CHAPTER 2-7

2. AUDIT OBJECTIVES AND PROCEDURES

(FINANCIAL STATEMENT AUDIT)

Upon completion of this unit, you should be able to:

 Explain the audit objective for specific accounts in the financial statement
 Identify the kinds of audit tests required for balance sheet and income statement accounts
 Differentiate between the need for test of control and test of balance
 Perform a test of control for various accounts on the financial statement
 Conduct a substantive tests for various accounts on the financial statement
 Analyze different audit findings so as to form audit opinion
In general, financial statement audit is conducted with the primary objective of determining
whether the overall financial statements are stated fairly and in accordance with specified criteria
(GAAP), income tax law and any other relevant legal requirement. Normally, the criteria are the
requirements of the applicable International Financial Reporting Standards (IFRSs) or country
specific accounting and reporting standards such as GAAP and any statutory provisions
applicable to accounting and reporting.

The financial statements most commonly comprises of the Balance Sheet, Income Statement,
Statement of Changes in Equity, Cash Flow Statement, and Notes to the accounts. The
assumption underlying an audit of financial statements is that the statements will be used by
different groups for different purposes. Therefore, it is more efficient to have one auditor who
will perform an audit and draw conclusions that can be relied upon by all users than to have each
user perform his or her own audit. If a user believes that the general audit does not provide
sufficient information for his or her purposes, the user has the option of obtaining more data. For
example, a general audit of a business may provide sufficient financial information for a banker
considering a loan to the company, but a corporation considering a merger with that business
may also wish to know the replacement cost of fixed assets and other information relevant to the
decision. The corporation may use its own auditors to get the additional information.
In general auditor undertake audit of financial statement to provide a reasonable assurance as to
the credibility and reliability of financial statement of an entity under audit. In due course the
auditor will follow all the audit principles, techniques, and procedures discussed in auditing
principles and practice as well in the previous units. In brief this unit will help you to look into
how the auditors practically approach his duty of financial statement audit.

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1.1 Audit of Current Assets
Current assets include cash and other assets that can be used or converted into cash within
relatively short period of time usually one year or one operating cycle.

Audit procedures for current assets discussed under the following parts are designed to validate
the transaction and balance related audit objectives. The first procedure is a transaction test (TA)
which enables the auditor to evaluate the design and implications of internal control over cash.
The second procedure is test of balance primarily designed to validate the existence of
management assertions on the year-end cash balance.
2.1.1 Auditing Cash and Cash Equivalent
In this part of this section, you will have a brief discussion on internal control that a client is
expected to design for cash, the test of control and test of balance for cash.
2.1.1.1 Meaning and Nature of Cash
Cash is a medium of exchange that a bank will accept for deposit. Cash is money in coins and
currency (notes). It also includes balances on deposit with financial institution, petty cash and
certain negotiable instruments accepted by financial institution for immediate deposit and
withdrawal. The negotiable documents include checks, certificate of deposit, credit card and
money orders.
2.1.1.2 Evaluating Internal Control over Cash

The evaluation of internal control over cash is among the foremost detail task of auditors due to
the fact that almost all transactions affect cash account and by its very nature cash is the most
liquid and tempted to miss appropriation and embezzlement. Therefore auditors devotes a
reasonably good depth of test on internal control over cash as it can highlight the possible audit
risk on cash account as well as in other accounts in balance sheet as well as income statement.

Most of the processes relating to cash handling are the responsibility of the finance department
under the controller of the treasurer. This process includes handling and depositing cash receipts,
signing checks, investing idle cash and maintaining custody of cash, marketable securities and
negotiable instruments. In addition the fi/nance department must forecast cash requirements and
make both short term and long term financing arrangements.

Ideally, assessment of internal control over cash is expected to assure auditor that the function of
the finance and accounts department should be integrated to provides assurance that, the
following general objectives of cash control are achieved:
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  All cash that should have been received was in fact received, recorded accurately, and
deposited promptly.
 Cash disbursements have been made for authorized purposes only and have been properly
recorded.
 Cash balances are maintained at adequate, level by forecasting expected cash receipts
and payments relating to normal operations. The need for obtaining loans or for investing
excess cash is thus made known on a timely basis.

To address the above stated general objectives of control over cash, an entity under audit must
have a well-designed and full implemented internal control mechanisms over cash receipt as well
as cash payment from the general cash in bank accounts as well as other impress cash funds.
The following are the different aspects of cash control:
2.1.1. Internal Control over Cash
(a) Control Objectives
The central control objectives are that:
 All sums are received and subsequently accounted for.
 No payments are made which should not be made.
 All receipts and payments are promptly and accurately recorded.
(b) Control Procedures
A detailed study of the operating routines of the individual business is necessary in developing
the most efficient control procedures. These universal rules for achieving internal control over
cash may be summarized as follows:
1. Do not permit any one employee to handle transaction from beginning to end.
2. Separate cash handling from record keeping.
3. Centralize receiving of cash as much as possible.
4. Record cash receipts immediately.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit each day’s cash receipts intact.
7. Make all disbursements by cheques with the exception of small from petty cash.
8. Have monthly bank Reconciliation prepared by employees not responsible for the
issuance or custody of cash. The completed reconciliation should be reviewed promptly
by an appropriate official.
9. Forecast expected cash receipts and disbursements and investigate variances from
forecasted amounts.
1. Internal control over cash receipts.
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Cash receipts resulted from a variety of activities. For example, cash is received from revenue
transactions, short and long term borrowings, the issuance of stock, and the sale of marketable
securities, long term investments, and other assets. The scope of this section is limited to cash
receipts from cash sale and collection from customers on credit sales. The basic internal controls
over cash receipts include the following:

 Authority to collect cash should be clearly defined.

 Collections should be recorded when received.
 The collector’s cash receipts should be reconciled to the eventual banking.
 Receipts should be banked immediately.
 Each day’s receipts should be recorded promptly in the cashbook.
 Sales ledger account should have no access to the cash.
The processing of receipts from cash and credit sales involves the following cash receipts
functions:
- Receiving cash receipts.
- Depositing cash in bank.
- Recording the receipts.
Segregation of duties in performing these functions is an important internal control activity.

Receiving cash receipts

A major risk in processing cash receipts transactions is the possible theft of cash before and after
a record of cash is made. Thus, control procedures should provide reasonable assurance that
documentation establishing accountability is created at the moment cash is received and that the
cash is subsequently safeguarded.
Depositing cash in bank
Proper physical controls over cash require that all cash receipts be deposited intact daily. Intact
means all receipts should be deposited; that is cash disbursements should not be made out of un-
deposited receipts.
Recording the receipts
This function involves journalizing over the counter and mail receipts and posting mail receipts
to customer accounts. Controls should ensure that only valid receipts are entered and that all
actual receipts entered at the correct amount.
To ensure that only valid transactions are entered, physical access to the accounting records or
computer terminals used in recording should be restricted to authorized personnel.
2. Internal Control Over Cash Disbursements
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There are two cash disbursements functions as follows:
1. Paying the liability
2. Recording the cash disbursements.
These functions should not be performed by the same department or individual. The basic
internal controls over cash disbursements include:
 Unused checks should be held in a secure place.
 The person who prepares checks should have no responsibility over purchase ledger or
sales ledger.
 Checks should be signed only when evidence of a properly approved transaction is
available.
 These checks should be evidenced by signing the supporting documents.
 Check signatories should be restricted to the minimum practical number.
 Two signatories at least should be required except perhaps for checks of small amounts.
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent their use to support further
check payments.
 Checks should preferably dispatch immediately.
Control over Petty Cash
 The level and location of cash floats should be laid down formally.
 Cash should securely hold.
 There should be restricted access to the floats.
 All expenditure should require a voucher system signed by a responsible official, not the
petty cashier.
 Vouchers should be produced before the check is signed for reimbursement.
 A maximum amount should be placed on a petty cash payment to discourage normal
purchase procedures being by passed.
 Periodically the petty cash should be reconciled by an independent person.

Bank Reconciliation as Control Mechanism

It is essential that responsibility for preparing bank reconciliation not be delegated to employees
who handle receipts or disbursement or who have access to unissued checks. In addition, bank
statement and accompanying paid checks should be delivered in sealed envelopes directly to the
person responsible for preparing bank reconciliation. Restricting access to bank statement and
accompanying paid checks to this person is important as it prevents other employees from

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attempting to conceal shortages or unauthorized transactions by altering the bank statement or
the accompanying paid checks.

2.1.1.3 Test of control

I. Cash Receipts
i) Test independent check of cash receipts to bank deposit slip.
ii) Test for evidence of a sequence check on any pre-numbered receipts for cash.
iii) Test authorization of cash receipts.
iv) Test for evidence of arithmetical check on cash received records.
II. Cash Payments
i) Inspect current check books for:
a) Sequential use of checks
b) Controlled custody of unused checks
c) Any signatures or blank checks.
ii) Test (to avoid double payment) to ensure that paid invoices are marked 'paid'.
iii) Test for evidence of arithmetical check on cash payments records, including cashbook.
iv) Examine evidence of authority for current standing orders and direct debits.
III. Bank Reconciliations
i) Examine evidence of regular bank reconciliations (usually one per month).
ii) Examine evidence of independent check of bank reconciliations (e.g. a signature).
iii) Examine evidence of follow-up of outstanding items on bank reconciliations. Pay
particular attention to old outstanding reconciling items that should be written back
such as old, un-presented checks.
IV. Petty Cash
i) Test petty cash vouchers for approval.
ii) Test cancellation of paid petty cash vouchers.
iii) Test for evidence of arithmetical check on petty cash records.
iv) Examine evidence of independent check of petty cash balance.

2.1.1.4 Substantive Audit Test of Cash

A. Auditing Cash Receipts

The audit procedures involved in the attainment of audit objectives pertaining to cash receipts are
discussed below.

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Existence/ occurrence: The specific audit objective is to determine whether all recorded cash
receipts transactions has occurred. As noted above, the audit concern with existence is the
inclusion of false cash receipts in the cash receipt journal, leading to an inflated current ratio.
This is especially important if the client is using the financial statements to apply for a bank loan.
Audit testing for existence involves vouching from cash receipt journal entries (or accounts
receivable ledger) to the prelisting and/or remittance advices. The prelisting and remittance
advices support the occurrence of the cash receipt. The auditor should also vouch from daily
deposit recorded to the cash account in the general ledger to bank records- deposit tickets and/or
bank statement.

