CH-13-14 Production and Payroll Processes – Auditing: An International Approach : Book Guide

CHAPTER 13 Production and Payroll Processes SOLUTIONS FOR REVIEW CHECKPOINTS 13-1 In the production process, the risks for inventory relate to two components: physical quantities and valuation (or pricing). Management should have strong controls over existence and completeness related to inventory quantities. Existence and completeness risks in inventory as well as related accounts receivable and payable balances are affected by cutoff errors. The valuation risk is affected by controls over pricing procedures for purchases and other manufacturing costs, and by the possibility that market values can fall below cost. Ownership risks relate to transfer of title to inventory, as it may not happen at the same time as the physical transfer. Presentation risks include disclosure of inventory pledged as collateral, descriptions of accounting policies, details of writedown and reversals. Ownership is the key assertion in the payroll process. 13-2 Production planning Inventory planning Production Cost accounting Auditors must understand management's approach to the conversion of resources and the unique production process to understand the flow of transaction processing. Without a thorough understanding of the production process, the related data processing and cost accounting cannot be fully comprehended and weaknesses in internal control can be overlooked. Of all the transaction cycles, this will be the most likely to be different for each auditee. 13-3 A walk-through of a production transaction will collect the following documents: Production order Bill of materials Materials requisitions Inventory record (raw materials issue) Journal entry (moving raw materials to work in process) Labour report (time records) Journal entry (charging labour to work in process) Production cost analysis Inventory record (finished goods addition) Journal entry (moving work in process to inventory) A "walk through" involves following a transaction from initiation through the various steps until the transaction is recorded in the formal accounting records. In the conversion cycle, the following would constitute a complete "walk through:" Step Documents Collected Controls Noted Prepare production orders Production Order (P.O.) Support for P.O. Prepare bill of materials and manpower needs Bill of materials (B.M.) Manpower needs (M.N.) Separation planning from production. Assign job order and foreman Note separation production supervisor from foreman duties. Job tickets and material requisitions prepared Job tickets (JT) Material requisitions (MR) Production foreman duties separated from authorization. Raw material records updated, issue slips prepared Issue slip (IS) Materials not issued without MR. IS prepared for all materials released. Observe time entered and foreman approval on JT Approval by foreman of hours. Direct labour report prepared Labour report (LR) Job tickets support L.R. Observe timekeeping, compare job tickets to clock cards Reconciliation hours per clock cards to hours per J.T. Material used report prepared Material used report (MUR) Issue slips and requisitions support MUR. Observe matching issue slips and material used report Records from sources reconciled. Observe matching job time tickets (or labour distribution) to labour report Records from separate sources reconciled. Enter costs in job cost sheets Job cost sheets (JCS) Support for all entries in JCS. Summary entry prepared. Summary entry form Job cost sheets support summary entries. Trace summary entry to General Ledger posting Separation of duties; cost accounting and general ledger. Preparation of completion report Report of units completed (RUC) Independent report of production completed. Observe units compared to RUC, post finished records Independent check of RUC. Products received report prepared Products received report (PRR) Independent records of units put into finished goods inventory. Observe comparison RUC and PRR Records from separate sources reconciled. Job sheets closed out, summary entry prepared Summary entry form Closed job sheets, RUC and PRR support summary entries. Trace summary entry to Separation of duties; cost accounting and general General Ledger posting ledger. 13-4 The separations of duties auditors are looking for are authorization of transactions, custody of assets, and recording of transactions, and periodic reconciliation. In the production cycle, these duties are separated as follows: Initial authorization is a production order prepared in production planning and control, authorizations of labour hours and material to be used are given by the foreman when job time tickets are given to employees and material requisitions are sent to raw materials stores, Raw materials stores maintains physical custody of raw materials and none are released without authorization (requisition) and record of withdrawal, Foreman maintains custody of work-in-process inventory, Independent recording of labour and materials in production cost analyses by cost accounting clerks from records after comparing two sources. 13-5 Omission of materials and labour used should be prevented by periodically examining documents from one source for missing document from second source. For example, dated raw materials inventory issues not matched to materials in the production cost analysis indicate a possible omission of material used in production. Use of pre- numbered documents and reports with accounting for numerical sequence is also a primary means of preventing omission of transactions. Prevention of double counting of material used or labour used should be issued by stamping documents as "posted" before they are filed in job folders, or through IT-based controls to prevent reposting of an entry. 13-6 Some work to obtain assurance about the reasonableness of the auditee's sales forecast needs to be performed. This work is not an examination or compilation of a forecast as contemplated by the attestation services standards. All the auditors need to accomplish is to learn about the assumptions built into the forecast for the purpose of ascertaining their reasonableness. In addition some work on the mechanical accuracy of the forecast should be performed to avoid embarrassing reliance on faulty calculations. 13-7 If high levels of production were planned and carried out in anticipation of high sales that did not occur, the inventory should show an increase. The potential problem is over-valuation (overstatement) of slow-moving or obsolete inventory and understatement of cost of goods sold. 13-8 Production reports record the completion of production quantities. When coupled with the related cost accounting reports, they are the company's record of the cost of goods placed into the finished goods inventory. In most cases, auditors will audit the cost reports in connection with determining the cost valuation of inventory and cost of goods sold. 13-9 The items auditors can use in an auditee's production asset and depreciation schedule include: Asset descriptions: Help auditors identify assets they can inspect. Beginning cost balance for each asset: Trace them to prior year working papers. Asset additions: Audit them for evidence of existence, valuation, ownership, and presentation and disclosure. Asset sales (dispositions): Audit them for evidence of occurrence, valuation (including amount of gain or loss), passage of ownership, and presentation and disclosure. Ending cost balance for each asset: Audit them for evidence of existence (physical inspection), valuation (other than temporary impairment), ownership, and presentation and disclosure. Trace total to general ledger and balance sheet. Beginning accumulated depreciation for each asset: Trace them to prior year working papers. Additions (depreciation expense) for the period: Audit the calculations for accuracy. Trace to expense account(s) and statement of cash flows. Dispositions of accumulated depreciation: Combine with asset cost to determine book value and amount of gain or loss on disposition. Trace to gain/loss account and to adjustment in statement of cash flows. Ending accumulated depreciation each asset: Audit the calculations for accuracy. Trace total to general ledger and balance sheet. 13-10 The primary functions that should be segregated in the production cycle are: - Authorization (production planning and inventory planning) should be performed by persons who do not have custody, recording, or cost accounting and reconciliation duties. - Custody of inventories (raw materials, work in process, and finished goods) should be in the hands of persons who do not authorize the amount or timing of production or the purchase of materials and labour, or perform the cost accounting recordkeeping, or prepare cost analyses (reconciliations) - Cost accounting (a recording function) should be performed by persons who do not authorize production or have custody of assets in the process of production. (However, you will usually find that the cost accountants prepare various analyses and reconciliations directly related to production activities.) 13-11 The production order document or record provides a control over the quantity of materials used in production by containing an approved list of materials that should be used. This list (bill of materials) can be compared to the actual materials used, as costed by the cost accounting department. 13-12 Improperly deferred costs and cost overruns have been found in "unbilled receivables," in the inventory account, and in "deferred charges--contract costs." 13-13 The purpose of this review question is to foster discussion toward what information an independent auditor needs to know. Items relevant to the quotation might include: 1. Reference to the professional requirement to have adequate technical training and proficiency as an auditor. 2. Reference to the professional requirement regarding "due professional care." 3. Obviously, the auditor must be knowledgeable about cost accounting to audit a manufacturing company. An auditor needs to know or at least have a good idea of how the cost relationships of an organization fit together in order to determine whether something is out of line. 4. In a manufacturing company, the inventories most likely will be a major asset which will require substantial audit work. 5. A proficient auditor must be knowledgeable in all phases of the business, including production, marketing, finance as well as accounting data processing, cost accounting and management accounting Cost accounting is part of the broader management accounting function in most organizations, a function which addresses the financial processes and information needed to support management decisions, and provides valuable data and analyses that can help auditors get the required understanding of how the business works. There are other valid approaches to responding as the question is very open ended. 13-14 This is a question about the direction of the test of controls, illustrating dual- direction test of controls sampling. To determine whether all authorized production was completed and placed in inventory or written off as scrap, the auditors should select a sample of approved production orders from the production planning department files or records, then trace them forward through cost accounting to inventory or write-offs. To determine whether finished goods inventory was actually produced and properly costed, the auditors should select a sample of production put in the inventory account, then vouch these production reports to approved production orders and cost calculations of material, labour, and overhead. 13-15 A template form of substantive audit program can provide a generic checklist of potential audit procedures, but it needs to be adapted so it responds to the risks present in a particular audit engagement, in order to meet the audit objectives and address the assessed risks of material misstatement. The auditor’s risk assessment is crucial to tailoring the substantive programs to address the specific risks in the business, and hence to performing an effective audit. 13-16 This analytical procedures provides substantive evidence about valuation. By noting differences in gross profit margin in the months before and after period end, any unintentional cutoff errors may be revealed, or management’s inappropriate use of closing journal entries to alter reported profit may also be evident. Analytical procedures help the auditor to identify unexpected behaviour in an account — comparing expectations from trends against actual to see if things look different than expected. 13-17 Raw materials pricing is tested by agreeing the recorded costs to suppliers’ invoices, shipping charges, customs brokers’ charges. If these are in foreign currencies the exchange calculation is also recalculated based on the appropriate exchange rate. For WIP and finished goods, the auditor will review cost elements and costing calculations by product for accuracy and reasonableness, compare labour rates used with the payroll records, and check that the overhead applied to inventory is based on reasonable overhead rates by comparing amounts applied with actual overhead in the accounting records. 13-15 The functions in a personnel and payroll process: Human resources (personnel and labour relations) - hiring and firing Supervision - approval of work time Timekeeping and cost accounting - payroll preparation and cost accounting Payroll accounting - cheque preparation and related payroll reports Payroll distribution - actual custody of cheques and distribution to employees, or authorization to initiate direct deposit payroll through a banking system. 13-19 A "walk through" of a personnel and payroll transaction would include discussions with each person handling personnel and payroll records. The following illustrates the steps and documents collected. Steps Document(s) Collected Hiring--human resources dept. Authorization to hire and rate assignment Deductions--personnel dept. Personnel forms, employee authorization for deductions (e.g., TD1 form) Timekeeping Time cards/records, time sheets, etc. Shops Production time reports Cost distribution Labour distribution work sheet Accounts payable Payroll journal entry support Cash disbursement Payroll cheques, or bank direct deposit summary If the payroll processing by IT-based computer, the time cards and production time reports would be traced to data input preparation validation and authorization procedures (this would include batch control in the timekeeping and production departments, if batch processing is used), to edit and validation error reports and other computer output indicating control, and finally to computer prepared cheques, labour distribution reports and summary general ledger entries. 13-20 In a payroll system, the functional responsibilities which should be separated include: 1. Human Resources (Personnel or Labour Relations) Department 2. Supervision 3. Timekeeping and Cost Accounting 4. Payroll Accounting 5. Payroll Distribution 13-21 a) Prevent or detect payment to a fictitious employee: - Paycheques prepared only for persons with employment authorization from the personnel department. - Paycheques prepared only for persons with approved work attendance, time. - Paycheques distributed only in person to persons identified as employees (or by electronic transfer to validated employee bank accounts). - Payroll register or list re-approved by supervisor after paycheques are prepared or distributed. b) Employees are expected to complain if they do not get paid (!). 13-22 Important information in employee's personnel files: - Employment application - Background investigation report - Notice of hiring - Job classification with pay rate authorization - Authorizations for deductions (e.g. health insurance, life insurance, retirement contribution, union dues, TD1 form for income tax exemptions) - Termination notice, and related forms for terminated employees such as the Employment Insurance ‘Record of employment’ 13-23 A personnel file should establish the reality of a person's existence and employment. The background investigation report (prior employment, references, social insurance number validity check, credentials investigation, perhaps a private investigator's report) is important for employees in sensitive areas such as accounting, finance, and asset custody positions. One of the primary general controls is capable personnel. Experience is rich with errors and frauds perpetrated by people who falsify their credentials (identification, college degrees, prior experience, criminal records, and the like). 13-24 Documentary support for validity and accuracy of payroll transactions: - Personnel file--hiring notice, rate and deduction authorizations - Timekeeping records--approval of pay base (time, production) - Payroll register--journal support for paycheque production (cash disbursement) - Cancelled cheques--actual payment document - Cost accounting labour cost analysis--reconciliation of labour cost distributed to expense and production to labour paid by payroll - Wages clearing account--should be zero balance - Government tax reports--should reconcile with YTD earnings records in detail and in total 13-25 Federal monthly or quarterly income tax withholding remittance summaries can be reconciled with the total of the employees' YTD earnings records. These tax remittance summaries do not contain detail schedules for each employee's earnings. Employees' T4 reports can be compared in detail to the YTD records. The total of the T4 gross earnings should match the total wages reported on the annual withholding tax return. In provinces that require detail schedules of earnings in annual tax withholding returns, the YTD earnings record details can be compared to the tax returns. 13-26 The purpose of examining endorsements on the back of payroll cheques is to try to detect spurious endorsements by fictitious employees or by other company personnel who may have stolen the cheques. Look for second endorsements and investigate whether they are signatures of other company personnel. 