CPA P2 Audit Practice & Assurance Services TOPIC 49: SUBSTANTIVE AUDIT PROCEDURES

Transcription

1 TOPIC 49: SUBSTANTIVE AUDIT PROCEDURES ( THE DESIGN AND CARRYING OUT OF TESTS OF SUBSTANCE ON SPECIFIC AUDIT AREAS ) 1

2 SUBSTANTIVE TESTING STATEMENT OF PROFIT OR LOSS Completeness all transactions and events that should have been recorded have been recorded Significant Assertions to Prove for the Income Statement Accuracy amounts have been appropriately recorded Cut Off recorded in the correct period Occurence transactions and events that have been recorded have occurred SALES Accounts receivable will often be tested in conjunction with sales. Auditors are seeking to obtain evidence that sales are completely and accurately recorded. This will involve carrying out certain procedures to test for completion of sales and also testing cut-off. 2

3 Completeness and occurrence of sales Analytical review is likely to be important when testing completeness. Auditors should consider the following: The level of sales over the year, compared on a month-by-month basis with the previous year The effect on sales value of changes in quantities sold The effect on sales value of changes in products or prices The level of goods returned, sales allowances and discounts The efficiency of labour as expressed in sales or profit per tax per employee In addition auditors must record reasons for changes in the gross profit margin (Gross profit x 100%), Analysis of the gross profit margin should be as Turnover detailed as possible, ideally broken down by product area and month or quarter. As well as analytical review, auditors may feel that they need to test completeness of recording of individual sales in the accounting records. To do this, auditors should start with the documents that first record sales (goods dispatched notes or till rolls for example), and trace sales recorded in these through intermediate documents such as sales summaries to the sales ledger. Auditors must ensure that the population of documents from which the sample is originally taken is itself complete, by checking for example the completeness of the sequence of goods dispatched notes. 3

4 Exam focus point Your must remember the direction of this test. Since we are checking the completeness of recording of sales in the sales ledger, we cannot take a sample from the ledger since the sample cannot include what has not been recorded. If on the other hand, the auditors suspect that sales may have been invalidly recorded, and have not occurred, then the sample will be taken from the sales ledger and confirmed to supporting documentation (orders, dispatch notes etc.) AUDIT PROGRAM: SALES -MEASUREMENT Check the pricing calculations and additions on invoices Check whether discounts have been properly calculated Check whether purchase tax has been added appropriately Other tests that may be carried out on sales include: Trace debits in the sales accounts to credit notes Check casting of sales ledger accounts and sales ledger control account Review reconciliation of sales ledger control account and other relevant reconciliations (for example till rolls) and investigate unusual items Sales cut-off We can now turn to the requirement to confirm that sales cut-off is satisfactory and hence sales are completely recorded. During the inventory count the auditors will have obtained details of the last serial numbers of goods outward notes issued before the commencement of the inventory count. 4

5 AUDIT PROGRAM: SALES CUT OFF Check goods dispatched and returns inwards notes around year-end to ensure: Invoices and credit notes are dated in the correct period Invoices and credit notes are posted ot the sales ledger and general ledger in the correct period Reconcile entries in the sales ledger control account around the year-end to daily batch invoice totals ensuring batches are posted in correct year Review sales ledger control account around year-end for unusual items Review material after-date invoices, credit notes and adjustments and ensure that they are properly treated as following year sales Goods on sale or return Care should be exercised to ensure that goods on sale or return are properly treated in the accounts. Except where the client has been notified of the sale of the goods they should be reflected in the accounts as inventory at cost and not as accounts receivable, otherwise profits may be incorrectly anticipated. PURCHASES Purchases and expenses When testing purchases and expenses, auditors are testing whether they are for valid reasons, that goods and services purchased have provided benefits to the company. They are also checking for accuracy of recording so again cut-off procedures will be important. 5

6 Occurrence and completeness of purchases As with sales, analytical procedures will be important. Auditors should consider: The level of purchases and expenses over the year, compared on a month-by-month basis with the previous year The effect on value of purchases of changes in quantities purchased The effect on purchases value of changes in products purchased (for example a change in ingredients), or prices of products How the ratio of trade accounts payable to purchases compares with previous figures How the ration of trade accounts payable to inventory compares with previous years figures AUDIT PROGRAM: PURCHASES COMPLETENESS AND OCCURRENCE Check purchases and other expenses recorded in the purchase or general ledger or cash book to supporting documentation (books of prime entry, invoices, delivery notes) considering whether: Purchases and expenses are valid (invoices addressed to the client, for goods and services ordered by the client, for the purposes of the business) Purchases and expenses have been allocated to the correct purchase or general ledger account Consider reasonableness of deductions from purchases or expenses by reference to subsequent events. Check whether valid debts are recorded in purchase ledger by checking credit notes One important expense is obviously wages and salaries which we consider below. 6

7 Purchases cut-off (completeness) The procedures applied by the auditors will be designed to ascertain whether: Goods received for which no invoice has been received are accrued Goods received which have been invoiced but not yet posted are accrued. Goods returned to suppliers prior to the year-end are excluded from inventory and trade accounts payable At the year-end inventory count the auditors will have made a note of the last serial numbers of goods received notes. Suggested substantive procedures are as follows: AUDIT PROGRAM: PURCHASES CUT OFF Check from goods received notes with serial numbers before the year-end to ensure that invoices are either Posted to purchase ledger prior to the year-end, or Included on the schedule of accruals Review the schedule of accruals to ensure that goods received after the year-end are not accrued Check from goods returned notes prior to year-end to ensure that credit notes have been posted to the purchase ledger prior to the year-end or accrued Review large invoices and credit notes included after the year-end to ensure that they refer to the following year Review outstanding purchase orders for indications of any purchases completed but not invoiced Reconcile daily batch invoice totals around the year-end to purchase ledger control ensuring batches are posted in the correct year Review the control account around the year-end for any unusual items 7

8 Purchase of goods subject to reservation of title clauses Under certain transactions, the seller may retain legal ownership of goods passed to a purchaser. The requirements are known as reservation of title. In UK cases, particularly the Romalpa case, it is suggested that a reservation of title clause will only be upheld if it states that the seller has a charge over the goods and the goods, any products made from them and any sale proceeds are kept separately and are readily identifiable. AUDIT PROGRAM: PURCHASES (RESERVATION OF TITLE) Ascertain how the client identifies suppliers selling on terms which reserve title by enquiry of those responsible for purchasing and the board Review and test the procedures for quantifying or estimating the liabilities Consider whether disclosure is sufficient by itself if the directors have decided quantification is impractical Consider the adequacy of the disclosures in the accounts Review the terms of sale of major suppliers to confirm that liabilities not provided for do not exist or are immaterial 8

9 Wages and salaries Although auditors may test other expenses solely by analytical review, they may carry out more detailed testing on wages and salaries, partly because of the consequences of failure to deduct income tax correctly. Analytical procedures will nonetheless be used to give some assurance on wages and salaries. Auditors should consider: Wages and salaries levels month-by-month with previous years Effect on wages and salaries of rate changes during the year Average wage per month over the year Sales/profits per employee Payroll proof in total (Pay rise x staff changes x staff mix) AUDIT PROGRAM: WAGES AND SALARIES CREDITOR Occurrence Check individual remuneration per payroll to personnel records, records of hours worked, salary agreements etc. Confirm existence of employees on payroll by meeting them, attending wages payout, inspecting personnel and tax records, and confirmation from managers Check benefits (pensions) on payroll to supporting documentation Measurement Check accuracy of calculation of remuneration Check whether calculation of statutory deductions is correct Check validity of other deductions (pension contributions, share save etc.) by agreement to supporting documentation (personnel files, conditions of pension 9

10 scheme) and check accuracy of calculation of other deductions Completeness Check casts of payroll records Confirm payment of net pay per payroll records to cheque or bank transfer summary Agree net pay per cash book to payroll Scrutinise payroll and investigate unusual items Past CPA Exam Questions See Substantive Topic Tracker 10

11 SUBSTANTIVE TESTING SOFP SUBSTANTIVE AUDIT PROCEDURES - INVENTORY IMPORTANCE OF INVENTORY Inventory is important to the audit for many reasons: In many companies, it is likely to be a very material figure (and is included both in the Statement of Financial Position and the Statement of Profit or Loss). Inventory valuation may be extremely difficult, especially where the Inventory is specialist or where there is work-in-progress. Where Inventory items are small and valuable, there is a high risk of theft. 11

12 Inventory values may be heavily reliant on a year-end Inventory count (which auditors are likely to attend) Inventory items may not all be at the client premises Where Inventory is moving near the year-end, the precise date of a sale or purchase may be hard to assess (and may not tie in with the invoice date) Valuation of WIP and overhead allocation can be subjective Issue of slow moving and obsolete stock saleability affected by demand and competition pharmaceuticals become out of date. Third party inventory Physical controls and susceptibility to theft, false sales, movement between different locations. IAS 2 Inventories and IAS 11 Construction Contracts. Timing of inventory counts and reliability of roll forward procedures if count not at year end. Degree of fluctuations in inventory levels As a result, Inventory is often audited by relatively senior members of the audit team. 12

13 Inventory Counting Procedures The Inventory count is an extremely useful piece of audit evidence, so wherever Inventory is a material figure, auditors are likely to attend at least 1 Inventory Count per year. By attending, auditors can assess the quality of the count. As an Inventory Count is a form of internal control, Inventory Count attendance by the auditor is therefore primarily a TEST OF CONTROL. The auditor will assess such issues as: How Inventory sheets are controlled, to ensure that none are lost Stock sheets serially numbered Control and return of all stock sheets, Sheets completed in ink and signed details to be shown on stock sheets, recording quantity, condition, Record details of last forms used Recording of quantity, condition and stage of production of WIP Recording of number of last GRN and GDN and internal transfer slips (cut-off) Reconciliation of count to inventory record and investigation and correction of differences The structure of counting teams i.e. teams of two counters Whether initial counts are being checked by a separate counting team How the count is planned, to ensure that all areas are counted once and only once - avoid double counting Whether counting staff are provided with instructions and are following those instructions Whether staff are counting areas that they have normal responsibility for How they are dealing with Inventory that is moving during the count 13

