out in the Framework, the entity shall depart from that requirement in
the manner set out in paragraph 20 if the relevant regulatory framework requires, or otherwise
does not prohibit, such a departure.
Going Concern
An entity shall prepare its financial statements, except for cash flow information, using the
accrual basis of accounting.
An entity shall present separately each material class of similar items. An entity shall present
separately items of a dissimilar nature or function unless they are immaterial.
Offsetting
An entity shall not offset assets and liabilities or income and expenses, unless required or
permitted by a PFRS.
Frequency of Reporting
Except when PFRSs permit or require otherwise, an entity shall disclose comparative
information in respect of the previous period for all amounts reported in the current period's
financial statements. An entity shall include comparative information for narrative and
descriptive information when it is relevant to an understanding of the current period's financial
statements.
When an entity changes the presentation or classification of items in its financial statements,
the entity shall reclassify comparative amounts unless reclassification is impracticable. When
the entity reclassifies comparative amounts, the entity shall disclose:
Consistency of Presentation
An entity shall retain the presentation and classification of items in the financial statements
from one period to the next unless:
(a) it is apparent, following a significant change in the nature of the entity's operations or a
review of its financial statements, that another presentation or classification would be
more appropriate having regard to the criteria' for the selection and application of
accounting policies in
(b) a PFRS requires a change in presentation.
735
Structure and content
An entity shall clearly identify the financial statements and distinguish them from other
information in the same published document.
An entity shall clearly identify each financial statement and the notes. In addition, an entity
shall display the following information prominently, and repeat it when necessary for the
information presented to be understandable:
(a) the name of the reporting entity or other means of identification, and any change in
that information from the end of the preceding reporting period;
(b) whether the financial statements are of an individual entity or a group of entities;
(c) the date of the end of the reporting period or the period covered by the set of financial
statements or notes;
(d) the presentation currency, as defined in PAS 21; and
(e) the level of rounding used in presenting amounts in the financial statements.
As a minimum, the statement of financial position shall include line items that present the
following amounts:
An entity shall present additional line items, headings, and subtotals in the statement of
financial position when such presentation is relevant to as understanding of the entity's
financial position.
When an entity presents current and non-current assets, and current and non-current liabilities,
as separate classifications in its statement of financial position. Deferred tax assets (liabilities)
are classified as non-current assets and liabilities.
An entity shall present current and non-current assets, and current and non-current liabilities, as
separate classifications in its statement of financial position in accordance with paragraphs
66-76 except when a presentation based on liquidity provides information that is reliable and
more relevant. When that exception applies, an entity shall present all assets and liabilities in
order of liquidity.
Whichever method of presentation is adopted, an entity shall disclose the amount expected to
be recovered or settled after more than twelve months for each asset and liability line item that
combines amounts expected to he recovered or settled:
(a) no more than twelve months after the reporting period; and
(b) more than twelve months after the reporting period.
Current Assets
Current Liabilities
An entity shall disclose, either in the statement of financial position or in the notes, further
sub-classifications of the line items presented, classified in a manner appropriate to the entity's
operations.
An entity shall disclose the following, either in the statement of financial position or the
statement of changes in equity, or in the notes:
(ii) the number of shares issued and fully paid, and issued but not fully paid;
(iii) par value per share, or that the shares have no par value;
(iv) a reconciliation of the number of shares outstanding at the beginning and at the
end of the period;
(v) the rights, preferences and restrictions attaching to that class including
restrictions on the distribution of dividends and the repayment of capital;
(vi) shares in the entity held by the entity or by its subsidiaries or associates; and
(vii) shares received for issue under options and contracts for the sale of shares,
including terms and amounts; and
(b) a description of the nature and purpose of each reserve within equity.
An entity shall present all items of income and expense recognized in a period:
As a minimum, the statement of comprehensive income shall include the line items that present
the following amounts for the period:
(a) revenue;
(c) share of the profit or loss of associates and joint ventures accounted for using the
equity method;
(ii) post-tax gain or loss recognized on the measurement to fair valueless costs to sell
or on the disposal of the assets or disposal group(s) constituting the discontinued
operation;
(h) share of the other comprehensive income of associates and joint ventures accounted
for using the equity method; and
_______________________
1
The components of other comprehensive income include:
(a) changes in revaluation surplus (see PAS 16, Property, Plant and Equipment and PAS 38,
Intangible Assets);
(b) actuarial gains and losses on defined benefit plans recognized in accordance with
paragraph 93A of PAS 19 Employee Benefits;
(c) gains and losses arising from translating the financial statements of a foreign operation
(see PAS 21 The Effects of Changes in. Foreign Exchange Rates);
(d) gains and losses on remeasuring available-for-sale financial assets (see PAS 39 Financial
Instruments: Recognition and Measurement);
(e) the effective portion of gains and losses on hedging instruments in a cash flow hedge (see
PAS 39).
An entity shall disclose the following items in the statement of comprehensive income as
allocations of profit or loss for the period:
An entity may present in a separate income statement (see paragraph 81) the line items in
paragraph 82(a)-(f) and the disclosures in paragraph 83(a).
An entity shall present additional line items, headings and subtotals in the statement of
comprehensive income and the separate income statement (if presented), when such
presentation is relevant to an understanding of the entity's financial performance.
An entity shall not present any items of income or expense as extraordinary items, in the
statement of comprehensive income or the separate income statement (if presented), or in the
notes.
An entity shall recognize all items of income and expense in a period in profit or loss unless a
PFRS requires or permits otherwise.
An entity shall disclose the amount of income tax relating to each component of other
comprehensive income, including reclassification adjustments, either in the statement of
comprehensive income or in the notes.
When items of income or expense are material, an entity shalldisclose their nature and amount
separately.
Circumstances that would give rise to the separate disclosure of items of income and expense
include:
(a) write-downs of inventories to net realizable value or of property, plant and equipment
to recoverable amount, as well as reversals of such write downs;
(b) restructurings of the activities of an entity and reversals of any provisions for the costs
of restructuring;
(c) disposals of items of property, plant and equipment;
(d) disposals of investments;
(e) discontinued operations;
(f) litigation settlements; and
(g) other reversals of provisions.
An entity shall present an analysis of expenses recognized in profit or loss using a classification
based on either their nature or their function within the entity, whichever provides information
that is reliable and more relevant.
(a) total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and to non-controlling interests;
(b) for each component of equity, the effects of retrospective application or retrospective
restatement recognized .in accordance With PAS 8; and
(c) [deleted]
(d) for each component of equity, a reconciliation between the carrying amount at the
beginning and the end of the period, separately disclosing changes resulting from:
An entity shall present, either in the statement of changes in equity or in the notes, the amount
of dividends recognized as distributions to owners during the period, and the related amount per
share.
Cash flow information provides users of financial statements with a basis to assess the ability of
the entity to generate cash and cash equivalents and the needs of the entity to utilize those cash
flows. PAS 7 sets out requirements for the presentation and disclosure of cash flow information.
Structure
(a) present information about the basis of preparation of the financial statements and the
specific accounting policies used in accordance with paragraphs 117-124;
(b) disclose the information required by PFRSs that is not presented elsewhere in the
financial statements; and
(c) provide information that is not presented elsewhere in the financial statements, but is
relevant to an understanding of any of them.
An entity shall, as far as practicable, present notes in a systematic manner. An entity shall
cross-reference each item in the statements of financial position and of comprehensive income,
in the separate income statement (if presented), and in the statements of changes in equity and
of cash flows to any related information in the notes.
Disclosure of Accounting Policies
(a) the measurement basis (or bases) used in preparing the financial statements; and
(b) the other accounting policies used that are relevant to an understanding of the financial
statements.
An entity shall disclose, in the summary of significant accounting policies or other notes, the
judgments, apart from those involving estimations (see paragraph 125), that management has
made in the process of applying the entity's accounting policies and that have the most
significant effect on the amounts recognized in the financial statements.
An entity shall disclose information about the assumptions it makes about the future, and other
major sources of estimation uncertainty at the end of the reporting period, that have a
significant adjustment to the carrying amounts of assets financial year. In respect of those assets
and liabilities, the notes shall include details of:
Capital
An entity shall disclose information that enables users of its financial statements to evaluate the
entity's objectives, policies and processes for managing capital.
Other Disclosures
(a) the domicile and legal form of the entity, its country of incorporation and the address of
its registered office (or principal place of business, if different from the registered
office);
(b) a description of the nature of the entity's operations and its principal activities; and
(c) the name of the parent and the ultimate parent of the group.
PAS 1 sets out the components of financial statements and minimum requirements for
disclosure in the statements of financial position, comprehensive income and changes in equity.
It also describes further items that may be presented either in the relevant financial statement or
in the notes. This guidance provides simple examples of ways in which the requirements of
PAS I for the presentation of the statements of financial position, comprehensive income and
changes in equity might be met. An entity should change the order of presentation, the titles of
the statements and the descriptions used for line items when necessary to suit its particular
circumstances.
The examples are not intended to illustrate all aspects of PFRSs, nor do they constitute a
complete set of financial statements, which would also include a statement of cash flows, a
summary of significant accounting policies and other explanatory information.
The illustrative statement of financial position shows one way in which an entity may present a
statement of financial position distinguishing between current and non-current items. Other
formats may be equally appropriate, provided the distinction is clear.