13-27 The common errors and frauds in the personnel and payroll cycle are (1) recorded employee transactions are not valid (fictitious employee), (2) recorded attendance transactions are not valid (fictitious hours), and (3) incorrect cost accounting for labour. Auditors look for separation of duties, proper authorizations and good reconciliations to prevent or detect/correct these errors and frauds. Auditors should be alert to a supervisor having too many incompatible responsibilities (e.g., hiring, authorization of hours, authorization of pay rate, distribution of pay cheques and dismissal--only authorization of hours is a proper responsibility). 13-28 The auditors need to be careful not to make themselves obvious. Standing around in a manufacturing plant at 6:00am in the standard blue pinstripe suit uniform is as good as printing "Beware of Auditor" on your forehead. People will then be on their best behavior, and you will observe nothing unusual. Perform an observation that has a chance of producing evidence of improper behavior. For example, find an unobtrusive observation post; use a video camera; get a knowledgeable office employee to accompany you to interpret various activities. 13-29 An auditor can determine whether the amount of labour cost charged to production was actually paid to employees by comparing the labour cost in production reports to the labour cost paid in payroll reports. Further tests of the payroll process itself will provide evidence regarding whether payments have been made only to bona fide employees. 13-30 The surprise observation enables the auditor to see how the distribution system really works and increases his chances of detecting fraud. Such an observation involves taking control of paycheques, then accompanying a company representative as the distribution takes place. The auditor checks to see that each employee is identified and that only one cheque is given to each individual. Unclaimed cheques are controlled and examined to detect any fictitious persons on the payroll. 13-31 Generalized audit software (GAS) could be used to match the following files and fields with all differences printed out (including unmatched employee numbers). Personnel master file--employee number matched to Payroll master--employee number Employee earning record--employee number Employee deductions--employee number Time card transactions--employee number Cost distribution--employee number Payroll master file--employee number matched to Employee earnings records--employee number compensation class Personnel master file--withholding factors (converted to deduction codes) matched to Payroll master--deduction codes GAS could also be used to convert time card transactions (with the payroll master, compensation and deduction tables) to current gross earnings, deductions and net earnings for one period to compare with the company’s records. This is called "parallel simulation." 13-32 Analysis of payroll transactions and balance would start with developing expectations for payroll expenses based on understanding the entity, including production volumes, new product lines, labour union agreements, prior period’s payroll expenses, industry changes, etc. Then the auditor would analyze trends and relations such as: a) Significant changes or trends in payroll expenses compared with prior period(s) and/or budgets in total and as a percentage of sales b) Payroll expenses compared with related accrued liabilities c) Average annual wage in comparison with work force, minimum wage rates, etc. d) Payroll expenses compared with nonfinancial information such as production volume, facility size, manufacturing process times, product-line changes e) Payroll and benefits by employee type or class by compared with prior period and budgets (e.g., benefits as a percentage of total payroll, average salary per employee, etc.). f) Calculating and assessing the reasonableness of average hourly rates and average salary per employee when compared with normal rates or salary classes. 13-33 Government forms in Canada include TD1 forms with information for individual income tax deductions for each employee, tables of current withholding rates, and T4 summaries report at the end of the year. Auditors can recalculate gross and net pay using employee TD1 and current tax withholding tables for income tax withheld, Canada Pension Plan and Employment Insurance deduction rates, and by examining authorization forms for other payroll deductions such as company pension plan or group insurance. When the period end is close to the calendar year-end, the total payroll costs can be compared to the T4 summary, and any significant differences must be investigated and documented. 13-34 The work on a completed production order (production cost report) should include (1) vouching the costs to supporting documentation of materials, labour, and overhead, and (2) vouching the production order to a customer contract, reading it for terms of sale. 13-35 Yes, indeed there is plenty wrong about auditors' helping auditees obtain bank loans to pay their accounting firm's fees. Obtaining financing is a management function. Where auditors engage in such activities, they become advocates for the auditee and impair their audit independence. They would be acting as if they were part of management, not independent auditors of management’s financial statements. 13-36 An auditor can find out whether control procedures are followed by auditee personnel first by asking the relevant questions on the internal control questionnaire. If the answer(s) is (are) affirmative, the controls can be tested by reperforming the auditee’s control procedures to determine whether they were performed satisfactorily. Examples of control deficiencies that may be discovered include: Failure to perform control procedures when documents for checking and comparisons are available. No separation of these duties and responsibilities: (1) transaction authorization, (2) recordkeeping, (3) custody of, or access to, assets, and (4) reconciliation of actual assets to the accounting records. The payroll employee who has responsibility for preparing personnel files for new hires, approval of wages, verification of time cards, and distribution of payroll cheques can "hire" fictitious employees, fake their records, and order cheques through the payroll system. SOLUTIONS FOR EXERCISES AND PROBLEMS EP13-1 ICQ Items: Possible Error or Fraud Due to Weakness Question Possible Error or Irregularity 1 Unauthorized production for personal use of employee. 2 Work in process omitted from job cost accounting. 3 Materials withdrawn from inventory or hours worked for unauthorized projects. 4 Foreman incorrectly requests material or assigns job skills. 5 Not all material or labour accounted for correctly. Supervisor could also conceal unauthorized material or labour in authorized job. 6 Production orders lost and accounting incomplete. 7 Labour or material used but not recorded. 8 Valid materials or time not accounted for, or invalid materials or time allowed. 9 Material usage omitted from charges to jobs. 10 Production may be started for uneconomic jobs or personal projects. 11 Materials and labour may be used for uneconomic jobs or personal projects. 12 Issue slips not compared to material used reports. Material withdrawn from inventory not accounted for. 13 Differences not investigated. Labour used not accounted for by assigning to a job. 14 Obsolete costs used, inventory improperly valued. 15 Comparison not made or difference not investigated. Production completed not put into inventory. 16 Accounting entries may get put in the wrong account. 17 Errors in summary entries not detected and corrected. EP13-2 Control tests related to control objectives Procedure b) Control Objective a) Strength (1) Valid work-in-process inventory transactions are recorded and none omitted. Preparation of summary material and labour entries. (2) Valid finished goods inventory transactions are recorded and none omitted. Preparation of summary finished goods inventory entries. (3) Recorded labour and material transactions are valid Independent check on materials and labour used. (4) All material issues are authorized. Issue forms secure and used by authorized personnel. (5) Recorded transactions are valid. Separation of recording from custody of assets. (6a) Material used recorded in proper period. Recording of materials used. (6b) Job accounting complete. Standard control number. (6c) Material used authorized. Material received, custody. (6d) Job cost accounting accurate. Proper material received. (6e) Material release recorded. Proper release of materials. (6f) Authorized issue of material and in proper period. Material release authorized and timely. (7) Inventory recorded in proper period. Timely recording. EP13-3 Cost Accounting Test of Controls Procedure Evidence Sample of Cost Accounting Payroll Analyses: C-1a Reconcile periodic totals with payroll register record of payments. Incomplete costing dev. C-1b Vouch costs to time records. Invalid time analyzed dev. C-2 Trace cost accounting labour distributions to management reports and postings in general ledger and subsidiary account(s). Inaccurate reporting dev. Incomplete accounting dev. Wrong classification dev. Sample of Recorded Labour Cost Items: C-3 Vouch labour cost entries to supporting labour cost analyses. Invalid entries deviation. Cost Accounting Test of Controls FIGURE EP13-4 Work-in-process inventory, tests of control The question requires one to consider what different errors discovered in control testing may indicate about control conditions and what action by the auditor would be appropriate to address the findings. Various interpretations are valid, depending on assumptions made. One possible set of analysis and conclusions is set out below. a) Labour cost recording is incomplete. Comparisons to budget (assuming budgets are realistic and designed for control purposes) are not being followed up. Alternately, labour costs efficiencies have been realized and budgets have not been updated to reflect this, or budgeting is not being done on a realistic basis. The auditor should make enquiries to determine what is actually occurring b) Validity of labour costs is in question. High frequency of discrepancies suggests either daily labour reports are incomplete (e.g. not regularly kept up to date for new employees, exacerbated if employee turnover is high), or false claims of hours worked are being entered. Follow up should be enquiry and examination of procedures for authorizing employee pay, to determine if the unidentified employees can, and did, receive pay. c) Accuracy (i.e. validity or completeness) of labour costs is in question. The control of comparison of labour cost entries to actual pay potentially is not being used effectively if these kinds of discrepancies are occurring but not being followed up. Further enquiries and examination to indicate frequency and whether the control is being applied effectively throughout the audited period. d) Validity and authorization of inventory costs is in question. The control of dual accumulation of costs (WIP listing and material usage report based on materials issued slips) indicates discrepancies. Enquiry whether both systems are being implemented (seems a costly system considering the risk involved, unless materials are very valuable and easy to steal) and whether comparison of actual material use to materials issued is followed up to resolve discrepancies, if not the control is not very effective. EP13-5 Auditor independence The question requires one to consider the audit independence issues. Cost deferrals manipulations are techniques used by WorldCom to overstate its results, a well-publicized fraud case. One issue of auditor independence is the arrangements around fees, for example if they appear to give the auditors an interest in the successful outcome of an IPO people may believe that the auditors would put their own interests in this ahead of their duty of care, i.e. their duty to be objective about the financial statement information in the interests of potential users ( such as potential investors in an IPO). This self interest of the auditors can lead to inadequate verification and even complicity with misstatements in the financial statements. Given incidents of corporate malfeasance and audit failure in the early 2000s (e.g., WorldCom, Enron, Andersens) increased severity of security market regulators’ penalties are intended to send the message that self interested behaviour by auditors is not tolerable, and in the case of public companies this can be very detrimental to the interests of investors and can destroy their confidence in the stock market. EP13-6 Strengths and weaknesses of inventory production controls a) Internal controls that appear to be effective to meet control objectives are: 1] When parts are received at the warehouse, the receiver compares the type of goods and quantity to a copy of the purchase order available online (accuracy, authorization).2] Checking goods received is segregated from accounting for the purchase. (authorization, validity) 3] Order entry and tracking are automatically prenumbered (completeness) 4] Parts inventory is stored in a locked area (authorization, completeness) 5] Requistions are prenumbered and completed by a supervisor (authorization, completeness) 6] Purchase order, receiving reports and suppliers invoices are matched prior to payment (accuracy, validity, authorization) 7] cheques are only issued once proper documents are on file (authorization, validity) b) Weak controls include: 1] The receiver can change the purchase order online without approval (authorization). The receiver could steal goods and cover it up by altering the records. 2] There is no indication that the accountant checks the preunumbered purchase orders are all accounted for (completeness). The purchase may be received and never recorded, or never received 3]There is no indication the supervisor’s parts requisitions are checked (authorization). The worker could alter the amount and cover up theft of parts. EP13-7 ICQ items: control objectives, control tests and possible error or fraud Question (abbreviated) Possible Error or Fraud 1. Employees paid by cheque? 1. Errors in withholding, rate. 2. Special payroll bank account used? hours or fictitious employee. 2. Bank reconciliation errors. 3. Independent payroll cheque signers? 3. Fictitious employees. Unauthorized payments. 4. Independent bank statement reconciliation? 4. Fictitious employees, incomplete accounting. 5. Payroll employees rotated, take vacations and bonded? 5. Fictitious employees. 6. Timekeeping independent of payroll? 6. Fictitious employees or hours. 7. Personnel department reports employees terminated to payroll department? 7. Terminated employees paid and another cashes cheques Fictitious employee) 8. Payroll compared to personnel files? 8. Fictitious employees. 9. Independent cheque distribution? 9. Fictitious employees. 10. Unclaimed wages controlled? 10. Improper cashing of cheques. 11. Occasional surprise payoff by internal auditors? 11. Fictitious employees. 12. Personnel department reports employees hired to payroll department? 12. Unauthorized employee paid. Fictitious employee) 13. Payroll cheques prenumbered? Sequence checked? 13. Cheques issued and not recorded. 14. Wage rates approved. 14. Unauthorized rates, improper rates. 15. Deduction authorizations signed by employees? 15. Incorrect deductions. 16. Hours and cost distribution approved by supervisor? 16. Hours overcharged (fictitious hours). 17. Timeclock used. 17. Incorrect hours claimed and paid 18. Payroll sheet signed and approved? 18. Unauthorized employees, hours, or rate. 19. Cost records reconciled to payroll? 19. Incomplete accounting--usually cost records not complete. 20. Periodic audit of payroll by internal auditors? 20. Undetected errors and irregularities (all of the above). 21. Classification instructions? 21. Misclassified debits in accounts. 22. Reconciliation with tax reports? 22. Over/underreporting. 23. Review by acctg officer? 23. Accounting and classification errors. EP13-8 ICQ items: control objectives, control tests, possible errors/fraud 1. a) Recorded payroll transactions are valid (no fictitious employees). b) Select a sample of personnel files for new hires and terminations and trace to reports submitted to the personnel department. Trace also to first or last paycheque issued and to cumulative payroll records. c) Paycheques might be delayed and terminated workers might continue to be "paid" (with theft of cheque by someone else) if payroll is not promptly notified of new hires and terminations. 2. a) Recorded payroll deductions are valid. b) Select a sample of payroll deductions and vouch them to signed authorizations. c) Incorrect amounts might be deducted from pay. 3. a) Recorded payroll transactions are valid and authorized. b) Observe the timekeeping operations to determine whether they are performed separately. c) If payroll department personnel were also responsible for time records, they would have effective control over transaction authorization (i.e., hours worked approval) and could overpay themselves or friends. 