Completeness: This assertions can be used to establish credibility of the accounting records by
tracing the handling of representative transactions from origin of final account balance, i.e., to
trace whether all cash received has been recorded or not. The extent of tracing to be done is a
direct function of the amount of internal control that is evident. The first step would be to prove
the footing of the cash receipts records for one or more months and trace the totals to entries in
the ledger accounts that are affected. For clients with a large volume of transactions and good
internal control, the proof of footings can usually be safely eliminated, but not, if the records are
handled by employees who have contact with cash or checks. Supporting documents should be
examined. Cash receipt source records would include remittance advices accompanying orders or
payments of account balances, receipts issued for over-the-counter payments, sales checks, or
cash register tapes.

Rights and obligations: This is not an issue with cash receipts.

Valuation: This is not an issue (except foreign currency transactions)

Cutoff: This assertion is checking that cash receipts are recorded in the correct period. That is,
scrutinizing whether they have been cutoff properly. The audit concern for cutoff is “window
dressing”, that is trying to make the current ratio or the quick ratio appears “good” with cash
receipts. This can be accomplished by holding the books open for a few days after year end, then
dating the receipts from early in the next year as December 31. One audit test for window
dressing involves the bank reconciliation. The other audit test involves preparing a schedule of
interbank transfers, and examining it for possible kiting. Kiting is a fraudulent scheme that seeks
to take advantage of “float”. Float in the banking system, refers to the timing differences
between the day a check is credited to an account in one bank, and debited to an account in
another bank.
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Presentation and disclosure: The auditor is expected to ascertain that receipts are credited to
the proper account, e.g. sales, accounts receivable. For this assertion, the main audit concern is
that cash received is credited to correct account. For example, sales, miscellaneous income, gain
on disposal of fixed assets, accounts receivable, notes receivable, etc. The related audit test is to
vouch from a sample of credits in cash receipts journal to the documentation which supports the
account credited.

Accuracy: The audit concern here is that cash receipts journal amounts are correctly posted to
the Accounts Receivable Subsidiary Ledger and the General Ledger Cash account. The related
audits tests are to foot (add) the cash receipts journal, and then compare the totals with the
general ledger and accounts receivable entries. Moreover, compare sales, accounts receivable, or
miscellaneous receipts by month and analyze the current ratio. Increase of the current ratio from
the previous year may indicate that cash receipts are overstated.

B. Auditing Cash Payment

Existence/occurrence: The auditor need to assert whether all recorded cash payments
transactions occurred or not. An inquiry should be made to ensure that invoices have been
internally checked and initiated by the authorized officials and payments are authorized, payee’s
acknowledgement should be checked and statements of account of the creditors should be
scrutinized.) The other audit procedure is to vouch from cash payments Journal to bank
statement, vouchers, purchase invoices, receiving reports, and purchase orders.

Completeness: This assertions can be used to establish credibility of the accounting records by
tracing the handling of representative transitions from origin to final account balance, i.e. to trace
whether all cash disbursements has been recorded or not. The extent of tracing to be done is a
direct function of the amount of internal control that is evident. The first step would be to prove
the footings of the cash disbursements records for one or more months and trace the totals to
entries in the ledger accounts that are affected. Then, for selected entries, supporting documents
should be examined. In the case of cash disbursements, source records would include vouchers,
invoices, receiving reports, and paid checks. A key issue related to fraud is overstating current
ratio. That is unrecorded cash payments increase current ratio. The audit procedure for this is to
trace from vouchers, purchase invoices, etc to cash payment Journal. In addition, to examine
bank statement (cut-off bank statement) in new year, and compare it to outstanding checks on
bank reconciliation.

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Rights and obligations: This is concerned with Checking whether cash payments were for valid
obligations of the client or not. For instance, payments for personal (non-business) items or
payments for goods not received (including double payments) may be made. This is probably the
key issue in testing cash payments. For example, examined payments for the purchases should be
vouched with cash memos of the suppliers. To insure that goods have actually been received, the
available documentary evidence, such as goods receiving notes, goods inward book, should be
examined. As well, the auditor should

 Examine cancelled checks for endorsement/ payee

 Vouch from cash payments Journal to purchase invoices, goods receiving reports,
purchase invoices, purchase orders and requisitions
 Use knowledge of business to identify bogus venders
 Examine supporting documents for cancellation
 Be aware of possible “kickbacks”
Valuation: The assertion is to check that correct price was paid, including discounts. Be aware
of possible bribes for overpayments. To ascertain the valuation compare prices on sales invoice
to purchase order and vendor price list/Performa invoices/bid documents and recalculate
purchases discounts.

Cutoff: This assertion is about checking that cash disbursements are recorded in the correct
period. As stated earlier the audit concern for allocation is “window-dressing,” that is trying to
make the current ratio or the quick ratio appears “good.” This can be accomplished for cash
disbursements by writing and recording checks to settle accounts payable, but not actually
mailing the checks until the next fiscal year. Checks may be posted in 2000 (to inflate current
ratio), but not mailed until 2001(to preserve cash flow). To ascertain the allocation objective,
examine paid dates on cancelled checks or paid dates in bank statement and note number of last
check of fiscal year.

Presentation and Disclosure: The specific audit objective is to determine whether payments are
debited to the proper account. For example, expenses may be recorded as assets. The auditor
should:

 Read asset or expense policy manual

 Refer to chart of accounts
 Examine account coding for purchase invoices for adherence to policy
 Be alert for payment of previously undisclosed contingent liabilities
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  Scan cash payments Journal for large/unusual payments, esp. to directors and other
related parties
Accuracy: It is about checking that arithmetic is correct on invoices and in cash payments
Journal. To ascertain the accuracy recalculate extensions and footing on purchase invoices and
recalculate cash payments Journal and compare to General Ledger.
C. Auditing Cash on Hand and Cash in Bank
Cash on hand consists of petty cash funds, changes fund, and un-deposited receipt. The auditor’s
first consideration in verifying cash in bank is to ascertain the actual balance on deposit. Some of
the relevant assertions and testing for assertions in the audit procedures of cash on hand and in
bank are covered in the parts that follow:
Existence/occurrence: The specific audit objective is to determine that all cash balances exist
and that cash is not overstated

a) Count cash on hand: All balances should be counted at once. This is to prevent the client
from moving cash from one branch to another and having it include in the count two or more
times. If it is impossible to count all locations at one time, each cash box should be sealed after
counting and the auditor should check that the seals are still intact after completing the count. If
the client has highly liquid investment, such as certificate of deposit, the auditor should verify
those at the same time as cash. It is very important that the cash custodian be present at all times
during the count. After the count, the auditor should ask the custodian to sign the paper.

Petty cash funds should be counted on surprise basis, some times before year end. The reason for
this is to detect if the petty cash custodian is borrowing from the cash box. If the cashier knows
the date on which the auditor will count cash, she /he can borrow many from friends to make up
the balance for the auditors count, and then take the money out of the box after the auditor
leaves.

b) Confirm bank account balances: Even though the balance in bank can be determined by
referring to the bank statement, standard practices requires that independent confirmation of the
bank balance be obtained directly from the bank.

c) Obtain cutoff bank statement: cut off bank statement is a partial statement which covers the
first week or two in the next fiscal year. It is sent directly to the auditor so that the client has no
opportunity to alter it. The auditor will use it especially in testing the bank reconciliation

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d) Test bank reconciliation: The auditor should thoroughly test the bank reconciliation prepared
by the clients by doing the following.

 Compare the balance per bank on the reconciliation to the bank confirmation and to the
beginning balance on the cutoff statement.
 Foot the column of numbers
 Traces outstanding checks and deposit in transit to the cut off statement
 Compare checks and deposits on the cut off statement with the bank reconciliation.
Completeness: The specific objective in this case is to determine whether all cash balances have
been recorded or cash was not understated. The audit tests employed for completeness are to
scan the ledger, looking for days during which there have been no debit to cash. The auditor may
also prepare a proof of cash. The other audit test would involve tracing deposit receipts to the
cutoff bank statement.

Rights and obligations: The use of cash is not restricted for cash on hand, of course, there is no
audit testing for rights. The possessor of cash is assumed to be its owner and proving otherwise is
almost impossible. However, in the cash bank account, the use of the money may be restricted in
some way. Examples of restriction include bond sinking funds and compensating balance
requirement. Audit testing of restriction on cash balance involves requesting a special
confirmation from the bank and it has to be disclosed in a financial statement.

Valuation: is not an issue, except for foreign currency balances

Cutoff: is not an issue except as discussed in the receipt

Presentation and disclosure: The specific audit objective is to determine whether all cash
balances are really cash rather than investment in bonds etc and whether sufficient disclosure is
provided. Some of the Items to be disclosed are:

 Certificate of deposit
 Sinking fund
 Compensating balance
 Overdraft
2.1.1.5 Fraud Audit Test for Cash
As we discussed under the nature of cash, cash is the most liquid asset which is prone to misuse
and misappropriation, the auditor usually performs audit procedure that enables to detect
intentional misstatement of cash account.
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Common Frauds on Cash Account
Weak internal control over cash would create opportunity for fraud or defalcation/theft/ of cash.
The most defalcations that call auditors to conduct a test of fraud are:
a. Lapping: refers to cash collection on account from credit customer may be postponed
(delayed). This is usually practiced as a temporary borrowing, but in long run they lead to
cover up by more elaborate means. This is possible if a single person is responsible to
receive cash from charge customers and keep records for accounts receivable at the same
time.
b. Check-kitting: refers to transferring of check from one bank to another when business has
two bank accounts say for example in Commercial Bank of Ethiopia Jimma branch and
Dashen Bank Jimma branch check is written to withdraw an account from CBE bank
account balance and deposited in Dashen Bank account. Due to lag (delay) of time in
clearance, the amount deposited in Dashen Bank may be reflected immediately in balance
of cash account at Dashen Bank, but not reflected as deduction from the account at
Commercial Bank of Ethiopia account soon. As a result of such technique a casher may
cover up cash shortage which an auditor might uncover under normal audit procedure.
c. Window dressing: cash shortage or cash position could be improved by holding the cash
book open/unclosed/ beyond the closing date to include subsequent cash receipt.
d. There are also other kind of frauds such as writing off bad debts, fictions Accounts
receivable casher payable to self, etc
In general, the frauds related to cash account can be controlled if the client has a strong internal
control over cash. Therefore, an auditor usually required to conduct an intense evaluation of the
internal control over cash before he/she decide to extend the normal audit test for cash to
procedures to detect fraud. If the auditor suspects that there is a risk of misstatement on cash
resulted from fraud, he/she can follow the following procedures summarized in the following
table.