The illustrations use the term 'comprehensive income' to label the total of all components of
comprehensive income, •including profit or loss. The illustration use the term 'other
comprehensive income' to label income and expenses that are included in comprehensive
income but excluded from profit or loss. IAS I does not require an entity to use those terms in its
financial statements.
x (xxx) (xxx)
Currency re-translations,
translations, net of taxes
Fair value changes and recycling on debt instruments, net of x - (xxx)
taxes
Fair value changes and recycling on cash flow hedges, net of (xxx) xxx
taxes
Share of other comprehensive income of associates and joint x xxx (xxx)
ventures
Items that are or may be reclassified subsequently to the
income statement (xxx) (xxx)
Re-measurement
measurement of defined benefit plans, net of taxes x (xxx) xxx
Fair value changes on equity instruments, net of taxes x (xxx) xxx
Share of other comprehensive income of associates and joint x xxx xxx
ventures
Items that will never be reclassified to the income statement xxx xxx
attributable to non-controlling
controlling interests xxx xxx
attributable to shareholders of the parent xxx xxx
ATLAS GROUP OF COMPANIES
Consolidated Statement of Financial Position
As at December 31, 2020
(in millions of pesos)
Current assets
Cash and cash equivalents x xxx xxx
Short-term investments x xxx xxx
Inventories x xxx xxx
Trade and other receivables x xxx xxx
Prepayments and accrued income xxx xxx
Derivative assets x xxx xxx
Current income tax Assets xxx xxx
Assets held for sale x xxx xxx
Total current assets xxx xxx
Non-current assets
Property, plant and equipment x xxx xxx
Goodwill x xxx xxx
xxx xxx
Intangible assets x
Investments in associates and joint venture x xxx xxx
Financial Assets x xxx xxx
Employee benefits assets x xxx xxx
Current income tax assets xxx xxx
Deferred tax assets x xxx xxx
xxx xxx
Total assets
Current liabilities
Financial debt x xxx xxx
Trade and other payables x xxx xxx
xxx xxx
Accruals and deferred income
Provisions x xxx xxx
Derivative liabilities x xxx xxx
Current income tax liabilities xxx xxx
Liabilities directly associated with assets held for sale x xxx xxx
748
Total current liabilities xxx xxx
Non-current liabilities
Financial debt x xxx xxx
Employee benefits liabilities x xxx xxx
Provisions x xxx xxx
xxx xxx
Deferred tax liabilities x
Other payables x xxx xxx
Total non-current liabilities xxx xxx
Equity x
Share capital xxx xxx
Treasury shares (xxx) (xxx)
Translation reserves (xxx) (xxx)
Other reserves (xxx) (xxx)
Retained earnings xxx xxx
Total equity attributable to shareholders of the parent xxx xxx
Non-controlling interests xxx xxx
Total equity xxx xxx
749
ATLAS GROUP OF COMPANIES
Consolidated Cash Flow Statement
For the Year Ended December 31, 2020
(In millions of pesos)
Notes 2020 2019
Operating activities
Operating profit x xxx xxx
Depreciation and amortization x xxx xxx
Impairment xxx xxx
Net result on disposal of business x (xxx) (xxx)
Other non-cash items of income expense x (xxx) xxx
Cash flow before changes in operating assets and liabilities xxx xxx
Investing activities
Capital expenditure x (xxx) (xxx)
Expenditure on intangible Assets (xxx) (xxx)
Acquisition of businesses x (xxx) (xxx)
Disposal of businesses x xxx xxx
Investment (net of divestments) in associates and joint ventures x (xxx) xxx
Inflows (outflows) from treasury investments xxx (xxx)
Other investing activities xxx (xxx)
Investing cash flow xxx (xxx)
Financing activities
Dividend paid to shareholders of the parent (xxx) (xxx)
Dividends paid to non-controlling interests (xxx) (xxx)
Acquisition net of disposal of non-controlling interests x (xxx) (xxx)
Purchase (net of sale) of treasury shares (a) (xxx) (xxx)
Inflows from bonds and other non-current financial debt x xxx xxx
Outflows from bonds and other non-current financial debt x (xxx) (xxx)
Inflows (outflows) from current financial debt x (xxx) xxx
Financing cash flows (xxx) (xxx)
750
ATLAS GROUP OF COMPANIES
Consolidated Statement of Changes in Equity
For the Year Ended December 31, 2020
(In millions of pesos)
Total
Equity
Attributa
ble to
Sharehol
ders of Non-con
Share Treasury Translatio Other Retained the trolling Total
Capital Shares n Reserves Reserves Earnings Parent Interest Equity
xxx (xxx) (xxx) (xxx) xxx xxx xxx xxx
Equity as at January 1, 2019
Equity as at December 31, 2019 xxx (xxx) (xxx) (xxx) xxx xxx xxx xxx
Total transactions with owners (xxx) (xxx) - - (xxx) (xxx) (xxx) (xxx)
Equity as at December 31, 2020 xxx (xxx) (xxx) (xxx) xxx xxx xxx xxx
751
The Accompanying Notes to Financial Statements cover the following areas:
1. Corporate Information.
The condensed trial balance of Patrick Corporation for the year ended December 31, 20X7
follows:
Debit Credit
Total assets P7,082,500
Total liabilities P1,700,000
Ordinary shares 1,250,000
Additional paid-in capital 2,097,000
Donated capital 90,000
Retained earnings , 1/1/X7 1,650,000
Net sales 6,250,000
Cost of sales 3,750,000
Selling and administrative expenses 1,212,500
Interest expense 122,500
Gain on sale of long -term investments 130,000
Income tax expense 300,000
Loss on disposition of plant assets 225,000
Loss due to earthquake damage 475,000
P13,167,500 P13,167,500
Other financial data for the year ended December 31, 20X7:
Income tax
Estimated tax payments P200,000
Accrued 100,000
Total charged to income tax expense (does not properly reflect
current of deferred income tax expense or intraperiod income
tax allocation for income statement purposes. P300,000
The applicable tax rate on all types of taxable income for the
current and future years is 30%.
Temporary difference
Excess of book basis over tax basis in depreciable assets (arising
from equipment donated as a capital contribution on December 31,
and expected to be depreciated over five year beginning in 20X8.
There were no temporary differences prior to 20X7. P90,000
Nondeductible expenditure
Officers' life insurance expense P70,000
Earthquake damage
This damage is considered unusual and infrequent. P70,000
Capital Structure
Ordinary shares, par value P5 per share, traded on a national
exchange: Number of shares
Required: Prepare a formal Statement of Profit or Loss and Comprehensive Income for Patrick
for the year ended December 31, 20X7.
753
Solution: Illustrative Audit Case 24
24-1
PATRICK CORPORATION
Statement Of Profit or Loss and Comprehensive Income
For Year Ended December 31, 20X7
Income tax
Current 199,500
Deferred 27,000 [1] (226,500)
Net income P 368,500
Explanation of Amounts:
[1] Deferred income tax for 20X7 Excess of book
basis over tax basis in depreciable assets (Expected to
reverse equally over next 5 years) P90,000
The December 31, 20X0 audited account balances of the Jaycee Company are shown below:
Ordinary shares, P10 par P 300,000
Cash 29,000
Buildings 1,440,000
Bonds payable (due 20X9) 770,000
Allowance for doubtful accounts 8,000
Additional paid-in capital on preference shares 115,000
Additional paid-in capital on ordinary shares 240,000
Accumulated depreciation: equipment 351,000
Accumulated depreciation: buildings 530,000
Accounts receivable 215,000
Accounts payable 224,000
Unrealized increase in value of securities @FVOCI 11,000
Trademarks (net) 37,000
Salaries payable 20,000
Retained earnings 462,000
Preference shares, P100 par 210,000
Patents (net) 98,000
Securities @FVOCI (short-term) 61,000
Land 300,000
Equipment 724,000
Inventory 372,000
Discount on bonds payable 54,000
Current taxes payable 89,000
Required:
Prepare the December 31, 20X0 Statement of Financial Position of the Jaycee Company.
755
Solution: Illustrative Audit Case 24
24-2
JAYCEE COMPANY
Statement of Financial Position
December 31 20X7
Assets
Current assets:
Cash P 29,000
Securities @FVOCI (short-term) 61,000
Accounts receivable P 215,000
Less: Allowance for doubtful accounts (8,000) 207,000
Inventory 372,000
Total current assets P 669,000
Property , plant and equipment:
Land 300,000
Buildings P1,440,000
Less: Accumulated depreciation (530,000) 910,000
Equipment 724,000
Less: Accumulated depreciation (351,000) 373,000
Total property , plant and equipment 1,583,000
Intangible assets:
Patents (net) P 98,000
Trademarks (net) 37,000
Total intangible assets 135,000
Total assets P2,387,000
Liabilities
Current liabilities:
Accounts payable P 224,000
Current taxes payable 89,000
Salaries payable 20,000
Total current liabilities P 333,000
Long-term liabilities:
Bonds payable (due 20X4) P 770,000
Less: Discount on bonds payable (54,000)
Total long-term liabilities 716,000
Total liabilities P1,049,000
Equity
Contributed capital
Preference shares, P100 par P 210,000
Ordinary shares, P10 par 300,000
Additional paid-inin capital on preferences shares 115,000
Additional paid-inin capital on ordinary shares 240,000
Total contributed capital P 865,000
Retained earnings 462,000
Accumulated other comprehensive income Unrealized increase
in value of securities @FVOCI 11,000
Total shareholders' equity P1,338,000
Total liabilities and shareholders' equity P2,387,000
Illustrative Audit Case 24-3: Worksheet for Statement of Cash Flows
The following information is available for the Josie Company:
Account Balances (in P000's)
December 31, 20X1 December 31, 20x2
Debits
Cash P 1,800 P 2,200
Accounts receivable 4,600 4,720
Notes receivable (short-term) 0 1,000
Inventories 12,000 9,700
Prepaid items 1,700 1,380
Land 11,000 17,100
Buildings and equipment 78,000 110,000
Goodwill 4,400 4,000
Treasury shares (ordinary shares, at cost,
P25 per share) 2,500 1,000
Totals P 116,000 P 151,100
Credits
Accumulated depreciation P 24,000 P 31,800
Accounts payable 6,000 8,210
Salaries payable 2,600 3,500
Miscellaneous current payables 1,400 1,200
Interest payable 0 140
12% bonds payable 0 7,000
Premium on bonds payable 0 650
Convertible preference shares, P50 par 9,000 6,500
Premium on preference shares 3,000 2,500
Ordinary shares, P10 par 18,000 23,500
Premium on ordinary shares 28,800 40,850
Retained earnings 23,200 25,250
Totals P 116,000 P 151,100
757
Additional information for the year:
P23,200
(a) Beginning retained earnings, unadjusted
Less: Prior period adjustment - correction of
(1,300)
understatement of depreciation (net of income taxes)
P21,900
Adjusted beginning retained earnings
12,000
Add: Net income
P33,900
P(4,000)
Less: Cash dividends
(4,650) (8,650)
Share dividends (150 shares at P31 per share)
P25,250
Ending retained earnings
(b) Last year depreciation expense was inadvertently understated in the amount of
P1,800. The correction was made this year to Accumulated Depreciation and to Retained
Earnings as a prior period adjustment. The company also received a related income tax
refund of P500.