4. a) Payroll and labour cost transactions are complete. b) Obtain reconciliation worksheets or check-off reports and see if the reconciliation is done. c) Cost accounting records might contain more or fewer dollars than actually paid (per payroll data). Simple errors in cost analyses might occur. EP13- 9 Major risks in payroll process Payroll Process Risk Control Objective Assertion Paying fictitious "employees" Validity, only valid transactions recorded Existence, employees exist Overpaying for time or production Accuracy, pay accurate amounts earned Valuation of payroll amounts, proper inventory, cost of goods sold, and expense amounts Incorrect accounting for costs and expenses Classification, correct classification of costs and expenses Presentation and disclosure, consistent, and EP13-10 Payroll processed by a service organization This discussion question brings up the auditors' responsibility when payroll is processed by an outside service organization, a common occurrence in many smaller businesses. The main point is that the audit control concerns are the same wherever the data are processed. Following are some of the discussion points that have come up in the past use of this question. * Audit planning will require determination of whether a report is available from the service organization, prepared by independent auditors (service auditors). Of particular interest is whether the service auditor's report covers "design only" or covers both "design and certain tests of controls." * When a service organization is used, auditee personnel are responsible for user input and output control, e.g., authorization, completeness (batching), reconciliation of input controls to output. * Specific contractual agreements of control responsibilities between the auditee and the service organization need to be examined and evaluated. * General controls are the responsibility of the service organization, e.g., system and program documentation; backup for computer processing, data files, documentation and staff; and restrictions over access to computer equipment, data files and programs. * Service organization processing requires increased emphasis on auditee procedures for verifying continuing authority, completeness and accuracy of master file. * Service organization processing requires increased emphasis on error correction and resubmission procedures. EP13-11 Payroll Tests of Controls Procedure Evidence Sample of Clock Cards: B-2 Note supervisors' approval. Trace to periodic payroll registers. Missing approval deviation Wrong hours deviation. Wrong employee deviation. Sample of Payroll Register Entries: B-1b Vouch hours paid to clock cards and supervisors' approval. Wrong hours deviation. Missing approval deviation. B-1c Recalculate gross pay, deductions, net pay. B-1d Recalculate payroll registers. Inaccurate pay calculation deviation. Inaccurate payroll summary deviation. B-1e Examine canceled payroll cheques and employee endorsements. Inaccurate cheque amt. dev. Invalid endorsement deviation. B-3 Vouch periodic payroll totals to payroll bank account transfer vouchers and deposit. Inaccurate payroll transfer deviation. Missing payroll transfer deviation B-4 Trace payroll entries to YTD records. Reconcile YTD records with total payrolls. Incomplete update deviation Inaccurate payroll (tax return) deviation. B-6 Trace payroll to management reports and to general ledger postings. Accounting incomplete dev. Accounting incomplete dev. SOLTUIONS FOR DISCUSSION CASES DC13-1 Control over departmental labour cost in job-cost system a) Compare aspects of control with which the labour-cost report proposal complies and examples from the case to support each of the aspects cited: 1. Proposal is flexible and widely applicable. Example--it can be used for all types of jobs. 2. Proposal should be economical. Example--data required are generally available and most calculations are made currently. 3. Proposal focuses attention at the proper organizational level. Example--the department is the basis for the report. 4. Proposal emphasizes a significant cost element. Example--labour is a major element of cost. 5. Proposal provides for quantitative evaluation. Example--job estimates act as standards. 6. Proposal provides for a comparison of actual results to standard to ascertain deviations. Example-- actual labour costs incurred by the department are compared to estimates. 7. Proposal provides for an independent party to make the comparison. Example--an accounting clerk makes the comparison. 8. Proposal emphasizes exception reporting. Example--only significant variances are sent to the production manager. 9. Proposal recommends corrective actions to go to someone who can take actions. Example--the recommendations are sent to the production manager. b) Common aspects of control with which the departmental labour-cost control method does not comply and examples from the case to support each of the aspects cited: 1. Proposal fails to reflect the nature and needs of the activity. Example--the appropriate comparison should be by job, not department's total. 2. Proposal fails to consider on-the-spot action. Example--no mention is made of possible responses within departments when variances arise. Most jobs are completed within the two-week payroll period. 3. Proposal fails to provide specific criteria for identifying problems. Example--the accounting clerk is given little guidance in determining whether a significant variance exists. 4. Proposal fails to reflect organizational pattern--emphasizing where responsibility for action lies. Example--department foremen do not receive a copy of the report when significant deviations occur. 5. Proposal fails to provide for prompt investigation. Example--investigation depends on the assistant controller's available time. 6. Proposal fails to consider changed conditions. Example--no mention is made of any considerations given to the estimation process or revisions. 7. Proposal fails to consider all possible causes. Example--no indication is given that costs other than labour were considered. DC13-2 Audit the Manufacturing PPE and depreciation allocated to inventory a) The Computer system is depreciated for a full year ($583,000), but depreciation should be calculated for only 8 months. Correct amount is $389,000. The depreciation on the Press should be $75,000 instead of $150,000. Somebody doubled the depreciation expense for this year. Accumulated Depreciation 269,000* Cost of Goods Sold 67,500 Inventory 7,500 General and Admin Expense 194,000 *583,000-389,000+150,000-75,000=269,000 b) List two audit procedures for auditing the fixed PPE asset additions. The best way to approach this requirement is to write a procedure for each assertion. Building 2: Existence: Inspect the building to determine that it is "in productive use" (evidence of existence). Ownership (Rights): Vouch the legal title papers and recorded deed for evidence of ownership. Valuation: Vouch the contractor's billings and the payments for evidence of appropriate cost valuation. Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Completeness: Inspect Building 1 and make inquiries about whether any part of it has been sold or leased since the new building was occupied (evidence of completeness of recording of dispositions, if any). Computer system. Existence: Inspect the computer and observe it in operation (existence) Ownership (Rights) and Valuation: Vouch purchase and title documents (ownership and cost valuation). Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for installation and testing costs that should be capitalized (evidence of completeness of recording asset cost). Truck 2 Existence: Inspect the truck and observe it in operation (existence). Ownership (Rights) and Valuation: Vouch purchase and title documents (ownership and cost valuation). Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Insurance may be required for lawful operation. Inquire about its use; if by executive officers, it may need to be reported as compensation in the proxy statement (public companies). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for typical additional costs (e.g. tax, title, license) that should be capitalized (evidence of completeness of recording asset cost). c) The loss on the sale of the Equipment A should be $542,000 ($5,000 - $3,958 - $500). The gain on the sale of Truck 1 (fully amortized) should be $1,000. The cash flow from investing activities should show cash inflow from sale of assets in the amount of $501,000. There should be cash outflow for purchase of assets in the amount of $ $45,522,000. DC13-3 Inventory costing errors, standard manufacturing costs The case involves a processing error for currency exchange on a purchased inventory cost component. An understanding of inventory costing has to be applied to analyze the problems in the case. An approach to analyzing the case is as follows. Other approaches are possible. a) Assuming Thermox will ultimately pay the exchange difference to the supplier, one impact is that accounts payable is understated by the amount of exchange that was underpaid. A further error exists in the standard costing formula, since the Canadian dollar price is significantly higher than the US dollar amount used in the formula. This will result in inventory and cost of sales, which are measured at standard cost, being understated. Because these errors tend to offset each other, there may not be large variances and the problem would not be evident through controls that involve monitoring cost variances. b) Records and analyses include the standard costing formula and materials listing for items that Thermox produces, the supporting documentation for material prices and other costs included in standard costs, the usage of the component that is incorrectly priced in work in process and finished goods inventory and goods sold during the period. The auditor would need to assess the extent to which the pricing error is reflected in production costs during the year (for costs of sales valuation) and in the year end inventory on hand (for WIP and finished goods valuation). For accounts payable, records include the total purchases of the item in question in US dollars, the amount paid and recorded in Canadian dollars, and management’s intent regarding payment of the difference. c) A control procedure of periodic comparison of standards cost components to actual suppliers being used and prices of components would detect changes of this kind. The procedures should also provide for revisions to be made to standards costs when appropriate, and these changes should be independently reviewed and approved. DC13-4 Audit of Electronics Inventory a) The PA must test the cut-off of sales and accounts receivable at the balance sheet date. If the items are to be excluded from inventory, the PA must ensure that sales invoices are prepared and revenues (and related accounts receivable) are recorded in the current year. But excluding the items from inventory and recording sales in the current year is probably inappropriate since the products have not yet been shipped to customers. The fact that the trucks were parked at the shipping duck suggests that they belong to the company, not an independent common carrier. As a result, title to the goods would not pass until delivery at the customers’ places of business, and revenue should not be recognized just because the trucks were loaded prior to year-end. b) The PA needs to perform additional tests of obsolescence. He should examine the perpetual records to determine the dates of production of the questionable items and the pattern of recent sales. Also, he should verify that the items are sold in the company’s current product line by examination of catalogues, price lists, etc. In addition, he should verify sales of these items subsequent to year-end. Finally, the PA must ensure that the goods are valued at the lower-of-cost or market by comparing the carrying cost to the net realizable values of the inventory. In doing so, the PA should discuss with appropriate personnel the size of the price discounts which will likely be required in order to “move” this stock. c) The PA should discuss this apparent change in the method of calculating costs (reclassification of period costs to product costs) with management to determine the reason for the change. Presumably there must have been a major change in the nature of work done by electrical engineering to justify the change in accounting policy. The PA should verify through discussions with engineering personnel and examination of available time records, that the costs charged to overhead actually relate to current production, and not new product development, etc. Finally, the PA should calculate the effect of the change in cost calculation upon inventories and net income and consider whether disclosure of the policy change in the final statements is necessary. d) The PA should thoroughly discuss the situation, and its possible implications, with management. The lack of agreement between the actual goods on hand and the perpetual records may indicate problems in the physical control over inventory items, problem with the perpetual inventory system, or with the conversion to the new perpetual system. The PA needs to consider the impact of these system problems on his assessment of control risk. He should also discuss any specific control problems in his management letter issued at the conclusion of the audit. However, since the company took a complete physical inventory at year-end, as long as the count was done accurately these system and control problems will not directly result in misstatements of balance sheet inventory amounts or recorded costs of sales. DC13-5 Audit of real estate business This is a comprehensive case that could be used for group work in class or as a major assignment, or as a class discussion to pull together the “big picture” and the details of planning an audit. a. Consideration before accepting this audit engagement - Is the PA firm independent? - Does the PA firm have the expertise to conduct the audit? - Does DDL’s management have the financial expertise to prepare financial statements or will it rely on the PA to an extent that impairs the PA’s ability to independently verify the financial statements? - Will the auditee be able to pay the audit fee? - Is the auditee a going concern? - Is management integrity in question? - Who are the main financial statement users? - Will the audit fee justify the auditor’s liability risk? - Other valid points b) Audit planning considerations The following is one approach to meeting the requirements of the case. There are other valid approaches that can be taken. UNDERSTANDING THE AUDITEE’S BUSINESS: KEY FACTS, CRITICAL SUCCESS FACTORS, BUSINESS FACTORS - real estate development business, multi-year development times - changing business model due to environmental regulation change, now to develop and OPERATE golf courses - have 4 approved sites for golf courses and 5 more eligible - offer to sell 8 properties that are still okay for subdivisions, or possibly form JV for this to share 50% of future cash flows - currently a private company, owner/managed, closely held, mortgage debt so far (secured by land) - plan to issue P/S to new investors - will need audited GAAP financial statements (this solution assumes DDL will continue to use ASPE as its “GAAP” and this financial reporting framework is acceptable to its prospective P/S investors and to the auditors, however an assumption that it will use IFRS is also feasible) - also need projected financial statements for new golf course business model - in past financial statements were only for tax, so tax minimization objectives would prevail, no audit was required - Dec 20x5 financial statements are provided (assume not finalized yet) - past profits vary widely year to year, due to business and tax minimization accounting choices - P/S have 6% dividend [assume 6% relates to issue price, assumption required about redemption feature, etc] CONSTRAINTS - financial statements need to be GAAP - FINANCIAL STATEMENT USERS & OBJECTIVES - basis for materiality and risk decisions Prospective preferred share investors, the most important users in this case because DDL needs financing to meet its business goals - their key objective for using accounting information is to predict future cash flow and future earnings/performance to pay dividends and if the value of golf course membership feature of preferred shares will increase in value - management evaluation also important to them, can DDL succeed in this new business?- assumptions required about investor’s investment goals, risk tolerance Mira Desai - She wants to provide financial information to meet new GAAP constraint, to allow prospective P/S investors to assess future cash flows available to cover dividends, to provide management evaluation information since they will not want to invest unless they feel DDL management has ability to succeed in the new golf course business, and to be helpful to her in decisions about operating her new golf course business. Tax postponement objective may be less important than other objectives at this time Amit, potential JV partner - past DDL performance information would help their decision Bank may be another user, as the change in land use may change its view on the collateral value and it may also use the projection to assess possible financing deals with DDL - other valid points KEY AUDIT ISSUES 1. 2. 3. Land Analysis/alternatives - there are three types: under development, held for development and held for sale - relevant information is different for each. Land held for golf course development is a capital asset, land for sale is an investment, and land held for sale is more like inventory in this case. Alternative valuation bases - cost, market value, Cost basis and writing off every cost possible is best for tax For management evaluation some smoothing out would be useful to reflect the long lead times by deferring costs until revenues start up may show the longer term performance. Market value would be best for cash flow prediction, what DDL is likely to receive for the properties it can sell. Market value (if arm’s length) also reflects revenue generating potential. Problem here is new business is unknown so many estimates will be required to provide useful information. JV option means cash flows from land would occur later, as the properties are developed and sold, and timing of income recognition depends on accounting policy choices for the JV Recommendation for audit approach - For GAAP financial statements cost basis is appropriate, and it is also acceptable to defer/capitalize development costs. Verify costs expenses and deferred costs to support documents. As management could also disclose market values to show cash flow potential and management’s abilities in property investment, the auditors should examine appraisals. Verify tax treatments, even if GAAP financial statements capitalize some of the development costs. 