Dr. Donald K. McConnell Jr. Audit of Operations Dr. Donald K. McConnell Jr. 11/9/2018

Audit of Operations Operating accounts are the revenue and expense accounts (sometimes called “P&L” accounts) Contemporary emphasis is on reported earnings, yet audits are still primarily balance sheet oriented 11/9/2018

How Do We Audit Operations? Audit of balance sheet accounts indirectly tests operating accounts Testing controls addresses inputs into operating accounts Analytical review tests operating accounts 11/9/2018

Balance Sheet Substantive Testing When we audit balance sheet accounts we are indirectly testing inputs into many operating accounts Examples: Confirmation of accounts receivable indirectly examines sales Substantive inventory testing addresses cost of goods sold The audit of fixed assets tests depreciation Analysis of notes receivable or payable tests interest expense and income 11/9/2018

What Are Tests of Controls? Procedures to assess the effectiveness of design and operation of internal controls Test the means, not the results of transaction processing Must be performed to assess control risk < maximum Do not directly test dollar amounts Typically done as dual tests: Tests of controls Substantive (dollar amount) tests of transactions 11/9/2018

Tests of Controls Testing controls often addresses controls over operating accounts Examples: Auditing a sample of 25 randomly selected entries for the nine months ended September 30: in the sales journal, tests sales In the purchases journal, tests debits to various expenses (in addition to assets) 11/9/2018

Analytical Review of Operating Accounts Fluctuation (flux) analysis of revenue and expense accounts Analytical financial statement ratios 11/9/2018

How Is Flux Analysis Done? Obtain trial balance in comparative form with last year Identify any revenue or expense accounts: Fluctuating by 10% or more from last year Where dollar amount of fluctuation exceeds tolerable misstatement Such accounts would require: A good client explanation, documented in the work papers, or Vouching entries exceeding a scope amount in those accounts 11/9/2018

Analytical Financial Statement Ratios Trend analysis of ratios of logically related accounts To identify unusual fluctuations requiring investigation Examples: Gross profit ratio Inventory turnover ratios: CGS/Avg or ending inventory Accounts Receivable turnover ratios: Net sales/accounts receivable 11/9/2018

Some Operating Accounts Typically Examined in Detail Certain revenue and expense accounts accounts would be: Scheduled out in detail items exceeding a scope dollar amount Vouch those items to supporting invoices, etc. for propriety of: Classifications Amounts recorded 11/9/2018

Examples: New accounts in the trial balance Must understand business purpose May be indicative of misstatements or improper accounting A personal experience: new credit balance was indicative of illegal management payments! Legal and professional expense. Why? Material fluctuations identified analytically Accounts where errors found in performing tests of controls 11/9/2018

More Examples: Accounts Where Errors Commonly Found Repairs and maintenance expense Lease expense Miscellaneous revenue and expense accounts Suspense accounts 11/9/2018