14 Also, while attending, the auditors can carry out SUBSTANTIVE procedures: Test Completeness, by selecting items of Inventory that can be physically seen, and tracing them to the Inventory count sheets Test Existence, by selecting items of Inventory from the Inventory count sheets, and physically confirming their existence Test Accuracy, by noting the condition and age of the Inventory, and the completeness of work-in-progress Test Cut-Off by noting the last GRN and GDN numbers Where Inventory items are at other locations, the auditor may require written confirmation of items held from a third party Different Types Of Inventory-Count Many companies perform a full year-end count. However, other methods exist: Year End Count: Happens as close the Year End as possible and in general it operates as the company s control to ensure that all the inventory on hand is counted and agreed to the Year end balance. Is disruptive to the client operations as trading is likely to be suspended during the count Continuous Inventory Counting involves counting part of the Inventory every few weeks or months, so that over the course of the year all items are counted at least once.auditors may attend one or more of these counts to establish whether the counts are reliable, and whether errors are properly adjusted on the Inventory system records. Perpetual/Continual counts are less disruptive to the trading operations of the business than a full year end inventory count. It may not always be possible for a company to carry out a full year-end count, so they may count a few days before or after the actual year-end. Auditors may need to perform rollback/forward tests on goods movements between the count and the year-end. Acceptable 14

15 provided records of inventory movements in the intervening periods are maintained such that movements can be examined and substantiated Assertions For Inventory, the most important assertions to test are those where the risk of error or misstatement is greatest. As inventory is an asset, it is liable to be overstated so as to boost total assets and increase profits by reducing costs of sale. Existence Inventories recorded in the Accounts may not exist if they have been stolen (especially if they are small, high value items). Accuracy/Valuation Inventories should be recorded at the lower of cost or Net Realisable Value (NRV). In a manufacturing company, cost will be made up of many elements materials, labour, and absorbed overheads and this increases the chance of error (deliberate or otherwise). Cost will also be complicated where there is work-in-progress, or specialist items. Inventories will be overvalued if their NRV has fallen below cost without adjustments being made. In industries where fashion or technology change quickly, sales prices may fall quickly. A similar problem arises where products go off, for example with food. Cut-Off Cut-off may be a problem, especially where there are many goods movements around the year-end. 15

16 Substantive Audit Procedures Used in relation to Inventory Existence Attend a physical inventory count at year end and complete the inventory count audit programme. The effectiveness of inventory counting procedures should be tested by direct observation, supported by inspection of documents and re-performance of test counts. Take copies of inventory sheets and compare with the final inventory figures to ensure that there have been no additions or omissions. If inventory count is carried out before the balance sheet date, perform a roll forward calculation, taking opening balance and movements during the period to arrive at the expected closing balance Completeness Ensure that any inventory held by third parties on behalf of the client are included in the final inventory figure Final Audit Work on Cut Off Select the final 10 Goods Despatch Notes (GDN s) of the year and trace the corresponding sales invoices to ensure they are recorded in pre year-end sales Repeat this process for Goods Received Notes (GRN s) and purchase invoices. 16

17 Select the first 10 GDN s and GRN s of the new year, and trace to invoices to ensure not recorded before the year-end Final Audit Work on Accuracy - Cost Cost should comprise all costs of purchase ((including taxes, transport, and handling) net of trade discounts received), costs of conversion ((including fixed and variable manufacturing overheads), and other costs incurred in bringing the inventories to their location and condition. In a non-manufacturing company, agree cost to purchase invoices For a manufacturer, all elements of the cost card should be verified: Agree materials prices to recent purchase invoices Verify materials quantities by observation, discussion with production staff, or by inspecting stores requests Agree labour rates to payroll Verify labour hours quantities by observation, discussion with production staff, or by reference to timesheets Consider reasonableness of overhead absorption method (e.g. by comparison with prior year methods) Analyse absorbed overheads to ensure overheads absorbed are production only and on basis of normal production levels. Obtain a copy of the reconciliation between the closing inventory figure per the inventory control account in the nominal ledger and the inventory listing. Obtain explanations for any large or unusual reconciling items and agree the inventory figure per the control account to the inventory figure in the financial statements. 17

18 Final Audit Work on Accuracy NRV For a sample of Inventory items, ensure NRV > Cost by analysis of sales prices achieved after year-end (or shortly before year-end if necessary). For items noted as damaged, or obsolete, during Inventory Count, consider reasonableness of any provisions made by client (damaged items may have since been repaired and sold, so the auditor should inspect records of repair work done and costs incurred) Final Audit Work on Rights and Obligations For a sample of items, inspect purchase invoices to confirm that company s name is present. Where items are held at a separate location, obtain written confirmation from the relevant third party that the items exist, are in good condition, and belong to the client. Where items have been bought (or sold) under a consignment Inventory, demonstrator, sale or return, or similar agreement, consider which party has the substance of ownership as at the year-end. Identify inventory items belonging to third parties and ensure they are excluded from the final inventory summary. Final Audit Work on Disclosure Agree opening Inventory to last year s closing Inventory figure. 18

19 Agree breakdown of Inventory items (raw materials, work-in-progress etc) to account balances in the nominal ledger. Ensure correct disclosure of inventory pledged as security for liabilities of the client or third parties. EXERCISE: TEXTILE WHOLESALERS Your firm is the auditor of Textile Wholesalers, a privately owned company, which buys textile products (e.g. clothing) from manufacturers and sells them to retailers. You attended the physical Inventory count at the company s Reporting Date of Thursday 31 October 20X2. The company does not maintain book Inventory records, and previous years audits have revealed problems with purchases cut-off. Your audit tests on purchases cut-off, which started from the goods received note (GRN), have revealed the following results: 19

20 Assume that goods received before the Reporting Date are in Inventory at the Reporting Date, and goods received after the Reporting Date are not in Inventory at the Reporting Date. A purchase accrual is included in Payables at the Reporting Date for goods received before the Reporting Date when the purchase invoice has not been posted to the purchase ledger before the Reporting Date. You are required: a. at the Inventory count: i) to describe the procedures the company s staff should carry out to ensure that Inventory is counted accurately and cut-off details are recorded; and ii) to describe the tests you would carry out and the matters you would record in your working papers. (11 marks) b. from the results of your purchases cut-off test described in the question: i) to identify the cut-off errors and produce a schedule of the adjustments 20

21 which should be made to the reported profit, purchases and Payables in the financial statements to correct the errors (5 marks) ii) to comment on the results of your test, and to state what further action you would take. (4 marks) (Total: 20 marks) SOLUTION TO EXERCISE: Textile Wholesalers Key answer tips Inventory is often one of the most material items on a company s Statement of Financial Position and one of the high risk areas for the auditor subjectivity on the question of valuation, possible obsolescence, pilferage, scope for fraud etc. This question focuses on audit work relating to the existence, much of which revolves around the Inventory count as a source of audit evidence. Part (a)(i) test your knowledge of what should constitute effective count procedures if a complete and accurate count is to be taken. In dealing with part (a)(ii) it is important to remember that the role of the auditor at the Inventory count is NOT to perform the count it is to generate audit evidence which will enable the auditor to reach a conclusion on the truth and fairness of the Inventory figures. Part (b)(i) requires a straightforward reconciliation type of exercise to identify items not correctly recorded it is then necessary to quantify the adjustment required to the financial statements. 21

22 Part (b)(ii) is expecting you to appreciate that a high error rate has been discovered in the data given in the question following basic auditing methodology, this would suggest that the scope of the cut off tests should be extended especially as this has been a problem in previous years. Part a) i) The Company should ensure the following procedures are carried out at the physical Inventory count ideally, there should be no movement of Inventory during the count, as this creates the risk that Inventory may be counted twice or not at all. Any movement of Inventory during the count should be minimised and strictly controlled. staff counting the Inventory should be issued pre-numbered Inventory sheets and an individual should record which sheets have been issued to each pair of counters. the area where the count is taking place should be tidy, and there should be no movement of Inventory during the count. Any items which are difficult to identify should be identified. the counters should be allocated areas to count Inventory, so that all Inventory is counted and none missed. ideally, staff who are responsible for Inventory should not count the Inventory (as this would result in a weakness in internal control). However, the counters should be competent to identify the Inventory which is being counted. staff should count the Inventory in pairs, with one member of staff counting the Inventory and the other recording it on the Inventory sheets. Inventory should be counted systematically, probably from left to right along shelves. Inventory should be marked when it is counted so that it is not missed or counted twice. details of Inventory counted should be written on the Inventory sheets in ball point pen. (not pencil ) Any alterations on the Inventory sheets should be initialled by the counter. The bottom of the Inventory sheet should be signed by the employees who have counted the Inventory. details of the items counted should include: 22

23 a description of the item its part number the quantity the Inventory sheets should record details of any Inventory which may be worth less than cost. This will include damaged, seconds and slow moving Inventory. management should perform test counts and check them to the counters counts. Any differences should be investigated (e.g. by recounting the Inventory). any incomplete Inventory sheets should be ruled off so that no items can be added. at the end of the count, the Inventory sheets should be collected, and a member of staff should check they are all returned. Details of Inventory sheet numbers used should be recorded. at the end of the count, management should ask staff the areas where they have counted the Inventory. They should randomly select areas of the factory and ask the counters who have counted Inventory in that area. Then they can test check Inventory has been counted by selecting items of Inventory and checking they appear on the Inventory sheets. management should record the numbers of the last goods received note and last dispatch note issued before the count. Part a) ii) As auditor, I will record details of the checks I have performed on the items above. In addition, I will: ensure the company s staff carry out the count in accordance with the instructions. perform test counts of the Inventory. This should be performed in two ways. I will select items from the Inventory sheets and count the Inventory (this ensures Inventory on the Inventory sheets exists). I will select items of Inventory, count them, and check they appear on the Inventory sheets (this ensures that Inventory which exists has been recorded on the 23