(c) Sixty treasury shares (ordinary) were reissued at P30 per share.
(d) Bonds payable with a face amount of P7,000 were issued for P7,750 on May 1, 20x2.
The bonds mature on May 1, 20X7, and pay interest semiannually. The straight-line
method is used to amortize the bond premium. Interest expense totaled P460 for 20x2.
(e) Fifty preference shares (originally issued at P60 per share) were converted into 100
ordinary shares.
(f) Land costing P2,900 was sold for P3,800.
(g) Three hundred ordinary shares were sold for P32 per share.
(h) Equipment costing P32,000 was purchased during the year.
(i) Land was acquired at a cost of P9,000 during the year.
(j) Depreciation expense was P6,000.
(k) Impairment of goodwill was P400.
(l) The company loaned money to one of its executives and received a P1,000 short-term
note receivable on December 31, 20X2. The note matures 90 days from the date of
issuance.
758
Required:
Requirement (1)
JOSIE COMPANY
Worksheet for Statement of Cash Flows
For Year Ended December 31 f 20X2
Credits
Accumulated depreciation 24,000 31,800 7,800 (b)6,000
(l-1)1,800
Accounts payable 6,000 8,210 2,210 (h)2,210
Salaries payable 2,600 3,500 900 (i) 900
Miscellaneous current payables 1,400 1,200 200 (j)200
Interest payable - 140 140 (k)140
12% bonds payable - 7,000 7,000 (n)7,000
Premium on bonds payable - 650 650 (v)100 (n) 750
Convertible preference shares, P50 par 9,000 6,500 2,500 (o-2)2,500
Premium on preference shares 3,000 2,500 500 (o-2) 500
Ordinary shares, P10 par 18,000 23,500 5,500 (o-1)1,000
(q)3,000
(u)1,500
Premium on ordinary shares 28,800 40,850 12,050 (m) 300
(o-1)2,000
(q)6,600
(u)3,150
Retained earnings 4 23,200 25,250 2,050 (l-1)1,800 (a)12,000
(t)4,000 (l-1) 500
(u)4,650
Totals 116,000 151,100 56,270 56,270
759
JOSIE COMPANY
Worksheet for Statement of Cash Flows
For Year Ended December 31, 20X2
Worksheet Entries
Debit Credit
Net cash Flow from Operating Activities
Net income (a)12,000
Add: Depreciation expense (b) 6,000
Impairment of goodwill (c) 400
Decrease in inventories (f)2,300
Decrease in prepaid items (g) 320
Increase in accounts payable (h)2,210
Increase in salaries payable (i) 900
Increase in interest payable (k)140
Income tax refund 1 (l-2)500
Less: Increase in accounts receivable (d) 120
Decrease in miscellaneous current payables (j)200
Gain on sale of land (p) 900
Amortization of bonds premium (v)100
760
Requirement (2)
JOSIE COMPANY
Statement of Cash Flows
For Year Ended December 31, 20X2
761
Illustrative Audit Case 24-4: Changes in Shareholders' Equity
On January 1, 20X7, the Francisco Company listed the following shareholders' equity section
of its statement of financial position:
Contributed capital P92,800
Preference shares, P 100 par 37,400
Ordinary shares, P5 par 21 ,500
Additional paid-in capital on preferences shares 58,700
Total contributed capital P210,400
Retained earnings 185,700
Total shareholders' equity P396 100
During 20X7 the following transactions and events occurred and were properly recorded:
Required: Prepare a statement of changes in shareholders' equity of the Francisco Company for
20X7. (Include retained earnings).
Problem 1
You have been assigned to examine the financial statements of International Company for the
year ended December 311 20X7. You discover the following situations:
5. In 20X7, the company sold for P3,700 fully depreciated equipment that originally cost
P22,000. The company credited the proceeds from the sale to the Equipment account.
6. During November 20X7, a competitor company filed a patent infringement suit against
International claiming damages of P220,000. The company's legal counsel has
indicated that an unfavorable verdict is probable and a reasonable estimate of the
court's award to the competitor is P125,000. The company has not reflected or
disclosed this situation in the financial statements.
7. International has a portfolio of trading securities. No entry has been made to adjust the
market. Information on cost and market value is as follows:
Cost Market
December 31, 20X6 P95,000 P95,000
December 31, 20x7 P84,000 P82,000
763
8. At December 31, 20X7, an analysis of payroll information, shows accrued salaries of
P12,200. The Accrued Salaries Payable account had a balance of P16,000 at December
31, 20X7 which was unchanged from its balance at December 31, 20X6.
9. A large piece of equipment was purchased on January 3, 20X7, for P32,000 and was
charged to Repairs Expense. The equipment estimated to have a service life of 8 years
and no residual value. International normally uses the straight-line depreciation method
for this type of equipment.
10. A P15,000 insurance premium paid on July l, 20X6, for a policy that expires on June 30,
20X9, was charged to insurance expense.
11. A trademark was acquired at the beginning of 20X6 for P50,000. No amortization has
been recorded since its acquisition. The trademark is deemed to have indefinite life.
Required:
Assume the trial balance has been prepared but the books have not been closed for 20X7.
Assuming all amounts are material, prepare journal entries showing the adjustments that are
required. Ignore income tax considerations.
Problem 2
Part 1
During the course of your examination of the 20X8 financial statements of Tally Company, the
following data were discovered. Give any correcting and adjusting entries called for by the
information given. Disregard any effects on income tax. Write your answers on the space
provided.
Adjusting Journal Entries,
12-31-20x8
1.Office equipment, purchased January 2, 20x7 at a cost of P22,000, having
estimated salvage value of P2,000 and an estimated life of five years, now is
reestimated to have a total life of 10 years from January 2, 20x5; the
estimated salvage value remains unchanged. The straight-line method of
depreciation is used.
2. Interest deducted in advance on notes payable amounts to P5,000. The
Interest Expense account has a debit of balance of P7,500. The company
failed to record interest deducted in advance at the end of 20X6, P3,000; and
at the end of 20x7, P3,100. All original entries were made to the Interest
Expense account.
3. Merchandise in transit, December 31, 20x8, F.O.B. shipping point, of
P15,000 was not included in the inventory as of December 31, 20X8, but
was entered in the purchases account in 20X8.
764
4. Merchandise costing P6,000 was included in the inventory as of
December 31, 20X7, but was not entered in the purchases account until
January 10, 20X8
5. On July 1, 2018, a three-year insurance policy was purchased for P3,600.
Prepaid expenses did not appear on the December 31, 20X8 statement of
financial position.
6. Store supplies inventories had been overlooked in adjusting the accounts
in previous years. Store supplies on hand were: 20X6, P450; 20X7, P900.
Store supplies on hand at the end of 20X8 are P1,450.
7. Accrued sales commissions due the salesmen had been overlooked in
adjusting the accounts at the end of 20X6 and 20X7. Accrued amounts were:
20X6, P675; 2017, P730. Accrued commissions at the end of 20x7 are P970.
8. Checks totaling P650 issued to former employees in are still outstanding.
Present whereabouts of such employees are unknown, and it is doubtful
whether the checks will be presented for payments.
9. Merchandise costing P800, received on December 31, 20X8, had been
included in the physical inventory taken on that date; however, the purchase
was recorded when the invoice was received on January 4, 20x9
10. In March 20X8, the company received a 25% ordinary share dividend on
100 shares of Brooks, Inc., ordinary shares acquired in 20X6 at P150. The
shares received as share dividend were sold for cash in April, 20X8, at P170
each and a revenue account credited for the full proceeds
11. The account "Advertising and Promotions" included an amount of
P90,000 which represented the cost of printing sales catalogues for a special
promotional campaign in December 20X9.
12. A check for P6,000 representing the repayment of an employee advance
was received on November 30, 20x8, but was not recorded until December
2, 20X8.
13. On December 1, 20x8 the company purchased for P205,000 a new
machine for its main factory. The machine is being depreciated on the
straight-line method over an estimated useful life of 10 years. When the new
machine was installed, the company paid for the following items which
were not included in the cost of the machine, but were charged to "Repairs
and Maintenance";
765
Delivery expense P 1,500
Installation cost 12,000
Rearrangement of related equipment 6,500
P20,000
14. On May 3, 20X8, Tally exchanged 500 treasury shares (P50.00 par value
ordinary shares) for a parcel of land to be used as a site for a new factory.
The treasury shares had cost P70.00 per share when it was acquired and on
May 3, 20X8, it had a fair market value of P80.00 per share. Tally received
P2,000.00 when an existing building on the land was sold for scrap. The
land was capitalized at P40,000.00, and Tally recorded a gain of P5,000.00
on the sale of its treasury shares.
You found the following journal entries in the books:
Land P40,000
Treasury shares P35,000
Gain on sale of treasury shares P 5,000
Cash P 2,000
Miscellaneous or Scrap income P 2,000
15. Tally uses the allowance account for uncollectible trade accounts
receivable. The allowance is based upon 3% of past due accounts (over 120
days) and 1% of current accounts as of the close of each month. Due to
changing economic conditions and climate, the amount of past due accounts
has increased significantly, and management has decided to increase the
percentage based on past due accounts to 5%. The following balances are
available:
As of
November 30, 20X8
Debit Credit
Accounts Receivable P390,000
Past due accounts
(included in Accounts Receivable) 12,000
Allowance for uncollectible accounts P28,000
As of
December 31, 20X8
Debit Credit
Accounts Receivable P430,000
Past due accounts
(included in Accounts Receivable ) 30,000
Allowance for uncollectible accounts 9,000
766
Part II
Below, in Column A, are the names of the debits and credits for several adjustments an auditor
found it necessary to make to the trial balance submitted to him by a company on December 31,
20X7. The company was instructed to record these adjustments on its books, but failed to do so.