Type of Possible
Fraud Possible Audit Test/Procedure
Window dressing  Trace deposits in transit to cutoff bank statements to determine deposit
date.

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Lapping  Confirm accounts receivable and give close attention to exceptions made
by customers about payment dates.
 Make a surprise count of the cash and customers checks on hand
 Compare the details of remittance lists (if prepared), stamped duplicate
deposit slips, and entries in the cash receipts book
Check-kitting  Prepare a schedule of the interbank transfers made for a few days before
and after the audit date.
 Obtain cutoff bank statements directly from the bank covering the seven
to ten day period after the balance sheet date.

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2.1.2 Audit of Accounts Receivables

In this section you will deal with audit of account receivable. The section contains the internal
control over accounts receivables, the test of control and substantive test of balance that auditor
perform during the audit of accounts receivable. For many business sales are made on credit and
thus auditors usually make a due attention in an audit of account receivable as they can have
evidence about the assets reported in the balance sheet as receivable as well as about the sales
revenue reported in the income statement. Like those of other accounts, the auditor approaches
an audit of receivable in two procedures; first it conducts assessment of internal control or
transaction test and performs an audit of balance to substantiate the validity of audit objectives.
In the process of conducting audit of accounts receivable, the auditor checks the sales and
receivable cycle, collection, the discount, allowance and returns offered to customer as well as
the process of determining bad debt expense or written-off debt that is proved to be
uncollectable.

In attaining the overall audit objective, the auditor design and implement transactions and audit
related audit objectives substantiate the effectiveness of the internal control system as well as to
substantiate the validity of expressed and implied assertion concerning balance of accounts
receivable.
2.1.2.1 EvaluatingInternal Control over Accounts Receivable
Good internal control for receivables includes:
 Any person who handles or has access to collect from customers should have no other
responsibility relating to account receivable.
 Responsibility for approval of credit to customers, account for returned goods, and
allowance for uncollectible accounts should be given to the general manager or high
ranking officers.
 A person authorized to approve non cash credit should under no circumstance have
access to cash collection.
 The handling of cash should be separated from the preparation of the accounting
records.
 A person who opens a mail should make a record in 3 copies of all cash received, retain
one copy for himself, send the cash and the second copy to the cashier and send the
thirdcopy to accounting department. The cashier will deposit the cash in a bank and send
the deposit slip to accounting department. The accounting department will control the
cash by comparing the third copy with the deposit slip sent to it.
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  Granting credit, collecting delinquent account, making records (accounting) and
cashiering, all should not be granted to a single individual.
 Using two types of account (subsidiary ledger and general ledger) and assigning
recoding in the two accounts to different employees.
2.1.2.2 Test of Control for Account Receivable
Test of control should be designed to check that the control procedures are being applied and the
objectives are being acceded. In relation to accounts receivable, the following tests can be
performed on a sample basis:

 Cary out sequence test checks on invoices, credit notes, shipping/dispatch notes orders to
ensure that all items are included and that there are no omissions or duplications.
 Check authorization for the:
 Acceptance of the order
 Dispatch of goods
 Raising of the invoice or credit notes
 Pricing and discounts
 Write-off of bad debts

In this procedure, the auditor checks that the relevant signature exists and that the control has
been applied in the process of credit sales and subsequent cash collection.

 Seek evidence of checking of the arithmetic accuracy of invoices, credit notes and sales
tax.
 Check dispatch notes and goods returned notes to ensure that they are referenced to
invoices and credit notes and vice versa.
 Check that control account reconciliations have been performed and reviewed.
 Ensure that batch total control have been applied by seeking signatures and tracing
batches from inputs to output.

In all the above cases, the auditor attempts to get satisfaction on the proper application of the
control procedure.
2.1.2.3 Test of Balance of Accounts Receivables
Once the auditor appraises and tests the system of internal control in order to ascertain that the
system of internal control over receivable is adequate, he/she further carries out substantive tests
in an attempt to ensure that, the transactions, sales, cash receipt, discounts, return and allowance
and bad debts in the accounts receivable subsidiary ledgers and controlling account, are in fact
completely and accurately recorded or the balance is not materially misstated.
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In audit of accounts receivable balance the audit program includes the following balance related
objectives:

i. Accounts receivable in the aged trial balance agree with related master files
amounts, and the total is correctly added and agrees with the general ledger
(detail tie-in)
ii. Recorded account receivable exist(existence)
iii. Existing accounts receivable are included(completeness)
iv. Accounts receivable are accurate( accuracy)
v. Cutoff for accounts receivable is correct( cut off)
vi. Accounts receivable are properly classified(classification)
vii. Accounts receivable are stated at realizable value(realizable value)
viii. The client has right to accounts receivable(rights)
ix. Accounts receivable presentation and disclosure are proper(presentation)

The followings are substantive audit test for account balance of accounts receivable:

Accuracy: is discussed first because the auditor must establish that the detailed record that
support the account to be audited agree with the general ledger account. The amounts continued
in the financial statements are derived from the general ledger balances. To test the fairness of a
financial statement amount, the auditor tests the general ledger account by examining the amount
or estimates that compose the balance. For many account, the general ledger balance is supported
by a subsidiary ledger or listing of the details that make up the balance. Normally, the auditor
performs a number of accuracy tests of the subsidiary ledger or listing before conducting other
tests of the account balance. This process is followed when accounts receivable are audited.
For example, the auditor agrees the accounts receivable subsidiary ledger of customers accounts
to the general ledger account receivable (control) account. This is typically accomplished by
obtaining a copy of the aged trial balance of accounts receivable and comparing the total balance
with the general ledger accounts receivable account balance. An aged trial balance of the
subsidiary ledger is used because the auditor will need this type of data to examine the allowance
for uncollectible accounts. The auditor must also have assurance that the details making up the
aged trial balance is accurate. This can be accomplished in a number of ways. One approach
involves mainly manual audit procedures. First, the aged trial balance is footed and cross footed.
Footing and cross footing mean that each column of the trial balance is added, and the column
totals are then added to ensure that they agree with the total balance for the account. Then a

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sample of customer accounts included in the aged trial balance is selected for testing. For each
selected customer account, the auditor traces the customer’s balance back to the subsidiary
ledger detail and verifies the total amount and the amounts included in each column for proper
aging. A second approach involves the use of computer-assisted audit techniques. If the general
controls over IT are adequate, the auditor can use a generalized audit software package to
examine the accuracy of the aged trial balance generated by the client’s accounting system

Validity: The validity of accounts receivable is one of the more important audit objectives
because the auditor wants assurance that this account balance is not overstated through the
inclusion of fictitious customer accounts or amounts. The major audit procedure for testing the
validity objective for accounts receivable is confirmation from customers. If some customers’
dose not respond to the auditor’s confirmation request, additional audit procedures may be
necessary. There are two types of confirmation called positive confirmation and negative
confirmation. Basically positive confirmations are letters sent to debtors asking them to confirm
directly to the auditor the amount of the balance in their respective accounts. The auditor wants a
response regardless of whether the customer agrees or disagrees with the stated balance. The
confirmation usually includes the amount from the client books, but it is possible to send a blank
confirmation and ask the clients to fill in the correct amount. The blank type of confirmation is
very good evidence because the customer has to actually look up the information on his or her
records and writes it down. But the response rate is usually lower because of the amount of work
involved for the customers. Negative confirmation on the other hand asks for a response only if
the debtor disagree with the recorded amount. Negative confirmation request are often simply
stamped or glued on to the clients regular monthly statements to the customer before it is sent
out. Positive confirmations are more reliable, partly because the auditor will follow up
confirmations which are not returned. If a negative confirmation is not returned, the auditor
assumes it is because the debtor agrees with the balance. Since negative confirmation are often
simply ignored by the receipt that assumption may not be correct. Negative confirmation are less
reliable, but are cheaper to send. A formal letter is not required, and no time is spent following
up.

SAMPLE POSITIVE CONFIRMATION LEETER

KK Company
Addis Ababa, Ethiopia
Control number: KK/108/2011
Date:2/01/2011

17
 To: BB Company
Dire Dawa, Ethiopia
Dear Sir:
Our auditor, Birhanu& Co., is conducting an audit of our financial statements. Please examine
the accompanying statement and either confirm its correctness or report any differences to our
auditors.
Your prompt attention to this request will be appreciated. An envelope is enclosed for your
reply.
Very truly yours,

[Client signature and title]

The replay from the client may be written as follows:

The balance receivable from us of Br.20, 000 as of 2/01/2011 is correct except as noted
below:

[Debtor name]
Date
By

Completeness: The auditor’s concern with completeness is whether all accounts receivable have
been included in the accounts receivable subsidiary ledger and the general accounts receivable
account, the reconciliation of the aged trial balance to the general ledger account should detect an
omission of a receivable from either the accounts receivable subsidiary ledger or the general
ledger account. If the client’s accounting system contains proper control totals and
reconciliations, such errors should be detected and corrected by the relevant internal control
procedures. Personnel in the billing department would be responsible for reconciling the two
totals. If such control procedures do not exist in a client’s accounting system, or if they are not
operating effectively, the auditor will have to trace a sample of shipping documents to sales
invoices, the sales journal, and the accounts receivable subsidiary ledger to ensure that the
transactions were included in the accounting records.

Cutoff: The cutoff objective attempts to determine whether all revenue transactions and related
accounts receivable are recorded in the proper period. On most audits, sales cutoff is coordinated
with inventory cutoff because the shipment of goods normally indicates that the earnings process
is complete. The auditor wants assurance that if goods have been shipped in the current period,
the resulting sale has been recorded, and also that if the sales have been recorded, the

18
corresponding inventory has been removed from the accounting records. In addition, the auditor
needs to determine if there is proper cutoff for sales returns.

Sales Cutoff: If there is no proper cutoff of revenue transactions, both revenue and accounts
receivable will be misstated for the current and following years. In most instances, errors related
to sales cutoff are due to delays in recognizing the shipment of goods or recognizing revenue
transactions in the current period in the next period or may recognize sales from the next period
in the current period. The first situation can occur by the revenue transactions not being recorded
in the sales journal until the next period. For example, sales that take place on the last two days
of the current year are recorded as sales in the next year by delaying entry until the current- year
sales journal is closed. The second situation is generally accomplished by leaving the sales
journal “Open” and recognizing sales from the first few days of the next period as current-period
sales.