24 Inventory sheets). If my count is different from the company s, I will count the Inventory again, with the employees present, and ensure the correct quantity appears on the Inventory sheets. I will record details of my counts, and the Inventory sheet numbers where the items appear, so that they can be followed up at the final audit. record the numbers of the Inventory sheets used in the count. record the last numbers of documents before the Reporting Date for recording: o receipt of goods from suppliers (i.e. last GRN number) o dispatch of goods to customers (i.e. last dispatch note number) o return of goods to suppliers o return of goods from customers photocopy a sample of Inventory sheets at the end of the count. They will be checked to ensure they have not been altered at a later date. inspect a sample of Inventory sheets to ensure they have been signed by the staff counting the Inventory. note any Inventory which may be worth less than cost (e.g. obsolete Inventory) and check that details have been recorded on the Inventory sheets. Part (b) (i) In the list of items given in the question, purchases cut-off is correct for items 1, 3 and 7. So the adjustments to profit are: 24

25 The test has highlighted four errors in a sample of 7 items, an error rate of 57%, which is very high. Only a relatively small sample of goods received notes have been selected (from the sample of GRN s covered, it appears to be between 20% and 25%). With the high error rate, there is evidence of serious purchases cut-off errors, and to quantify the potential error, a larger sample of items should be selected, covering a longer period. It is suggested the period should cover two weeks before the Reporting Date to two weeks after the Reporting Date, and a greater proportion of GRN s should be selected. If there are cut-off errors at the end of these periods (i.e. two weeks before the Reporting Date and two weeks after the Reporting Date), the period for checking cut-off should be extended. In addition, the company s management should be notified of the problem. They could help by checking cut-off and giving me a schedule of the items they have checked and the errors they have found. As further checks of purchases cut-off, I would check purchase accruals at the Reporting Date. They should be for goods received before the Reporting Date which have not been included on the purchase ledger before the Reporting Date (i.e. item 3 in the question). A purchase accrual should not be included where: 25

26 goods are received before the Reporting Date and the purchase invoice has been posted to the purchase ledger before the Reporting Date (item 2), or goods are received after the Reporting Date (item 6). If the company uses the date on the purchase invoice when posting purchase invoices to the purchase ledger, I would check that no invoices have been posted to the purchase ledger before the Reporting Date which have a date after the Reporting Date (i.e. none are dated or later). Also, I would check that invoices posted to the purchase ledger after the Reporting Date, which have a date before the Reporting Date, are either included in purchase accruals, or the goods have been received after the Reporting Date (by checking the date on the GRN). Part (b) (ii) As a further check of purchases cut-off, I would check the reconciliation of suppliers statements to the balances on the purchase ledger, and investigate any differences. For instance, if there are invoices on the supplier s statement which are not on the client s purchase ledger, I will check the goods were received after the Reporting Date (if they were received before the Reporting Date, and were not included in purchase accruals, there would be a purchases cut-off error). This work should quantify the total purchases cut-off error, which should be included in the summary of unadjusted errors in my audit working papers. 26

27 Questions to Practice - Inventory 27

28 28

29 29

30 30

31 31

32 32

33 33

34 34

35 35

36 SUBSTANTIVE AUDIT PROCEDURES - RECEIVABLES & PREPAYMENTS For Receivables and prepayments, the most important assertions to test are those where the risk of error or misstatement is greatest. As receivables and prepayments are assets, they are liable to be overstated so as to boost total assets and increase profits by increasing sales in the case of receivables and reducing expenses, in the case of prepayments. Existence A Receivable may not exist if the customer owing the money has no intention (or ability) to pay the balance owed. Alternatively, the Receivable may be for goods or services that have never been supplied. Cut-Off Similar to the existence issue, a Receivable may not have been created in substance before the Reporting Date. Sales may have been invoiced in advance (possibly deliberately), or prepayments recorded for expense items which have already been enjoyed before the Reporting Date. Accuracy/ Valuation/Measurement The Receivables figure may be overstated if bad or doubtful debts have not been accounted for. Key Records for auditing Receivables - receivables listing and aged analysis Inherent risks affecting trade Receivables may be increased by: (a) large number of new customers; (b) significant changes in collectability; 36

37 (c) new products; (d) competitors introducing new products with a possible increase in provision for bad debts (e) above-average returns; (f) new staff; (g) complex computerized accounting system. Receivables Circularisation (Also Called Direct Confirmation) Just as the Inventory-Count provides a great deal of evidence when auditing Inventory, a Receivables confirmation may provide a great deal of evidence for Receivables. The auditor selects a representative sample of year-end customer balances from the client s year-end sales ledger. A letter is sent to each customer selected asking them to confirm the balance they believe to be owed as at the Reporting Date. To allow the customer time to respond, these letters are typically sent very shortly after the client s year-end, not on the final audit. There is then time for customer responses to be collected (and if necessary chased!) before the final audit work is performed. The letters may ask for balances to be confirmed in a number of ways: A positive confirmation, where the customer is asked to either Agree or disagree with a balance stated in the letter (Risk that customer may just agree because it is less than what is actually owed), or Actually state the balance they think is owing (Likely to result in fewer responses because more effort is required to obtain the balance) A negative confirmation, where the customer is asked to respond only if they disagree with the stated balance. A non reply may indicate agreement or simply a decision made to not reply because the customer has calculated that they actually owe more. 37

38 Not all audit firms use circularisation, as a number of problems exist: Many customers fail to respond to the requests If customers are told a balance that looks too low, they may agree with it! Customers may fill in the wrong balance in error With negative confirmations, it is hard to assess whether a non-reply indicates the balance to be correct, or that the customer has simply failed to reply However, where used successfully they provide evidence regarding existence, rights and obligations, accuracy and occurrence. However, when customers confirm a balance, they are not guaranteeing that they have the ability or intention to pay up and so a response to a receivables circularisation request provides only partial evidence as to the accuracy assertion. No audit work will be required to assess the need for provision for bad debt. Specific Substantive Audit Procedures for Receivables Circularisation Obtain a receivables listing from the client and cast it and agree it to the balance per the Receivables Control A/c and agree back to the draft FS figure for receivables. Agree the current year opening balance for receivables to the prior year closing audited balance. If possible, obtain an aged receivables analysis of the year end receivables balance or auditor to perform one. Calculate the sample size based on materiality and tolerable misstatement Extract the sample using an appropriate sampling technique (Random, Systematic, Haphazard, Monetary Unit, Block) - Special attention paid to: Old unpaid accounts Accounts written off during the period 38

39 Accounts settled by round sum payments Accounts with nil balances Accounts paid by date of examination Stratification of sample is common Prepare circularisation letters on the client s headed notepaper and arrange for them to be signed by an appropriate member of management Enclose a customer statement with the letter and a pre paid envelope addressed to the auditors. Replies will be sent by customers directly to the auditor which makes them good audit evidence, as it increases reliability of the evidence. Post the letters off Follow up procedures Auditors must follow up on: Receivables who disagree with the balance stated for positive and negative confirms Receivables who do not respond, positive confirms only Reasons for disagreements Dispute between client and customer - identify reasons and make provision if appropriate Cut-off problems with sales or monies received - Cut-off testing may have to be extended Monies posted to wrong accounts or in cash in transit - Auditor should check for evidence of other mis-postings and ensure cash-in-transit is cleared promptly Teeming and lading stealing money and incorrectly posting other receipts - if suspected detail testing on cash receipts, especially posting of cash receipts Follow Up Where there has been a failure to Respond Positive method must follow up those receivables who fail to respond Send second requests Followed by phone call with clients permission After several attempts pass the account to a responsible official (preferably outside sales accounting dept) to investigate. 39

40 Alternative Procedures where it has not been possible to Confirm Trade Receivables via Circularisation If ultimately no confirmation, alternative procedures to audit the trade receivable balance include the following Inspect post year end receipts for evidence of receipt of cash Verify valid purchase order received Verify the year end receivable balance by reference to invoices, credit notes and payments received Obtain explanations where subsequent invoices paid Substantive Audit Procedures for Receivables Existence Select a sample of trade receivables for circularisation. Included in the sample should be nil balances and credit balances. Ensure each circularisation is followed up. (Refer to previous notes on circularisation) Obtain a breakdown of the trade Receivables figure in the Financial Statements and agree a sample back to individual sales ledger account balances Verify that the breakdown of sales ledger balances adds up For a sample of balances, agree individual entries back to sales invoices, bank statements, credit notes etc. 40

41 Accuracy/Valuation Perform a reconciliation of the Receivables ledger control account to the sum of Personal Receivable ledger balances at the year-end, obtaining explanations for any differences. At the final audit, obtain the most recent breakdown of trade Receivables and establish which year-end balances remain uncollected. For these unpaid items, review customer correspondence files for evidence of problems or disputes and discuss findings with directors (obtaining written confirmation of their opinions as necessary) Calculate the Receivable days figure and compare with prior year (and possibly other firms in the industry). If ratio is rising, discuss with directors how this has affected their bad and doubtful debt provision Review the provision for bad debts and check for reasonableness Select a sample of balances from the aged debt listing and agree to the individual debtor s account in the debtor s ledger Agree invoices to price lists and check tots of additions and extensions on invoices for arithmetical accuracy If trade receivables are denominated in foreign currencies, ensure translation into domestic currency is at a correct exchange rate Review receivables listing for long outstanding debts for which no provision has been made Cut-Off Obtain a sample of dispatch dockets prior and post year end and agree to corresponding invoices. Ensure invoices are posted in the correct accounting period. 41

42 Ensure source documents (dispatch dockets and invoices) are numerically sequenced. Obtain a sample of credit notes prior and post year end and ensure they are posted to the correct period. For a sample of cash receipts from customers prior and post year end, trace to the receivables control account and bank account and ensure they are posted to the correct period. Examine goods dispatched for which no invoice has been raised and ensure they relate to sales in the current period and have been posted correctly Completeness Agree current year opening balance for trade receivables to prior year closing audited balance for receivables Select a sample of sales invoices and trace them through to the relevant sales ledger entries. Confirm reconciliation with sales ledger control. Review large amounts received since the Reporting Date and analyse invoices to establish whether balances represent amounts that were due at the Reporting Date. Perform an analytical review of the trade receivables figure and ensure any fluctuations are not due to incompleteness of sales 42