In column B indicate the entries necessary to adjust the trial balance Submitted to the auditor on
December 31, 20X8 because of the company's failure to make the adjustments on its books.
Amounts have been omitted. If you think no adjustment is necessary, write "none" in the space
provided.
767
Problem 3
Selected preadjustment account balances and adjusting information of Sunshine Cosmetics Inc.
for the year ended December 31, 20X7, are as follows:
768
Adjusting Information:
a) Cost of inventory in the possession of consignees as of December 31, 20X7, P67,200
was not included in the ending inventory balance
b) After preparing an analysis of aged accounts receivable, a decision was made 3%
to increase the allowance for doubtful accounts to a percentage of the ending
accounts receivable balance
c) Purchase return and allowances were unrecorded. They are computed as a 6%
percentage of purchases (not including freight-in)
d) Sales commissions for the last day of the year had not been accrued. Total
sales for the day P7,200
Average sales commissions as a percent of sales 3%
e) No accrual had been made for a freight bill received on January 3, 20X8, for P1,600
goods received on December 29, 20X7
f) An advertising campaign was initiated November 1, 20X7. This amount was P3,636
recorded as "prepaid advertising" and should be amortized over a six-month
period. No amortization was recorded
g) Freight charges paid on sold merchandise and not passed on to the buyer were 8,400
netted against sales. Freight charges on sales during 20x7
h) Interest earned but not accrued P1,380
i) Depreciation expense on a new forklift purchased March 1, 20X7, had not
been recognized. (Assume all equipment will have no salvage value and the
straight-line method is used. Depreciation is calculated to the nearest month.)
Purchase price P15,600
Estimated life in years 10
j) A "real" account is debited upon the receipt of supplies. Supplies on hand at P3,200
year-end
k) Income taxes rate (on all items) 32%
Required:
769
Problem 4: Preparation of Audit Adjustments and Net Income Determinations
Daffodil, Inc., a new client, prepared the trial balance set forth below, as of December 31, 20X8,
the close of its second year of operations. You were engaged to examine the records and the
examination resulted in the necessity of applying the entries required in the additional data.
DAFFODIL, INC.,
Trial Balance
December 31, 20X8
Cash P 64,000
Accounts receivable 200,000
Provision for doubtful accounts P 1,000
Inventories, Dec. 31, 20x7 223,000
Unexpired insurance, Dec. 31, 20X7 6,000
Land 220,000
Buildings 330,000
Accumulated depreciation, buildings 6,600
Machinery 148,000
Accumulated depreciation, machinery 15,000
Sinking fund assets 25,000
Unamortized bond discount 25,000
Treasury shares, ordinary 35,000
Accounts payable 88,000
Bond interest accrued 3,750
First mortgage, 6% sinking fund bonds 226,500
Ordinary share capital 500,000
Premium on ordinary shares 50,000
Share donation 60,000
Retained earnings, Dec. 31, 20X7 74,150
Sales 875,000
Purchases 283,500
Payroll 169,000
Factory operating expenses 121,500
Administrative expenses 35,000
Bond interest 15,000
Totals P1,900,000 P1,900,000
770
Additional data:
1. The P500,000 of ordinary shares had been issued at a 10% premium to the vendors of
the land and buildings on January 2, 20X7, the date of organization. Shares of a par
value of P60,000 was donated by the vendors and was recorded by a debit of P60,000 to
Treasury Shares and a credit to Share Donation. It was donated because the proceeds
from its subsequent sale were to be considered as an allowance on the purchase price of
land and buildings in proportion to their values as first recorded. The treasury shares
were sold in 20X8 for P25,000, which amount was credited to the Treasury Shares
account.
2. On December 31, 20X8, a machine costing P5,000 when the business started was
removed. The removed machine had been depreciated at 10% during the first year. The
only entry made was crediting the Machinery account with its sales price of P2,000.
3. Depreciation is to be provided on the straight-line basis, as follows: buildings, 2% of
cost; and machinery, 10% of cost. Ignore salvage value.
4. Inventories at December 31, 20X8, were P175,000.
5. The provision for doubtful accounts is to be adjusted to 1% of the accounts receivable
balance as of December 3 1, 20X8.
6. Three years' insurance is carried on buildings and machinery; and a premium of P9,000
had been paid on January 2, 20x7.
7. The first-mortgage, 6% sinking fund bonds of a par value of P250,000 mature in 10
years from January 1, 20X7 with interest payable on April 1 and October 1. They were
sold on January 1, 20X7 at 90; the discount is to be amortized over the life of the bonds
on a straight-line basis.
8. Sinking fund is built up on the straight-line basis, with a provision that installments
after the first shall be decreased by the amount of the annual 6%, interest, which
interest is to be added to the fund. The records disclose that the proper installment to
the sinking fund was paid by the company on December 31, 20X8, but that the amount
was/ charged in error to the First-Mortgage, 6% Sinking Bonds account. 9.
9. The sinking fund trustee reports that he added P1,500 interest to the fund on December
31 , 20X8. This has not been recorded by the company.
Required:
Prepare the audit adjustments and an eight-column worksheet, setting forth the net income or
loss for the year ended December 31, 20X8. (Ignore income taxes).
771
Problem 5
You have been engaged to audit MASIPAG CORPORATION, a new client, for the year ended
December 31, 20X8. The company prepared the trial balance set forth below, as of December
31, 20X8, the close of its second year of operations.
Unadjusted Trial Balance
Debit Credit
Cash P 874,000
Marketable securities — Trading 382,000
Accounts receivable 1,040,000
Allowance for doubtful accounts P 11,250
Notes receivable 600,000
Discount on notes receivable -
Accounts receivable — others -
Inventory, December 31, 20X8 1,551,500
Prepaid expenses 369,000
Long -term bond investment 738,300
Land and building 4,512,500
Accumulated depreciation - Building -
Equipment 1,674,000
Accumulated depreciation -Equipment 180,000
Other assets 50,000
Accounts payable 642,000
Bank loan payable 1,500,000
Accrued expenses payable 59,000
Other current liabilities 50,000
Income taxes payable 197,800
Estimated warranties 55,000
Ordinary share capital 5,000,000
Additional paid-in capital 1,655,250
Retained earnings, December 31, 20x7 1,593,220
Sales 6,950,000
Cost of sales 4,400,000
Operating expenses 1,302,537
Other income 85,000
Other expenses 75,000
Provision for income tax 409,683
P17,978,520 P17,978,520
772
During the course of your audit, you obtained additional information relative to the accounts in
the trial balance, as follows:
CASH
1) In the audit of Cash, you found out that on December 28, 20X8, Masipag recorded and
wrote check payments to merchandise suppliers amounting to P500,000. A number of
checks amounting to P200,000 were mailed on January 5, 20X9.
2) On December 29, 20X8, a customer's check for P 10,000 was returned by the bank and
marked "DAUD" (drawn against uncleared deposit). Corresponding entry was made by
the client on January 3, 20X9.
3) Verification of the other reconciling items in the bank reconciliation statement as of
December 31, 20X8 yielded the following findings:
a) A bank debit memo dated December 15, 20X8 for P412,500 representing payment
of a six-month loan inclusive of interest of P12,500.
b) Several bank deposits directly made by the customer in December, 20x8 totaling
P75,000.
c) Bank charges for December, 20X8 amounting to P1,500.
d) Interest income on various savings account deposits, net of 20% withholding tax,
P16,000.
e) Undeposited collections from customers P35,000 received by the bank on January
2, 20X9.
4) Included in the cash account is petty cash fund of P10,000. Among the fund items
found during the January 2, 20X9 count were:
773
MARKETABLE SECURITIES - TRADING
5) Analysis of the Marketable Securities revealed the recording of the following
transactions
20X8 Debit Credit
Purchased 20,000 shares of Electro
January 15
Company P500,000
July 15 Received cash dividend P40,000
Received 2,000 shares dividend, market
September 30
value per share was P27 (Note 1) 54,000
November 30 Sold 4,400 shares for P30 per share 132,000
554,000 172,000
December 31 Balance 382,000
554,000 554,000
ACCOUNTS RECEIVABLE
6) Analysis of accounting records revealed that all receivables are being recorded in a
single account — Accounts Receivable. The entries to this account are summarized
below:
Debits
January 1 Balance after deducting credit balance of P20,000 P 530,000
Charges sales 6,505,900
Charge for goods out on consignment (Note 1) 750,000
Refund to customers for January 1 credit balance 20,000
Claim against common carrier for shipping damages 30,000
IOUs from employees 5,000
Advances to suppliers 50,000
7,890,900
Credits
Collections from customers, including overpayment of P50,000 6,500,000
Write offs 30,000
Merchandise returns and allowances 55,900
Collections from consignees 250,000
Collections on carrier claims 15,000
6,850,900
December 31, 20X8 1,040,000
7,890,900
774
Note 1 Goods delivered to consignees were marked up at 25% of cost. Unsold goods in the
possession Of the consignees as of December 31, 20X8 costing P400,000 were not included in
the ending inventory.
NOTES RECEIVABLE
7) On December 1, 20X8, Masipag sold land in exchange for a P600,000 non-interest, 1
year promissory note. The 10% interest rate was the going market rate for similar notes.
Masipag had paid P220,000 to acquire the land in 2014. The accountant made the
following entry relative to this transaction:
Notes receivable 600,000
Land 220,000
Other income — gain 380,000
INVENTORIES
8) You observed the physical inventory of goods in the warehouse on December 31, 20X8
and were satisfied that it was properly taken. You found out that at December 3 1, 20X8
the last receiving report (RR) used was 1063 and that no shipment had been made on
any sales invoices (SI) with numbers larger than no. 968. Inventory on December 31,
20X8 per client's list amounted to P1,551,500. You also obtained the following
additional information:
a) Included in the physical inventory were goods which had been purchased and
received on RR no. 1060 but for which an invoice was not received until 20X9. The
cost was P60,000.
b) A truckload of goods costing P25,000 en route to Masipag Company on December
31, 20X8 was received on receiving report no. 1064. The material was shipped
FOB shipping point.
c) Goods exposed to rain while in transit and deemed unsalable were included in the
physical inventory. Their invoice cost was P12,500 and freight charge of P3,500
had been paid on the goods and included in inventory. Claim has already been filed
with the insurance company.
