AUDITING: A RISK

ANALYSIS APPROACH

Larry F. Konrath

Electronic Presentation
by Harold
O. Wilson
KEY CONCEPTS OVERVIEW
Internal Controls; Irregularities
Sales transactions; Accounts
Receivable Balances
Cash Receipts transactions; Cash
Balances
Audit Programs (Instructions)
Analytical Procedures
Working Papers
Learning Objectives
Define substantive testing.
Identify audit objectives related to
revenues.
Develop revenue cycle audit
programs.
Modify audit programs (internal
controls, warning signs, study of
industry, analytical procedures).
 The Accounting Cycle:
What companies do!
SALES Various*
Ac Rec Ac Pay
CASH

SALES CASH IN CASH OUT PURCHASES

SCHEMA FOR ACCOUNTING & TESTING!

* Inventories, Other Assets, Expenses of all kinds!
 Revenue/Receipts Cycle:
Basic Documentation!

SALES Accts Rec CASH

CR DR DR
bal. bal. bal.
SALES CASH RECEIPTS
Sales Invoices & Deposit Slips &
Shipping Tickets Remittance
Advices
 Cash & Receivables at FYE:
Basic Documentation!

SALES AcRec CASH

DR DR
Bal. Bal.

Confirmations & Counts &

Subsequent Bank
Collections Reconciliations
Substantive Tests vs.
Tests of Controls
Substantive audit testing: Obtaining evidence
in support of transactions and balances.
Nature, timing, extent =
f(judgment, risks, materiality)
Audit programs = Instructions = f(planning,
inherent risk, control risk, test results)
Tests of controls do not include balance
testing nor analytical procedures.
Auditor Focus, on any selected
account, is...
The Debits The Internal
Controls
The Credits
The Audit Program

The Balance The Working

Papers

Note: Confidence in debit & credit processing has

been established at interim points; at FYE the focus
is on THE BALANCES!
 DETECTION RISK
FACTORS at FYE
Auditor’s desired Audit Risk, and IR
& CR assessments.
Company Philosophies.
Company Good times vs. Bad times.
Industry & Market Scenarios.
Personnel & Pressures.
Interim Tests of Transactions & Controls.
 AUDIT PROGRAM
DEVELOPMENT
• Interim work compared documents
(e.g., deposit slips) to bookkeeping
outputs, account postings, etc.
• The Audit Trail is known.
• Working Papers support many,
but not all, Account Balances.
• All material account balances need
LEAD SCHEDULES, and tie-ins..
 SUBSTANTIVE
AUDIT PROGRAMS
• Audit Risk--associated with each
transaction cycle.
•Cases & warning signs.
•Audit judgment = f(risks, materiality,
cost consciousness, etc.)
•Excellent internal controls--may allow
use of interim dates for “balance”
testing (e.g., confirmations), IF no
detrimental effect on detection risk.
 ANALYTICAL PROCEDURES

• Working papers -- on many balances;

use for ratio & trend analyses.
• Sampling can be misleading; what’s the
Big Picture?
• Inconsistencies often follow changes.
• Study people! Train your “Sixth Sense.”
• Sufficiency of audit evidence!
Counts, Confirmations, Calculations,
Comparisons, and Conservatism!

Great audit tools at FYE

for any cycle in light of
objectives, procedures &
evidence needed!
 The CLIENT’S FYE
ASSERTIONS to VERIFY

The asset(s) exist and are controlled.

The accounting has been complete, current.
The assets are ours; we have the rights.
The valuations are proper.
The presentations, terminology, and
disclosures are proper.

Auditors test these specific assertions!

Emphasis & Direction of
Substantive Testing
Consider caution and suspicions--fraud is
not uncommon; courts often involved.
“Smoothing” of reported earnings is not
necessarily fraudulent—but, it’s often
a thin line.
A balanced audit approach (neutrality)
may be modified as cases demand.
REVENUE RECOGNITION
THEORIES & CLIENTS
Clients--Desire early recognition of
revenue; often pressured to do so.
Auditors--Conservative!
Uncertainly/Contingencies = Problems!
Franchisee problems.
Debt transfer problems.
Credit policies & problems.
Guarantees are problems.
JUDGMENT, ETHICS,
LIABILITIES & RISKS
The auditor must know GAAP to audit
GAAP!
“Thick skin” is necessary! The auditor
controls his/her ethics & opinions!
Departures from GAAP, sometimes
unintentional, do happen.

The Board of Directors has final authority over reports.

COMPUTER-ASSISTED
SUBSTANTIVE TESTS
Computers aid in gathering, analyzing and
evaluating evidence (e.g., testing math, prices,
selecting specific criteria, using industry data).
Computer programs aid in amortization printouts,
statistical sampling analysis, calculations, aging
accounts receivable, etc.
Downloading client data into PCs, use known “test
data” to obtain confidence in the client’s CIS.
Reports and OCR software aid in data analysis,
spreadsheet templates, & working trial balances.
 FAQ?

What’s between SALES and the

COLLECTIONS? …paperwork?