43 Rights and Obligations Audit evidence obtained in order to achieve the existence objective will normally provide sufficient evidence as to the ownership. In addition the following may also be carried out: Review the client s terms of sales and other agreements or contract. Consult the client s major customers confirming the client s terms of sale with them When checking sales invoices, verify that the invoice is in the client s name. Disclosure Ensure correct classification between trade receivables less than and after one year. Ensure amounts receivable from group companies are separately disclosed. Bad Debts ISA 540 Audit of Accounting Estimates Accuracy/Valuation The audit work on bad debts gives evidence as to the accuracy assertion for trade receivables Reviewing cash received post year end provides evidence of collectability and hence valuation. Provides some comfort on rights and obligations but a receivables circularisation should be carried out as well. Procedures to Confirm Accuracy of Bad Debts Confirm adequacy of provision review correspondence with solicitors, debt collectors, liquidation letters 43

44 Examine and assess customers files on overdue debts Consider if amounts owed may not be recovered where round sum payments made where subsequent invoices are paid Examine aging of debts Review customer files, aged debtor listing and receivables circularisation for evidence of potential bad debts Check accuracy of aged receivable analysis compare with dates on invoices and matching receipts check basis for calculating specific provisions Sales Receivables normally checked in conjunction with sales. Auditors seeking evidence that sales are completely and accurately recorded. Completeness and occurrence of sales. Analytical review is important i.e. comparing prior year sales with current year sales and investigation of significant differences/confirmation of expected patterns. Completeness of Sales Perform an analytical review of revenue in light of trading conditions during the year and making adjustments for known changes and other variables. Obtain explanations for any material variances. If possible recompute revenue based on known prices and independent dispatch of production records. 44

45 Review the client s accounting policies governing the recognition of a sale to ensure that all revenue includes amounts to which the client is entitled. For a sample of transactions obtain goods despatched notes or customer orders and ensure the following: A corresponding invoice has been raised showing details of all goods supplied The correct selling prices are used agree to authorised price lists or other supporting documentation To ensure population of documents is complete, check sequence of goods despatched notes for completeness i.e. to identify any gaps in the sequence The sale has been posted correctly to the nominal ledger Occurrence of Sales If auditor suspects sales have been invalidly recorded and have not occurred take sample from sales ledger and confirm to supporting documentation (orders, despatch notes) i.e. agree to supporting documentation. Accuracy of Sales Recalculate pricing calculations and additions on invoices. Verify if discounts properly calculated. Recalculate VAT to verify it is added appropriately. Trace debits in sales account to credit notes. Recalculate casting of sales personal ledger and control account. Review reconciliation and investigate unusual items. 45

46 Sales cut-off covered off in the work for trade receivables Inspect goods despatched and return inwards notes around year end to ensure Invoices and credit notes dated in correct period, posted to sales ledger and general ledger. Reconcile entries in sales ledger control account around year-end daily invoice totals. Review post year end invoices, credit notes and adjustments to ensure properly treated as following year sales and sales returns as appropriate. PREPAYMENTS Prepayments often repeat from year to year, as items such as rent, rates, subscriptions, insurance tend to be fairly consistent. Typical substantive tests would be: Compare this year s breakdown of prepayments with prior year, seeking explanations for differences (Analytical Procedure) Agree a sample of prepayments back to invoices, and re-calculate (Accuracy) Inspect a representative sample of invoices, especially near the client s Reporting Date, for potential further prepayments. 46

47 EXERCISE: GOODFOOT S RECEIVABLES ISA 505 External Confirmations deals with a number of different types of external confirmation. External confirmation is a useful method of obtaining audit evidence in relation to Receivables. a) In relation to external confirmation of Receivables: i) explain the difference between a positive and a negative confirmation ii) explain the two different types of positive confirmation and the advantages and disadvantages of each iii) list the reconciling items highlighted by external confirmation of Receivables. b) Describe the principal risks associated with financial statement assertions relating to Receivables. c) Goodfoot is a small company which manufactures high quality shoes and sells them to small retailers. This is your first year as auditor. Goodfoot has a Receivables ledger with approximately 750 accounts. A number of the Receivables accounts are old, some have nil or credit balances and some should probably be written off. The company s client base is mixed. Bad debts have generally represented about 2% of the total Receivables figures and a general provision of 1.5% has been made in the past in addition to any specific provisions. Most of the bad debts relate to smaller customers but there are some very slow moving larger accounts in the current year. The total value of Receivables is 750,000, 60% of which comprises some thirty large accounts, and 40% of which comprises a large number of small accounts. You have tested the system of internal controls over Receivables and it appears to be working adequately. In you experience, external confirmation of Receivables in this sector generally has a response rate of just over 50%. Required: Describe the audit work you will perform on Receivables and bad debts at Goodfoot. 47

48 SOLUTION TO EXERCISE: Goodfoot s Receivables Key answer tips Part (a) should be a good source of marks as it is a textbook question on accounts Receivable confirmations. Part (b) should also be a straightforward statement of basic auditing knowledge. Part (c) requires you to deal with the practical aspects of the audit of Receivables. Your answer will focus heavily on confirmation as a major source of audit evidence in this area. As always, you must reflect the facts given in the question the quality of control procedures, for example, will influence the type and volume of audit work. Part (a) External confirmation i) Positive and negative confirmations. Negative confirmations request a reply from the Receivable only if the Receivable disagrees with the amount. Positive confirmations request a reply in any case. Negative confirmations are generally only used with a representative sample of a large number of small accounts where internal controls are strong. ii) Positive confirmations. There are two types of positive confirmation. In the first type, the amount owed is stated by the client and the Receivable is asked to agree or disagree. If the Receivable disagrees, he is asked to provide an explanation of why he disagrees in the form of reconciling items. In the second type, the Receivable is asked to fill in the balance. The advantage of the first type is that the Receivable may perform the reconciliation. The principal disadvantage is the fact that the Receivable may simply agree with any amount stated, particularly if it is understated. With the second type, the Receivable is less likely to reply as more work is involved, but the amount stated represents what is in the Receivable's records. It is not possible for the Receivable to perform the reconciliation in this case. iii) Reconciling items. Reconciling items include: cash, goods and credit notes in 48

49 transit and other timing differences, debit notes, contras, journal entries, disputed items, and simple errors on the side of either Receivable or supplier. Part (b) Financial statement assertions Receivables Assets are generally more at risk from overstatement than from understatement, There is a risk that Receivables are overstated by the under-provision for bad debts. If assets are overstated, profits are likely to be overstated and it is therefore sometimes tempting to underprovide for bad debts in order to show a better profit figure, as well as for management purposes. Bad debts can sometimes be hidden by the use of credit notes and similar devices; whilst this does not affect the overall profit figure, it can affect the presentation of the financial statements. Part (c) Audit work on Receivables and bad debts i) Comfort can be taken from the proper operation of internal controls over Receivables and it is therefore possible to reduce the level of substantive testing. ii) The primary focus of substantive testing will be the external confirmation. A 50% response rate is quite adequate. All of the thirty largest accounts can be circularised together with a representative sample of the remainder, paying particular attention to old accounts, nil balances and credit balances. iii) For those accounts where there is no reply, and for any other accounts selected for testing it will be necessary to gain comfort on the amount Receivable by reviewing cash received 49

50 after the period end. Where cash has not been received, it will be necessary to review signed delivery notes, contracts, the pattern of payments, etc. iv) For accounts confirmed, any differences should be thoroughly investigated and followed up, with the help of the client if necessary. It should be remembered that where a Receivable agrees that an amount is owed, it does not automatically follow that the amount will be paid. v) The bad debt provision should be reviewed in the light of past experience and current period conditions. Generally, specific provisions are permissible for tax purposes but not general provisions and the tax computation should be checked. vi) The arithmetical accuracy of the ledger should be checked as should the correct presentation of the amounts in the financial statements. vii) A review of invoices and credit notes around the period-end may highlight the need for additional provisions. viii) Analytical procedures on the ageing of Receivables by comparison with prior periods will give comfort on bad debt provisions. ix) Sales cut-off testing should be performed to ensure that amounts have been correctly recorded in the correct period. Past Exam Questions See Substantive Topic Exam Tracker 50

51 Questions to Practice B STAR 51

52 52

53 Solution to B Star 53

54 54

55 SEELEY LTD 55

56 56

57 SOLUTION TO SEELEY 57

58 58

59 SUBSTANTIVE TESTING OF NON CURRENT ASSETS In your exam, it is likely that you will need to suggest substantive procedures that auditors could use to verify non current assets (and related entries, such as depreciation charges) in the financial statements of an organisation. A useful tool to assist you is to think what are your objectives? There are 7 financial statement assertions (also referred to as objectives) that were introduced in the session on Audit Evidence. They were: 1. Completeness all transactions, assets/liabilities and disclosures are included in the Accounts 2. Occurrence all transactions in the Accounts took place (i.e. are real)) 3. Disclosure an item is adequately disclosed/classified in the Accounts 4. Rights and Obligations assets/liabilities belonged (in substance) to the company at the year end 5. Accuracy /Valuation any reported values are accurate and appropriate 6. Cut-Off a transaction/event is recorded in the correct accounting period 7. Existence assets/liabilities existed at the year end With any substantive test, one of the initial procedures will involve the auditor obtaining/preparing a listing, recasting it, and ensuring that the listing ties into the balance per the ledger and back to the FS For non current assets, the most important assertions to test are those where the risk of error or misstatement is greatest: 59

60 EXISTENCE Assets reported in the financial statements may not exist if they have been stolen, or disposed of without the company s knowledge ACCURACY/VALUATION The initial cost of an asset may be misstated. Cost may not be as simple as an invoice value, and some items of expenditure may be hard to judge as capital or revenue in their nature (for example, development expenditure). Once recorded, assets are usually depreciated (or amortised), and sometimes revalued. These exercises can often lead to errors. RIGHTS AND OBLIGATIONS Ownership of assets should be tested, as companies could claim rights of use for assets to bolster their statements of Financial Position. However, ownership does not necessarily result in assets being included on a statements of Financial Position. The company should have the substance of ownership (rights of use, obligations of an owner), without necessarily holding legal title (examples of this include finance leased assets). The other assertions remain important and should be tested, but the most important objectives for non current assets are those above Non Current Asset Register The non current asset register is a very important aspect of the internal control system surrounding non current assets. Balances in the non current asset register reconcile with the net book value of the plant and equipment account in the general/nominal ledger. 60