775
d) Sales invoices nos. 969 and 970 for P13,000 dated December 31, 20X8 were
recorded in the sales book on the same date.
PREPAID EXPENSES
Note 1 In 20X8, Masipag purchased two insurance policies covering a period of one year
from the date the policy premium was paid for. Details follow:
Note 2 Inventory of supplies as of December 31, 20X8 revealed that P4,000 were still
unused at year-end.
Note 3 Masipag renewed the lease contract for 3 years with Realtors, Inc. subject to
renewal every three years with a priority right to buy the property if the owner decides to
sell it later on. The company paid a deposit equivalent to three months rental and advance
rental for a year. The lease contract states a monthly rental of P20,000 and became
effective July 1, 20X8.
10) On June 1, 20X8, Masipag purchased as a long-term investment 800 of the P1,000 face
value, 8% bonds of Universal Corporation for P738,300. The bonds were purchased to
yield 10% interest. Interest is payable semiannually on December 1 and June 1. The
bonds mature after 5 years. Masipag uses the effective interest method of amortization.
The only other entry made by the company relative to this investment was for the
receipt of interest of P32,000 on December 1, 20X8.
776
LAND AND BUILDING
11) Masipag recently acquired a building and the surrounding land. The company's
accountant established a single Land and Building account and has made the following
entries:
Land and Building
20x8 account
January 3 Acquisition price P4,250,000
January 3 Prepayment of insurance on building (2years) 55,000
March 7 Renovation costs on building 425,000
April 1 Entertainment cost to familiarize the public with new
facility opened that day 20,000
P4,750,000
December Depreciation for 20x8, computed by straight-line
31 method with 20- year life 237,500
Balance P4,512,500
Additional findings:
a) Upon acquisition, the land was independently appraised at P 1,150,000 and the
building at P3,450,000.
b) Company computes depreciation using the straight-line method.
c) The building is expected to have a residual value of 10% of its cost basis at the end of
its 20-year life. The building was placed in service on April 1, 20x8
EQUIPMENT
12) Masipag Company acquired a used delivery truck for P 543,500 on July 1, 20X8. The
following expenditures were made upon acquisition and debited likewise to Equipment
account:
New tires P40,500
Body repair and paint 44,500
Installation of special shelves 25,500
One-year insurance premium 20,000
Management expected the truck to be of service for four years and to be driven a total of
80,000 kilometers. Expected salvage value is P100,000. Depreciation has not been
provided on this truck and will be computed using service quantity-kilometers. The truck
was driven 8,000 kilometers
777
ACCOUNTS PAYABLE
13) Accounts payable account includes deposits from customers amounting to P50,000.
ESTIMATED WARRANTIES
14) Masipag has a one-year product warranty on selected items. The estimated warranty
liability on sales made during 20X7 and still outstanding as of December 31, 20X7
amounted to P55,000. The warranty costs on sales made in 20X8 are estimated at P
145,000. The actual warranty costs incurred during 20X8 are as follows:
Upon payment of the above, the bookkeeper debited P130,000 to warranty expense.
OTHER EXPENSES
15) During December 20X8 a competitor company filed a suit against Masipag claiming P
100,000 in damages. Masipag's legal counsel believes that an unfavorable outcome is
very remote. Masipag however wanted to be conservative and decided to set up the loss
and estimated liability of P50,000. This was included in the other current liabilities
account.
16) The 33% effective tax was determined to be appropriate for calculating the provision
for income taxes for the year ended December 31, 20X8. Ignore computation of
deferred portion of income taxes.
Required:
Prepare audited statement of financial position and statement of profit or loss and
comprehensive income as of December 31, 20X8.
778
Problem 6
You have been appointed to audit the financial statements of FELICITY COMPANY for the
year ended December 31, 20X8.
779
The following are your findings:
1. Audit of Cash
a. The company's loan for P36,000 was approved by the bank on December 31, 20X8.
The loan will be paid in six-equal quarterly payments. The bank erroneously credited
the proceeds of this loan to another borrower's account. This did not appear as one of
the reconciling items in the company's bank reconciliation as at December 31, 20X8.
Principal P36,000
Bank charges (2,000)
Interest (3,000)
P31,000
b. One of the checks returned on January 15, 20X9, dated December 31, 20X8 for
P2,000, for a 20X8 operating expense, was actually not written until January 3, 20X9.
This check appeared as one of the outstanding checks in the company's bank
reconciliation as at December 31, 20X8.
780
4. Audit of Inventories
A reconciliation between physical count and the balance of the company's share card
which ties up already with the balance of the inventories company's general ledger is as
follows:
The company depreciated its building for the year 20X8 equal to 10% of the appraised
value. Based on the report of the appraiser, the remaining life of the building is 5 years.
8. Other Findings
Two checks verified to have been recorded in 20X8 cash disbursements book
amounting to P22,000 appearing in the January 20X9 cut-off bank statement are not
traceable to the outstanding checks of the December 31, 20X8 bank reconciliation
prepared by the company's personnel.
781
Required:
Based on the above data, prepare the audited statement of financial position and
statement of profit or loss and comprehensive income as of December 31, 20X8.
Problem 7
You have been asked by a client to review the records of Mabolo Company, a small
manufacturer of precision tools and machines. Your client is interested in buying the
busying the business, and arrangements have been made for you to review the
accounting records. Your examination reveals the following:
1. Mabolo Company commenced business on April 1, 20X4, and has been reporting
on a fiscal year ending March 31 . The company has never been audited, but the
annual statements prepared by the bookkeeper reflect the following income before
closing and before deducting income taxes.
Year Ended Income
March 31 Before Taxes
20x5 P71,600
20x6 111,400
20X7 103,580
20x5 P6,500
20x6 none
20X7 5,590
Sales price was determined by adding 30% to cost. Assume that the consigned
machines are sold the following year.
3. On March 30, 20X6, two machines were shipped to a customer on C.O.D. basis.
The sale was not entered until April 15, 20X6, when cash was received for P6,100.
The machines were not included in the inventory at March 31 , 20X6. (Title passed
on March 30, 20x4).
782
4. All machines are sold subject to a 5-year warranty. It is estimated that the expense
ultimately to be incurred in connection with the warranty will amount to 1/2 Of 1%
Of sales. The company has charged an expense account for warranty costs
incurred.
5. A review of the corporate minutes reveals the manager is entitled to a bonus of 1/2
of 1% of the income before deducting income taxes and the bonus. The bonuses
have never been recorded or paid.
6. Bad debts have been recorded on a direct write-offs basis. Experience of similar
enterprises indicates that losses will approximately 1/4 of 1% of sales. Bad debts
written off were:
7. The bank deducts 6% on all contracts financed. Of this amount, 1/2 % is placed in
a reserve to the credit of Mabolo Company that is refunded to Mabolo as finance
contracts are paid in full. The reserve established by the bank has not been reflected
in the books of Mabolo. The excess of credits over debits (net increase to the
reserve account with Mabolo on the books of the bank for each fiscal year) were as
follows:
20X5 P3,000
20X6 3,900
20X7 5,100
P12,000
783
8. Commissions on sales have been entered when paid. Commission payable on
March 31 of each year were as follows:
20X5 P1,400
20X6 800
20X7 1,120
After considering the effect of errors discussed from Item 2 to Item 8, answer the
following questions.
Questions:
2. What is the net adjustment to the 20X6 net income before taxes?
a. P6,826 increase
b. P6,826 decrease
c. P7,420 decrease
d. P7,420 increase
3. What is the net adjustment to the 20X7 net income before taxes?
a. P8,760 decrease
b. P8,285 decrease
c. P8,761 increase
d. P8,285 increase
784
Problem 8
The following income statement items appeared on the adjusted trial balance of Saturn
Manufacturing Corporation for the year ended December 31, 20X7 (P in 000's): sales revenue,
P15,300; cost of goods sold, P6,200; selling expenses, P1,300; general and administrative
expenses, P800; interest revenue, P85; interest expense, P180. Income taxes have not yet been
accrued. The company's income tax is 40% on all items of income or loss. These revenue and
expense items appear in the company's income or loss. These revenue and expense items appear
in the company's income statement every year. The company's controller, however, has asked
for your help in determining the appropriate treatment of the following nonrecurring
transactions that also occurred during 20X7 (P in 000's). All transactions are material in
amount.
Investments were sold during the year at a loss P220. Saturn also had unrealized gains of P320
for the year on investments accounted for as securities available for sale.
One of the company's factories was closed during the year. Restructuring costs incurred were
P1,200.
During the year, Saturn completed the sale of one of its operating divisions that qualifies as a
component of the entity. The division has incurred an operating loss of P560 in 20X7 prior to
the sale, and its assets were sold at a gain of P1,400.
In 20X7, the company's accountant discovered that depreciation expense in 20X6 for the office
building was understated by P200.
Questions:
1. The income from continuing operation after tax for the year amounted to
a. P2,091.
b. P3,485.
c. P2,085.
d. P2,991.
785
2. The income (loss) from discontinued operation net of tax expense is
a. P840.
b. P480.
c. P405.
d. P504.
4. Other comprehensive income (loss) net of tax for the year amounted to
a. P48.
b. P192.
c. P(48).
d. P(192).
Problem 9
The following accounts and balances pertain to Zirkle Corporation on December 31,
20X0.
Accounts payable P 38,300
Accounts receivable 43,900
Accumulated depletion 165,300
Accumulated depreciation 70,000
Paid-in capital in excess of par 369,000
Advances from customers (advances pertain to goods that Zirkle Corporation will supply in 20X1) 4,500
Advances to suppliers (advances pertain to goods that suppliers will provide in 20X1) 7,100
Allowance for doubtful accounts 2,600
Appropriation for plant expansion 58,500
Bond issue costs 21,300
786
Bond sinking fund 190,700
Building 210,000
Cash 21,100
Ordinary shares (P1 par, 50,000 shares authorized, 40,000 shares issued and outstanding) 40,000
Franchise 32,400
Interest payable 3,000
Investment in bonds -long-term (at amortized cost; market value P72,000 ) 65,000
Land 99,500
Land held for future plant site 138,000
Instructions:
Prepare a balance sheet in good form.