4. Revenue recognition and profit measurement Analysis/alternatives - For subdivision business the revenue recognition choice reflects the old tax minimization objective, and also this not so relevant now as decisions now are based on new business. Alternatives are to expense as much as possible, capitalize as much as possible and recognize when income arises, or an approach somewhere in between. DDL may now want change to a cost deferral approach to make 20x5 profit measure reflect smooth performance, so prospective investors can see DDL has been successful in its past real estate ventures, and this would be acceptable under GAAP. Golf courses will take even longer, two years, so deferrals can provide useful information about the investment required and return on investment. The analysis of this issue requires assumptions since information is missing about how the golf courses will generate revenues, e.g. memberships, public greens fees, both, etc. Also assumptions are needed about operating costs post opening and management expertise - does DDL have managers who know the golf course business? Recommendation for audit approach - For GAAP financial statement verify that the deferred development costs related to golf courses such as interest, property tax, earthwork, etc. relate to earning revenues in future, for expenses test details to supporting invoices. 5. Estate lot business Analysis/alternatives - the portion of the land that is earmarked for this purpose is different from the golf course lands, so it should be classified and reported separately. Recommendation for audit approach - Verify management estimate of % to be used this way and the amount is classified as land held for sale. The market value expected to be received is relevant information, if management discloses it the auditors need to verify to the independent appraisal. Consider getting independent appraisals, for example if those available from DDL are not considered sufficiently independent. 6. Contingent liability Analysis/alternatives - The potential lawsuit is relevant to users interested in future cash flow prediction (certainty and amount). The case facts suggest some disclosure is required to comply with GAAP and avoid ‘fraudulent misrepresentation.’ There are estimates and judgment involved, how likely is it that DDL will have to pay, are their lawyers’ assessments right? The accounting options are to disclose potential claim but not amount as it is too uncertain, or DDL could also disclose the maximum expected to be paid Recommendation for audit approach - Ensure disclosure in compliance with GAAP, i.e. disclose the legal issue and maximum possible cost, as well as lawyers’ assessment that it is unlikely DDL will have to pay. If this claim has been ‘in the news’ the prospective investors likely know and it will make them suspicious to see no mention in financial statements - so not disclosing is very risky to DDL and to auditors. (If IFRS is assumed, reference to IAS 37 paragraph 27 could be relevant here as it differs from ASPE) 7. Government loan Analysis/alternatives - This would not be a revenue now under GAAP - it would need to be shown as a ‘liability’ or a deferred credit now - When the government’s conditions are met (and it seems likely they will be) it represents an offset to the cost of land or development costs - if the 50% estimate relates to land having been acquired and some development costs incurred then the credit goes against cost of land or these development costs. Recommendation for audit approach - For GAAP, assess the basis for recording 50% now. If DDL management cannot support this estimate, DDL can show whole amount as a deferred liability - and it still gives information to users that DDL has future benefit that will help it succeed in new venture. 8. Equipment lease- Analysis/alternatives – Is this lease capital or operating? The present value of future lease payments will be less than purchase price (but that seems below market) However, the lease covers whole useful life, and assuming this is the ‘economic life”, the >75% criterion is relevant, and met. Recommendation for audit approach - For GAAP it is a capital lease, and the auditors need to verify the lease is shown as asset and liability and the amounts are correctly calculated. Ensure current portion of lease principal is classified as current liability. Recalculate interest and depreciation expenses. (Note that is IFRS is assumed, IAS 17 is relevant) Note that assumption are required to analyze the case, and other valid approaches/points could be accepted. DC13-6 Control tests, evaluation of possible diversion of payroll funds a) In addition to the usual payroll audit procedures, the audit program should include special procedures directed to the areas of internal control weaknesses. 1. Determine by inquiry, scanning of payroll sheets and minutes of the salary committee which offices had high turnover in personnel. Scanning of payroll sheets might reveal alterations of salaries and deductions. 2. For selected offices, recalculate the totals for a representative number of payrolls. 3. Check computation of salaries and deductions. 4. Trace payroll deductions to the branch office's accounting statements. 5. Trace earnings and deductions to individual payroll records. 6. Compare signatures on payroll sheets with signatures on TD1 forms or other personnel forms. 7. Compare questionable signatures with handwriting samples of the branch manager. 8. Compare payroll sheets and minutes of the salary committee for agreement as to starting dates, terminations, promotions, salary adjustments and transfers. 9. Compare dates on TD1 forms and other personnel forms with payroll sheets as further indication of correct starting date. 10. Review reports submitted by the area supervisors for references to personnel. 11. Consider the relationship of the number of personnel and salary costs in comparison to the business volume. 13. Prepare negative confirmations to be mailed with T-4 forms. Investigate any unclaimed T-4 forms. 14. Observe a salary distribution, or if not possible, include in your field working paper instructions the requirement that the field auditor should list personnel working in the office for subsequent comparison to the payroll records, and/or select names of people in the branch who were paid and ask to meet them. b) Internal control has many weaknesses because of the reliance on one person, the branch manager. 1. Fictitious new employees might be "hired and released" within a short time. 2. Fictitious part-time or temporary personnel might be placed on the payroll. 3. A terminated employee might be continued on the payroll for some time before a termination notice is forwarded. 4. Unclaimed wages might be diverted. 5. A branch manager might overpay him/herself by not deducting for unauthorized absences. 6. Legitimate salary increases or promotions might be diverted. 7. Deductions for withholding tax and net pay might be changed. 8. Hours might be increased and salary recomputed. DC13-7 Croyden Factory, Inc., Evaluation of Flowchart for Payroll Control Weakness a) Weaknesses in the system of internal control are the following: 1. Lack of approval of the supervisor's clock card by an appropriate higher level of management is an unsound practice. Employees should not be permitted to maintain their own time records and submit them without approval. 2. The computation of regular and overtime hours prepared by payroll clerk no. 2 that is used in the preparation of the payroll register is not compared with the summary of regular and overtime hours prepared by the supervisor. 3. Arithmetic computations and rates of pay used in the preparation of the payroll register are not checked by a person who is independent of their preparation and payroll register columns are not verified (re-added) by a person other than the preparer of the payroll register. 4. Payroll cheques are not reconciled to the payroll register in order to prevent improper disbursements. 5. A signature-stamp machine should not be in the custody of any payroll clerk who has access to unsigned cheques. 6. Payroll is not approved by an officer of the company. 7. Since the paymaster should be independent of the payroll process, signed payroll cheques should not be distributed by the supervisor. 8. Unclaimed payroll cheques should be in the custody of an employee who is independent of the payroll process. 9. The comparison of (regular and overtime) hours indicated on payroll cheque (or attachments) with (regular and overtime) hours indicated on clock cards should not be performed by the clerk who is responsible for the original computation of (regular and overtime) hours indicated on clock cards. 10. The comparison of gross and net payroll indicated on payroll cheque (or attachments) with gross and net payroll indicated in the payroll register should not be performed by the clerk who is responsible for preparing the payroll register. b) One should inquire whether 1. Payroll clerk no. 2 checks clock cards for the supervisor’s written approval. 2. Payroll overtime is indicated on clock cards. 3. Employment, wage, and related data in payroll files are periodically crosschecked with personnel files for agreement. 4. The punching of clock cards is observed by a timekeeper. 5. Other mitigating internal control measures (for example, bonding, required vacations, and so forth) are in existence. DC13-8 Vane Corporation: Control Weaknesses in Computerized Payroll System Control Weakness: Payroll Procedure Recommendations 1. Time card is not adequate. 1. Time cards should be preprinted and/or prenumbered. 2. Timekeeping function is inadequate. 2. Company should employ a time clock and timekeeping should be a separate department. 3. Inadequate control in completion of time. 3. Supervisor should approve (sign) all time cards and job tickets. 4. Inadequate control in the collection of time cards and distribution of paycheques. 4. a) Timekeeping should control the issuing and collecting of time cards. b) Paycheques should not be distributed by supervisor. They should be mailed directly to the employee, distributed by direct deposit to workers’ bank accounts. 5. Inadequate job cost reporting. 5. Job costing should be integrated with payroll system; time cards and job tickets should be reconciled daily. 6. Weakness in handling non-routine changes such as new employees, terminations, pay rate changes, etc. 6. Personnel department should be the only one authorized to make changes. 7. Inadequate labour reports for supervisors. 7. Improved timekeeping function and integration of payroll and job costing system could provide supervisors with the desired reports. 8. Payroll cheques are written on regular bank account. 8. A separate imprest payroll bank account should be established to limit possible losses through fraudulent disbursements and to facilitate easier reconciliation of accounts. (Item numbers for this section are keyed to the seven errors listed in the problem.) Control Weakness: Computer Processing Recommendations 1. Cheque not processed due to transposition error. 1. Preprinted time cards, and employ an edit run to check validity of employee number, e.g., check digit, or install a scan card entry system. 2. No limit test on payroll processing of gross wages. 2. A limit test should be incorporated into the program to flag any employee's record whenever gross wages exceed $300 per week; and produce a listing of all exceptions for management review to determine if the amounts were accurate or needed to be corrected. 3. No controls to assure that all items submitted were processed (poor batching methods). 3. Implement programmed batch controls, e.g., a total of employee number, record counts. 4. a) No protection against inadvertent deletion of critical files and records. b) Possible limited file reconstruction ability. 4. a) Restrict access to hard drives, programs and files to necessary personnel by user ids and passwords. Others should have read only or no permissions. b) Backup copies of at least two previous payroll registers should be maintained off-line. Periodic backup copies on disk or separate drives should be created and stored off-site. 5. a) No limit test of processing of labour hours. b) Lack of input verification. 5. a) A limit test should be incorporated into the program to halt the processing of any employee record whose labour hours exceed 60; a listing of all exceptions would be prepared for review to determine if the hours were right or needed to be corrected. b) Errors can be eliminated by key verification or use of a time clock. 6. Records are skipped, indicating summary journal entries are not proved properly. 6. Examine program logic, ensure there are reconciliation processes in place to agree totals of cheques issued to summary posting to general ledger accounts. 7. Improper modifications of data by data processing employee. 7. Management reports of all pay rate changes and other non-routine changes should be automatically produced by the program, and reviewed regularly by manager who is independent of payroll processing and who has authority to authorize pay changes. DC13-9 Risk assessments and responses for manufacturing inventory a) Factors that support accepting SHS, with explanation based on facts given in SHS case, include the following: - Is the PA firm independent? - Does the PA firm have the expertise and resources to conduct the audit? - Is the client a going concern? - Is management trustworthy & competent? - Do they need an audit? - Is the risk arising from known users of the financial statements reasonably determinable and acceptable? We should consider the following detailed points in support of the acceptance decision in this case. --Obtaining and reviewing financial information about prospective client: Are there unusual accounts or business practices that audit firm is not familiar with? As auditors we need to understand business risks. --SHS manufactures a specialized product, solar panels/systems: We need to understand this process, the nature of sales agreements, warranties, etc. SHS has patents for its products - we may have valuation or ownership challenges in doing this audit, but assuming we have handled it in past it is likely we can continue to do so this year. Is the financial condition good? --SHS profits are around $0.66 million, but has a deficit in R/E due to start up period losses. It has Assets- Liabilities around $5 million and liabilities of around $5.6 ( but excluding the shareholder loan liabilities are only about 200k). The financial condition looks fairly sound for now, but if the shareholder uses the new funds from an IPO to take her funds back out, the financial condition would worsen, thus creating some uncertainty that SHS can continue as a going concern. Evaluation of audit firm's independence --SHS is a new audit decision, and we need to check that all the audit firm’s staff have no conflicts, and are independent. Does audit firm have competency and resources to do an effective audit? --Considering SHS’s size, location, and the nature of its operations, our main concern would be whether our firm is capable to complete the audit Determine management’s willingness to accept responsibility for financial statements that are fairly presented in accordance with GAAP/acceptable framework and accept responsibility for adequate internal control --We will need to check whether SHS’s new management has competency and integrity, and enforces good controls. We will need to get an engagement letter from them confirming these points. b) Quantitative starting point: 5-10% normal operating income Base: Calculated from trial balance information given: Income = $664,000 $ 664,000 @ 5% = $33,200 @ 10% = $ 66, 400 Take 5% to provide lower end of preliminary range, or other reasonable approach Justification: Quantitative - Consider the starting point above in relation to other f/s components: e.g. 1/2 to 1% revenues, total assets, etc. Qualitative - Consider that SHS is going public soon , inventory is its main asset of interest, “solar energy systems” are high value items, sales are low volume but high value, etc. Calculate performance materiality as 70% of materiality level ( or other amount with valid reasons) explain its use is to ensure our work is performed in enough precision that we have reasonable assurance that there is not a misstatement that would be material at the overall financial statement level. Conclusion on Materiality levels: A range of values could be generated, and supported based on the analysis above and the auditor’s best judgment c) Our decision on acceptable audit risk level is based on the nature of the SHS engagement, and consequences of audit failure We should make note of the following factors in the SHS case facts, which have an impact on audit risk (AR) level that we can accept after performing this audit:. The following factors would lower the AR we would want to accept: -Public vs. private company -- SHS is planning to go public soon -Users will be making risky financial decisions based on the financial statements if there is an IPO, because public investors will use prior audited f/s to check trends, financial strength, etc. so will be using this year’s audited f/s SHS has plans to grow so it faces new risks if its strategy doesn’t work Management's reputation/integrity, willingness accept responsibilities for preparing GAAP f/s, designing and implementing adequate I/C and to provide written representations -- at SHS this is unknown Other factors would tend to support accepting a somewhat higher AR: New CFO is experienced professional accountant SHS’s financial health/risk