2. Auditing Operations
Corporate earnings are considered as an extremely important indicator of health and well-being of corporations
Measurement of income is generally regarded as the single most important function of accounting

3. Conservatism in the Measurement of Income
Powerful influence on revenue and expenses
Important because of subjectivity involved with accounting estimates
Assets – accountants choose lower of two or more reasonable alternative values
Liabilities – higher amount is chosen
Results in income statement with a low or conservative income figure

4. Objectives for audit of revenue and expenses
1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to revenues and expenses. 2. Consider internal control over revenues and expenses. 3. Assess the risks of material misstatement of revenues and expenses and design further audit procedures that: a. Establish the occurrence of recorded revenue and expense transactions. b. Determine the completeness of recorded revenue and expense transactions. c. Establish the accuracy of revenue and expense transactions. d. Verify the cutoff of revenue and expense transactions. e. Determine that the presentation and disclosure of revenue and expense accounts are appropriate, including the proper classification of amounts and the proper presentation of earnings-per-share data.

5. Figure 16-1 Comparative Income Statement Analysis

6. Relationships Between Balance Sheet and Income Statement Accounts
Balance Sheet Item
Revenue
Expenses
Accounts receivable
Notes receivable
Securities and
investments
Sales
Interest,
Interest, dividends,
gains, investee’s income
Uncollectible
accounts Uncollectible notes Losses
Inventories
Purchases, cost of goods sold, payroll
Property, plant and
equip.
Intangible assets Prepaid expenses Accrued liabilities
Rent, gains
Royalties
Depreciation; repairs
Amortization Various expenses Various expenses
Interest-bearing debt
Interest 2 2

7. Misc. Revenue (1 of 2)
Mixture of minor items, some nonrecurring and others received at regular intervals
Auditor should analyze account to look for items improperly recorded as miscellaneous:
Collections on previously written-off accounts or notes receivable
Write-offs of old outstanding checks or unclaimed wages
Proceeds from sales of scrap
Rebates or refunds of insurance premiums
Proceeds from sales of plant assets

8. Misc. Revenue (2 of 2) Auditor should
Propose adjusting journal entry to classify items correctly
Perform analytical procedures and investigate unusual fluctuations
Can detect material amounts of unrecorded revenue and
Significant misclassifications affecting revenue

9. Figure 16-2 Professional Fees Analysis

10. Substantive Tests for Selling, General and Administrative Expenses (1 of 2)
Perform analytical procedures
Develop an expectation of the account balance
Use budgeted amounts, prior-year audited balances, industry averages, relationships among financial data and relevant nonfinancial data
Determine the amount of difference from the expectation that can be accepted without investigation
Use estimates of materiality
Compare the company’s account balance with the expected account balance
Investigate significant deviations from the expected account balance 3 3

11. Substantive Tests for Selling, General and Administrative Expenses (2 of 2)
Obtain or prepare analyses of selected expense accounts
Examine accounts based on results of analytical procedures
Which accounts? AICPA suggests
Advertising
Research and development
Legal expenses and other professional fees
Maintenance and repairs
Rents and royalties
Obtain or prepare analyses of critical expenses in the income tax return 3 3

12. Payroll Importance – typically largest operating cost
Payroll fraud had been common and often substantial but now fraud difficult to conceal because of:
Extensive segregation of duties relating to payroll
Use of computers with proper controls for preparation of payrolls
Filing of frequent payroll reports to the government

13. Segregation of Functions--Payroll
Separate departments should handle:
Employment (personnel)
Timekeeping
Payroll preparation and record keeping
Distribution of pay to employees

14. Internal Control over Payroll Documentation
Typical questions
Are employees paid by check or direct deposit?
Is a payroll bank account maintained on an imprest basis?
Are the activities of timekeeping, payroll compilation, payroll check signing, and paycheck distribution performed by separate departments or employees?
Are all operations involved in the preparation of payrolls subjected to independent verification before the paychecks are distributed?
Are employee time reports approved by supervisors?
Is the payroll bank account reconciled monthly by an employee having no other payroll duties?

15. Audit Program for Payroll (1 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures:
a. Compare names and wage or salary rates to records maintained by the human resources department.
b. Compare time shown on payroll to time cards and time reports approved by supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by employees.
e. Test extensions and footings of payroll.

16. Audit Program for Payroll (2 of 2)
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific procedures (continued):
f. Compare total of payroll with total of payroll checks issued.
g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
h. If wages are paid in cash, compare receipts obtained from employees with payroll records.
i. If wages are paid by check, compare paid checks with payroll and compare endorsements to signatures on withholding tax exemption certificates.
j. If wages are paid by direct deposit, compare listing of employee payments with payroll and direct deposit authorizations.
k. Observe the use of time clocks by employees reporting for work and investigate time cards not used.