787
Problem 10
You have been appointed as auditor of Makulay Corporation, an SME. Presented below is the
balance sheet of Makulay Corporation as of December 31, 20X7.
Makulay Corporation
Balance Sheet
December 31, 20X7
Assets
Goodwill (Note 2) P 1,200,000
Buildings (Note 1) 16,400,000
Inventories 3,121,000
Land 7,500,000
Accounts receivable 1,700,000
Treasury shares (50,000 shares) 870,000
Cash on hand 1,759,000
Assets located to trustee for plant expansion
Cash in bank 700,000
BSP Treasury notes, at cost and fair value 1,380,000
P34,630,000
Equities
Notes payable (Note 3) P 6,000,000
Share capital - Ordinary; authorized and issued, 1,000,000 shares, no par 11,500,000
Retained earnings 6,580,000
Appreciation capital (Note 1) 5,700,000
Income taxes payable 750,000
Reserve for depreciation recorded to date on the building 4,100,000
P34,630,000
Note 1: Buildings are stated at revalued amount. The excess of revalued amount over cost
was P 5,700,000. Depreciation has been recorded based on revalued amount.
Note 2: Goodwill in the amount of P1,200,000 was recognized because the company
believed that book value was not an accurate representation of the fair market value of the
company. The gain of P1,200,000 was credited to Retained Earnings.
788
Note 3: Notes payable are long-term except for the current installment due to P1,000,000.
Questions:
1. The audited total current assets as of December 31, 20X7 would amount to
a. P6,580,000.
b. P6,850,000.
c. P8,660,000.
d. P6,880,000.
2. The net carrying value of property, plant and equipment would amount to
a. P19,800,000.
b. P14,100,000.
c. P18,900,000.
d. P19,900,000.
789
Problem 11
The following is a June 30, 20X7, post-closing trial balance for East Company, as SME:
Additional Information:
3. The notes payable account consists of two notes of P500,000 each. One note is due on
September 30, 20X7, and the other is due on November 30, 20X8.
790
4. The mortgage payable is payable in semiannual installments of P50,000 each plus
interest. The next payment is due on October 31, 20X7. Interest has been properly
accrued and is included in accrued expenses.
5. Five hundred thousand shares of no par ordinary shares are authorized, of which
200,000 share have been issued and are outstanding.
6. The land account include P50,000 representing the cost of the land on which the
company's office building resides the remaining P250,000 is the cost of land that the
company is holding for investment purposes.
Questions
791
APPENDIX A
Audited Financial Statements of
Selected Companies in the
Philippines
792
Sample 2019 and 2018
Audited Financial Statements
Philex Mining Corporation
Manila Electric Company and Subsidiaries (Meralco)
Puregold Price Club, Inc. and Subsidiaries (Puregold)
1. Corporate Information.
793
INDEPENDENT AUDITOR'S REPORT
Opinion
We have audited the consolidated financial statements of Philex Mining Corporation and its
Subsidiaries (the Group) which comprise the consolidated statements of financial position as at
December 31, 2019 and 2018, and the consolidated statements of income, consolidated
statements of comprehensive income, consolidated statements of changes in equity and
consolidated statements of cash flows for each of the three years in the period ended December
31, 2019, and notes to the consolidated financial statements, including a summary of significant
accounting policies.
In our opinion, the accompanying consolidated financial statements present fairly, in all
material respects, the consolidated financial position of the Group as at December 31, 2019 and
2018, and its consolidated financial performance and its consolidated cash flows for each of the
three years in the period ended December 31, 2019, in accordance with accounting principles
generally accepted in the Philippines applied on the basis described in Note 2 to the
consolidated financial statements.
We conducted our audits in accordance with Philippine Standards on Auditing (PSAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for
the Audit of the Consolidated Financial Statements section of our report. We are independent of
the Group in accordance with the Code of Ethics for Professional Accountants in the
Philippines (Code of Ethics) together with the ethical requirements that are relevant to our
audits of the consolidated financial statements in the Philippines, and we have fulfilled our
other ethical responsibilities in accordance with these requirements and the Code of Ethics. We
believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis
for our opinion.
Key audit matters are those matters that, in our professional judgment, were of most
significance in our audit of the consolidated financial statements of the current period. These
matters were addressed in the context of our audit of the consolidated financial statements as a
whole, and in forming our opinion thereon, and we do not provide a separate opinion on these
matters. For each matter below, our description of how our audit addressed the matter is
provided in that context.
We have fulfilled the responsibilities described in the Auditor's Responsibilities for the Audit
of the Consolidated Financial Statements section of our report, including in relation to these
matters. Accordingly, our audit included the performance of procedures designed to respond to
our assessment of the risks of material misstatement of the consolidated financial statements.
The results of our audit procedures, including the procedures performed to address the matters
below, provide the basis for our audit opinion on the accompanying consolidated financial
statements.
As at December 31, 2019, the carrying value of the Group's deferred exploration costs
amounted to =26P.62 billion. Under PFRS 6, Exploration for and Evaluation of Mineral
Resources, these deferred exploration costs shall be assessed for impairment when facts and
circumstances suggest that the carrying amounts exceeds the recoverable amounts. The ability
of the Group to recover its deferred exploration costs would depend on the commercial viability
of the reserves. We considered this as a key audit matter because of the materiality of the
amount involved, and the significant management judgment required in assessing whether
there is any indication of impairment.
The Group's disclosures about deferred exploration costs are included in Note 13 to the
consolidated financial statements.
Audit response
The carrying value of the Group's property, plant and equipment amounted to =3P.19 billion
after recognizing an allowance for impairment amounting to =1P.46 billion during 2019. The
impairment mainly relates to mine and mining properties, Under PAS 36, an entity is required
to assess whether indicators for impairment exist and if they exist, an impairment test is
required. The assessment of the recoverability of the carrying value of property, plant and
equipment requires judgment in assessing whether there is an indication that an asset should be
impaired and in measuring any such impairment. The principal risk relates to Group's estimates
of future cash flows and discount rates, which are used to project the recoverability of property,
plant and equipment.
795
The Group's disclosure about property, plant and equipment are included in Note 10 to the
consolidated financial statements.
Audit response
We reviewed management's assessment of the recoverability of the carrying value of mine and
mining properties by evaluating whether indicators for potential impairment exist. We
evaluated management's assessment of the existence of the impairment indicators. We have
compared the assumptions used within the future cash flows model to budget business plans,
forecasted metal prices, foreign exchange rates and historical production costs. We have
compared the production quantities in the future cash flows model against the estimated ore
reserves declared by the competent person's report, We have involved our valuation specialists
to assist us in the analysis of the discount rate.
Other Information
Management is responsible for the other information. The other information comprises the
information included in the SEC Form 20-IS (Definitive Information Statement), SEC Form
17-A and Annual Report for the year ended December 31, 2019, but does not include the
consolidated financial statements and our auditor's report thereon. The SEC Form 20-IS
(Definitive Information Statement), SEC Form 17-A and Annual Report for the year ended
December 31, 2019 are expected to be made available to us after the date of this auditor's report.
Our opinion on the consolidated financial statements does not cover the other information and
we will not express any form of assurance conclusion thereon.
In connection with our audits of the consolidated financial statements, our responsibility is to
read the other information identified above when it becomes available and, in doing so,
consider whether the other information is materially inconsistent with the consolidated
financial statements or our knowledge obtained in the audits or otherwise appears to be
materially misstated.
Management is responsible for the preparation and fair presentation of the consolidated
financial statements in accordance with accounting principles generally accepted in the
Philippines applied on the basis described in Note 2 to the consolidated financial statements,
and for such internal control as management determines is necessary to enable the preparation
of consolidated financial statements that are free from material misstatement, whether due to
fraud or error.
In preparing the consolidated financial statements, management is responsible for assessing the
Group's ability to continue as a going, concern, disclosing, as applicable, matters related to
going concern and using the going concern basis of accounting unless management either
intends to liquidate the Group or to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Group's financial reporting
process.
796
Auditor's Responsibilities for the Audits of the Consolidated Financial Statements
Our objectives are to obtain reasonable assurance about whether the consolidated financial
statements as a whole are free from material misstatement, whether due to fraud or error, and to
issue an auditor's report that includes our opinion. Reasonable assurance is a high level of
assurance, but is not a guarantee that an audit conducted in accordance with PSAs will always
detect a material misstatement when it exists. Misstatements can arise from fraud or error and
are considered material if, individually or in the aggregate, they could reasonably be expected
to influence the economic decisions of users taken on the basis of these consolidated financial
statements.
As part of an audit in accordance with PSAs, we exercise professional judgment and maintain
professional skepticism throughout the audit. We also:
Identify and assess the risks of material misstatement of the consolidated financial
statements, whether due to fraud or error, design and perform audit procedures
responsive to those risks, and obtain audit evidence that is sufficient and
appropriate to provide a basis for our opinion. The risk of not detecting a material
misstatement resulting from fraud is higher than for one resulting from error, as
fraud may involve collusion, forgery, intentional omissions, misrepresentations, or
the override of internal control.
Obtain an understanding of internal control relevant to the audit in order to design
audit procedures that are appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the Group's internal control.
Evaluate the appropriateness of accounting policies used and the reasonableness of
accounting estimates and related disclosures made by management.
Conclude on the appropriateness of management's use of the going concern basis of
accounting and, based on the audit evidence obtained, whether a material
uncertainty exists related to events or conditions that may cast significant doubt on
the Group's ability to continue as a going concern. If we conclude that a material
uncertainty exists, we are required to draw attention in our auditor's report to the
related disclosures in the consolidated financial statements or, if such disclosures
are inadequate, to modify our opinion. Our conclusions are based on the audit
evidence obtained up to the date of our auditor's report. However, future events or
conditions may cause the Group to cease to continue as a going concern.
