Auditing Operations and Completing the Audit 1

Outline Auditing operations Auditing payroll Completing the audit Miscellaneous revenue Miscellaneous SG&A expenses Auditing payroll Completing the audit Evaluating audit findings Post-audit responsibilities

Relationships Between Balance Sheet and Revenue Accounts Relationship of Revenue to Balance Sheet Accounts Balance Sheet Item Revenue Accounts receivable Sales Notes receivable Interest Securities and other investments Interest, dividends, gains on sales, share of investee’s income Property, plant and equipment Rent, gains on sale Intangible assets Royalties 2 2

Miscellaneous Revenue Mixture of minor or non-recurring revenue transactions. Items that may be misclassified as miscellaneous revenue. Collection on previously written-off receivables Write-offs of old outstanding checks Proceeds from sale of scrap Refunds or rebates of insurance premiums Proceeds from sales of plant assets

Relationships Between Balance Sheet and Income Statement Accounts Relationship of Expenses to Balance Sheet Accounts Balance Sheet Item Expenses Accounts and notes receivable Uncollectible accounts and notes expense Inventories Purchases, cost of goods and payroll Property, plant and equipment Depreciation and repairs and maintenance Intangible assets Amortization Accrued liabilities Commissions, fees, bonuses, product warranty expenses, etc. Interest-bearing debt Interest

Substantive Tests for Selling, General and Administrative Expenses Perform analytical procedures Develop an expectation of the account balance Determine the amount of difference from the expectation that can be accepted without investigation Compare the company’s account balance with the expected account balance Investigate significant deviations from the expected account balance Obtain or prepare analyses of selected expense accounts Obtain or prepare analyses of critical expenses in the income tax return 3 3

The Audit of Payroll Payroll is often a company’s largest operating cost. Potential payroll frauds Fictitious employees Overpaying employees Continuing to pay employees after termination

Payroll Functions Human resources Timekeeping Authorized pay rate Employment papers / payroll deductions Timekeeping Electronic clocks Supervisor oversight of timekeeping Payroll preparation and recordkeeping Time cards Payroll journals Labor distributions Employee earnings records Distribution of paychecks Paymaster Imprest account / regular reconciliation Proof of identity / employee signature

Audit Program for Payroll Obtain an understanding of internal control over payrolls Perform tests of controls as necessary Compare name, wage rates, and payroll deductions to HR records. Compare time on payroll to time reports approved by supervisors. Test extensions and footing of payroll. Compare payroll total to total of checks issued. Observe the use of time clocks. Observe the distribution of paychecks.

Audit Program for Payroll Perform substantive tests of payroll Substantive Tests Audit Objectives Perform analytical procedures Investigate fluctuations in payroll Obtain a summary of amounts of officers’ compensation and trace to authorization. Existence/occurrence Completeness Valuation Test compensation from profit-sharing or bonus plans. Test commission earnings Test pension obligations

Audit Procedures Completed Near the End of Field Work Search for unrecorded liabilities Review the minutes of meetings Perform final analytical procedures Perform procedures to identify loss contingencies Perform the review for subsequent events Obtain the representation letter 4 4

Loss Contingencies Def.: A possible loss stemming from past events that will be resolved as to existence and amount by some future event. Loss contingencies should be reflected in the financial statement amounts when: It is probable that a loss had been sustained before the balance sheet date The amount of the loss can be reasonably estimated Loss contingencies should be disclosed in the notes to the financial statements when it is at least reasonably possible that a loss has been sustained Loss contingencies need not be disclosed when the possibility of loss is remote 5 5

Loss Contingencies Types of loss contingencies Litigation Income tax disputes Guarantees of indebtedness Accounts receivable sold or assigned with recourse Environmental issues Commitments General risk contingencies

Loss Contingencies Procedures for loss contingencies Review minutes of BOD meetings. Send letter of inquiry to client’s attorneys. Send confirmation letters to financial institutions requesting information on contingent liabilities. Review correspondence with financial institutions for evidence of guarantees of indebtedness, or sales or assignments of accounts receivable. Review reports and correspondence with regulatory agencies to identify potential fines or assessments. Obtain a representation letter from management indicating that all liabilities known to officers are recorded or disclosed.

Subsequent Events Covers period between balance sheet date to date of auditor’s report (last day of fieldwork). Type I subsequent event Involves conditions that existed on or before balance sheet date Must adjust financial statement amounts to reflect event Type II subsequent event Involves conditions coming into existence after the balance sheet date. Must disclose in footnotes if omission would cause financial statements to be misleading.

Subsequent Events Examples of Type I subsequent events Large receivable at balance sheet date proves to be uncollectible due to subsequent bankruptcy of debtor. Customer check included in ending cash subsequently proves to be uncollectible. Settlement of pending litigation.

Subsequent Events Examples of Type II subsequent events Business combination Pro forma results often disclosed Substantial casualty losses Significant changes in financial position or financial structure Major personnel changes Product line changes Labor strikes Disclosure generally required Disclosure generally not required

Subsequent Events Audit procedures relating to subsequent events Review latest interim financial statements and minutes of BOD meetings. Inquiries to appropriate client officials. Letter of inquiry to client’s attorneys. Representation from management in representation letter.

Evaluating Audit Findings Overall review of the audit Evaluate sufficiency and competency of evidence in the workpapers. Evaluate total likely misstatement Known misstatements Projected misstatements Other estimated misstatements Review the sufficiency of disclosures Disclosure checklists Client approval of adjusting entries and disclosures

Required Communication With the Audit Committee Significant deficiencies in internal control The auditors’ responsibilities for the audit and other information included with the financial statements Significant audit adjustments made Proposed audit adjustments evaluated by management as immaterial Disagreements with management or other difficulties The auditors’ viewpoint on an accounting or auditing matter if management contacted other auditors about the matter A discussion of the quality of accounting principles and estimates 6 6

Post-Audit Considerations Subsequent discovery of facts existing at the date of the audit report Auditor must immediately investigate If material, auditor should advise client to make appropriate disclosures to anyone relying on the financial statements. If management refuses, auditor should contact BOD members, any regulatory agencies, and if practicable any persons relying on the statements.

Post-Audit Considerations Subsequent discovery of omitted procedures Auditor should assess importance of omitted procedures to audit opinion. If opinion is impaired, the auditor should attempt to perform the omitted procedures or appropriate alternative procedures. Auditor should consult legal counsel.