61 Typical details maintained about a non current asset in the register include: Cost of each asset Date of Acquisition Description of the Non Current Asset with serial number/chassis number as appropriate Location of the non current asset What depreciation method is being used Accumulated Depreciation to date charged on the Asset, and consequently the Net Book Value of the Asset The Expected Useful Life of the Asset Insurance Cover The non current asset register provides a useful control where, for example, assets are vulnerable to misappropriation or they are portable. Regular physical inventory of such assets provides evidence as to their existence and may be sufficient to enable auditors to forgo the need to inspect such assets physically at the reporting date. The non current asset register is a key link for the auditor between the physical assets and the balance in the property, plant & equipment nominal ledger accounts which underpin the Financial Statements 61

62 Financial Statements Non Current Asset Register Physical Asset Substantive Procedures Used In Relation To Non current Assets There are hundreds of potential audit procedures for each area of the accounts. They are not all reproduced here, and you do not need to know them all. However, you may need to suggest procedures for non current assets generally, or for particular aspects; so it is helpful if you practice generating as many tests as possible. 62

63 TANGIBLE NON CURRENT ASSETS Existence Select a representative sample of assets from the non current asset register and physically inspect them. For all reported additions in the year, consider whether the new asset is replacing an older one. If so, inspect the asset register to verify that the disposal has been recorded - i.e. that the non current asset disposed have been removed from the Asset register Review the Repairs and maintenance account for evidence of existence of assets Completeness Obtain or prepare a summary of non current assets showing: Cost Accumulated Depreciation Net Book Value And Reconcile the opening position with the closing position from prior year audited numbers Select a representative sample of assets visible at the client premises and inspect the asset register to ensure they are included Examine the repairs and maintenance accounts in the nominal ledger for large and unusual items that may be capital in nature Verify disposals to sales documentation (invoice) and recast calculation of profit/loss Accuracy/Valuation/Measurement Depreciation is a key figure for the Accuracy/Valuation of Non Current Assets!! Reperform depreciation calculations by: 63

64 Selecting a representative sample of assets from the register and recalculating the charge for the year Recasting the list of individual asset depreciation charges Agreeing the total charge to the Accounts Alternatively, agree this year s charge as reasonable by taking last year s charge and amending it for additions, disposals, revaluations, changes in method or policy etc. Compare the predicted charge for the year with the actual charge, and seek explanations for any material differences - i.e. an analytical procedure (developing forecasts and compare to actual) Assess depreciation policies for reasonableness by: Comparing methods used with prior year Comparing methods used with similar companies Analysing the recent trend of profits and losses on asset disposals Compare depreciation rates (by category of asset) with previous years and policy rates Check that policies and rates are disclosed in accounts Check depreciation for assets that are being disposed of - Has all accumulated depreciation been eliminated on disposal If any assets have been revalued during the year: agree new valuation to valuer s report verify that all similar assets have also been revalued no cherry picking of just the assets which have risen in value reperform depreciation calculation to verify that charge is based on new carrying value Is the Valuation reasonable review: 64

65 Experience of valuer Scope of work Methods and assumptions used in line with standards Revaluation surplus correctly recorded Revaluation gains and losses accounted for in line with IAS 16 When physically inspecting assets, take note of their condition and usage. Any obvious physical damage may require a write down to the asset For a representative sample of assets, agree cost to purchase invoice (or other relevant documentation) ensuring all relevant costs have been included. Non Current assets bought in a foreign currency should not be adjusted for Fx at the year end date as they are non monetary assets If any assets have been self constructed by the company, obtain analysis of costs incurred and agree to backing documentation (timesheets, materials invoices etc) Review Insurance policies in force for all assets to ensure cover is sufficient and check expiry dates Consider need for Impairment Review as set out in IAS 36. Rights And Obligations For a representative sample of recorded assets, obtain and inspect ownership documentation: Title deeds for properties; Land Registry Certificates Registration documents for vehicles Insurance documents may also help to verify ownership (and asset values) 65

66 Where assets are leased, inspect lease document to assess whether lease is operating or finance (if the latter, the asset should be included on the company s Statement of financial position) Disclosure Agree opening balances with prior year Accounts Compare depreciation rates in use with those disclosed For revalued assets, ensure appropriate disclosures made (e.g. name of valuer, revaluation policy) and that gains/losses are disclosed in Other Comprehensive Income, where required Agree breakdown of assets between classes with the nominal ledger account totals Complete Accounts Disclosure Checklist Occurrence / Cut-Off When examining asset invoices, verify that item was purchased and in place before the year end Additions Procedures to confirm rights and obligations, valuation and completeness: Verify invoices, architects certificates Check capitalisation of expenditure is correct by considering whether: Capital/revenue distinction is correctly drawn Capitalisation is inline with consistently applied company policy Check purchases are authorised by directors/senior mgt. Verify additions properly allocated to correct non-current asset accounts Ensures appropriate grant claims made and received Additions are recorded in non-current assets register and general ledger 66

67 For a representative sample of additions per the Non Current Asset Register, auditor to agree cost capitalised to original supplier invoice. Disposals Procedures to confirm rights and obligations, completeness, occurrence, measurement/accuracy Verify with supporting documentation transfer of title, sales price, completion and payment dates Recalculate profit or loss on disposal Verify that disposals have been authorised by inspecting minutes of directors meetings Consider whether proceeds are reasonable If assets used as security, ensure correctly released Auditor to agree disposal proceeds to bank statements and cashbook Audit of Construction Contracts A long term contract is generally a contract entered into for the design, Manufacture or construction of a single substantial asset, or the provision of a service, where the time taken is such that the contract activity falls into different accounting periods The Major risks attaching to such contracts are as follows: The costs incurred to date may be misstated The stage of completion may not be accurate leading to errors in the profit recognised in the financial statements Estimates of future costs may be inaccurate Invoices issued and cash received to date may be incorrectly calculated The account receivable may be irrecoverable The auditor should ensure that revenue and expenses have been correctly recognised and that any asset recognised for cost incurred in relation to future activity are recoverable. Procedures are as follows: Verify revenue figures to certification of work completed in year, or if unavailable, work completed to date excluding revenue recognised in prior years Verify cost figures to invoices and ensure that they relate to current period. 67

68 Ensure that capitalised costs relating to future activity relate to future activity by reviewing invoices and work schedules Review contract to ensure that capitalised costs are recoverable Undertake bad debt review recognised and ensure that any debt which is not collectable has been treated as an expense INVESTMENT PROPERTY A key factor to consider when auditing investment properties is whether one exists according to the criteria of IAS 40 Investment Property Investment Property: Property held to earn rentals or for capital appreciation or both. An entity may own land or a building as an investment rather than for use in the business. Property: Land and/or building (including part of a building) held by owner or lessee (finance or operating lease) Note: A building owned by the reporting entity (or held by the entity under a finance lease) and leased out under an operating lease qualifies as an Investment Property under IAS 40. Note: IAS 40 provides that an asset whose use has yet to be determined is held as an investment property. The following are not investment property Property intended for sale in the ordinary course of business (Accounted for under IAS 2 Inventories) Property being constructed or developed on behalf of third parties (Accounted for under IAS 11 Construction Contracts) Owner occupied property e.g. Head Office (IAS 16 PPE) Property being constructed or developed for future use as an investment property (IAS 16 until construction or development is complete, then treat as an investment property) Property being leased to another entity under a finance lease i.e. the reporting entity does not control the asset 68

69 Substantive Tests Investment Property Verify rental agreements, ensuring that occupier is not a connected company and that the rent has been negotiated at arm s length If the building has recently been built, inspect architects certificates to ensure that construction work has been completed The second important assertion in relation to investment properties is valuation/accuracy. IAS 40 requires that investment properties either be held at cost (benchmark treatment) or at fair value. This approximates as open market value. The auditor should be able to verify this by reference to a valuer s certificate, as professional valuation is encouraged under the IAS. The auditors should seek to verify the cost to appropriate evidence, for example purchase invoice or, of self constructed, costing records, payroll etc The last key issue with regard to investment properties is disclosure. The auditor should review the disclosures made in the financial statements in relation to investment properties to ensure that they have been made appropriately, in accordance with IAS 40. If the benchmark treatment is used, a key disclosure is that of the fair value of the asset. 69

70 INTANGIBLE NON CURRENT ASSETS Recognition criteria: IAS 38 requires an enterprise to recognise an intangible asset, whether purchased or self-created (at cost) if, and only if: it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise; and the cost of the asset can be measured reliably. Examples of possible intangible assets include: computer software patents copyrights licenses franchises customer and supplier relationships marketing rights Intangibles can be acquired: by separate purchase as part of a business combination by self-creation (internal generation) i.e. development expenditure DEVELOPMENT EXPENDITURE Where costs are incurred in developing a new product or asset, these costs can be capitalised if evidence exists that the costs will generate benefits in future periods. (Refer to IAS 38 ) Where a product is being developed, the auditor will need to assess whether: The product will be completed o It is technically possible o The finances are available to complete the development 70

71 The completed product s sales will be in excess of the costs The costs being capitalised relate to the development project Remember PIRATE!! P robable Future Economic Benefits I ntention to Complete and use/sell R esources adequate to complete and use/sell A bility to use/sell T echnical Feasibility E xpenditure can be reliably measured Key assertions exist (genuine assets) and valuation. Audited with reference to reporting standards Only purchased goodwill or other intangibles meeting criteria under IAS 38 and IFRS3 should be capitalised Audit evidence invoices, specialist valuations Audit of amortisation similar to depreciation amortise an intangible asset over its useful economic life As such, typical audit procedures will include: Examining a prototype of the product, to assess likelihood that it will be completed (an industry expert may be needed) Reviewing the results of product testing to date Analysing the development budget and comparing it to actual costs and finance available. Where finances in place, agreeing balances or loan facilities with bank records 71