Evaluate the overall presentation, structure and content of the consolidated financial
statements, including the disclosures, and whether the consolidated financial
statements represent the underlying transactions and events in a manner that
achieves fair presentation.
Obtain sufficient appropriate audit evidence regarding the financial information of the
entities or business activities within the Group to express an opinion on the
consolidated financial statements. We are responsible for the direction, supervision
and performance of the audit. We remain solely responsible for our audit opinion.
797
We communicate with those charged with governance regarding, among other matters, the
planned scope and timing of the audit and significant audit findings, including any significant
deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with
relevant ethical requirements regarding independence, and to communicate with them all
relationships and other matters that may reasonably be thought to bear on our independence,
and where applicable, related safeguards.
From the matters communicated with those charged with governance, we determine those
matters that were of most significance in the audit of the consolidated financial statements of
the current period and are therefore the key audit matters. We describe these matters in our
auditor's report unless law or regulation precludes public disclosure about the matter or when,
in extremely rare circumstances, we determine that a matter should not be communicated in our
report because the adverse consequences of doing so would reasonably be expected to
outweigh the public Interest benefits of such communication.
The engagement partner on the audit resulting in this independent auditor's report is Alexis
Benjamin C Zaragoza Ill.
Partner
CPA Certificate No. 109217
Provisions for impairment losses - net of reversal (Notes 10, 12, and 26) (848,560) (67,033) -
Other- net (4,266) 91,160 58,117
(876,518) (135,710) 2,028
Basic/Diluted (Loss) Earnings per share (Note 30) (P0.131) P0.123 P0.336
801
PHILEX MINING CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in Thousands)
802
INDEPENDENT AUDITOR'S REPORT
Opinion
We have audited the consolidated financial statements of Manila Electric Company and its subsidiaries
(the Group), which comprise the consolidated statements of financial position as at December 31, 2018
and 2017, and the consolidated statements of income, consolidated statements of comprehensive income,
consolidated statements or changes in equity and consolidated statements of cash flows for each of the
three years in the period ended December 31, 2018, and notes to the consolidated financial statements,
including a summary of significant accounting policies.
In our opinion, the accompanying consolidated financial statements present fairly, in all material respects.
the consolidated financial position of the Group as at December 31, 2018 and 2017, and its consolidated
financial performance and its consolidated cash flows for each of the three years in the period ended
December 31 2018 in accordance with Philippine Financial Reporting Standards (PFRSs).
We conducted our audits in accordance with Philippine Standards on Auditing (PSAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for the Audit
of the Consolidated Financial Statements section of our report. We are independent of the Group in
accordance with the Code of Ethics for Professional Accountants in the Philippines (Code of Ethics)
together with the ethical requirements that are relevant to our audit of the consolidated financial
statements in the Philippines, and we have fulfilled our other ethical responsibilities in accordance with
these requirements and the Code of Ethics. We believe that the audit evidence we have obtained is
sufficient and appropriate to provide a basis for our opinion.
Key audit matters are those matters that, in our professional judgment, were of most significance in our
audit of the consolidated financial statements of the current period. These matters were addressed in the
context of our audit of the consolidated financial statements as a whole, and in forming our opinion
thereon. and we do not provide a separate opinion on these matters. For each matter below, our
description of how our audit addressed the matter is provided in that context.
We have fulfilled the responsibilities described in the Auditor's Responsibilities for the Audit of the
Consolidated Financial Statements section of our report, including those in relation to these matters.
Accordingly, our audit included the performance of procedures designed to respond to our assessment of
the risks of material misstatement of the consolidated financial statements. The results of our audit
procedures, including the procedures performed to address the matters below, provide the basis for our
audit opinion on the accompanying consolidated financial statements.
Revenue recognition
The Group's revenues from the sale of electricity represent 97% of its consolidated revenues and arise
from its service contracts with a large number of customers that are classified as either commercial,
industrial or residential, located within the Group's franchise area. The Group's financial statements
provide the relevant disclosures related to the rate-making regulations and regulatory policies of the
Energy Regulatory Commission (ERC). This matter is significant to our audit because the revenue
recognized depends on (a) the complete capture of electric consumption based on the meter readings over
the franchise area taken on various dates; (b) the propriety of rates computed and applied across customer
classes; and (c) the reliability of the IT systems involved in processing the billing transactions. In
addition, the Group adopted PFRS 15, Revenue from Contracts with Customers, effective January 1,
2018, which involves the application of significant judgment on the assessment that (a) the Group is a
principal in these revenue arrangements, (b) revenues are adjusted via the true-up mechanism; and (c)
accounting for the electricity, re-connection and other non-standard connection fees as arising from a
single performance obligation that will be satisfied over the period when the services are expected to be
provided.
Notes 2, 4, 22, 23, 29 and 31 provide the relevant disclosures related to the rate-making regulations and
regulatory policies of the ERC.
Audit response
We obtained an understanding and evaluated the design of, as well as tested the controls over, the
customer master file maintenance, accumulation and processing of meter data, and interface of data from
the billing system to the financial reporting system. In addition, we performed a test recalculation of the
bill amounts using the ERC - approved rates and formulae, as well as actual costs incurred, and compared
them with the amounts reflected in the billing statements. We involved our internal specialist in
understanding the IT processes and in understanding and testing the IT general controls over the IT
systems supporting the revenue process.
On PFRS 15 adoption, we obtained an understanding of the Group's implementation process and tested
the relevant controls. We reviewed the PFRS 15 adoption documentation and the updated accounting
policies as prepared by management, including revenue streams identification and scoping and contract
analysis. We obtained sample contracts and reviewed the performance obligations identified to be
provided by the Group, the determination of transaction price and other considerations received from
customers, and the timing of the revenue recognition based on the period when services are to be
rendered. We also reviewed the notes disclosure on the adoption of PFRS 15.
The Group has defined benefit retirement and other long-term post-employment benefits plans for all
regular employees. We consider this as a key audit matter because the valuation of the benefits obligation
involves a significant level of management judgment. The valuation also requires an actuary whose
calculations involve the use of certain assumptions, such as prospective salary increase, discount rate,
mortality rates, and employee turnover rates that could have a material impact on the calculation of the
benefits expense and liability.
807
Note 25 to the consolidated financial statements provide the relevant disclosures related to this matter.
Audit response
We obtained are understanding of the Group's defined benefit retirement and other long-term
post-employment benefits plans as well as the processes included in estimating the amounts of the related
liability and expense. We also involved an internal specialist to assist us with our review of the scope,
bases of assumptions, methodology and results of the work by the Group's actuary, whose professional
qualifications and objectivity were also evaluated. We compared the key inputs used, such as the attrition
rates, discount rate, and future salary increase rate against the Group's internal data and external
references. We also inquired about the basis of the salary rate increase and compared it against the
Group's forecast Moreover. we reviewed the required disclosures in the consolidated financial
statements,
The Group is involved in certain proceedings for which the Group has recognized provisions for
probable costs and/or expenses, which truly be incurred, and/or has disclosed relevant information about
such contingencies. This matter is important to our audit because the assessment of the potential outcome
or liability involves significant management judgment and estimation.
Notes 1 8, 21 and 28 to the consolidated financial statements provide the relevant disclosures related to
this matter.
Audit response
We examined the bases of management's assessment of the possible outcomes and the related estimates
of the probable costs and/or expenses that are recognized and/or disclosed in the Group's consolidated
financial statements. In addition, we evaluated the input data supporting the assumptions used, such as
tax rates, historical experience, regulatory rulings and other developments. against the Group's internal
and external data and performed recalculations and inspection of relevant supporting documents. We
also reviewed the disclosures on provisions and contingencies in the Group's consolidated financial
statements.
Management is responsible for the other information. The other information comprises the information
included in the SEC Form 20-1S (Definitive Information Statement), SEC Form 17-A and Annual
Report for the year ended December 31, 2018 but does not include the consolidated financial statements
and our auditor's report thereon. The SEC Form 20-1S (Definitive Information Statement), SEC form
17-A and Annual Report for the year ended December 31 , 2018 are expected to be made available to us
after the date of this auditor's report.
Our opinion on the consolidated financial statements does not cover the other information and we will
not express any form of assurance conclusion thereon.
Other Information
In connection with our audits of the consolidated financial statements, our responsibility is to read the
other information identified above when it becomes available and, in doing so, consider whether the
other information is materially inconsistent with the consolidated financial statements or our knowledge
obtained in the audits, or otherwise appears to be rnaterially misstated.
808
Responsibilities of Management and Those Charged with Governance for the Consolidated
Financial Statements
Management is responsible for the preparation and fair presentation of the consolidated financial
statements in accordance with PFRSs, and for such internal control as management determines is
necessary to enable the preparation of consolidated financial statements that are free from material
misstatement, whether due to fraud or error.
In preparing the consolidated financial statements, management is responsible for assessing the Group's
ability to continue as a going concern, disclosing, as applicable, matters related to going concern and
using the going concern basis of accounting unless management either to liquidate the Group or to cease
operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Group's financial reporting process.
Our objectives are to obtain reasonable assurance about whether the consolidated financial statements as
a whole are free from misstatement, whether due to fraud or error, and to issue an auditor's report that
includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an
audit conducted in accordance with PSAs will always detect a material misstatement when it exists.
Misstatements can arise from fraud or error and are considered material if, individually or in the
aggregate, they could reasonably be expected to influence the economic decisions of users taken on the
basis of these consolidated financial statements.
As part of an audit in accordance with PSAs, we exercise professional judgment and maintain
professional skepticism throughout the audit. We also:
Identify and assess the risks of material misstatement of the consolidated financial statements,
whether due to fraud or error, design and perform audit procedures responsive to those risks,
and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion.
The risk of not detecting a material misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
Obtain an understanding of internal control relevant to the audit order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing
an opinion on the effectiveness of the Group's internal control.
Evaluate the appropriateness of accounting policies used and the reasonableness of accounting
estimates and related disclosures made by management.