The test of sales cutoff is straightforward. The auditor first identifies the number of the last
shipping document issued in the current period. Then a sample of sales invoices and their related
shipping documents is selected for a few days just prior to, and subsequent to, the end of the
period. Assuming that sales are recorded at the time of shipment (FOB- shipping point), sales
invoices representing goods shipped prior to year-end should be recorded in the current period,
and invoices for goods shipped subsequent to year- end should be recorded as sales in the next
period. Any transaction recorded in the wrong period should be corrected by the client. For
example, suppose the last shipping document issued in the current period was numbered 10,540,
and none of the recorded revenue transactions sampled from a few days prior to year- end should
have related shipping document numbers higher than 10,540. And none of the sampled revenue
transactions recorded in the first few days of the subsequent period should have related shipping
document numbers lower than 10,540. In a computerized system such tests are still necessary
because a delay in entering data may occur, or management may manipulate the recognition of
the transactions.

Sales Returns Cutoff: The processing of sales returns may differ across entities. When sales
return are not material, or if they occur irregularly, the entity may recognize a sales return at the
time the goods are returned when sales return represent a material amount, the auditor needs to
test for proper cutoff. Using the procedures similar to sales cutoff, the auditor selects a sample of
receiving documents for few days prior to and subsequent to the end of the period. The receiving

19
documents are traced to the related credit memorandum. Sales return recorded in the wrong
period should be corrected if material.

Ownership: The auditor determines whether the account receivables are owned by the entity
because accounts receivable that have been sold should not be included in the entity’s financial
statement. For most audit engagements, this doesn’t represent a problem because the client owns
all the receivables. However, in some instances client may sell its account receivable. The
auditor can detect such an action by reviewing bank confirmation. Cash receipt for payments
from organization that factor accounts receivable, or corporate minutes for authorization of the
sales or assignment of receivables.

Valuation: Two major valuation issues are related to accounts receivable. The first issue relates
to the valuation of the revenue and cash receipts transactions that make up the details of the gross
amount of account receivables. The concern her is with the quantity and pricing of the items
included on the sales invoices and the proper recording of cash received including any discount.
This affects the gross amount of accounts receivable as well as sales. Test of control and
substantive test of transaction normally provides evidence about these types of pricing errors.
Pricing errors, especially when the consumer has been overcharged or proper payment hasn’t
been recorded may also be detected via confirmation.

The second valuation issue relates to the net realizable value of accounts receivable. The auditor
is concerned with determining that the allowance for uncollectible accounts, and thus bad debt
expense, is fairly stated. The allowance for uncollectible account is affected by internal factors
such the client’s credit granting and cash collection policies and external factors such as the state
of the economy, condition in the clients industry, and the financial strength of the clients
customer. In verifying the adequacy of the allowance for uncollectible accounts, the auditor
starts by assessing the client’s policies for granting credit and collecting cash. If the client
establishes strict standards for granting credit, the likely hood of a large number of bad debts is
reduced. The second step in assessing the adequacy of the allowance account involves
examining the client’s prior experience with bad debts.

Classification: The major issues related to the classification objectives are

 Identifying and reclassifying any material credits contained in accounts receivable

 Segregating short term and long term receivables
 Ensuring that different types of receivables are properly classified.

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In many entities, when a customer pays in advance or a credit is issued, the amount is credited to
the customer’s accounts receivable account. The auditor should determine the amount of such
credits and if material, reclassify them as either a deposit or another type of labiality. The second
issue requires that the auditor identify and separate short term receivable from long term
receivables, should not be included with trade accounts receivable. The auditor must also ensure
that non trade receivables are properly separated from trade accounts receivable. For example
receivable from officers, employees, or related parties should not be included with trade accounts
receivable because users might be misled if such receivables are combined. The last two issues
are also related to the disclosure audit objective

Disclosure: Disclosure is an important audit objective for accounts receivables and related
accounts. While management is responsible for the financial statements, the auditor must ensure
that all necessary disclosures are made. Examples of disclosure items for receivables are:

 Short and long term receivables

 Pledged or discounted receivables
 Receivable from related parties
 Receivables by type (trade, officer, employee, affiliated, and as on)

2.1.3 Auditing for Inventory

2.1.3.1 Inventory Management Process

The inventory management process is affected by the internal control procedures for revenue,
purchasing and payroll processes. The acquisition of and payment for inventory are controlled
via purchasing process. The cost of both direct and indirect labor assigned to inventory is
controlled through the payroll process. Last, finished goods are sold and accounted for as part of
the revenue process. Thus, the “cradle-to-grave” cycle for inventory begins when goods are
purchased and stored and ends when the finished goods are shipped to customers. The following
are the more important documents and records that are normally involved in the inventory
system. In advanced IT system, some of these documents and records may exist for only a short
time or only in machine readable form.

 Production and schedule

 Receiving report
 Material requisition
 Inventory master file
 Production data information
 Cost accumulation and variance report
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  Inventory status report
 Shipping Order
2.1.3.2 Internal Control over Inventories

The followings are internal control procedures that should exist in the client’s business to control
inventory properly

 Purchase or other commitment should be initiated only by authorized personnel, preferably

on the basis of competitive bid.
 Purchase orders for good and materials are placed as needed and for optimum quantity
 Follow up should be made on purchase orders if delivery has not been made by the
scheduled delivery date
 Incoming shipment should be accepted only if the receiving department has authorization
in the form of a copy of purchase order.
 Quantity and quality of goods received should be as specified before payment is
authorized
 Terms, prices, and clerical accuracy of vendors invoice should be correct before payment
is authorized
 Refund or credit should be received for all purchase returned and allowance
 The need to reorder signaled as soon as the amount of inventory on hand reaches a
minimum safety balance
 Inventory quantity should be adequately protected against losses from theft, spoilage,
unauthorized withdrawal by employee.
 There should be full accountability for both units and birr for inventory quantity received,
on hand and issued or sold.
 Difference between book and physical inventories are ascertained, differences adjusted and
the amount of overage or shortage should be properly accounted for.
 Proper authorization exists for inventory quantity removed from stock
 All transactions pertaining to the issue or sales of inventories quantity should be accounted
for and entered in the controlling record.
 Inventory issues should be valued according to an acceptable method and the costs should
be accounted for in a manner that provides adequate information for management
including variance from standard

2.1.3.3 Audit Objectives for Testing Inventory

General Audit
Objective Specific Audit Objective
Validity Determine whether recorded inventory actually exists
Completeness Determine whether all inventories are recorded
Cutoff Determine whether all transaction that affect inventory are record in the
correct period
Ownership Determine whether all recorded inventories are owned by the entity and
whether it is subject to any liens or restrictions.
Accuracy Determine whether inventory is properly accumulated from journals to
ledgers
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 Valuation Determine whether inventory is properly valued in accordance with
GAAP
Classification Determine whether inventory is properly classified in the general ledger
and the financial statements
Disclosure Determine whether all disclosure related to inventories are included in
the financial statement

2.1.3.4 Test of Account Balances for Inventory

Accuracy: Testing the accuracy of inventory requires obtaining a copy of the compilation of the
physical inventory quantities and prices. The inventory compilation is footed, and the
mathematical extensions of quantity multiplied by price are tested. Additionally, test counts
made by the auditor during the physical inventory and tag control information are traced into the
compilation. Many times the client has adjusted the general ledger inventory balance to agree to
the physical inventory amount (referred to as book–to–physical adjustment) before the auditor
begins the substantive tests of account balances. If the client has made the book- to physical
Adjustment, the totals from the compilation for inventory should agree with the general ledger.

When the client maintains perpetual inventory system, the totals from the inventory compilation
should also be agreed to these records. The auditor can use computer-assisted audit techniques to
accomplish these audit steps. For example, the auditor can use a generalized or custom audit
soft–ware package to trace test control information into the client’s computer file of the
inventory compilation. The extensions and footing can also be tested at the same time.

Validity or Existence: is one of the more important audit objectives for the inventory account.
Observation of the physical inventory is the primary audit step used to verify this objective. If
the auditor is satisfied with the client’s physical inventory count, the auditor has sufficient,
competent evidence on the validity or existence of recorded inventory.

Completeness: The auditor must determine whether all inventories have been included in the
inventory compilation and the general ledger inventory account. The tests related to the
observation of the physical inventory count provide assurance that all goods on hand are
included in inventory. Tracing test counts and tag control information into the inventory
compilation provides assurance that the inventory counted during the physical inventory
observation is included in the compilation. In some cases, inventory is held on consignment by
others or is stored in public warehouses. The auditor normally confirms or physically observes
such inventory.

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Cutoff: In testing the cutoff objective for inventory, the auditor attempts to determine whether
all sales of finished goods and purchases of raw materials are recorded in the proper period. For
sales cutoff, the auditor can examine a sample of shipping documents for a few days before and
after year-end for recording of inventory shipments in the proper period. For purchases cut off,
the auditor can examine a sample of receiving documents for a few days before and after year-
end for recording of inventory purchases in the proper period.

Ownership: The auditor must determine whether the recorded inventory is actually owned by
the entity. Two issues related to ownership can arise. First, the auditor must be sure that the
inventory on hand belongs to the client. If the client holds inventory on consignment, such
inventory should not be included in the physical inventor. Second, in some industries, goods are
sold on a” bill-and hold” basis. In such a case, the goods are treated as a sales but the client holds
the goods until the customer needs them. Again, the auditor must be certain that such goods are
segregated and not counted at the time of the physical inventory.

Valuation: A number of important valuation issues are related to inventory. The first issue
relates to the costs used to value the inventory items included in the compilation. When the client
purchases inventory, Valuation of the inventory can normally be accomplished by vouching the
costs to vendors’ invoices. When the client uses standard costs, the auditor audits the standard
cost as discussed previously. The second valuation issue relates to the lower-of –cost-or market
tests for inventory. The auditor normally performs such tests on large-dollar items or on the
client’s various product lines. A third valuation issue relates to obsolete, slow- moving, or excess
inventory. The auditor should ask management about such issues. When these issues exist, the
inventory should be written down to its current market value. Finally, the auditor should
investigate any large adjustments between the amount of inventory shown in the general ledger
account and the amount determined from the physical inventory account for possible
misstatement.