72 Analysing market research results to assess likely sales (in some circumstances, industry publications may already have assessed the product s likely market) Reviewing a breakdown of the capitalised costs to verify that they relate only to the project Carry out an Impairment Review of Development Expenditure SIC 32 Intangible Assets Web Site Costs, states that an entity s own website that arises from development and is for internal or external access is an internally developed intangible asset that is subject to the requirements of IAS 38. All expenditure on developing a website solely for advertising and promoting an entity s own products and services should be recognised as an expense when incurred. However, if an entity is able to demonstrate that a website is capable of generating future economic benefits (for example, orders can be placed through the website), then the related costs can be capitalised (i.e. PIRATE) 72

73 INVESTMENTS Where a company has investments, the auditor will need to agree: Existence Agree recorded investments with ownership documents (e.g. share certificates), verifying that the company s name is present enquire of banks/brokers etc. Valuation Where investments are held at valuation, agree value (e.g. to year-end inventory market prices, or by assessment of the accounts of the company the investment is in) Disclosure Discuss management plans for investments to ensure correct split between non current and current assets and obtain written confirmation as necessary Board Minutes may back up what management say (and some investments may already have been sold since the year end) Investment Income Analyse Inventory Exchange records to verify that all investment income, rights issues, bonus issues etc have been received and accounted for by the company Agree dividends and interest received to bank statements and cashbook, ensuring recorded in the correct accounting period. 73

74 EXERCISE: SPRINGFIELD NURSERIES Your firm is the auditor of Springfield Nurseries, a company operating three large garden centres which sell plants, shrubs and trees, garden furniture and gardening equipment (such as lawnmowers and sprinklers) to the general public. You are involved in the audit of the company s non current assets. The main categories of non current assets are as follows: i) Land and buildings (all of which are owned outright by the company, none of which are leased) ii) Computers (on which an integrated inventory control and sales system is operated) iii) A number of large and small motor vehicles, mostly used for the delivery of inventory to customers iv) Equipment for packaging and pricing products. The company holds records of these assets on a computerised non current asset register. The depreciation rates used are as follows: i) buildings 5% each year on cost ii) computers and motor vehicles 20% each year on the reducing balance basis iii) equipment 15% each year on cost You are concerned that these depreciation rates may be inappropriate. Required: a) Explain the main risks associated with financial statement assertions relating to non current assets. (3 marks) b) List the sources of evidence available to you in verifying the ownership and cost of: 74

75 i) the land and buildings ii) the computers and motor vehicles. (9 marks) c) List the procedures you would perform to check the appropriateness of the depreciation rates on each of the three categories of non current asset. (5 marks) d) Describe the action you would take if you disagreed with any of the depreciation rates used and explain the potential effect of the disagreement on your audit report. (3 marks) (Total: 20 marks) 75

76 SOLUTION TO EXERCISE: Springfield Nurseries Key answer tips This question is principally testing your knowledge of the audit approach to non current assets, although some marks are also to be gained from your knowledge of the audit report. Part (a) focuses on the risks associated with the financial statement assertions these assertions clearly need to be learned thoroughly as part of your examination preparation. For part (b) think about the different types of evidence which are available to the auditor and which ones are appropriate in each case. Note that you are only dealing with evidence as to ownership and cost this should be standard audit verification work. Part (c) relates to depreciation rates. Having knowledge of what is the norm will help you answer this question, but a lot of insight here can be gained from a common sense approach and an appreciation of the nature of the assets involved. Part (d) relates to the audit report remember (as always) to consider materiality which is an important factor in such a subjective area as this. a) Main risks i) All assets in practice are liable to be overstated rather than understated; where assets are overstated it is likely that profits are overstated. ii) There is a risk that the non current assets do not exist, or that they are overvalued either because they are impaired in some way or have been under-depreciated. iii) There is also a risk that non current assets are overstated because of the inclusion of items (such as small tools) that should be expensed through the profit & loss account rather than capitalised in the statement of financial position. 76

77 iv) As with all financial statement assertions, there is a risk that the values are misstated because of errors in the accounting and internal control systems. b) Ownership and cost i) Land and buildings Ownership will be evidenced by purchase documents or other documents of title The ownership of land will normally be shown in some sort of central land register maintained by a government or other department (the Land Registry!) Ownership may also be evidenced indirectly by the payment of insurance premiums and other costs associated with the ownership of land and buildings The cost of land and buildings may be shown in the purchase documentation, and also in documentation relating to the taxes that are payable when land and buildings are transferred Payments should be traced through the cash records. ii) Computers and motor vehicles Both ownership and cost of computers and motor vehicles will be shown in the purchase documentation and in the cash records Motor vehicles also normally have associated documentation that show the tax payable and the history of ownership it is common to mark both computers and vehicles with security codes designed to prevent and detect theft, these codes may be invisible to the eye, but visible by using special lights; the knowledge of and a proper record of these codes provide some evidence of ownership 77

78 Computers and motor vehicles may be held on leases, in which case the leasing documentation should be inspected The physical existence and use by company of the computers, motor vehicles (and land and buildings) also provide some evidence of ownership. c) Depreciation rates i) The depreciation rates on the buildings may be too high (buildings are commonly depreciated over 50 years). The depreciation rates on the computers, motor vehicles and equipment might be too low (computer equipment is often over depreciated over three years and motor vehicles over four years, on a straight line basis). ii) Enquire of management as to the reasons for the depreciation rates (and why they are different to the rates suggested above, bearing in mind the fact that there may be special considerations to be taken into account), any recent changes in rates, and the reason for the choice of the straight line-reducing balance methods. iii) Review the actual life of all of the assets by inspecting assets that are fully depreciated to see if they are still in use; if they are, the depreciation rate may be too high. Where assets that are not yet fully depreciated are no longer in use, the depreciation rates may be too low. iv) Review the profit or loss on disposals of assets; profits may indicate that depreciation rates are too high, losses may indicate that rates are too low. 78

79 v) Inspect a representative sample of new assets, assets that have been depreciated to half their original value and assets that have been written off, and review the physical condition of the assets. d) Disagreement with rates i) Assess whether the total error in the depreciation is material to the financial statements; if it is not, it will have no direct effect on the audit report, although the error should be added to the summary of unadjusted differences (and if these are material, an adjustment to the financial statements may be necessary). ii) If the amounts involved are material to the financial statements, it will be necessary to request management to make an adjustment to the financial statements. If management agrees, it will be possible to issue an unmodified audit opinion. If management refuses, it will be necessary to issue an except for modified opinion (explaining the disagreement), or even an adverse opinion (stating that the financial statements do not present fairly the position) if the amounts involved affect the view given by the financial statements as a whole. Modified audit opinions relating to disagreements over depreciation policies are relatively rare (often because the amounts involved are immaterial), adverse opinions are very rare. iii) If there is a serious disagreement, it may be necessary to review other areas in which management estimates form the basis of the accounting treatment. 79

80 Past Exam Questions Refer to Substantive Topics Exam Tracker Practice Question 80

81 SUBSTANTIVE TESTING OF BANK AND CASH For bank and cash, the most important assertions to test are those where the risk of error or misstatement is greatest. As cash is an asset, it is liable to be overstated. Bank can be an asset or a liability (Overdraft, loans etc), so if a liability, it could be understated. Existence Stated balances (of bank or cash) may not exist if money has been stolen, or if the directors wish to overstate the company s assets. Accuracy/Valuation Bank balances may be misstated if year-end reconciling items have not been properly adjusted. Occurrence / Cut-Off Recording of cash payments and receipts near the year-end may be mis-timed (either deliberately or in error). BANK A typical audit procedure is to seek confirmation of bank balances, loan agreements and other matters direct from the client s bank. A bank report for audit purposes (known commonly as the bank letter) is sent by the auditor shortly after the client s Reporting Date. The report is a standard document requesting information, and the bank will charge the client a small fee for answering it. 81

82 Assuming the report is obtained and is from a trusted bank, it gives evidence that bank accounts exist and that balances are accurately stated on the Statement of Financial Position(subject to any reconciling items). Protocol Around Obtaining the Bank Letter Auditor to get client to firstly sign the bank letter which in doing so, allows the bank to send the reply to the letter directly to the auditor. Auditor to send confirm and signed client approval directly from audit firm to the bank Request bank to send original confirm directly to audit firm (enhances the appropriateness of the audit evidence) Commonly requested information on a Bank Letter: Full titles of all bank accounts, balances on current deposit, loan and other accounts. Information on nil balance accounts and any account closed during the financial year, as well as interest earned and interest charged. Maturity and interest rate terms on loans or deposits Lines of credit/standby facilities Security, charges, liens or any other collateral given or received Contingent liabilities letters of guarantee etc. If client refuses to provide written permission to enable the bank letter to be sent, then the auditor is to consider if valid grounds for refusal and if there are, apply alternative procedures : o Recast the Bank Reconciliation 82

83 o o Agree Outstanding cheques to post year end bank statements Agree Outstanding lodgements to post year end bank statements If auditor does not think there are valid grounds for refusal then is a limitation of scope and will have an impact on the auditor s report if it remains unresolved Substantive Audit Program for Bank NB * Auditor to obtain a listing of system balances for all bank accounts in existence at year end, recast and agree to the draft financial statements. Auditor to agree opening nominal ledger balance for bank accounts to closing audited nominal ledger balance per prior year audited financial statements. Issue and receive bank letters. Verify arithmetic of bank reconciliation. Trace cheques shown as not presented to post year end bank statements and note date of clearance on bank rec and obtain explanations for any unusual items not cleared by the time of the audit (Cut Off) Where there appears to be a particularly large number of outstanding cheques (payments) at the year end, the auditors should investigate whether these were cleared within a reasonable time in the new period. If not, this may indicate that despatch occurred after the year end (Cut Off) Compare Cash Book and Bank Statement in detail for the last month and check any items outstanding at reconciliation date to bank rec Review bank rec previous to year end rec and ensure all items cleared in the last period or taken forward to year end rec Obtain explanation for any items in cash book not in bank statement and vice versa Verify that un-cleared lodgements were paid in pre year end by checking date of paying in slips (Cut off) Verify balances on the bank rec with cash book, bank statement and general ledger Verify bank balance with reply from bank and with bank statement 83