Conclude on the appropriateness of management's use of the going concern basis of
accounting and based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the Group's ability to
continue as a going concern. If we conclude that a material uncertainty exists, we are
required to draw attention in our auditor's report to the related disclosures in the
consolidated financial statements or, if such disclosures are inadequate, to modify our
opinion. Our conclusions are based on the audit evidence obtained up to the date of our
auditor's report. However, future events or conditions may cause the Group to cease to
continue as a going concern.
809
Evaluate the overall presentation, structure and content of the consolidated financial
statements,
tements, including the disclosures, and whether the consolidated financial statements
represent the underlying transactions and events in a manner that achieves fair presentation.
Obtain sufficient appropriate audit evidence regarding the financial inform
information
ation of the entities
or business activities within the Group to express an opinion on the consolidated financial
statements. We are responsible for the direction, supervision and performance of the audit.
We remain solely responsible forf our audit opinion.
We communicate with those charged with governance regarding, among other matters, the planned
scope and timing of the audit and significant audit findings, including any significant deficiencies in
internal control that we identity during our audit.
We also provide those charged with governance with a statement that we have complied with relevant
ethical requirements regarding independence, and to communicate with then all relationships and other
matters that may reasonably be thought to bear on our iindependence,
ndependence, and where applicable, related
safeguards.
From the matters communicated with those charged with governance, we determine those matters that
were of most significance in the audit the consolidated financial statements of the current period and
an are
therefore the key audit matters. We describe these matters in our auditor's report law or regulation
precludes public disclosure about the matter or when in extremely rare circumstances, we determine that
a matter should not be communicated in our report
report because the adverse consequences of doing so would
reasonably be expected to outweigh the public interest benefits of such communication.
Opinion
We have audited the consolidated financial statements of Puregold Price Club, Inc. and its
Subsidiaries (the "Group"), which comprise the consolidated statements of financial position as
at December 31, 2018 and 2017, and the coconsolidated
nsolidated statements of comprehensive income,
consolidated statements of changes in equity and consolidated statements of cash flows for
each of the three years in the period ended December 31, 2018, and notes, comprising
significant accounting policies and
a other explanatory information.
In our opinion, the accompanying consolidated financial statements present fairly, in all
material respects, the consolidated financial position of the Group as at December 31, 2018 and
2017, and its consolidated financi
financial
al performance and its consolidated cash flows for each of the
three years in the period ended December 31, 2018, in accordance with Philippine Financial
Reporting Standards (PFRS).
Key audit matters are those matters that, in our professional judgment, were of most
significance in our audit of the consolidated financial statements of the current period. These
matters were addressed in the context of our audit Of the consolidated financial statements as a
whole, and in forming our opinion thereon, and we do not provide a separate opinion on these
matters.
The risk
Revenue is an important measure used to evaluate the performance of the Group and is
generated from various sources. It is accounted for when sales transactions are completed,
when goods are delivered or services are rendered to the customers and all economic risks of
the Group are transferred. While revenue recognition and measurement is not complex for the
Group, revenues may be inappropriately recognized in order to improve business results and
achieve revenue growth in line with the objectives of the Group, thus increasing the risk of
material misstatement.
Our response
820
The risk
The Group holds significant balances pertaining to goodwill, trademark and customer
relationships as a result of several business acquisitions. The annual impairment test of these
assets was significant to our audit since this is complex and judgmental by nature as it is based
on assumptions of future market and/or economic conditions. The key assumptions used
include growth rates, discount rates and sensitivity analyses.
Our response
We performed the following audit procedures, among others, around impairment testing of
goodwill, trademark and customer relationships:
We obtained the Group is discounted cash flow model that tests the carrying
value of goodwill.
We evaluated the reasonableness of key assumptions used by management in
deriving the recoverable amount. These procedures included using our own
internal valuation specialist to evaluate the key inputs and assumptions for
growth and discount rates.
We reviewed the cash flows used, with comparison to recent performance, trend
analysis and market expectations, and by reference to prior year's forecast, where
relevant, and assessing whether the Group has achieved them.
We evaluated the adequacy of the disclosures in respect of impairment of
goodwill in the consolidated financial statements.
Other Information
Management is responsible for the other information. The other information comprises the
information included in the SEC Form 20-IS (Definitive Information Statement).
SEC Form 17-A and Annual Report for the year ended December 31, 2018, but does not
include the consolidated financial statements and our auditors' report thereon.
The SEC Form 20-IS (Definitive Information Statement), SEC Form 17-A and Annual Report
for the year ended December 31, 2018 are expected to be made available to us after the date of
this auditors' report.
Our opinion on the consolidated financial statements does not cover the other information and
we will not express any form of assurance conclusion thereon.
In connection with our audits of the consolidated financial statements, our responsibility is to
read the other information identified above when it becomes available and, in doing so,
consider whether the other information is materially inconsistent with the consolidated
financial statements or our knowledge obtained in the audits or otherwise appears to be
materially misstated.
821
Responsibilities of Management and Those Charged with Governance for the Consolidated
Financial Statements
Management is responsible for the preparation and fair presentation of the consolidated
financial statements in accordance with PFRS, and for such internal control as management
determines is necessary to enable the preparation of consolidated financial statements that are
free from material misstatement, whether due to fraud or error.
In preparing the consolidated financial statements, management is responsible for assessing the
Group's ability to continue as a going concern, disclosing, as applicable, matters related to
going concern and using the going concern basis of accounting unless management either
intends to liquidate the Group or to cease operations, or has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the Group's financial reporting
process.
Our objectives are to obtain reasonable assurance about whether the consolidated financial
statements as a whole are free from material misstatement, whether due to fraud or error, and to
issue an auditors' report that includes our opinion. Reasonable assurance is a high level of
assurance, but is not a guarantee that an audit conducted in accordance with PSA will always
detect a material misstatement when it exists. Misstatements can arise from fraud or error and
are considered material if, individually or in the aggregate, they could reasonably be expected
to influence the economic decisions of users taken on the basis of these consolidated financial
statements.
As part of an audit in accordance with PSA, we exercise professional judgment and maintain
professional skepticism throughout the audit. We also:
Identify and assess the risks of material misstatement of the consolidated
financial statements, whether due to fraud or error, design and perform audit
procedures responsive to those risks, and obtain audit evidence that is sufficient
and appropriate to provide a basis for our opinion. The risk of not detecting a
material misstatement resulting from fraud is higher than for one resulting from
error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
Obtain an understanding of internal control relevant to the audit in order to design
audit procedures that are appropriate in the circumstances, but not for the purpose
of expressing an opinion on the effectiveness of the Group's internal control.
Evaluate the appropriateness of accounting policies used and the reasonableness
of accounting estimates and related disclosures made by management.
Conclude on the appropriateness of management's use of the going concern basis
of accounting and, based on the audit evidence obtained, whether a material
uncertainty exists related to events or conditions that may cast significant doubt
on the Group's ability to continue as a going concern. If we conclude that a
material uncertainty exists, we are required to draw attention in our auditors'
report to the related disclosures in the consolidated financial statements or, if
such disclosures are inadequate, to modify our opinion. Our conclusions are
822
based on the audit evidence obtained up to the date of our auditors' report.
However, future events or conditions may cause the Group to cease to continue as
a going concern.
Evaluate the overall presentation, structure and content of the consolidated
financial statements, including the disclosures, and whether the consolidated
financial statements represent the underlying transactions and events in a manner
that achieves fair presentation.
Obtain sufficient appropriate audit evidence regarding the financial information
of the entities or business activities within the Group to express an opinion on the
consolidated financial statements.
We are responsible for the direction, supervision and performance of the group audit. We
remain solely responsible for our audit opinion. We communicate with those charged with
governance regarding, among other matters, the planned scope and timing of the audit and
significant audit findings, including any significant deficiencies in internal control that we
identify during our audit.
We also provide those charged with governance with a statement that we have complied with
relevant ethical requirements regarding independence, and communicate with them all
relationships and other matters that may reasonably be thought to bear on our independence,
and where applicable, related safeguards.
From the matters communicated with those charged with governance, we determine those
matters that were of most significance in the audit of the consolidated financial statements of
the current period and are therefore the key audit matters. We describe these matters in our
auditors' report unless law or regulation precludes public disclosure about the matter or when,
in extremely rare circumstances, we determine that a matter should not be communicated in our
report because the adverse consequences of doing so would reasonably be expected to
outweigh the public interest benefits of such communication.
The engagement partner on the audit resulting in this independent auditors' report is Dindo
Marco M. Dioso.
823
List of References
Arnes, Alvin A.; Loebbecke, James K., Auditing: An Integrated Approach, Eighth Edition,
New Jersey, 2018.
Cabrera, Ma. Elenita B., Applied Auditing, GIC Enterprises, Manila, 2019.
Carmichael, D.R., Willingham, John, Auditing Concepts and Methods, McGraw Hill Book co.,
NY, 2018.
Hubbard, Thomas; Johnson, Johnny D., Auditing: Concepts, Standards, Procedures, Revised
Edition, Dame Publications, Inc., USA, 2019.
IFAC, Guide to Using ISAS in the Audits of Small and Medium Sized Entities, 4th' Edition,
2018.
International Standards on Auditing, IFAC approved as of January 2019.
Konrath, Larry F., Auditing Concepts and Applications: A Risk Analysis Approach, West
Publishing Co., USA, 2018.
Philippine CPA Board Examination in Auditing Problems, Board of Accountacy, PRC.
Philippine Financial Reporting Standards approved by Financial Reporting Standards Council
(FRSC).
Philippine Standards on Auditing (PSAs) approved as of January 3:10 2019, Auditing and
Assurance Standards Council.
Rittenberg, Larry E; Johnstone, Karla M; Grambling, Aubrey A., Auditing: A Business Risk
Approach, 8th Edition, South-Western Cengage Learning, USA, 2014
Whittington, O. Ray; Kurt; Pany, Principles of Auditing and Other Assurance Services, 20th
Edition, McGraw-Hill / Irwin, Inc., USA, 2018.
Websites:
www.acpapp.org www.picpa.com.ph
ww.aasc.org.ph ww.prc.gov.ph
www.ifac.org www.sec.gov
www.google.com