Classification: In a manufacturing company, the auditor must determine that inventory is

properly classified as raw materials, work in process or finished good. In most manufacturing
companies, proper classification can be achieved by determining which manufacturing
processing department has control of the inventory on the date of the physical count. For
example, if inventory tags are used to count inventory and they are assigned numerically to
department, classification can be verified at the physical inventory. The auditor can ensure that
each department is using the assigned tags. The tag control information by department can be

24
compared to the information on the inventory compilation to assure that it is properly classified
among raw materials, work in process, and finished goods.

Disclosure: Several important disclosure issues are related to inventory For example,
management must disclose the cost method, such as LIFO or FIFO, used to value inventory.
Management must also disclose the components (raw materials, work in process, and finished
goods) of inventory either on the face of the balance sheet or in the footnotes. Finally, if the
entity uses LIFO to value inventory and there is a material LIFO liquidation, footnote disclosure
is normally required. Other information’s which requires disclosure are:

 Long term purchase contract

 Purchase from related parties
 Pledged or assigned inventory
 Warranty obligation
 Unusual loss
 Consigned inventory

Observing Physical Inventory

The auditor’s observation of inventory is generally accepted auditing procedure. However, the
auditor is not required to observe all inventories, but only inventory that is material. Internal
auditors may also observe physical inventory. The primary reason for observing the clients
physical inventory is to establish the validity or existence of the inventory. The observation of
the physical inventory also provides evidence on the ownership and valuation audit objectives.
Based on the physical inventory count, the client compiles the physical inventory. While the
form of compilation may differ among entities, it normally contains a list of the item by type and
quantity, the assigned cost for each item, the inventory value for each item, and a total for the
inventory.

Prior to the physical count of the inventory, the auditor should be familiar with the inventory
location, the major items in inventory and the client’s instructions for counting inventory. During
observation of physical inventory, the auditor should do the following.

 Ensure that no production is scheduled or if production is scheduled, ensure that proper

control are established for movement between departments in order to prevent double
counting.

 Ensure that there is no movement of goods during the inventory count. If movement is
necessary, the auditor and client personnel must ensure that the goods are not double
counted and that all goods are counted.
25
  Make sure that the clients count teams are following the inventory count instruction, the
auditor notify the client’s representation in charge of the area.

 Ensure that inventory tags are issued sequentially to individual departments for many
inventory counts; the goods are marked with multi copy inventory tags. The count teams
record the type and quantity of inventory on each tag, and one copy of each tag is then
used to compile the inventory, such as detailed inventory listing on handheld computers,
the auditor should obtain copies of the listing or files prior to the start of the inventory
count.

 Perform test counts and record a sample of counts in the working papers. This
information will be used to test the accuracy and completeness of the client’s inventory
compilation.

 Obtain tag control information for testing the client’s inventory compilation. Tag control
information includes documentation of the numerical sequence of all inventory tags and
accounting for all used and unused inventory tags. If inventory listings are used by the
clients, copies of listing will accomplish the objectives of documenting the entire
inventory count.

 Obtain cutoff information, including the numbers of the last shipping and receiving
document issued on the date of the physical inventory count.

 Observe the condition of the inventory for items that may be obsolete, slow moving or
carried in excess quantity.

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

2.2 Auditing Noncurrent Assets

2.2.1 Evaluating Internal Control over Fixed Asset

The following internal control procedures should be implemented to properly control fixed asset:

 Capital budgeting approach should be used to the authorization of plant expenditure.

 Comparison of budgeted and actual expenditure should be made periodically to see how
effective such expenditure was being controlled and to permit corrective actions to be taken
where necessary.
 Expenditure for plant asset must also be properly classified according to whether they
should be capitalized or expensed.
 After the fixed asset is acquired, detailed accounting record of them should be maintained
in a plant ledger with a separate page for each items.

26
  An identifying serial number should be given to each fixed asset. The identification number
is used to facilitate the taking of physical inventory, to determine whether items have been
dismantled, scraped or sold without proper treatment in the accounting recode and
whether theft or other losses have occurred.
 Depreciation charges should be accurately determined particularly when disposal occurs.
 Historical cost, date of acquisition, accumulated depreciation, period of use, and major
repair and improvement should be properly kept and shown on the plant ledger.
 All maintenance or special work order done in the factory should be authorized by work
orders and the accounting department should be informed for record keeping.
 Discarding, sales or exchange of plant asset should be properly authorized by the
concerned official and communicated to the accounting department on the date of disposal.
 Purchase requisition should be initiated in relevant department and authorized at the
appropriate level with in the entity. However, highly technical equipments should be
purchased only after passing though a specific skilled professional.
 There should be a limit to the authorization at each managerial level to ensure that larger
projects are brought to the attention of high level management for approval before
commitment are made.

2.2.2 Tests of Controls

The auditor needs to conduct test of control to ass the effectiveness of internal control over
noncurrent tangible assets to determine the depth and breadth of the substantive test of balance.
i. Check authorization of purchase to board minutes, capital expenditure budgets and
capital expenditure form.
ii. Check authorization for disposals of significant assets.
iii. Confirm existence of noncurrent asset register which adequately identifies assets and
comments on their current condition. Ensure register reconciles to nominal ledger.
iv. Test evidence of reconciliation of register to physical checks of existence and condition
of assets.
v. Check authorization of depreciation rates, and particularly changes in rates.
vi. Examine evidence of checking of correct calculations of depreciation.
2.2.3 Tests of AccountBalances-Property, Plant, and Equipment

The following discussion summarizes the substantive tests of balances for the property, Plant and
equipment accounts for each audit objective. The discussion that follows focuses on the major
audit procedures conducted by the auditor. Accuracy is discussed first because the auditor must
establish that the detailed property, plant, and equipment records agree with the general ledger
account.

27
Accuracy: The auditor verifies the accuracy of property, plant, and equipment by obtaining a
lead schedule and detailed schedules for additions and dispositions of assets. This lead schedule
is footed, and the individual accounts are accurate.

Validity: To test validity, the auditor obtains a listing of all major additions and vouches them to
supporting documents such as vendors’ invoices. If the purchase was properly authorized and the
asset has been received and placed in service, the transaction is valid. In addition, the auditor
may want to verify that assets recorded as capital asset actually exist. For major acquisitions, the
auditor may physically examine the capital asset. Similarly, disposition of assets must be
properly authorized, and the supporting documents such as sales receipts should indicate how the
disposal took place. Generally, the auditor obtains a schedule of all major dispositions and
verifies that the asset was removed from the property, plant, and equipment record. If the
disposition is the result of a sale or exchange, the auditor would verify the cash receipt for the
result of the asset or documentation that another asset was received in exchange.

The auditor must also ascertain the validity of lease transactions by examining the lease
agreements entered into by the entity. If the lease agreement is properly authorized and the asset
is placed in service, the evidence supports the validity of the recorded asset.

Completeness: The auditor has some assurance about the completeness objective from the
control procedures in the purchasing process and, if present, the additional control procedures
discussed previously in this chapter. If the auditor still has concerns about the completeness
objective, he or she can physically examine a sample of assets and trace them into the property,
plant, and equipment subsidiary ledger. If the assets are included in the subsidiary ledger the
auditor has sufficient evidence supporting the completeness objective.

Cutoff: On most engagements, cutoff is tested as part of the audit work in accounts payable and
accrued expenses. By examining a sample of vendor invoices, from a few days before and after
year-end, the auditor can determine if capital asset transactions are recorded in the proper period.
Inquiry of client personnel and a review of lease transactions for the same period can provide
evidence on proper cutoff for leases.

Ownership: The auditor can test for ownership by examining the vendor’s invoices or other
supporting documents. In some instances, the auditor may examine or confirm property deeds or
title documents for proof of ownership.

28
 Valuation: Capital assets are valued at acquisition cost plus any cost necessary to make the
asset operational. The auditor tests the recorded cost of new assets by examining the vendor
invoices and other supporting documents used by the client to establish the recorded value of the
assets. If the client has material self- constructed assets, the auditor conducts detailed audit work
on the construction-in process account. This includes ensuring that interest is properly
capitalized as a cost of the asset. The other valuation issue the auditor must address is the
recognition of depreciation expense. If the client uses a computer to process and account for
capital assets, the auditor may be able to use computer-assisted audit techniques to verify the
calculation of depreciation for various assets. Alternatively; the auditor may re compute the
depreciation expense for a sample of capital assets. In making this calculation, the auditor
considers the reasonableness of the estimated life of the asset, the depreciation methods used for
book and tax purposes, and any expected salvage.

Classification: First, the classification of a transaction into the correct property, plant, and
equipment account is normally examined as part of the testing of the purchasing process. The
auditor’s tests of controls and substantive tests of transactions provide evidence as to the
effectiveness of the control procedures for this objective. Second, the auditor should examine
selected expense accounts such as repair and maintenance to determine if any capital assets have
been correctly recorded in these accounts. An account analysis of transactions included in the
repairs and maintenance account is obtained, and selected transactions are vouched to supporting
documents. In examining the supplies expense items or whether it would be more appropriate to
capitalize the cost. For example, the auditor may examine an invoice from a plumbing contractor
that shows that the water pipe system for a building has been replaced during the current period.
If the amount of this transaction was material and improves the building, it should not be
expensed as a repair but rather should be capitalized as a building improvement. Last, the auditor
should examine cash material lease agreement to verify that the lease is properly classified as an
operating or capital lease.

Disclosure: Shows a number of important items that may require disclosure as part of audit of
property, plant, and equipment. Some of these disclosures are made in the “summary of
significant accounting policies” foot note, while other items may be disclosed in separate
footnotes. The followings are some of the items to be disclosed:

 Class of capital asset and valuation base

 Depreciation method and use full life

29
  Non operating asset
 Construction or purchase commitment
 Liens and mortgage
 Acquisition and disposal of major operating facilities
 Capitalized and other lease arrangement

2.3 Auditing Liabilities

A balance sheet will contain many liabilities grouped under various headings such as:

 Trade creditors/Accounts payable

 Notes payable
 Bank loans and overdraft
 Other creditors including accrued taxes, pension/provident fund payable and accrued
and deferred income

Liabilities in the balance sheet are reported as current liability if the amounts fall due within one
year, otherwise long-term liabilities. During an audit of liability the auditor is also expected to
follow some procedures test for the existence of contingent liabilities that need to be
incorporated in the note to the financial statement.