of business failure -- SHS is financially sound On balance, it would be prudent to aim to achieve a fairly low AR on this engagement. d) In order to design an effective audit, auditors must understand the business and the economic environment of the business, including factors set out in CAS 315, such as: Economic conditions - there has been growth in sales in past years, but a recession may affect future expected growth Geographic locations - they are selling around the world, so there may be some areas where economies are strong, allowing sales to stay strong - they are buying raw materials on world markets, so they face supply and shipping risks Developments in taxation and regulation - government solar energy incentives, relevant environmental standards can affect their strategy and their success Specific industry characteristics & risks - New technologies are used, and their manufacturing specifications must be very precise Business objectives- They are aiming to grow sales, expand capacity Key strategies employed to meet those objectives - quality control, research/improve production processes, etc. Risks that threaten achievement of those objectives - They need to obtain special materials - so they face price changes risk. Their success depends on product quality & their reputation needs to be defended, SHS’s technology is new so there is a risk it will not work well, and/or that newer technological developments will make SHS’s technology obsolete. e) (Note Inventory in manufacturing business, will have raw material, WIP and finished goods - the assessment below is for finished goods. Assessment for raw material or WIP risk assessments may differ.) Assertion-based risk assessments with reasons: Existence: low - Solar energy systems are not easily stolen, verification by physical inspection can provide very reliable evidence Completeness: medium - This assertion depends on good controls over recording all purchases, and moving costs through the production accounting process, there is a possibility of missing recording some costs unless controls are good. This indicates a need to understand controls to meet this audit objective. Valuation: - high - there are questions of whether the systems can be sold at the expected price, whether the raw materials of suitable quality can be obtained at expected prcies. It is a complex production process so there are questions about whether all production costs get captured, including overhead allocations. The NRV also may be difficult to estimate due to the specialized nature and limited market for the products. Ownership: low - It seems unlikely for SHS management to record manufactured inventory that is not owned, but we need to understand purchase/sales contract terms, management controls in place in any case. Written management representations regarding this assertion will be particularly important. Presentation: low - Classification not complex, accounting policies for inventory valuation & disclosure are clear to apply, management has strong accounting skills. f] The following substantive procedures would be considered to respond to the risk above. Analytical procedures Perform the following analysis and obtain satisfactory explanations from management for relationships observed: a) Compare gross profit margin (i.e., as a percentage of sales) by product and compare with prior periods. b) Compare gross profit margin by product with the standard mark-up. c) Compare gross profit margin by month for the last two fiscal periods. Note any differences in the gross profit margin in the months before and after the period end. Tests of details of transactions and balances Select the significant items contained in the inventory balance and perform the following procedures: Raw material Agree cost to suppliers’ invoices, shipping charges, and customs brokers’ charges. WIP and finished goods Review cost elements and costing calculations by product for accuracy and reasonableness. Compare labour rates used with the payroll records. Overhead applied to inventory Assess the reasonableness of overhead rates used by comparing amounts applied with actual overhead in the accounting records. Ensure inventory costs in a foreign currency have been translated at the period-end exchange rate. Assess reasonability of accounting policies chosen by the entity in relation to common practice in the industry, consistency with previous periods, and impact on net income. Obtain evidence of current market prices of raw materials and finished goods, and expected costs of selling these, and determine whether net realizable value exceeds the carry costs. If not, a write down to NRV is required for fair presentation. DC13-10 Payroll process - False claims for hours worked To obtain evidence to determine whether wages were paid to valid employees for actual time worked at the authorized pay rate, the following procedures would be performed: Test of Controls Auditors should make enquiries (e.g., internal control questionnaire) about the error-checking procedures performed by hospital accounting personnel. Although the procedures and documents for control were in place, the controls did not operate because nobody at the hospital ever compared the ward shift logs to time cards, and nobody examined the supervisory approval signatures for their validity. The scam was easy in the temporary personnel agency situation because the nurses submitted their own time cards to the agency for payment. The same scam might be operated by the hospital’s own employees if they, too, could write their time cards and submit them to the payroll department. Test of control audit procedures are designed to determine whether control procedures are followed properly by the organization. Since the comparison and checking procedures were not performed, the auditors should identify this control weakness, and would therefore not perform control tests on non-existent controls. However, the substantive tests described following are similar in design to the procedures that could be used in tests of controls, but these are performed to determine whether nurses were paid improperly (a substantive purpose). Audit of Balances Select a sample of agency billings and their supporting documentation (time sheets). Vouch rates billed by the agency to the contract for agreement to proper rate. Vouch time claimed to hospital work attendance records (ward shift logs). Obtain handwriting examples of supervisors’ signatures and compare them to the approval signatures on time cards. Use personnel records to determine whether supervisors were actually employed by the hospital at the time they approved the time cards. Use available work attendance records to determine whether supervisors were actually on duty at the time they approved the time cards. Handwriting comparison can provide evidence that the signatures were not written by the supervisors. Audit results: These procedures should allow the auditors to find that Nurse Jane (and others) had not signed in on ward shift logs for days they claimed to have worked. Further investigation would show that the supervisors who supposedly signed the time cards were not even employed by the hospital at the time their signatures were used for approvals. The auditors quickly found that Nurse Jane (and others) had not signed in on ward shift logs for days they claimed to have worked. Further investigation showed that the supervisors who supposedly signed the time cards were not even employed by the hospital. CHAPTER 14 Finance and Investment Process SOLUTIONS FOR REVIEW CHECKPOINTS 14-1 Reference is to the Park 'N Fly vignette in the chapter. This question highlights the problem of specific quantitative criteria in accounting standards. A desperate management can craft transactions to meet the letter of the rules while violating their spirit. Some auditors would insist on capitalization and liability recognition; others would breathe a sigh of relief that the client avoided violating the "no additional debt" loan covenant. Some auditors follow the general rule: "When in doubt, fix it or disclose it." With reference to IAS 17.10 (d) (and similar CICA Handbook Section 3065) a lease should be capitalized if substantially all the risks and rewards of ownership are transferred to the lessee. The auditor needs to decide if these conditions have been met, and provide reasons for the conclusion. This increasing need under IFRS to provide reasons that justify the conclusion illustrates the importance of critical thinking as explained in chapter 3. Under previous accounting standards such as section 3065.06 a “bright line” rule such that if present value of lease payments amounts to at least 90% of the fair value of the leased asset then the lease should be capitalized, there is less need for principles-based reasons. 14-2 Actions by the board of directors or finance committee are usually required as authorization for loans payable. Auditors would want to read all minutes of the board and executive committees, extracting copies of all financial matters, including loans payable authorizations. 14-3 "Off-balance sheet information" refers to information that relates to obligations and commitments assumed by the clients that do not appear on the balance sheet as current or long term liabilities. Such information should be disclosed by the client in the footnotes to the financial statements. Therefore, the auditors must be alert to these items and gather evidence that will allow the auditors to determine if the footnote disclosure is adequate. Such information includes: leases, endorsements on discounted notes or others' obligations, guarantees, repurchase or remarketing agreements, commitments to purchase at fixed prices, commitments to sell at fixed prices, legal judgment, litigation, pending litigation. 14-4 The features of capital stock that are of importance to the audit are: number of shares authorized and outstanding, conversion terms, dividend payment, expiration dates and terms of warrants, rights and options, and terms of any stock dividends and splits. 14-5 The information that can be confirmed when outside parties such as independent registrars and transfer agents are used by the client include the items featured in the answer to review question 14.4 above. Many of these items can be corroborated by the auditors inspecting the reports from these agents, reading the minutes of the directors and reading prospectuses. 14-6 To obtain relevant audit data about investment securities, auditors' procedures include: When physical negotiable securities are in custody of client personnel- # Inspecting the securities in the presence of a responsible client officer. # Personally examining the securities while other negotiable fund sources are sealed off or are being examined simultaneously. # Obtaining a written statement from the client's representative that the securities were returned intact. When negotiable securities are held by an outside service organization (often this ‘custody’ will be in the form of electronic records)- # Obtaining the information by confirmation from the independent party (e.g., trustee) who holds the securities or records of ownership. 14-7 A controlled count of the client's investment securities consists of the audit team gaining access to the securities in the presence of a responsible client officer. The count is first controlled by simultaneously counting or sealing off other negotiable funds (such as securities held as collateral) and second by the auditors personally conducting the count. When the count is completed, the auditors should obtain a written statement from the client's officer that the securities were returned intact. A securities count working paper should include a record of the name of the company represented by the certificate, the interest rate for bonds, the dividend rate for preferred stocks, the due date for bonds, the serial numbers on the certificates, the face value of bonds, the number or face amount of bonds and stock shares, and notes on the name of the owner shown on the face of the certificate or on the endorsements on the back (should be the client company). 14-8 A "destruction certificate" is an attestation by a contractor that canceled stock certificates and bonds have been mutilated, burned, or otherwise destroyed to take them out of circulation. 14-9 A compensating control for finance and investment process accounts is a control feature used when a standard control procedure (such as strict segregation of functional responsibilities of custody, recording and independent review) is not specified by the company. In the area of finance and investment, the compensating control feature is the involvement of two or more persons in each kind of important functional responsibility. If involvement by multiple persons is not specified, then oversight or review can be substituted. For example, the board of directors can authorize purchase of securities or creation of a partnership. The CFO or CEO can carry out the transactions, have custody of certificates and agreements, manage the partnership or the portfolio of securities, oversee the recordkeeping, and make the decisions about valuations and accounting (authorizing the journal entries). These are rather normal management activities, and they combine several responsibilities. The compensating control can exist in the form of periodic reports to the board of directors, oversight by the investment committee of the board, and internal audit involvement in making a periodic reconciliation of securities certificates in a portfolio with the amounts and descriptions recorded in the accounts. 14-10 According to auditing standards specific relevant aspects of control over the production of accounting estimates include: # Management communication of the need for proper accounting estimates. # Accumulation of relevant, sufficient, and reliable data for estimates. # Preparation of estimates by qualified personnel. # Adequate review and approval by appropriate levels of authority. # Comparison of prior estimates with subsequent results to assess the reliability of the estimation outcomes. # Consideration by management of whether particular accounting estimates are consistent with the company's operational plans and current operating conditions. Auditors' can make these inquiries: # Who prepares estimates? # When are they prepared? # What data are used? # What logical method is used to develop the estimates? # Have the data sources and/or estimation methods changed from prior year? # Who reviews and approves the estimates? # Have you compared prior estimates with subsequent actual events? 14-11 Based on the Gulf & Western-Resorts International anecdote: When a company has produced an estimate of an investment valuation based on a nonmonetary exchange, an auditor can look to the company's tax return to check on consistent tax treatment. In the G&W case, a much lower valuation would have been found, and a serious question (red flag) would have been raised. 14-12 If a company does not monitor notes and loans payable for due dates and interest payment dates in relation to financial statement dates, these misstatements can appear in the financial statements: # Understated interest expense and understated current liabilities resulting from failure to accrue interest expense. # Understated current liabilities and overstated long-term debt resulting from failure to classify the "current portion of long term debt" in current liabilities. 14-13 Transactions in long-term debt, capital stock, paid-in capital, and retained earnings are usually not tested as a matter of an internal control evaluation. These transactions are generally audited completely by reference to authorizations, tracing them to events reflected in the accounts and related disclosures, and by vouching to cash receipts and disbursements and other formal documentation for verification of the transaction amounts. Subjecting these transactions to detailed audit procedures is explained by the great importance of these transactions and their limited number. 14-14 Some of the typical assertions found in owners' equity descriptions and account balances are: 1. The number of shares shown as issued is in fact issued. 2. No other shares (including options, warrants, and the like) have been issued and not recorded or reflected in the accounts and disclosures. 3. The accounting is proper for options, warrants, and other stock issue plans, and related disclosures are adequate. 4. The valuation of shares issued for noncash consideration is proper in conformity with accounting principles. 5. All owners' equity transactions have been authorized by the board of directors. 14-15 Confirmations for shareholder equity: Capital stock may be subject to confirmation when independent registrars and transfer agents are employed. Such agents are responsible for knowing the number of shares authorized and issued and for keeping lists of stockholders' names. The basic information about capital stock, such as number of shares, classes of shares, preferred dividend rates, conversion terms, dividend payments, shares held in the company name, expiration dates, and terms of warrants and stock dividends and splits, can be confirmed with the independent agents. Many of these items can be corroborated by the auditors' own inspection and reading of share certificates, charter authorizations, directors' minutes, and registration statements. However, when there are no independent agents, most audit evidence is gathered by vouching share record documents (such as certificate book stubs). When circumstances call for extended procedures, information on issued and outstanding shares may be confirmed directly with the holders. For notes, loans and bonds payable, written confirmations are usually obtained from the independent parties to whom these are payable. If these are payable to banks, the standard bank confirmation may be used. Formal debt instruments can be confirmed by letter to the bondholders or their agents. The confirmation requests should include questions of amount, interest rate, due date, collateral, restrictive covenants and other terms. If the auditor is concerned about unrecorded liabilities, audit procedures used to search for unrecorded liabilities include sending confirmation requests to lenders with whom the company has done business in the recent past even if no liability balance is shown at the confirmation date. 14-16 Some of the typical assertions found in the long-term liability accounts are: 1. All material long-term liabilities are recorded. 