17. Substantive Procedures for Payroll

18. Audit of Statement of Cash Flows
Amounts are audited in conjunction with the audit of balance sheet and income statement accounts
Presentation and disclosure important audit objective is important
Operating
Investing
Financing

19. 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

20. Loss Contingencies
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

21. Litigation
Most common loss contingency – pending or threatened litigation
Letter of inquiry to client’s legal counsel
Evidence of pending and threatened litigation
Unasserted claims - need to be disclosed if probable and reasonably possible
SAS 12
Auditors should obtain from management a list describing and evaluating threatened or pending litigation

22. Other Contingencies Income tax disputes
Accommodation endorsements and other guarantees of indebtedness
Accounts receivable sold or assigned with recourse
Environmental issues
Commitments
General risk contingencies

23. Audit Procedures for Loss Contingencies
1. Review the minutes of directors’ meetings to the date of completion of fieldwork. 2. Send letter of inquiry to client’s lawyer 3. Send confirmation letters to financial institutions to request information on contingent liabilities of the company. 4. Review correspondence with financial institutions for evidence of accommodation endorsements, guarantees of indebtedness, or sales or assignments of accounts receivable. 5. Review reports and correspondence from regulatory agencies to identify potential assessments or fines. 6. Obtain a representation letter from the client indicating that all liabilities known to officers are recorded or disclosed.

24. Responsibility for Subsequent Events

25. Procedures to Identify Subsequent Events
Review latest available financial statements and minutes of the board and selected committees
Inquiry about matters dealt with at meetings for which minutes are not available
Inquiry of management
Obtain lawyer’s letter
Obtain representations from management

26. Obtain Representation Letter
Purpose is to have the client’s principal officers acknowledge that they are primarily responsible for the fairness of the financial statements
Dated as of the date of the audit report
Not a substitute for application of necessary audit procedures

27. Misstatements Known misstatements Likely misstatements Evaluation
Specific misstatements identified during the course of the audit
Likely misstatements
Due to extrapolation from audit evidence or differences in accounting estimates
Evaluation
Material misstatements must be corrected
Quantitative and qualitative factors

28. Qualitative Materiality Factors
Likely to be material when:
Arise from an item capable of precise measurement (e.g., the amount of a sale) rather than from an estimate (e.g., the amount in the allowance for doubtful accounts).
Mask a change in earnings or other trends.
Hide a failure to meet analysts’ consensus expectations for the company.
Change a loss into income, or vice versa.
Concern a particularly important segment or other portion of the registrant’s business.
Affect compliance with regulatory requirements, loan covenants, or other contractual requirements.
Increase management’s compensation.
Involve concealment of an unlawful transaction.
Are of an amount that management or the auditors believe would affect the stock’s price.

29. Total Likely Misstatement Overstatements (Understatements)
W/P ref.
Current Assets
Noncurrent Assets
Current Liabilities
Noncurrent Liabilities
Owners’ Equity
Income before Taxes
Tax Expenses
Uncorrected Known Misstatements
D-8
Overstatement of prepaid expenses
$6,500
$2,600
$6,500 (2,600)
F-6
Overstatement of prior years’ depreciation
($10,000)
(4,000)
(10,000) 4,000
M-4
Unrecorded liabilities
(11,215) 4,486
11,215 (4,486)
11,215
4,486
Projected Misstatements
C-5
Overstatement of accounts receivable (confirmation results)
30,000
12,000
30,000 (12,000)
Other Estimated Misstatements
C-10
Understatement of allowance for uncollectible accounts
5,000
2,000
(2,000)
________
Total Likely Misstatements
$41,500
$5,871
$25,629
$52,715
$21,086
Amount considered material
$100,000
$125,000
$200,000
$150,000

30. Evaluation Materiality: Considering Previous Year Uncorrected Misstatements
SEC SAB 108
Situation:
$70,000 current year misstatement
$60,000 balance sheet carryover from preceding year
If either the $70,000 or the $130,000 total ($70, ,000) is material to this year, an adjustment must be made.
The current year’s income is decreased by at least $70,000
If the $60,000 is immaterial this year, it will also decrease current year income
If the $60,000 is material this year, prior year financial statements should be adjusted.

31. Review the Engagement
Review of work of audit staff accomplished through review of audit working papers
Typically performed by seniors
Review of working papers not completed until near (of after) completion of fieldwork
Partner and manager devote attention to accounts with higher risk of material misstatement
Second partner review prior to issuance of audit report

32. Reporting on Other Information with the Financial Statements7 7

33. Required Communication with Those Charged with Governance
Auditor responsibility under generally accepted auditing standards (e.g., to form and express an opinion, and management’s responsibilities)
An overview of the planned scope and timing of the audit
Significant findings from the audit
Qualitative aspects of accounting practices
Audit difficulties encountered
Uncorrected misstatements
Disagreements with management
Management consultations with other accountants
Auditor independence issues
Other issues. 6 6

34. Post-Audit Responsibilities
Auditor subsequent discovery of facts existing at date of report
Advise client to make appropriate disclosure of the facts to anyone actually or likely to be relying upon the audit report and financial statements
If client refuses to make disclosure, CPA should inform each member of board and notify regulatory agencies

35. Subsequent Discovery of Omitted Audit Procedures
Discovered during peer review or other subsequent review of working papers
Assess importance of omitted procedures to their previously issued opinion
If omission impairs ability to support issued opinion and report being relied upon by third parties, attempt to perform omitted procedure or appropriate alternative procedure