In an audit of liabilities the auditors’ duty is fourfold, namely:

a. To verify the existence of liabilities shown in the balance sheet,

b. To verify the correctness of the money amount liability accounts,

c. To verify the appropriateness of the description given in the accounts and the
adequacy of disclosure,

d. To verify that all existing liabilities are actually included in the accounts.

During an audit of liabilities the auditors has to recognize the following points that differentiate
the audit of asset and liability.

 Management fraud designed to improve the apparent financial position of a company

usually involves an overstatement of asset but an understatement of liability. A transaction
which has given rise to labiality need merely be ignored in the record to achieve the
desired effect. The auditor’s problem is then much more difficult, for there is no

30
 convenient starting point to an examination designed to disclose possible unrecorded
liability.
 Defalcation by employee present less problem in the case of liability account since
defalcation usually involves the abstraction and manipulation of asset.
 Most liabilities are a statement of facts whereas most assets involve valuation problem
based on individual judgment. Only some of the estimated liabilities such as a provision
for cost to be incurred in connection with product guarantees involve problems similar to
those of asset valuation.

Internal Control over Liability

Some of the internal control procedures that should exist over liabilities are listed as follows:

 The authority to borrow money should be restricted to only two or three officials of the
company.
 Large borrowings should be made only under specific authorization of the board of
directors.
 All interest payment should be subject to close scrutiny before they are approved to be
certain that interest is paid for known liabilities.
 Voucher system should be used in processing account payables.
 Two records (subsidiary ledger and controlling account) should be kept for account
payables and should be reconciled periodically.
 The client should maintain detailed record of long term debt transaction to ensure that
all borrowing and repayment of principal and interest are recorded.

2.3.1 Auditing Current Liabilities (AccountsPayable and Accrued Liabilities)

The discussion below is related to audit of account balance of account payable and accrued
expense. The auditor first test accuracy in order to ensure that the detailed records support the
general ledger accounts.

Accuracy: The accuracy of account payable is determined by obtaining a listing of accounts

payable, footing the listing and agreeing it to the general ledger control account. The items
included on this listing are the unpaid individual vouchers or the balance in the individual ledger
account in the subsidiary record

31
Validity: The auditor’s major concern with this audit objective is whether the recorded liabilities
are valid obligations of the entity. To verify the validity of liability, the auditor can vouch sample
of the items included on the listing of account payable, or the accrued account analysis to
voucher packets or other supporting documents. If adequate source documents are present, the
auditor has evidence that the amount represents valid liabilities. In some circumstances, the
auditor may obtain copies of the monthly vendor statement or send confirmation request to
vendors to test the validity of the liability.

Completeness: Completeness is an important audit objective for accounts payable and accruals
because auditors are concerned about unrecorded liability. Therefore, auditors frequently conduct
extensive test to ensure that all liabilities are recorded. Such tests are commonly referred to as a
search for unrecorded liabilities. The following audit procedures may be used as a part of the
search for unrecorded liabilities.

 Ask management about control procedures used to identify unrecorded liabilities and
accruals at the end of an accounting period.
 Obtain copies of vendor’s monthly statements and reconcile the amount to the clients
account payable record.
 Confirm vendor accounts, including accounts with small or zero balances.
 Vouch large dollar items from the purchase journal and cash disbursement journals for a
limited time after year and; examine the date on each receiving report or vendor invoice
to determine if the liability relates to the current period.
 Examine the files of unmatched purchase orders, receiving reports and vendors invoice
for any unrecorded liabilities.

Cutoff: The cutoff objectives attempts to determine whether all purchase transactions and related
account payables are recorded in the proper period. On most audits, purchase cutoff is
coordinated with the clients physical inventory count. Proper cutoff should also be determined
for purchase returns

Ownership: Generally, there is little risk related to this objective because clients seldom have an
incentive to record liability that is not obligation of the entity. Review of the voucher packet for
adequate supporting document relating liabilities to the client provides sufficient evidence to
support these audit objectives.

Valuation: The valuation of account payable and accrual is generally not a difficult audit
objective to test. Account payables are recorded at either the gross amount of the invoice or the
net of the cash discount if the entity normally takes cash discount the valuation of accruals

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depends on the type and nature of the accrued expense. Most accruals are relatively easy to value
and proper valuation can be tested by examining the underlying source document.

Classification: The major issues related to the classification objectives are:

 Identifying and reclassifying any material debits contained in account payables

 Segregating short term and long term payables
 Ensuring that different types of payables are properly classified.

Proper classification can usually be verified by reviewing the accounts payables listing and the
general ledger accounts payables. If material debits area present, they should be reclassified as
receivables or as deposit if the amount will be used for future purchase. Any long term payables
should be identified and reclassified to the long term liability section of the balance sheet. Also,
if payables to officers, employees or related parties are material they should be included with the
trade account payables. The auditor should also ensure that accrued expenses are properly
classified.

Disclosure: Even though management is responsible for the financial statement, the auditors
must ensure that all necessary financial statement disclosure is made for account payables and
accrued expense. Examples of disclosure items for purchasing process related liabilities include:

 Payables by type (trade, officers, employees etc.)

 Short and long term payables

2.3.2 Auditing Long-Term Liabilities

Common types of long term debt financing include notes, bonds, and mortgage. More
sophisticated type of debt financing include collateralized mortgage obligation, repurchase and
reverse repurchase agreement. Long term debts may have a number of features that can affect the
audit procedures used. For example, debt may be convertible to in to stock or it may be
combined with warranty, options, or rights that can be exchanged for equities. Debts may be
callable under certain conditions or it may require the establishment of a sinking fund to ensure
that the debt can be repaid. Last, debt may be either unsecured or secured by asset of the entity.
The auditor’s consideration of long term debt however is not different than for any financial
statement account. The auditor must be assured that the amount shown on the balance sheet for
the various types of long term debt is not materially misstated. This assurance extends to the

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proper recognition of interest expense in the financial statements. Summary of audit objectives
and test of account balance for long term debt is given in the table below.

Audit Objective Test Of Account Balance

Validity Examine copies of new notes or bond agreement. Examine board of
director’s minutes for approval of new lending agreement. Confirm notes or
bonds directly with creditors
Completeness Obtain bank confirmation for notes from a bank. Confirm bonds or notes
from creditors. Review interest expense for payment to debt holders not
listed on the debt analysis schedule
Cutoff Review debt activity for a few days before and after year end to determine
if the transaction are included in the proper period
Accuracy Obtain an analysis of notes payable and bonds payables, and accrued
interest payable ,foot schedules and agree totals to the general ledger
Valuation Examine new debt agreement to ensure that they were recorded at the
proper value. Confirm the outstanding balance for notes or bonds and the
last date on which interest has been paid. Re compute accrued interest
payable
Classification Examine the due date on notes or bonds for proper classification between
current and long term debt. Review debt for related party transactions or
borrowing from major shareholders
Disclosure Examine notes or bond agreement for any restriction that should be
disclosed in the foot notes.

2.4 Auditing Stockholders’ Equity

In this subsection, the audit for stockholders’ equity, which is essential part of financial
statement audit in corporations in which the auditor is directly responsible to report to
stockholders.

2.4.1 Evaluating Internal Control over Stockholders’ Equity

For most entities, stockholders’ equity includes common stock, preferred stock, paid-in capital,
and retained earnings. In recent years, numerous financial instruments have been developed that
contain both debt and equity characteristics and affect the audit of stockholders’ equity. Various
stock options and compensation plans also impact the audit of stockholders’ equity. Following
are the three major types of transactions that occur in stock holders’ equity:

 Issuance of stock: This includes transactions such as sale of stock for cash, the exchange
of stock for assets, services, or convertible debt and issuance of stock splits.
 Repurchase of stock: This includes the reacquisition of stock (referred to as treasury
stock) and the retirement of stock.

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  Payment of dividends: This includes the payment of cash dividend or issuance of stock
dividends.

Many large entities, such as publicly traded companies, use an independent registrar agent, and
dividend-disbursing agent to process and record equity transactions. The registrar is responsible
for ensuring that all stock issued complies with the corporate charter and for maintaining the
control totals for total shares outstanding. The transfer agent is responsible for preparing stock
certificates and maintaining adequate stockades’ records. The dividend- disbursing agent
prepares and mails dividend checks to the stockholders record. When an entity uses an
independent check to the stockholders record, and dividend disbursing agents, the auditor may be
able to obtain sufficient evidence by confirming the relevant information with those parties. If an
entity uses its own employees to perform the stock transfer and dividend disbursement functions,
the auditor needs to perform more detailed testing of the stock related record and transactions
that occurred during the period. The following internal control objectives, internal control
procedures, and segregation of duties are relevant when client personnel transfer stock and
disburse dividend.

Following are the major internal controls for stockholders’ equity.

 Verify that stock and dividend transactions comply with the corporate charter.
 Verify that stock and divided transactions have been properly approved.
 Verify that stock and dividend transactions have been properly valued.
 Verify that all stock and dividend transactions have been properly posted and
summarized in the accounting record.
 The individual responsible for issuing, transferring and canceling stock certificate should
not have any accounting responsibility.
 The individual responsible for maintaining the detailed stockholders record should be
independent of the maintenance of the general ledger control account.
 The individual responsible for maintaining the detailed stockholders records should not
also process each receipts or disbursements.
 Appropriate segregation of duties should be established among the preparation,
recording, signing and mailing of dividend checks.

2.4.2 Auditing Capital Stock Accounts

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When auditing the capital stock accounts, the auditor is normally concerned with the validity,
completeness, valuation and disclosure objectives.

Validity and Completeness: All valid stock transaction is approved by the board of directors.
Therefore, the auditor can test the validity of capital stock transactions by tracing the transactions
recorded in the current year to the board of director’s minutes. When an independent registrar
and transfer agent are used by the entity, the auditor confirms the total number of shares
outstanding at the end of the period. If the amount of shares outstanding on the confirmation
reconciles to the general ledger capital-stock accounts, the auditor has evidence that the total
number of shares outstanding at the end of the year is correct.

If the entity does not use outside agents, it will maintain a stock register and/ or a stock
certificate book. The auditor may perform the following tests:

 Trace the transfers of shares between stockholders to the stock register and/or stock
certificate book (valuation and completeness).
 Foot the shares outstanding in the stock register and/or stock certificate book and agree
them to total shares outstanding in the general ledger capital-stock certificates
(completeness).
 Examine any canceled stock certificates (validity).
 Account for and inspect any uninsured stock certificates in the stock certificate book
(completeness).