2. Liabilities are properly classified according to their current or long-term status. The current portion of long- term debt is properly valued and classified. 3. New long-term liabilities and debt extinguishments are properly authorized. 4. Terms, conditions, and restrictions relating to noncurrent debt are adequately disclosed. 5. Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate. 6. All important contingencies are either accrued in the accounts or disclosed in footnotes. 14-17 Investment cost can be vouched to brokers' advices, monthly statements and cancelled cheques. The auditors can similarly vouch the price of securities sold and investment income to this documentary evidence and then trace amounts to income, gain and loss, and cash accounts. 14-18 If investments are sold at substantial losses early in the period following year-end, there is evidence that there were unrealized losses on those securities at the balance sheet date. Accordingly, the auditor will consider whether these unrealized losses were reported properly in the financial statements of the period under audit. 14-19 The importance of "substance versus form" is significant in the recognition and reporting of assets, liabilities, income, and expense of transaction and relationships. The concept is that financial statements should contain numbers and descriptions reflecting the real relationships in transactions and relationships, not the narrowly defined legal relationships that may be contrived in contracts designed to withhold disclosure and reporting. Verity Company's product repurchase agreement was a secured loan obscured by a contrived "sale" with a related party. Digilog's failure to consolidate DBSI was a too-clever skirting of the consolidation principles. 14-20 Some of the "trouble spots" for auditors in the audits of investments and intangibles are: # Valuation of investments at fair values and recognition of unrealized gains and losses in comprehensive income. # Determination of significant influence relationship for equity method investments. # Proper determination of goodwill in purchase-method consolidations. # Capitalization and continuing valuation of intangibles and deferred charges. # Realistic distinctions of research, feasibility, and production milestones for capitalization of software development costs. # Adequate disclosure of restrictions, pledges, or liens related to investment assets. 14-21 The single most significant control consideration in connection with clever accounting and fraud in finance and investment accounts is the integrity and accounting knowledge of senior managers. They are the people who initiate, authorize, have custody, and order the accounting treatment of these accounts. 14-22 Fraud in financial and tax reporting is more likely to exist in the finance and investment accounts. Senior officials concerned with stock market reactions or loan applications may desire to falsify financial statements or tax returns "for the good of the company," without much regard to the good of investor and lender decisions or tax collection. 14-23 When an auditor suspects violation of securities laws, the factual and descriptive information should be taken to a competent lawyer for review and an opinion. Auditors can advise company management and those charged with governance to consult with the regulatory authorities about the necessity for conforming with the law in connection with contemplated transactions. 14-24 The danger for auditors when company officials engage in undisclosed related party transactions is that accounting values may be manipulated in a number of ways involving purchase of assets at inflated prices, leases with affiliates, acquisitions of patents for shares given to an inventor or promoter, sales to affiliates, and fallacious decisions about amortization. Business history has recorded several cases of non-arm's-length transactions with promoters, officers, directors, and controlled companies (even "dummy" companies) designed to drain the company's resources and fool the auditors. All transactions with persons closely associated with the company (related parties) should be audited carefully with reference to market values, particularly when a nonmonetary transaction is involved (such as shares exchanged for patent rights). Sales and lease-back and straight lease transactions with insiders likewise should be audited carefully. Special efforts should be made to determine whether other parties to major transactions are related parties, even if the relationship is not disclosed by management. SOLUTIONS FOR EXERCISES AND PROBLEMS EP14-1 a. The three questions in the problem could be called "environment" questions. They assess whether there are company- level controls over these assets. The third question involves procedures that would be done at the outside brokerage company, a ‘service organization’. Cassandra’s auditor may need to contact the brokerage house or obtain a report from the ‘service organization’ auditor regarding control procedures at the brokerage. b. Questions specific to control objectives are: Validity 1. Are marketable securities investment transactions supported by invoices from brokers or other documents supporting securities not obtained through brokers? Completeness 2. Do the cash disbursements procedures contain directions for identifying and accounting for investments in marketable securities? Authorization 3. Are written authorizations to purchase marketable securities transmitted to the controller's office for reference awaiting completion of transactions? Accuracy 4. Does the controller approved investment security transactions for proper calculation of interest purchased in bond transactions, special terms of options, warrants, and other features of complicated investment securities? Classification 5. Does the board of directors, vice president of finance, or treasurer tell the controller in writing the intent of the management in connection with classifying investments as long term of short term? Accounting 6. Are subsidiary records of investments kept? Reconciled periodically with a control account and to reports received from the brokerage house? Are sales proceeds analyzed to account for gains and losses? Proper Period 7. Does the controller's office receive notice of dividends declared in companies in which investments are held so accounting can match the proper period? Do accountants have instructions to accrue interest to the date of the financial statements? EP14-2 a. The objectives (specific assertions) for the non-current investment securities about which the auditor needs to obtain evidence are: * Existence of the investment securities at the balance sheet date. * Ownership of the investment securities. * Cost and current market value of the investment securities. * Proper presentation and disclosure of the investment securities in the financial statement. * Proper recognition of interest income. * Proper recognition of investment gains and losses. Obtaining this evidence would involve verifying: * Investment securities are on hand or are properly held by a trustee. * Investment costs and market values. * Investments pledged as collateral are properly disclosed. * Investments that confer significant influence on investee company are accounted for by the equity method. * Investment income earned has been received and recorded, or accrued. b. The following audit procedures should be undertaken with respect to the audit of Bass' investment securities: * Inspect and count securities in the company's safe and safe deposit box. * Examine brokers' statements to obtain assurance that all transactions were recorded. * Examine documents in support of purchases and sales of investment securities. * Inspect the minutes of the board of directors meetings. * Review the audited financial statements of the (25 percent) investee. * Verify the equity method of accounting was used for carrying value of the investment in Commercial Industrial. * Obtain a client representation letter that confirms the client's representations concerning the noncurrent investment securities. * Verify the calculation of interest income. * Review the propriety of the presentation and disclosure of the securities in the financial statements. * Make certain that the client representation letter includes the proper assertions concerning accounts payable. * Investigate and resolve confirmation exceptions and other matters requiring followup. EP14-3 a. Instructions to be given to the assistant regarding the examination of the securities kept in the safe deposit box include the following: 1. A copy of the client's inventory of the contents box should be obtained and used in connection with the inspection of the securities. Comparing the contents of the box and the inventory will provide assurance that all securities listed in the inventory are on hand. (The validity of the inventory will be determined by examination of the transactions pertaining to investments.) The copy of the inventory, after being checked, should be added to the auditor's working papers as evidence of work performed. 2. The bank's record of persons entering the deposit box should be examined to determine that only authorized persons have had access to the box and that there was no entry to the box between December 31 and January 11. Entry to the box between those dates may be an indication that a security was returned to safekeeping after being "borrowed" at year-end. The security may have been "borrowed" and used as collateral to obtain cash to cover a shortage at December 31. 3. The assistant should be instructed to insist that the treasurer be present while the securities are being examined. His presence will deter any future claim that, if a security is missing at a later date, the assistant took it. 4. The following details of the securities should be examined: a. The name of the registered owner (Demot Corp.) appearing on each security other than bearer bonds should be noted. b. The dates stamped on share certificates giving the dates that the certificates were prepared should be noted and subsequently compared with cash disbursements. c. The name of the corporation issuing the security and the class of the security (Class A, 1st Preferred, etc.) should be noted for assurance that a lower priced security (perhaps somewhat similar in corporate name or a different security of the issuing corporation) has not been substituted for a higher priced security. d. The face value of bonds and the number of shares represented by each share certificate should be compared with the inventory to determine that the entire amount of the corporation's holdings of each security is on hand. e. The serial numbers of the securities should be compared with those on the inventory and, for those securities carried over from the prior year, compared with the serial numbers of securities listed in the prior year's working papers. A change in serial numbers that cannot be properly explained may be an indication of manipulation of the securities. f. The certificate should be read to ascertain that interest rates and payment dates for bonds and the dividend rates and payment dates, if given, for preferred shares. This information may be used later in the verification of investment income. g. Bonds should be examined to determine maturity dates. Maturity dates are needed for checking the computation of the amortization of bond premiums or discounts. h. Coupon bonds should be inspected to determine that no past-due interest coupons are unclipped and all future interest coupons are attached. i. The auditor should be alert for any obvious alterations to securities or forged certificates. j. The auditor should also examine the reverse side of the certificates to determine whether they have been endorsed for transfer. The presence of an endorsement may be an indication that the security had been converted temporarily for some use, perhaps fraudulent, in the past. k. Any worthless securities on hand should also be examined and compared with the client's inventory and with prior-year working papers. Any missing securities should be noted for subsequent follow-up to determine that the client had received the funds derived from the sale or redemption of securities deemed worthless in error. b. The treasurer's entry into the safe deposit box on January 4 has violated the auditor's control over liquid assets which must be counted simultaneously or kept under control until counted to avoid the substitution of a counted asset for an uncounted asset in an attempt to conceal a shortage. The auditor would probably apply the following additional procedures: 1. Reconcile bank balances at both year-end at the count date. 2. Obtain a bank confirmation as of the count date. 3. Examine cash entries between year-end and the count date for any unusual entries. 4. Examine all investment transactions taking place between the balance sheet date and the count date to verify the amount of the investments at the balance sheet date. 5. If the client keeps a large fund of cash on hand, make a surprise count of the cash fund. 6. Review the transactions since year-end relating to any other assets, such as mortgages owned, to determine if any substitutions have been made. 7. Visit the Chamber of Commerce and take a look at the photograph. EP14-4 a. The dividend and interest income should be verified by comparing the income as recorded to an independent source, i.e., a newspaper, dividend record, etc. Bond interest income may be verified by computation. b. Market value can be checked by reference to independent sources, such as newspapers. In cases where there is no ready market, estimates may be based on the best information available. (A recent sale would be regarded as best.) c. Authority for security purchases could be established by reading 1. The document containing the authorization, such as company's minutes, and 2. The loan agreement with the bank. Permission from the bank may be required to invest loan proceeds in securities. EP14-5 a. Audit program 1. Discuss the nature of the project and the people, materials, and facilities used on it with someone well acquainted with it. 2. Examine internal control surrounding the use of materials, personnel, and facilities used in research, and the related accounting. 3. Secure or prepare an analysis of the total cost and a. Vouch materials charged to the project with requisitions, invoices, or other documents, scrutinizing them for appropriateness to the job (test the period January 20x1 to October 20x2). b. Ascertain that labour charged to the project was actually performed on it by testing payroll using time or job cards or other available records of work. c. Scrutinize any charges for overhead made to the project for equitableness in the light of total overhead cost, other applications of overhead, and the possibility of idle capacity. d. Compare the actual cost to the original and revised budgeted or appropriated amounts. Investigate any substantial difference. e. Investigate and test that costs of the project were charged to expense in the proper periods over the two years involved. 4. Examine letters, patent, and applications therefore and correspondence thereon to satisfy yourself that the patent application resulted from the work on "Project Able." Enquire of management regarding the commercial viability of the results of Project Able to assess whether further development costs would be capitalized under IAS 38.57-62 5. Trace research and development costs to the expense account. b. The problem with the purchased computer program is the allocation of its costs to Project Able and to future projects. 1. Discuss with informed executives and R & D personnel the applicability of the program in Project Baker and future projects. 2. Review the record of the use of the program on Project Able. 3. The recorded amortization of $5,000 indicates that the program is usable on nine projects of the magnitude of Project Able. a. Discuss the planned use of the program on Project Baker. b. Ascertain whether there are plans for future projects or if the $5,000 is simply a guess. EP14-6 The following adjusting entries account for the information listed in the question. It is assumed that the client has not yet made any entries related to this information. 1. Machinery ______________________________ 17,000 Patents ___________________________ 17,000 To transfer cost of improving machinery to the fixed asset account. (Since this cost was incurred in December of the year under audit, depreciation would not be material.) Cost of goods sold _____________________ 4,000 Patents ___________________________ 4,000 To record straight-line amortization of patents for the year. 2. Advertising expense--error correction __ 24,000 Goodwill __________________________ 24,000 To correct the accounting error of last year of improperly capitalizing an expense item. 3. Equipment ______________________________ 8,500 Accounts receivable--nontrade __________ 2,500 Leasehold improvements ____________ 11,000 To record equipment in the proper account and to record a receivable for the real estate taxes. Amortization expense--current year _____ 1,500 Amortization expense--error correction _ 1,500 Accumulated amortization ____________ 3,000 To record current amortization of leasehold improvements on a straight-line, 10-year basis and correct the error of failure in previous year to record amortization. No adjustment to depreciation of equipment since it was acquired in December. EP14-7 a. The audit objectives in the examination of long-term debt are to determine that: 1. All liabilities were properly recorded. 