84 Scrutinise bank statement and cash book before and after year end for exceptional entries Identify if accounts are secured on assets of the company Are bank accounts subject to any restrictions For a sample of cheques review the date prepared, sent and presented CASH Some companies have very small cash balances, so that they can cover small expenses such as office tea and coffee, stationery, window cleaning etc. In these circumstances the amounts being spent are unlikely to be material to the Financial Statements. A surprise petty cash count may be undertaken, in an attempt to gain assurance that the cash is not being stolen or spent on inappropriate items. The petty cash book will also be reviewed for items that may have an effect on other areas of the Financial Statements (e.g. cash wages may indicate that payroll taxes have been underrecorded). For companies who have cash sales (e.g. bars, retailers), cash balances are likely to be material. Even if all yearend cash has been banked, the amount of cash passing through tills is likely to be one of the most important figures to the auditor. Internal auditor - cash counts have a role in fraud prevention. Substantive procedures for Cash may include: Performing cash counts at a sample of sites/tills and reconciling them to till records and/or cashbooks Planning for a cash count: Best if all locations counted at the same time 84

85 Cash may include unbanked cheques received, credit card slips in addition to notes and coin Determine locations where cash is held and which warrant a count Decisions recorded in current audit file: Precise time(s) and location(s) of count(s) Names of audit staff conducting the counts Names of client staff to be present Location not visited obtain letter from client confirming the balance Carrying out the Count Follow up procedures o All cash/petty cash books written up to date in ink at time of count All balances counted at same time Cash may include unbanked cheques received, credit card slips - these should be counted at same time as notes and coins Auditors not left alone at any time having a custodian from the client present, and requiring his/her signature on return of the cash minimizes the possibility, in the extent of a shortage, of the custodian claiming that all cash was intact when released to the auditors for counting (i.e. the custodian trying to pass off a shortage of cash onto the Auditor) All cash and securities counted must be recorded on working papers and filed on current audit file Unbanked cheques and cash receipts subsequently paid in and agreed to bank rec Balances as counted are reflected in the accounts Agreeing amounts banked to daily till records Question and Answer: Substantive Audit Of Bank 85

86 Past Exam Questions See Substantive Topic Tracker 86

87 SUBSTANTIVE AUDIT PROCEDURES PAYABLES ACCRUALS,PROVISIONS & CONTENGENCIES Liabilities are liable to be understated so as boost total assets and increase profits. For current liabilities, the most important assertions to test are those where the risk of error or misstatement is greatest: Completeness There is a clear incentive for directors to leave payable balances out of the Financial Statements. Liabilities that have arisen as at the year-end often have no associated cash payment or paperwork until long after the year-end, making it difficult for the auditor to know of their existence. Cut-Off The cut-off problems are the same as those noted in earlier Sessions on Inventory and Receivables. 87

88 Accuracy Are Payable Balances carried at the correct amount in the financial statements understatement is a key risk area Disclosure Payables often have associated disclosures that are essential to a proper understanding of the company s position. This is especially true for loans (link disclosures on Bank Letter) and provisions and contingent liabilities, although these are not Payables as such). To summarise, be aware of possibility of understatement of liabilities to improve liquidity and profits. Primary objectives will be to ascertain if liabilities at year end completely and accurately recorded. Subdivide objective into: Satisfactory cut-off and Accurately recorded TRADE PAYABLES (PAYABLES) Listing of trade payables balances is the primary source for sampling. This listing will be extracted by client from the payables ledger. To verify extraction properly performed: 1. Check purchases ledger accounts to the list of balances and vice versa 2. Reconcile total on list to payables control account Client should also prepare a schedule of trade and sundry accrued expenses. 88

89 Confirmation of Trade Payables Confirmation of trade payables is possible (similar to receivables circularisation) but it is not used regularly in practice because the auditor can test trade payables by examining reliable, independent evidence in the form of supplier invoices and supplier statements. Confirmation of trade payables provides audit evidence primarily for the completeness, accuracy and obligation assertions (but, equally, it offers no assurance that unrecorded liabilities will be discovered) Auditors use a positive confirmation, referred to as a blank or zero confirmation. This confirmation does not state the balance owed but requires the supplier to declare the amount owed at the year end and to provide a detailed statement of the account. When the confirmation is received back the amount must be reconciled with the entity s records. It is recommended to confirm trade payables only when, the suppliers being confirmed are those with which the company has engaged in substantial levels of business and do not issue monthly statements and/or statement is not available at the reporting date 89

90 Reconciliations of Accounts Payables with Supplier Statements Supplier statements, as a source of documentary evidence originating outside of the entity, are a reliable source of audit evidence to support balances and provide evidence as to the existence, completeness and accuracy of balances. When selecting accounts for testing, the auditor should consider the volume of business during the year, not just the balance outstanding at the year end, because the risk is understatement of balances Most differences between balances on supplier statements and the year end accounts payables listing are likely to be due to goods/cash in transit (i.e. cut off issues) and disputed amounts. Completeness (i.e. the Search for Unrecorded Liabilities) Compared with the audit of asset balances, the audit of trade payables places more emphasis on gathering audit evidence about the completeness assertion, due to the risk that trade payable balance has been deliberately understated in the financial statements. Substantive audit procedures in respect of completeness include: Review cashbook after year-end for payments that may indicate liabilities that existed at the year-end. Where these are found, trace to invoice to ensure recorded before the year-end. Review key expense accounts such as legal and professional fees, as amounts paid shortly after the Reporting Date are likely to indicate matters that existed before the year end. Calculate payable days and compare with prior year - Analytical Procedure! 90

91 Compare list of purchase ledger accounts with prior year to ensure that no major balances have been omitted Review goods received notes (GRN s) which have not been matched to invoices at year end Review post year end invoices to received, to ascertain if they related to the pre year end Cut-Off The tests are the same as those in the Session on Inventory GRN/Purchase Invoice Goods received, but no invoice, are accrued (GRN accrual) Goods received which have been invoiced but not yet posted, are accrued Goods returned prior to year end excluded from inventory and accounts payable At year end (inventory count) auditor notes the serial numbers of the last GRNs Check GRNs from before year end to ensure invoices either: 1. Posted to purchase ledger before year end 2. Included in schedule of accruals 1. Review schedule of accruals to ensure that goods received after year end not accrued Review large invoices and credit notes recorded after the year end to ensure they relate to the following year Review outstanding purchase orders for indications of purchases completed but not invoiced 91

92 Accuracy/Valuation Agree a sample of entries on payables ledger accounts back to purchase invoices, credit notes, cashbook (i.e. back to the source documentation) For a sample of suppliers, perform a reconciliation of year-end supplier statements to purchase ledger balances Perform a reconciliation of the purchase ledger control account to the sum of individual purchase ledger balances Check that the list of purchase ledger balances has been correctly drawn from the books, and that it adds up Purchases and expenses Occurrence and completeness - were they for valid business reasons and accurately recorded Analytical procedures to be used o Level of purchases & expenses over the year o Effect on value of purchases of changes in quantities, products or prices of products o Ratio of trade creditors to purchases, to stock and comparison to previous years Check purchases and other expenses recorded in purchase or general ledger or cash book to supporting doc: Valid (i.e. the Occurrence Assertion) invoices addressed to client, ordered by client, for purposes of business Allocate to correct purchase or general ledger account 92

93 ACCRUALS Substantive tests - analytical procedures and reconciliation techniques are useful. Areas to search for possible accruals: last year s accruals; expense items where an accrual would be normal; Goods received not invoiced Invoices received and payments made after the year end; knowledge of business (common accruals utility costs, interest, wages, tax) Verify accruals are accurately calculated and verify by reference to subsequent payments and supporting documents. Review Statement of Profit or Loss and prior year figures for all likely accruals. Inspect post year end payments for evidence of possible accruals required at the year end. Consider basis for round sum accruals. PAYE, PRSI and USC - Normally one month s deductions outstanding at Year End - Verify amount paid to Revenue, by checking receipted returns. 93

94 VAT o Usually two months outstanding at year end o Verify reasonableness to annual/next return o Verify last amount paid pre - year to cash book and VAT 3 return PROVISIONS AND CONTINGENCIES ISA 540 Auditing Accounting Estimates; ISA 501 Audit Evidence (litigation); Accounting standards - IAS 37 Provision a liability of uncertain timing or amount Recognition Provision required when: when entity has a present obligation (legal or constructive) as a result of a past event, and it is probable that a transfer of economic benefits will be required to settle the obligation and a reasonable estimate can be made of the obligation. Measurement best estimate of expenditure Changes in provision adjusted at each reporting date and adjusted to reflect the current best estimate 94

95 Contingent liability is either (a) a possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity s control or (b) a present obligation that arises from past events but is not recognised because it is not probable that a transfer of economic benefits will be required to settle the obligation or because the amount of the obligation cannot be measured with sufficient reliability. Main types of contingencies disclosed by companies are: Guarantees Lawsuits or claims ending Contingent Asset is a possible asset arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity s control. 95

96 Accounting Treatment Probable > 50% Possible outflow/inflow of outflow/inflow of economic economic resources resources Remote chance of outflow of economic resources (Contingent) Liability Provision is Disclose contingent Don t disclose recognised and liability disclosed Contingent Contingent asset Don t disclose Don t disclose Asset disclosed when inflow not virtually certain Per ISA 540, Auditing Accounting Estimates, The auditor should adopt one or a combination of the following approaches in the audit of an accounting estimate: Review and test the process used by management to develop the estimate; Use an independent estimate for comparison with that prepared by management; or Review of subsequent events which provide audit evidence of the reasonableness of the estimate made. 96

97 Process Used By Management to Develop the Estimate: The steps ordinarily involved in reviewing and testing of the process used by management are: Evaluation of the data and consideration of assumptions on which the estimate is based; Testing of the calculations involved in the estimate; Comparison, when possible, of estimates made for prior periods with actual results of those periods to determine if any adjustments should be made; and Consideration of management's approval procedures. Independent Estimate The auditor may make or obtain an independent estimate and compare it with the accounting estimate prepared by management. When using an independent estimate the auditor would ordinarily evaluate the data, consider the assumptions and perform audit procedures on the calculation procedures used in its development. It may also be appropriate to compare accounting estimates made for prior periods with actual results of those periods. Review of Subsequent Events Transactions and events which occur after period end, but prior to completion of the audit, may provide audit evidence regarding an accounting estimate made by management. 97