Valuation: When capital stock is issued for cash, the assessment of proper valuation is
straightforward. The par, or sated, value for the shares issued is assigned to the respective
capital-stock account, while the difference between the price and par, or stated, values assigned
to each transaction. The proceeds from the sale of stock are normally traced to the cash receipts
records.

The valuation issue is more complex when capital stock issued in exchange for assets or
services, for a merger or acquisition, for convertible securities, or for a stock dividend. For
example, when a stock dividend is declared and the number of shares issued is less that 20
percent of the shares outstanding, the dividend is recorded at fair market value. The fair market
value of the stock dividend is charged to retained earnings and credited to common stock and
paid-in capital. To test valuation, the auditor can re compute the stock dividend and trace the
entries into the general ledger.
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Disclosure: A number of important disclosures are frequently necessary for stockholders’ equity.
Examples of stockholders’ equity disclosures include:

 Number of shares authorized, issued and outstanding

 Call provision, prices, and dates for preferred stock
 Preferred stock sinking fund
 Stock option or purchase plane
 Restriction on retained earnings and dividend

The normal sources of this information include the corporate chatter, minutes of the board of
directors’ meetings, and contractual agreements.

2.4.3 Auditing Dividends

Generally all dividends that are declared and paid will be audited as there are concerns with
violations of corporate bylaws or debt covenants. When the entity uses an independent dividend
–disbursing agent, the auditor can confirm the amount disbursed to the agent by the entity. This
amount is agreed with the amount authorized by the board of directors. The auditor can re
compute the dividend amount by multiplying the number of shares outstanding on the recorded
date by the amount of the per share dividend approved by the board of directors. This amount
should agree to the amount disbursed to share holders and accrued at year –end .If the auditor is
concerned about the client’s control over dividend disbursements; he or she may test the payee
names and amounts on the individual canceled checks with the stock register or stock certificate
book. The auditor also reviews the entity’s compliance with any agreements that restrict the
payment of dividends.

2.4.4 Auditing Retained Earnings

Under normal circumstances, retained earnings are affected by the current year’s income or loss,
as well as dividends paid. However, certain accounting standards require that some transactions
be included in retained earnings. Prior-period adjustments, correction of errors, valuation
accounts for marketable securities and foreign currency translation, and changes in
appropriations of retained earnings are examples of such transactions. The auditor begins the
audit of retained earnings by obtaining a schedule of the account activity for the period. The
beginning balance is agreed to the prior year’s working papers and financial statements. Net
income or loss can be traced to the income statement. The amounts for any cash or stock
dividends can be verified as described earlier. If there are any prior-period adjustments, the
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auditor must be certain that the transactions satisfy the requirements of relevant accounting
standards. Any new appropriations or changes in excising appropriations should be traced to the
contractual agreements that required the appropriations. Last, the auditor must make sure that all
necessary disclosures related to retained earnings are made in the footnotes. For example, many
debt agreements restrict the amount of retained earnings that is available for payment as
dividend.

2.5 Auditing for Income Statement Accounts

In this section, the audit of revenue and expense account which are another important financial
statement items which have potential for misstatements will be explained in brief.
2.5.1 Auditing Revenue (Income) Accounts
Major source of income from many companies is sales revenue; however some companies may
drive revenue from other sources such as rent, interest, and dividend. Like those of other
accounts explained above, the auditor approaches the audit of revenue account, in such a ways
that it is possible to get satisfactory evidence as to the reliability of the revenue system and the
validity of all management assertions. On the following part the nature of revenue account and
the associated audit tests are discussed below.

2.5.1.1 Revenue Recognition

Revenue recognition is reviewed at the beginning of this duty because knowledge of this
underlying concept is fundamental to auditing the revenue process. Additionally, revenue must
be recognized in conformity with GAAP in order for an auditor to issue an unqualified opinion.
Revenue producing transactions generally consists of the sales of a product or the rendering of
service. FASB defined revenue as “the inflow or other enhancement of asset of an entity or
settlement of its liability from delivery or producing goods, rendering service, or other activities
that consists the entity’s major or central operation”. FASB statement requires that before
revenue is recognized, it must be realized and earned. Revenue is realized when a product or a
service is exchanged for cash, a promise to pay cash or other assets that can be converted in to
cash. SEC provides the following criteria for revenue recognition.

 Persuasive evidence of an arrangement exists

 Delivery has accrued or services have been rendered.
 The seller’s price to the buyer is fixed or determinable.
 Collectability is reasonably assured

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2.5.1.2 Overview of Revenue Process

Three types of transactions are typically processed by the revenue process

 The sales of goods or rendering of service for cash or credit

 The receipt of cash from the customers in payment for the goods or services
 The return of good by the customers for the credit or cash
The following list shows the most important document and records that are normally contained
in the revenue process. However, in advanced IT system, some of these documents and records
may exist for only a short period of time or may be maintained only in machine readable form.

 Customer’s sales order  Accounts receivable subsidiary ledgers

 Credit approval form  Aged trail balance of accounts
 Open order report receivable
 Shipping documents  Remittance advice
 Sales invoice  Cash receipt journal
 Sales journal  Credit memorandum
 Customer’s statement  Write off authorization

2.5.1.3 Evaluating Internal Control for Revenue

The followings are some the internal controls that should exist in the revenue process.

 The credit function should be segregated from the billing function. If one individual has
the ability to grant credit to a customer and also has responsibility for billing those
customers, it is possible for sales to be made to customers who are not creditworthy. This
can result in bad debt expense.
 The shipping function should be segregated from the billing function. If one individual
who is responsible for shipping goods is also involved in the billing function, it is
possible for unauthorized shipments to be made and for the usual billing procedures to be
circumvented. This can result in unrecorded sales transaction and theft of goods.
 The account receivable function should be segregated from the general ledger function. If
one individual is responsible for the account receivable records and also for the general
ledger, it is possible for that individual to conceal unauthorized shipment. This can result
in unrecorded sales transactions and theft of goods.
 The cash receipts function should be segregated from the accounts receivable function. If
one individual has access to both the cash receipt and the accounts receivable records, it
is possible for cash to be diverted and the shortage of cash in the accounting records to
be covered. This can result in theft of the entity’s cash.
 Customers order and shipping documents should be approved before revenue is
recognized and recorded.

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  Accounting for the numerical sequence of shipping document and sales invoices,
matching shipping documents with sales invoice, reconciling the sales invoice to the daily
sales report.
 There should be proper verification of the information contained, shipped, price and
terms. The sales invoices should also be verified for mathematical accuracy before being
sent to the customer

2.5.1.4 Substantive Test of Revenue Transactions

Validity: Auditors are concerned about the validity objective for revenue transaction because
clients are more likely to overstate sales than to understate them. Sales to factious customers and
recording of revenue when goods have not been shipped or services have not been performed. In
order to test this, the auditor can observe and evaluate the segregation of duties and can also
examine a sample of sales invoice for the presence of an authorized customers order and
shipping document.

Completeness: The major misstatement that concern the auditor is that goods are shipped or
services are performed and no revenue is recognized. Failure to recognize revenue means that the
customer may not be billed for goods or services and the client doesn’t receive payment. The
audit procedure to test this is that the auditor selects a sample of bills of lading and traces each
one to its respective sales invoice and to the sales journal. If all bills of lading are recorded in the
sales journal, the auditor would have evidence that all goods shipped are being billed

Cutoff: If the client doesn’t have adequate control to ensure that revenue transactions are
recorded on timely basis, sales may be recorded in the wrong accounting period. The auditor can
test this objective by comparing the date on bill of lading with the date on the respective sales
invoices and the date the sales invoices was recorded in the sales journal.

Valuation: Revenue transactions that are not properly valued results in misstatement that
directly affect the amount reported in the financial statement. The audit procedure for this
objective is comparison of prices and terms on sales invoices to authorized prices list and terms
of trade.

Classification: The use of chart of account and proper codes for recording transactions should
provide adequate assurance about these objectives. The auditor can review the sales journal and
general ledger for proper classification, and can test sales invoice for proper classification by
examining programmed control to ensure that sales invoices are coded by the type of product or
service.

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Posting and summarization: In any accounting system, there is always a possibility that
transaction are not properly summarized from source document or posted properly from journals
to the subsidiary and general ledgers. In the revenue process control totals should be utilized to
reconcile sales invoices to the daily sales report and the daily recording in the sales journal
should be reconciled with the posting to the accounts receivables subsidiary ledger.

The above discussion mainly emphasis on audit procedures for sales revenue, however there are
also other types of incomes that have to be audited. The control mechanism and audit procedures
for other income accounts are discussed in relation to other balance sheet accounts. The
followings are some of the examples

 Interest income /notes receivable

 Dividend and gain on sales/securities and other investment
 Rent income /unearned rent
 Royalties/ intangible assets

2.5.2 Auditing Expense Accounts

Up to know, you have gone through the audit procedures for various balance sheet accounts and
revenue account from the income statement. In this section, therefore, our main emphasis is to
discuss the audit procedure for payroll, as payroll expense is large in amount and is the most
exposed to fraud and misstatement. Audit procedures for other types of expenses were discussed
together with other balance sheet accounts. For example you have seen the audit of depreciation
with fixed asset and the bad debt with accounts receivable. Thus, you can apply relatively
similar procedure in an audit of other expense accounts.

2.5.2.1 Internal Control over Payroll Expense

Establishment of strong internal control over payroll is important:

 To prevent payroll fraud such as listing of fictitious person on the payroll, overpaying
employers, continuing employee on the payroll after their separation, etc.

 To process employee earning quickly and accurately.

 As existence of various payroll tax laws which require that certain payroll records be
maintained and that payroll data is reported to the employee and to government
agencies.

2.5.2.2 Methods of Achieving Internal Control over Payroll

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  Using budgetary control for labor cost in a manufacturing companies
 Separation of duties related to payroll such as function of employment, time keeping,
payroll preparation, distribution of payee to employees etc
 Proper employment function
 At time of hiring employee by personnel department, employee salary should be set in
advance; the employee should sign and authorize any payroll deduction and formal
notices should be sent to payroll department about the new hiring.
 A change in an individual salary should be formally communicated to payroll department
in advance
 Penalties for absenteeism and other deductions should be formally communicated to
payroll department in advance
 Terminations of employee should be notified as early as possible
 Proper time keeping and paying system should be implemented
 Payroll checks should be signed by authorized official
 Formal notice should be sent to the pay roll accountant about the new hiring

2.5.2.3 Audit Program for Payroll

The following audit procedures are representatives of the work generally completed to establish
the proprietary of payment for salaries, wages, bonuses and commissions.