2. Items recorded as liabilities are bona fide obligations. 3. Interest expense and/or amortization was properly computed and recorded. 4. The client is not in violation of restrictions or requirements imposed on it by the terms of the loan agreement. 5. Satisfactory authority existed to enter into long-term obligation agreements. 6. All long-term obligations are properly classified in the balance sheet. 7. Assets pledged as security are adequately disclosed. b. The following procedures should be included in an audit program for the examination of the long-term note between Ronlyn and Second National Bank: 1. Confirm the loan and terms of the agreement with the bank. 2. Review the agreement between Ronlyn and the bank to determine that: a. The debt is long term (by reference to dates). b. Provisions of the agreement have not been violated, e.g., that Ronlyn is complying with any restrictions on the payment of dividends, on the amount of working capital to be maintained, or on the uses to which the funds may be employed and is maintaining the plant pledged as security for the loan. c. The agreement was signed by person(s) having authority. 3. Trace the receipt of funds into the bank account and cash receipts book. 4. Check the computation of interest expense for the period May 1 to June 30, and trace the recording of the expense and the accrual on the books. 5. Determine that authority to borrow was granted and is recorded in the board of directors' minutes. EP14-8 a. The procedures you should employ in examining the Broadwall loans are as follows: * Obtain an understanding of the business purpose of the loans made by the president. * Confirm the loans, including terms, by direct communication. * Recompute interest expense and interest payable. * Review minutes of meetings of the board of directors for proper authorization. * Verify payments made during the year and transactions after the year end. * Read the notes to the financial statements regarding the loan agreements and evaluate the adequacy of disclosure and compliance with restrictions. * Obtain a management representation letter. b. Broadwall's financial statements should disclose the following information concerning the loans from its president: * The nature of the related-party relationship. * The dollar amounts of the loans. * Amounts due the president and, if not otherwise apparent, the terms and manner of settlement. EP14-9 In each case any actual failure to comply would need to be reported in a footnote to the statements in view of the possible serious consequences of advancing the maturity date of the loan. The individual audit steps follow: 1. Check balance sheets at beginning and through the previous fiscal year for working capital ratio. If under 2 to 1, check compensation of officers for compliance with limitation. 2. Examine client's copies of insurance policies or certificates of insurance for compliance with the covenant, preparing schedule of book value, appraised or estimated actual value and coverage for report. Confirm policies held with trustee. 3. Examine vouchers supporting tax payments on all property covered by the indenture. By reference to the local tax laws and the vouchers, determine that all taxes have been paid before the penalty-free period expired. If vouchers in any case are inadequate, confirm with trustee who holds the tax receipts. 4. Vouch payments to sinking fund. Confirm bond purchases and sinking fund balance with trustee. Observe cremation certificates or equal evidence of destruction of bonds for bonds canceled. Report the fund as an asset, preferably giving the composition as to cash and bonds held alive, if any. EP14-10 a. (i) The audit program for the examination of Pate Corporation's Shareh Capital account would include the following procedures: 1. Examine the articles of incorporation, the bylaws, and the minutes of the board of directors from the inception of the corporation to determine the provisions or decisions relating to share capital such as classes of shares, no par value, authorized number of shares, authorization of the sale of new issues or additional sales of unissued stock, declarations of stock splits and dividends in the form of cash or stock, and granting of stock options or stock rights. (Presentation and Disclosure audit objectives.) 2. Examine the share certificate stub book and determine whether the total of the open stubs agrees with the Share Capital account in the general ledger. Examine canceled share certificates which are generally attached to the corresponding stub. Information on the stubs regarding the number of shares, date, etc., for both outstanding and cancelled share certificates should be compared with the Share Capital account. All certificate numbers should be accounted for. (Existence and Completeness audit objectives.) 3. Analyze the Share Capital account from the corporation's inception and audit all entries. Trace all transactions involving the transfer of cash either to the cash receipts or the cash disbursements records. If property other than cash was received in exchange for shares, trace the recording of the property in the proper asset account and consider the reasonableness of the valuation placed on the property. If the analysis of the Share Capital account disclose that the corporation has engaged in share repurchase transactions, determine that the increases or decreases in net assets resulting from these transactions have not been placed in the Retained Earnings account. (Valuation objective.) (ii) The audit procedures to be applied to the examination of the Contributed Capital are usually applied at the same time that the Share Capital account is being examined because the two accounts are interrelated. The account should be analyzed and the entries audited when the related entries in the Share Capital account are audited. (iii) The following audit procedures would be applied to the Retained Earnings account: 1. Analyze the account’s continuity from its inception. Consider the validity of the amounts representing income or loss that were closed from the Profit and Loss account. (Valuation objective.) 2. Any charges or credits made directly to the Retained Earnings account should be investigated and their treatment reviewed in relation to generally accepted accounting principles. (Valuation objective.) 3. Actions of the board of directors that affected retained earnings should be traced to the account analysis. (Presentation and Disclosure objective.) 4. Conditions, such as loan covenants or contingent liabilities, that were uncovered during the audit that might require or make desirable the placing of restrictions on retained earnings should be brought to the client's attention, and provision should be made for proper disclosure in the financial statements. (Presentation and Disclosure objective.) 5. Entries recording cash or stock dividends should be traced to the minutes of the board of directors for authorization and to the Cash account or the Capital Stock account. A separate computation should be made by auditors of the total amount of dividends paid based upon their schedules of outstanding stock as an overall test of the validity of the distributions. If stock dividends have been distributed, the amount removed from retained earnings should be reviewed for compliance with generally accepted accounting principles. (Valuation audit objective.) b. In conducting the audit, the auditors audit retained earnings as they do other items on the balance sheet for several reasons. A principal reason is that this part of the audit is an assurance or double check that no important item was overlooked in the examination of the accounts that were the contra or balancing part of the entry recorded in retained earnings. An example of an important item that may be overlooked would be a balance sheet account that was closed during the year under audit and the ledger card for the account removed from the general ledger current file. Another reason is that, though the entry in the contra account may have been examined, the auditors may have overlooked that the balancing part of the entry was to retained earnings, a treatment that may have been contrary to generally accepted accounting principles; their examination of retained earnings would bring this noncompliance to their attention. SOLUTIONS FOR DISCUSSION CASES DC14-1 This case is intended to evoke discussion of significant controlling interests in investments. a. The issues revolve around 1. Conflicts of interest. Students should recognize the apparent existence of nonarm's-length transactions in the transfer prices of products to Hardy Hardware from Hardy Products. However, whether the prices are not equivalent to market prices is not certain. Hardy Hardware may outperform the rest of the industry for other reasons, and Hardy Products' net of 1 percent on sales may be characteristic of its business (although the 1 percent is extremely low). The brothers have no apparent conflict between themselves. Any conflict would have to be perceived as being between the brothers and the public shareholders. 2. The criterion presumption for using the equity method is a 20 percent stock ownership, and Hardy Hardware's ownership amounts to only 15 percent. However, there are other controlling influences at work, namely James Hardy's effective control of Hardy Hardware (20 percent) and his consequent ability to dictate the voting of the 15 percent interest in Hardy Products. b. Some might say that this interrelationship of investments constitutes a significant controlling influence that, while not vested entirely in the investor corporation (Hardy Hardware), certainly operates to the benefit of Hardy Hardware. Whether to insist upon the equity method in this case re-presents a difficult decision, as the former auditor apparently found out. c. The auditor should seek to compare the transfer prices to market-determined prices for the same or similar goods. The possibility exists that Hardy Products is charging breakeven prices so that Hardy Hardware can show better operating results. d. Adequate disclosure in this case is not an easy issue. Certain provincial Security Commission rules require disclosure of transactions with controlling persons. Hardy Hardware will certainly have to observe regulations in statements filed with the provincial Commission, and the auditor might protect himself as well as serve the public shareholders by insisting upon similar disclosures in the annual report. The "related party transaction" disclosures specified in IAS 24 would be appropriate. DC14-2 Hide the Loss Under "Goodwill:" Related Party Transaction Manipulation AUDIT APPROACH Objective: Obtain evidence of the valuation of assets given in exchange for shares and notes to find the proper valuation of recorded goodwill. Control: Control rests with the management and accounting estimates of the value of the assets given in exchange. Estimates of this type should be made with faithfulness to the underlying nature of the assets and their proper valuation. Test of Controls: Auditors should determine the extent of management involvement in major investment and disposal transactions. Studying the minutes of the board and internal correspondence can help contribute this information. All other procedures bear directly on the substantive valuation evidence. Audit of Balance: Since the Amron share valuation was based on the transfer of the ammunition business assets to the new corporation, the underlying composition and book value of the assets should be determined in detail. This work should reveal that the Amron shares’ carrying value included the deferred cost amount of $7 million. The hard part is discerning that the business purpose of the transactions is to get out of the sporting ammunition manufacturing business. If the auditors concentrate on the flow of the transaction and don't get the big picture, they might miss the event of discontinuance. The Big Industrial-Gulwest transaction appears to be clear. Gulwest received shares and a note with total value of $5.4 million. Piercing the veil of the intervening corporate creation transactions and transfers, Gulwest gave assets that were on its original books at $12.4 million. Discovery Summary. The evidence of value received and cost given indicated a loss of $7 million. Auditors need to be perceptive and clever to identify it directly with the discontinued line of business, or even to call it "discontinued." Nevertheless, they were able to identify the amount as a loss and force its recognition in the Gulwest income statement. The spurious "goodwill" was removed from the Gulwest balance sheet. DC14-3 In Plane View: Related Party Transaction Valuation AUDIT APPROACH Objective. Obtain evidence to determine the proper valuation of asset exchanges involving noncash property. Control. Management should have policies and procedures for documenting the valuation of noncash property given and received in exchanges of assets. In this case, since the Wing shares had a quoted market value, their value was the proper amount to use when valuing the airplane received by Whiz. (The value of the airplane is less reliably determinable.) Test of Controls. Auditors should inquire about investment asset dispositions, especially any involving noncash consideration. Upon learning from inquiries or from scanning the accounts, the transaction documentation should be studied to determine whether control of the accounting determinations was exercised. This procedure is part of the substantive work as well as a test of control. Audit of Balances. Upon knowing the date of the transaction purchasing the airplane from Wing and the number of Wing shares transferred, the auditors can look up the quoted market price in newspapers or other library sources for market price history. The finding of the market price should determine the proper amount to record for the airplane. Auditors should have a list of all subsidiary companies and should be able to recognize the Mexican subsidiary as a related party. With this relationship, the amount of the transaction price is suspect. However, efforts can be made to obtain new and used airplane prices to determine whether the $3,750,000 price to the Mexican subsidiary bore any relation to observable airplane valuations. If the value were $3,750,000, the "gain" exists in the transaction with the subsidiary, subject to elimination in consolidation. This "gain," if any, should not be offset against the loss from the exchange with Wing. Discovery Summary. The auditors were astute. They found that the market value of the Wing shares was $2,520,000, and insisted that the airplane be valued at $3 million instead of $3,750,000, thus making the loss on the exchange of Wing shares $750,000 larger. They also made sure that the subsequent gain on the sale to the Mexican subsidiary was eliminated in consolidation, awaiting any future profit confirmation by a sale to an outside party. DC14-4 The main assertions for long-term debt and interest expense are ⸀ Existence ⸀ Completeness ⸀ Authorization/ownership ⸀ Valuation ⸀ Presentation Audit procedures would include: ⸀ Review of Board minutes for approvals (authorization, existence) ⸀ Confirmation with lenders of all details of each debt instrument(all assertions) ⸀ Analysis of the continuity of long-term debt instruments, i.e., opening principal balance, amounts paid back during year, new amounts borrowed during year, ending principal balance (existence, completeness) ⸀ Reasonability test of interest expense (validity, completeness) DC14-5 Long-Term Debt Working Paper Review Please refer to the PowerPoint slides on this DC. The working paper contains the following deficiencies: 1. The subject matter of the working paper is not properly indicated in the title. 2. There is no indication of any follow-up on the identified error in the accrued interest payable computation. 3. There is no indication whether the confirmation exception was resolved. 4. The loan with the unwaived violation of a provision of the debt agreement is misclassified as long-term. 5. The liability activities of Lender's Capital Corp. and the working papers totals do not cross-add correctly. 6. There is no indication of cross-referencing of the shareholder loan to the related party transactions working papers. 7. There is no investigation of the payment on the stockholder loan that was reborrowed soon after year-end. 8. There is no consideration of the need to impute interest expense on the 0% shareholder loan. 9. There is no indication that the dates under "interest paid to" were audited. 10. There is no indication that the unusually high average interest rate ($281,333/$1,406,667 = 20%) was noted and investigated. 11. The working paper does not support the overall conclusions expressed. 12. The tickmark "R" is used but not explained in the tickmark legend. 