Determining the Extent of TODB Risk model factors Acceptable audit riskAcceptable audit risk Inherent riskInherent risk Control riskControl risk Materiality (partially depends on AAR)

Determining the Extent of TODB Risk model factors Materiality Results of other tests Tests of controls Tests of controls Substantive tests of transactionsSubstantive tests of transactions Analytical proceduresAnalytical procedures

Analytical Procedures 2007 Gross 2006 Gross 2007 Gross 2006 Gross Margin Margin Margin Margin GW IND GW IND GW IND GW IND Hardwood Softwood Plywood

Analytical Procedures Softwood increased 3.9%, industry stable Changes usually most informative (also want to understand differences from industry) Easier to spot errors in disaggregated data

Analytical Procedure Follow-up Client will be able to suggest likely non-error causes, which you will evaluate. Consider error causes What errors would cause gross profit to increase?

Error Causes of Gross Profit Increase Sales overstated Fictitious salesFictitious sales Cutoff error - January sale recorded in December (COS not matched)Cutoff error - January sale recorded in December (COS not matched) Cost of sales understated Inventory overstatedInventory overstated Purchases understated or cutoff error - December purchase recorded in JanuaryPurchases understated or cutoff error - December purchase recorded in January

Extent of Tests Amount of testing for TODB objectives will depend upon results of TOT for related transaction objectives: –see following slide for related objectives (from Ch. 6) – see table in notes for specific tests –main sampling application in TODB for AR is confirmations

Assertion Trans. Obj. Balance Obj. Assertion Trans. Obj. Balance Obj. Existence Occurrence Existence Existence Occurrence Existence Completeness Completeness Completeness Completeness Completeness Completeness Accuracy Accuracy Accuracy Accuracy Valuation Classific. Classific. Valuation Classific. Classific. or Timing Cutoff or Timing Cutoff Allocation Post. & Summ. Detail tie-in Allocation Post. & Summ. Detail tie-in None NRV None NRV Rights & Obl. N/A Rights & Obl. Rights & Obl. N/A Rights & Obl. Pres. & Disc. N/A Pres. & Discl Pres. & Disc. N/A Pres. & Discl

Confirmations Key Objectives existence accuracy (valuation) Weak evidence for completeness - why?

Confirmation are required unless (SAS # 67): Accounts receivable are immaterial.Accounts receivable are immaterial. Confirmations are expected to be ineffective.Confirmations are expected to be ineffective. Combined IR and CR are low, and other evidence reduces audit risk to an acceptably low level.Combined IR and CR are low, and other evidence reduces audit risk to an acceptably low level.

Confirmations Why would auditors like to minimize confirmations? What is the alternative to confirmations?

Positive Confirmations Emphasis in testing is usually larger, and older accountsEmphasis in testing is usually larger, and older accounts Testing may be balance or individual invoiceTesting may be balance or individual invoice –Invoice may increase response rate –Reduces extent of reconciling items –However, provides less assurance

Negative Confirmations Used when Internal control effectiveInternal control effective Many small balancesMany small balances Customers expected to give adequate considerationCustomers expected to give adequate consideration

Alternative Procedures 1. Subsequent cash receipts 2. Shipping document Any untested portion should be treated as an error for projection purposes.

95% of returned confirmations indicated the customer owed a smaller balance. This may be explained by: a. Cash receipts journal was held open after year-end. year-end. b. There are a large number of unrecorded liabilities. liabilities. c. Sales journal was closed prior to y/e. d. Sales journal was held open after year- end. end.

 FIGURE Aged Trial Balance for Hillsburg Hardware Co. Aged Trial Balance for Hillsburg Hardware Co.

 FIGURE Analysis Analysis of Allowance for Uncollectible Accounts for Hillsburg Hardware Co. Analysis Analysis of Allowance for Uncollectible Accounts for Hillsburg Hardware Co.

Estimated Estimated Estimated Estimated Age Percentage Percentage (days) Amount Uncollectible Uncollectible Less than 3014,217, , ,869, , ,869, , ,408, , ,408, , ,038, , ,038, ,732 > than , , , ,084 Totals20,196,800 1,334,789

Auditing Allowance Beginning Balance from prior year Beginning Balance from prior year Less: write-offs tested Less: write-offs tested Plus: current provision Plus: current provision (bad debt expense) residual (bad debt expense) residual Ending balance tested TODB Ending balance tested TODB

Cutoff Testing Sales Cutoff - Primary focus is on sales recorded just before year-end Cash receipts cutoff - Primary focus is on receipts recorded before year-end Purchases Cutoff - Primary focus is on purchases recorded after year-end ( does not affect A/R)

Sales Cutoff Errors Key issue is whether COS is matched. Determining factor is whether good are included or excluded from inventory. Y/E physical - inventory normally correct

Sales Cutoff Errors Shipped 1/2Sale - $10,000 Recorded 12/31COS - $7,000 Counted in Income Effect Counted in Income Effect inventory? of Error___ inventory? of Error___ Yes$10,000 Yes$10,000 No $3,000 No $3,000

Cutoff Adjustments Error 1 - inventory correct Sales 10,000 Accounts receivable 10,000 Accounts receivable 10,000 Error 2 - inventory not correct Sales 10,000 Inventory 7,000 Accounts receivable 10,000 Accounts receivable 10,000 Cost of sales 7,000 Cost of sales 7,000