1. Perform test over payroll transactions for selected pay period

 Trace sample names and wages on the payroll to records maintained by the
personnel department
 Trace time shown on the payroll to time card and time report approved by the
supervisor
 Determine basis of deduction from payroll and compare with records of deductions
authorized by the employee.
 Compare total payroll with total payroll checks issued.

2. Observe the use of time clocks by the employee reporting for work and investigate time card not
used.

3. Surprise observation of pay distribution

4. Obtain or prepare a summary of compensation to officers for the year and trace to contracts,
minutes of directors meeting or other authorization

5. Investigate any extraordinary fluctuations in salaries, wages and commissions

6. Test tax and pension payment to the respective authority on the appropriate date.

Other expenses are audited together with balance sheet accounts that we discussed previously.
Some of these are listed below:

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  Accounts receivable/ Uncollectible account expense
 Inventories /Cost of goods sold, supplies expense
 Property, plant of Enid /depreciation expense and repair and maintenance expense
 Accrued liabilities / Salary exp, warranty exp, interest exp
 Interest bearing debt / Interest expense

2.6 Completing Auditing Task

In the previous sections, we have discussed about, how to plan and design an audit approach, and
how to perform tests of control and substantive tests of transactions, perform annalistically
procedures and tests of detail balances. This subsection deals with completing auditing task.
Once the auditor finalizes the evaluation of internal control system and test of balances for each
account on the financial statement, he/she needs to get information concerning contingent
liabilities, review subsequent events, accumulate final evidence, evaluate the results, and
communicate with the audit committee and management.

2.6.1 Review for Contingent Liabilities and Commitments

A contingent liability is a potential future obligation to an outside party for an unknown amount
resulting from activities that have already taken place. Three conditions are required for a
contingent liability to exist:

 There is a potential future payment to an outside party or the impairment of some other
assets that would result from existing conditions,
 There is uncertainty about the amount of four payment or impairments, and
 The outcomes will be resolved by some future events. For example a lawsuit that has
been filed but not yet resolved meets all the three of these conditions.

This uncertainty of the future payment can vary from extremely likely to highly unlikely.
GAAPs describe three levels of likelihood of occurrence and the appropriate financial statement
treatment for each levels of likelihood. These requirements are summarized in the table below.

Likelihood of Occurrence of Events Financial Statement Treatment

 Remote ( slight chance)  No disclosure is necessary
 Reasonably possible ( more than
 Footnote disclosure is necessary
remote, but less than probable)
 If the amount can be reasonably estimated,
financial statement accounts are adjusted.
 Probable ( likely to occur)
 If the amount cannot be reasonably
estimated, note disclosures is necessary

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The followings are certain contingent liabilities that are concern to the auditor:

 Pending litigation for patent infringement, product liability or other action

 Income tax disputes
 Product warranties
 Notes receivable discounted
 Guarantees of obligations of others
 Unused balance of outstanding letter of credit

Auditing standards make it clear that management, not the auditor, is responsible for identifying
and deciding the appropriate accounting treatment for contingent liabilities. In many audits, it is
impractical for auditors to uncover contingencies without management’s cooperation.
The auditor’s objectives in verifying contingent liabilities are to evaluate the accounting
treatment of known contingent liability and to identify to the extent practical, anycontingency not
already identified by the management. The following are some audit procedures commonly used
to search for contingent liability
 Inquire of management about the possibility of unrecorded contingencies
 Review current and previous year’s internal revenue agent reports for income tax
settlements. The reports may indicate areas or years in which there are unsettled
disagreements.
 Review the minutes of directors and stockholder’s meeting for indications of lawsuits or
other contingencies
 Analyze legal expense for the period under and review invoices and statements from legal
counsel for indications of contingent liability especially lawsuits and pending tax
assessment
 Obtain a letter from attorney performing legal services for the client as to the status of
pending litigation or other contingent liability
 Review working papers for any information that may indicate a potential contingency.
For example, bank confirmation may indicate notes receivable discounted or guarantees
of loans.
 Examines letters of credit in force as of the balance sheet date and obtain a confirmation
of the used and unused balances
As the verification mechanism in an audit of contingent liability heavily depend on inquiry of the
management and attorney/legal officer, SAS 12(AU 37) informs auditor to qualify the report for

44
any refusal of responding inquiry on contingent liabilities in which the management/attorney has
knowledge and for refusal to the auditors’ request of financial statement disclosure.

2.6.2 Subsequent Events

The auditor must review transactions and events occurring after the balance sheet date to
determine whether anything occurred that might affect the fair presentation or disclosure of the
current-period statements. The auditing procedures required by SAS 1 (AU 560) to verify these
transactions and events are commonly referred to as the review for subsequent events or post-
balance-sheet review.
The auditor’s responsibility for reviewing for subsequent events is normally limited to the period
beginning with the balance sheet date and ending with the date of the auditor’s report. Since the
date of the auditor’s report corresponds to the completion of the important auditing procedures in
the client’s office, the subsequent events reviews should be completed near the end of the
engagement.
Types of Subsequent Events

Two types of subsequent events require consideration by management and evaluation by the
auditor: those that have a direct effect on the financial statements and require adjustment, and
those that have no direct effect on the financial statements but for which disclosure is advisable.
Those that have a Direct Effect on the Financial Statements and Require Adjustment: These
events or transactions provide additional information to management in determining the fair
presentation of account balances as of the balance sheet date and to auditors in verifying the
balances. For example, if the auditor is having difficulty determining the correct valuation of
inventory because of obsolescence, the sale of raw material inventory as scrap in the subsequent
period would indicate the correct value of the inventory as of the balance sheet date.
Such subsequent period events as the following require an adjustment of account balances in the
current year’s financial statements if the amounts are material:
 Declaration of bankruptcy by a customer with an outstanding accounts receivable balance
due to deteriorating financial condition
 Settlement of a litigation at an amount different from the amount recorded on the books
 Disposal of equipment not being used in operations at a price below the current book
value
 Sale of investments at a price below recorded cost
Whenever subsequent events are used to evaluate the amounts included in the statements, care
must be taken to distinguish between conditions that existed at the balance sheet date and those
that came into being after the end of the year. The subsequent information should not be

45
incorporated directly into the statements if the conditions causing the change in valuation did not
take place until after year-end. For example, the sale of scrap in the subsequent period would not
be relevant in the valuation of inventory for obsolescence if the obsolescence took place after the
end of the year.

Those That Have No Direct Effect on the Financial Statements but for Which Disclosure is
Advisable: Subsequent events of this type provide evidence of conditions that did not exist at the
date of the balance sheet being reported on but are so significant that they require disclosure even
though they do not require adjustment. Ordinarily, these events can be adequately disclosed by
the use of footnotes, but occasionally one may be so significant as to require supplementing the
historical statements with statements that include the effect of the event as if it had occurred on
the balance sheet date.
Following are examples of events or transactions occurring in the subsequent period that may
require disclosure rather than an adjustment in the financial statements:
 Decline in the market value of securities held for temporary investment or resale
 Issuance of bonds or equity securities
 Decline in the market value of inventory as a consequence of government action barring
further sale of a product
 Uninsured loss of inventories as a result of fire

In uncovering subsequent events, the auditor follows procedures similar with the test of
contingent liabilities. The possible procedures auditor can perform to discover subsequent events
include:
i. Inquire management
ii. Correspond with attorneys
iii. Review internal statements prepared subsequent to the balance sheet date
iv. Review records prepared subsequent to the balance sheet date
v. Examine minutes issued subsequent to the balance sheet date
vi. Obtain a letter of representation from management

2.6.3 Going Concerns

SAS 59 (AU 341) requires the auditor to evaluate whether there is a substantial doubt about a
client’s ability to continue as a going concern for at least one year beyond the balance sheet date.
That assessment is initially made as part of planning but is revised whenever significant new
information is obtained. For example, if the auditor discovered during the audit that the company
had defaulted on a loan, lost its primary customer, or decided to dispose of substantial assets to

46
pay off loans, the initial assessment of going concern may need revision. A final assessment is
desirable after all evidence has been accumulated and proposed audit adjustments have been
incorporated into the financial statements.

Analytical procedures are one of the most important types of evidence to assess going concern.
Discussions with management and a review of future plans are important considerations in
evaluating analytical procedures. Knowledge of the client’s business gained throughout the audit
is important information used to assess the likelihood of financial failure within the next year.

2.6.4 Evaluating Findings

Proper evaluation of evidence requires that the auditor understand the types of evidence that are
available and their relative reliability. The auditor must be capable of assessing when a sufficient
amount of competent evidence has been obtained in order to determine whether specific audit
objective have been achieved. The ability to evaluate evidence appropriately is another important
skill an auditor must develop. Proper evaluation of evidence requires that the auditor understand
the types of evidence that are available and their relative reliability. The auditor must be capable
of assessing when a sufficient amount of competent evidence has been obtained in order to
determine whether specific audit objective have been achieved.

In evaluating evidence, an auditor should be through in increasing for evidence and unbiased in
its evaluation. For example, suppose an auditor decides to mail accounts receivable confirmation
to 50 customers. Suppose further the client has a total of 500 customer accounts receivable. In
auditing the 50 customers, the auditors must gather sufficient evidence on each of the 50
accounts. In evaluating evidences, the auditor must remain objective and must not allow the
evaluation of the evidence to be biased by other considerations. For example, in evaluating a
client’s response to an audit inquiry, the auditor must not allow any personal factors to influence
the evaluation of the client’s response.

2.6.5 Forming an Audit Opinion

After the auditor has completed all the audit procedures, it is necessary to combine the
information obtained to reach an overall conclusion as to whether the financial statements are
fairly presented. This is a highly subjective process that relies heavily on the auditor’s
professional judgment. In practice the auditor continually combine the information obtained as
she or he proceeds through the audit. The final combination is simply a summation at the
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completion of the engagement. When the audit is completed, the auditor must issue an audit
report to accompany the client’s published financial statement. The report must meet well
defined technical requirement that are affected by the scope of the audit and the nature of the
findings.

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