13. There is no indication that the working paper was prepared by client personnel. DC14-6 a. In order for the auditor to place reliance on evidence obtained from another professional, the auditor must be satisfied tha the other professional is competent and independent. If the professional is another auditor, an additional requirement is that the evidence must not be otherwise economically available. b. The procedure which Clark should follow in determining whether to rely on Lane’s work are: i) Satisfy herself that Lane’s findings appear reasonable. ii) Have or obtain assurance that the data supplied to Lane by the client is appropriate. iii) Satisfy herself that Lane’s findngs support the related assertions in the financial statements. c. If Clark is issuing an unqualified report, Lane should not be mentioned in the auditor’s report. In the case where Lane’s work has led to a scope limitation it’s appropriate to mention Lane’s involvement in connection with the qualification. DC14-7 The role of the Board is set out in corporate by-laws. In many corporations the Board hires, fires and oversees the activities of the top management. Generally, the Board is required to approve management decisions that can have a significant impact on the corporation’s financial condition and future viability. Financing and investing activities tend to be large dollar value, long-term commitments and so Board oversight is most needed for these kinds of decisions, so generally they must be approved by the Board and documented in the minutes. Day-to-day operating decisions are not monitored as closely by the Board, which generally would monitor operating performance by reviewing periodic financial reports from management, e.g., monthly or quarterly financial statements. The auditor can assess the effectiveness of the Board’s oversight by reviewing the composition of the Board, the qualifications and experience of its members, how many are ‘outside directors’ who are independent of management, its meeting frequency, the decisions and actions the Board takes as documented in the minutes of its meetings, . DC14-8 The case requires one to analyze control risks arising from contracting on movements in economic variables. One possible approach is as follows. a) The control risks of derivatives also are ‘derivative’ in that what can go wrong depends on the future movements in commodity prices, foreign exchange and interest rates. Assessing the probabilities of various outcomes and their financial impact on Barrick requires assessing these probabilities, monitoring the movements in the underlying economic variables, assessing the financial impact of these movements on the contracts and positions Barrick has in place, and determining when actions are required based on the risk management parameters established by the company’s Finance Committee. Key controls appear to include the oversight of the Finance Committee in establishing and monitoring the derivatives positions and trading, and segregation of duties of the execution of the derivatives activities to the company’s Treasury function. The Treasury department likely uses an on-line service to constantly track the movements in the relevant economic variables, financial models to generate current impact on Barrick’s positions, with benchmark position values that produce red flags when trading or other action is required to keep within the risk management limits prescribed by the Board’s Finance Committee. b) Audit procedures could involve enquiries about procedures and decisions, reviews of reports and data sources, verification of input data to original sources, evaluation of model functions and whether they comply with the Finance Committees’ policy, evaluation of the risk management policy itself and whether the financial statement disclosures are adequate to communicate the impact of the risk strategy on Barrick’s future performance. DC14-9 Audit of finance transactions, Internet business This is a comprehensive case that could be used for group work in class or as a major assignment, or as a class discussion to pull together the “big picture” and the details of planning an audit. The following is one approach to meeting the requirements of the case. There are other valid approaches that can be taken. ROLE The newly appointed auditor of a public company that has been audited for the past two years (the first two years that it was public) by a different audit firm. As the decision has already been made by the audit firm to accept the client, acceptance considerations are not required at this stage. The audit plan should include the following components, described in the context of the facts of the case UNDERSTANDING THE ENTITY: KEY FACTS OF CLIENT’S BUSINESS SITUATION (facts and analyses that need to be applied in developing the audit programs) ▪ CSI is a public co., new shares are being issued, the share price has fallen, CSI needs cash to succeed/grow ▪ aggressive growth plan, new President is motivated to increase revenues and share price ▪ business model is new, and technology dependent ▪ there is a high risk of business failure ▪ SME customer base suggests trade credit risk high ▪ this is linked to SME economy’s health ▪ Directors hold shares, also have loans to CSI that they want repaid, CSI needs cash to repay these loans, it is also important to note that these are related party transactions ▪ Accounting issues related to business: CSI uses contracts for advertising, contracts for system development, website development fees, barter network transactions, patent on technology, executive stock options, deferring development costs ▪ We have draft 20X5 financial statements, there would be audited 20X4 and 20X3 financial statements filed with securities regulator so we should obtain those, along with all other information filed with the securities regulator ▪ The scope of the audit covers the full set of financial statements, they must be prepared under GAAP since CSI is a public company, but the draft financial statements may not GAAP ▪ information is limited, management integrity is questionable due to aggressive plans, cash needs ▪ Prospective investors are the most important users in this case ▪ CSI objective to raise cash ▪ this may affect their financial reporting choices ▪ key objective for CSI’s accounting information is to assist prospective investors to predict future cash flows and future earnings/performance ▪will the shares increase in value (this is important in this case because the CSI are unlikely to pay dividends) ▪ accounting information will also be used by investors for management evaluation, can management succeed in this business? do they have integrity? ▪ assumptions are required about investor’s investment goals, risk tolerance Understanding the client’s systems and controls - no information is given in case so assumptions are required. Assume there are reasonable systems but due to concerns about new management and its incentives, a substantive approach is chosen. The auditor’s understanding of the client’s business, its environment, risks, systems and controls are the basis developing an appropriate overall strategy that sets out the audit’s timing and the approach to be used to gather sufficient, appropriate evidence. As discussed in Handbook 5150, the overall strategy addresses the following: ⸀ planning materiality ⸀ identifying material financial statement components ⸀ identifying high risk audit areas ⸀ determining the audit evidence required to assess internal control effectiveness (if the auditor is required to provide an assurance report on management assertions about internal control effectiveness this additional responsibility is included here) ⸀ the control framework or criteria to be used to assess control risk ⸀ nature and volume of transactions ⸀ any changes in the industry, legal and regulatory environment, any changes in GAAP, and any changes in the company’s management or operations that can affect financial reports Engagement letter: The aspects of the overall strategy that involve client resources and cooperation are communicated to client management and the audit committee. This helps make the necessary arrangements for gaining access to whatever records and client personnel will be required for interim and final audit work. Establish audit firm’s internal resource as requirements indicated by the overall strategy, for example, how many audit staff are required on the team and what experience levels do they need; are specialists required for IT or tax issues; are external specialists required for valuation assistance; will other offices of the audit firm be involved for multi-location businesses: or will other auditors’ work be relied on for major subsidiaries audited by another audit firms?; timing of audit team meetings; timing and experience levels required for working paper reviews. Control assessment: The assessment of the client’s internal controls involves assessing management’s controls both at the company-level and the application level (transactions, balances and disclosures, and the assertions of each). Details of this assessment are covered in Chapter 9, and the appendix to the Part III Prelude provides a questionnaire that guides the auditor in this assessment for the overall strategy development stage of the audit. Detailed audit plan and specific programs used to perform the audit. Identify CSI’s business processes and related accounting cycles. Revenues, Receivables and Receipts process; Purchases, Payables and Payments process; Production and Payroll processes; Financing, Investing and Earnings processes For each process, cost-effective and efficient audit programs should be set out specifying the nature, extent and timing of audit procedures that will be used to assess the inherent and control risk that could lead to material misstatements, the planned further audit procedures that will be done in response to these risks to reduce them to an acceptably low level and issue an audit opinion. The detailed audit plan also covers decisions about staffing - how will less experienced staff be directed, especially with regard to exercising professional skepticism, how will their work be supervised and reviewed, and what time budgets will be? The following are key risk areas presented in the CSI case that should be addressed in the design of the detailed audit plans 1. Revenue and expense recognition ▪ using gradual recognition as services are provided, choices made appear to recognize revenue much earlier than cash receipts - “when service is provided” could be long before cash inflow - choices also defer recognizing expenses even if cash outflow already occurred ▪ need to factor in probability of cancellations - management states they do this but a lot of estimates are required, management’s estimates may be very/too optimistic - the financial information is not very useful as is Audit issues - need get special purpose financial information about cancellation rates, collection rates, to assess actual cash flows and 'future revenue generating' potential -other valid approaches/points 2. Bad debts ▪ draft financial statement approach appears okay, the NRV valuation complies with GAAP ▪ additional relevant valuation information could be: collection history, aging, credit analysis of client base Audit issues - we should evaluate this information from perspective of management possibly being too aggressive in making their estimates ▪ we need financial information about accounts receivable collection history, and to examine trends/history of collections and write-offs ▪ other valid approaches/points 3. Barter networks ▪ draft financial statement are using fair value estimates and recognizing these as though these were cash flows ▪ these are subjective, management evaluations so there is a lot of leeway for management to be very aggressive here Audit issues - - additional relevant valuation information we require includes more detail of market values of bartered goods/services, we should compare to what actual cash-based transactions would be valued at for these kinds of services, we need to find out about the barter partners and whether they have aggressive objectives too - we should consider whether the barter transactions are critical to CSI’s business or just a way to jack up revenues (therefore misleading) - evaluate this information from perspective of management possibly being too aggressive ▪ consider whether the financial statements are providing enough information to evaluate the barter aspect of financial performance separately, as it may not be properly measured ▪ other valid approaches/points 4. System development contract with retail chains ▪ this seems like a significant business opportunity, the potential dollar amounts large Audit issues - we need to consider if the percentage of completion method is appropriate when CSI has not done this kind of contract before - does $6.5/13.5 recognition ratio match ‘completion’? - what are the related costs incurred to date? have these been expensed to match the revenues? what recourse do the chains have if CSI fails to develop acceptable system? ▪ additional relevant valuation information we could try to obtain related to this includes: expected completion timing and costs from actual project developers rather than Mr. Dorado who is possibly being too aggressive; more information on expected profitability, potential for new contracts of this kind, for cash flow prediction as the contracts appear to have been paid up front and this may be a successful future profit line for CSI ▪ other valid approaches/points 5. Stock options ▪ CIS needs to expense the fair value of the stock options under current GAAP, as estimated using an option pricing model Audit issues - we are dealing with information of questionable reliability as management assumptions are involved, we need to consider what is the impact of estimated compensation expense on earnings ▪ the options are out of the money now, but these are potentially dilutive to shareholders if share price increases, we need to find out how many are issued, will more be issued? how many? what’s a reasonable market salary for these executives excluding options? - potential new common shareholders could have their interests significantly affected making this a risk area for us as the auditors ▪ other valid approaches/points 6. Patent ▪ this non-arms length transaction results in the patent’s ’cost’ being included on the balance sheet as an asset, so the valuation is questionable - this could be an area of dispute in finalizing the audit Audit issues - we need to consider what is the revenue generating potential of this patent - also the ‘sale’ would have created significant ‘revenue’ that need to eliminate this when analyzing CSI’s results as it is ‘unusual’ and not a permanent income event ▪ we need to question whether the amortization policy is appropriate given rapid technological change is a risk ▪ a key point is this amount is owing to the Director involved as a counterparty to the flip, so the cash from this share issue will essentially transfer this cash to the Shareholder…this is bogus i.e. indicates that the cash raised from the new shares will go to make the existing shareholder/directors whole on the (bad?) investments they have already made and not to funding new growth opportunities - this presents a risk situation for the auditors as investors may be mislead and lose money because of relying on misleading financial information ▪ other valid approaches/points 7. Deferred development costs ▪ note that this increased income Audit issues - are the amortization rates reasonable? straight-line is usually used as declining balance methods does not result in expensing the whole amount, we need to consider whether expensing them is better for users to evaluate future earnings and cash flows ▪ other valid approaches/points 8. Capital or operating lease ▪ the PV of lease is approx $1.4 m, representing >90% of the current cost, the lease term is the same as the useful life, Audit issues - therefore this lease would be capitalized and shown as asset and obligation in the B/S ▪ other valid approaches/points RECOMMENDATIONS (summary of above) -generally the company’s accounting choices are aggressive and income maximizing so earning reported are low quality for cash flow prediction, which is the main interest of users of the audited financial statement A number of points will need to be negotiated with CSI management to ensure the audited financial statements provide a clear picture of the business and its current financial condition to existing and prospective investors. DC14-10 Critical Thinking and Estimation Uncertainty of CAS 540 As discussed in Appendix 7D, from the auditor’s point of view the estimation uncertainty includes audit risk and accounting risk. The auditor controls audit risk for estimates involving the finance and investment process through the procedures discussed in this chapter. Assuming audit risk can be reduced to acceptable levels the main concern then becomes the proper reporting of the estimates. But since under CAS 540 auditors now have responsibility to monitor estimation uncertainty, auditors now also need to consider accounting risk, and how to reduce accounting risk for a recorded estimate to acceptable levels. To calculate accounting risks for the finance and investment process auditors may need to work with specialists in finance and actuaries (e.g., see DC14-6). Appendix 7D illustrates how an adjusting entry can reduce accounting risk from .99 to .01 for a simple financial instrument. Note that valuing the investment at zero shows how risky the investment is. This way accounting risk reflects the business uncertainty of the investment. For more complex instruments the basic reasoning is the same, just the calculations may become more complicated. This is one reason why the auditor may need to refer to specialists. When that is the case, however, the auditor must be able to explain to the specialist the accounting risk concept and what the acceptable level of this risk is. If as in Appendix 7D illustration the appropriate estimate of the investment is zero then the auditor must consider whether this investment needs to be disclosed in the notes to the financial statements. As explained in the application case for chapter 10, consistent with statistical decision rules if the probability the investment will be realized is below the acceptable risk then there is no need to disclose this investment to be consistent with statistical reporting. However, such an investment would need to be disclosed if its probability of realization falls within the range of acceptable risk and (one minus acceptable risk). This helps make operational a completeness of disclosure rule for fairness of presentation. See application case discussion for chapter 16. Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathiryn Bewley 9780071051415