98 The auditor's review of such transactions and events may reduce, or even remove, the need for the auditor to review and perform audit procedures on the process used by management to develop the accounting estimate or to use an independent estimate in assessing the reasonableness of the accounting estimate. Substantive Audit Program: Provisions/Contingencies Obtain details of all provisions included in the accounts and all contingencies disclosed. Obtain detailed analysis of all provisions, show opening balance, movements and closing balances and agree to the draft financial statements Agree Current Year Opening balance for provisions to prior year audited closing balance. Determine if company has present obligation: Review correspondence Discussions with the directors Determine for each material provision if it is probable that transfer of economic benefit required to settle obligation: o Inspect post year end payments o Review correspondence with solicitors, banks o Write to solicitor o Discuss past provisions with directors o Consider likelihood of reimbursement Review assumptions used to calculate provisions and contingencies and consider the reasonableness of those assumptions Recalculate all provisions 98

99 Compare amount provided with any post year end payments and with any amount paid in the past for similar items o If not possible to estimate provision, check contingent liability is disclosed in accounts o Consider nature of client s business. would you expect to see any other provisions e.g. warranties. o Consider adequacy of disclosure of provisions, contingent assets and contingent liabilities. ISA 501: Litigation The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity which may result in a material misstatement of the financial statements. Such procedures would include the following: Make appropriate inquiries of management including obtaining representations. Review minutes of those charged with governance and correspondence with the entity's legal counsel. Examine legal expense accounts. Use any information obtained regarding the entity's business including information obtained from discussions with any in-house legal department. 99

100 OTHER CURRENT LIABILITIES Agree year-end tax Payables to tax computations (and correspondence with tax authorities) Agree payroll tax Payables to the payroll records for the final week/month Consider company s bonus schemes and assess whether amounts need to be accrued at the Reporting Date 100

101 EXERCISE: TOLLERTON You are the senior in charge of the audit of Tollerton (a private company), and you are auditing the company s Payables at 30 April 20X2. A junior member of the audit team has been checking suppliers statements to the balances on the purchase ledger. He is unable to reconcile a material balance, relating to Carlton, and has asked for your assistance, and your suggestions on the audit work which should be carried out on the differences. The balance of Carlton on Tollerton s purchase ledger is shown below: 101

102 Carlton s terms of trade with Tollerton allow a 2% cash discount on invoices where Carlton receives a cheque from the customer by the end of the month following the date of the invoice (i.e. a 2% discount will be given on March invoices paid by 30 April). On Tollerton s purchase ledger, under Status the cash and discount marked Alloc 1 pay invoices marked Paid 1 (similarly for Alloc 2 and Paid 2 ). 102

103 Tollerton s goods received department checks the goods when they arrive and issues a goods received note (GRN). A copy of the GRN and the supplier s advice note is sent to the purchases accounting department. You are required to: a) prepare a statement reconciling the balance on Tollerton s purchase ledger to the balance on Carlton s supplier s statement ( 4 marks) b) describe the audit work you will carry out on each of the reconciling items you have determined in your answer to part (a) above, in order to determine the balance which should be included in the financial statements (10 marks) c) in relation to verifying Payables: i) consider the basis you will use for selecting suppliers statements to check to the balances on the purchase ledger ii) describe what action you will take if you find there is no supplier s statement for a material balance on the purchase ledger. ( 6 marks) (Total: 20 marks) 103

104 SOLUTION TO EXERCISE: Tollerton Key answer tips Part (a) draws more on your basic accounting ability than your auditing knowledge it should not be a difficult task for a student at this stage of their CPA studies! In answering Part (b) should make comments on the audit work relating to each reconciling item but you should direct most of your attention to the more material areas these are mainly in transit items. Note that auditing questions can deal with several related topics here some reference should be made to purchases cut off in the context of the unrecorded invoices. Part (c) deals with the question of the selection of suppliers statements and the audit procedure if no current statements are available. Selection of items for audit testing will often be based on the criterion of materiality this can be applied here. In this context, materiality can be based on the size of the outstanding year-end balance but this may be cyclical and may give a distorted view. An alternative (preferable?) approach is to base materiality on the number of purchases made from the supplier. The question of audit work where no current supplier statement exists should be largely a matter of common-sense what would YOU do? 104

105 Part (a) Reconciliation of purchase ledger balance to balance on supplier s statement: Part (b) Looking at each of the items above: i) As the difference due to the disallowed discount is very small, I may perform very little work on this item, and record it as an unadjusted error. However, if detailed checks were considered necessary, they would be as described below. Discussion with management is a key first step in this process. From the date of the cash received which pays the February invoices, it appears that Carlton may not have received the cheque until after 31 March, so it would not be entitled to the cash discount of 2%. The date the cheque for 6,163 was received by Carlton can be found by looking at Tollerton s bank statement and 105

106 checking the date it was cleared by the bank. If this is about 10 April, it indicates that Tollerton delayed sending the cheque to Carlton. If it is earlier than 10 April, Carlton may have been slow at posting cheques to its sales ledger. I will look at Tollerton s bank statement, and see if cheques issued on 31 March were slow at being cleared by the bank. If the delay is a week or more, this indicates that Tollerton delays sending cheques to most Payables. If most of these cheques are cleared within a week, it indicates that Carlton is slow at paying customers cheques into the bank. In addition to these checks, I will ask Tollerton s purchase ledger controller about this item, and inspect correspondence with Carlton. If Tollerton usually pays this disallowed discount to Carlton, this disallowed discount should be added to the purchase ledger balance. If Carlton eventually allows the discount, there is no need to add the discount to the balance. ii) The apparent transposition error on invoice 6080 would be checked by inspecting the invoice. If the invoice shows 3,752, then an additional payable of 180 should be added at the Reporting Date to correct this error. No adjustment will be necessary if Tollerton s figure is correct. Advise management. iii) It appears that invoice 6210 for 4,735 has not been included on Tollerton s purchase ledger. As this invoice is dated some time before the Reporting Date, the first question to ask is whether the goods have been received. I will check whether the goods have been received by looking for the appropriate goods received note (I may have to ask Carlton for details of this item, if no invoice can be found at Tollerton). If the goods have been received, I will check if there is a purchase invoice. If there is a purchase invoice, I will ask the purchases department why the invoice has not been posted to the purchase ledger. This will probably be because of a dispute, normally either an incorrect price, the wrong quantity or some faults with the goods. If the goods relating to 106

107 this invoice are in Inventory (or have been sold) a purchase accrual should be made for this item. If an excessive price has been charged for the items, a lower price can be used, provided the same price is used to value the Inventory. If there is a short delivery, the purchase accrual would be for the actual goods received, rather than for those on the invoice. I will inspect correspondence on this item with Carlton to assess what will be finally agreed. If there is no evidence of the goods being received by Tollerton, I will ask Carlton for details confirming that Tollerton has received the goods (this may be via Tollerton s purchasing department). If there is no evidence that Tollerton has received the goods, then no purchase accrual for this invoice is necessary. iv) For invoice 6355, the question is whether Tollerton received the goods before the Reporting Date. I will check if Tollerton received the goods before the Reporting Date by looking at the date on the goods received note. If the date is before the Reporting Date, then Tollerton should include a purchase accrual at the Reporting Date for this invoice. If Tollerton received the goods after the Reporting Date, no purchase accrual is required. A further check that the goods were received is to look at the quantities of the items in Inventory at the Reporting Date. If the quantities in Inventory at the Reporting Date are about the same as, or more than, those on the invoice, there is strong evidence that the goods were received before the Reporting Date. v) The cheque on 30 April appears to be cash in transit. I will check the date the cheque is cleared by the bank after the Reporting Date. If this is within a 107

108 week, and most other cheques are cleared within a week, then this is validly cash in transit. If most cheques issued immediately before the Reporting Date take more than a week to clear, it indicates they were sent to suppliers after the Reporting Date, in which case they should be deducted from payments before the Reporting Date and added to Payables (as these were payments made after the Reporting Date). vi) If, as appears likely, the cheque for 6,005 is not received by Carlton until some time after the Reporting Date, then the discount of 123 will be disallowed by Carlton. If this discount is disallowed, it should be added to Payables at the Reporting Date. Checks on this item are similar to those for item (i) above. Part (c) i) The suppliers statements I will select for checking to the purchase ledger balances will concentrate on: accounts with large balances, and accounts who are large suppliers to the business (i.e. those who have a large volume of transactions with Tollerton). A sample of smaller value Payables will be selected, to check that the purchase ledger is accurate for processing lower value Payables and purchase invoices. A statistical basis could be used for randomly selecting accounts, such as monetary unit sampling, but it is unusual for auditors to use this method. A weakness of using monetary unit sampling is that it would have a low chance of selecting accounts with a small balance on the purchase ledger, but where the actual balance owing is large (like the one illustrated in part (a) of the question). 108

109 The second basis of selecting accounts (i.e. selecting large suppliers to the business) would have a greater chance of selecting such Payables. ii) If there is no supplier s statement for a large balance on the purchase ledger, I will ask the purchase accounting department if such a statement exists. If no statement exists at 30 April, I will ask if there is a statement at 31 May. If there is a statement at 31 May, I will use it to check the balance on the purchase ledger at 30 April. If there is no statement on the client s premises, I will contact the supplier (with the client s permission) and ask them either to send me a copy of the statement, or confirm the balance on the client s purchase ledger. If it is not possible to contact the client, I will consider whether the client s system is reliable at processing purchase invoices. I will look at the balance on the purchase ledger and consider whether it is reasonable - the value of April s purchase invoices should be similar to March s. Also I will look at correspondence with the supplier, and check if there are any invoices on hold which have not been posted to the purchase ledger. I will see if any goods were received immediately before the Reporting Date, and check that they have either been posted to the purchase ledger or included as a purchase accrual. Based on these investigations, I will decide whether the purchase ledger balance is correct. Past CPA Exam Questions See Substantive Exam Topic Tracker 109

110 Practice Question - Payables, Accruals & Provisions Solution to Practice Question 110