After closing the sale--getting

the Sales Order signed--there
are a number of dealings,
subject to audit:
After the sale…and before the
MONEY IS HERE!
Credit & price approvals on all
customer orders.
Shipment: order picking, packing,
shipping tickets.
Sales Invoices based on the above;
reviewed for support before
recording, mailing.
Monthly Statements.
INTERNAL CONTROL
CHECKLIST: Revenues
Customer orders required for Sales Orders.
Credit approval required for Shipping Tickets.
Shipping Tickets required for loading.
Shipping Tickets required for Sales Invoices.
Sales Invoices (reviewed for pricing, clerical
accuracy) required for A/R entries.
Monthly statements reconciled to A/R ledgers,
and mailed by disinterested parties (DIP).
INTERNAL CONTROL
CHECK LIST: Cash Receipts
Remittances deposited intact daily.
Receipts recorded daily by DIP.
Receipted deposit slips matched to other cash
details, as Remittance Advices.
Monthly bank reconciliations of all cash
accounts by DIP.
Approved pre-numbered documentation
required; subsidiary ledgers’ support.
INTERNAL CONTROL
CHECK LIST: Cash Receipts
Credit memos & non-cash credits (e.g., bad
debt write-offs) properly authorized.
Approved documentation & security codes
required for computer inputs to Cash, A/R
and Inventory.
Sales Tabulations reviewed, approved, and
reconciled to Customer Orders and
Unfilled Orders Files, Unbilled shipments.
Cash & Sales Tabulations compared to plans
& budgets, etc.
 Monitoring

Sales Discounts statistics.

Sales Returns & Allowances statistics.
Collection status (carrying the customer).
Non-cash credits to Receivables (CMs).
Potential for bad debts.
Inventory control; Unfilled orders file.
Customer Relations (service, guarantees).
 INTERNAL CONTROLS
What the client does is compared to what
the auditor would desire! Any weakness
or omission should be viewed as either
• Minor (even immaterial), or
• Major (to be in the Letter to
Management )-- IF MAJOR, SOME
CHANGE IN A “STANDARD
AUDIT PROGRAM” IS REQUIRED.
 AUDIT PROGRAM FORMAT

(Instructions) Done Comments &

W/P reference
by
S Accounting cycle event
T Internal Controls
E Audit Program B-7
P Work papers
# The sequence is indicated above!
 AUDIT PROGRAM Thinking:
• Listing the accounting cycle events.
• Reviewing related internal controls.
• Procedures to subject the controls &
data to verification (audit)-- The
Audit Trail.
• Working Papers support many,
but not all, Audit Program steps.
 FAQ?

What are some opening & closing steps that

are in virtually every caption’s Program?

Read the prior year’s audit program; revise AP.

Prepare ICQ, and assess risks, revise memos, detail
weaknesses, draft Management Letter.
Obtain information as to … and vouch to support.
Scan for, investigate, & clear exceptions (AJEs?).
Express your opinion on the caption under audit.
GENERALIZED AUDIT
PROGRAM

Test of each prescribed control for legal,

procedural & policy compliances.
Scan for and investigating the unusual.
Trace & vouch (documents to records,
records to documents, subsidiary ledgers).
Verify prenumbering (no skips or misses).
Analyze for fraud if control absent or weak.
GENERAL AUDIT
PROGRAMS always include...

List Exceptions & the

Dispositions of same.
Write a memo expressing
your opinion on this
caption.
Observations...

These examples of audit program steps serve

to show the look and feel of audit procedures.
“Exceptions” are to be emphasized.
Fraud is always a consideration.
Interim auditing provides the basis for FYE
substantive testing & verifications of balances.
 FAQ: Conservatism at FYE?
If inherent risk and control risk are
[still] assessed at “maximums” after
interim testing, is the auditor being
conservative, realistic, or just
oversampling at fiscal year end?

Perhaps other changes or some FYE tests

have [properly] impacted judgment!
Notes on Work papers &“Tick
Marks: If you see it, tick it!”
Auditors develop a “standard” set of
personal marks (at bottoms of their own
work papers). Examples with colors:

C Confirmed c Calculated
^ Footed ^^ Crossfooted
c Examined cancelled check
X Exception Matched (below)
~ Various (standard marks)
And other notations…that
MUST BE INITIALED!

N/C/N Not Considered

Necessary

N/C/M
Not Considered
Material
AUDIT PROGRAM:
Accounts Receivable (1/4)

Test year-end sales cut-off procedures

& consistency with sales /inventory
cut-offs.
Test year-end FOB points with cut-
offs of shipping tickets & support.
Verify pre-numbering where applicable.
Inquire about & verify pledged items,
credit limits, credit balances.
AUDIT PROGRAM:
Accounts Receivable (2/4)

Test prescribed controls for legal,

procedural & policy compliance.
Obtain an Aged Analysis of Accounts
Receivable & tie-in to G/L.
Test mathematics of Aged Analysis.
Discuss Aged Analysis and details with
appropriate official(s); compare
to historical statistics.
AUDIT PROGRAM:
Accounts Receivable (3/4)

Mail confirmations to selected A/R:

Use Positives for larger accounts.
Use Negatives for smaller accounts.
Trace subsequent collections for non-
respondents, document same.
Consider second, third request on all
material accounts.
List & investigate all exceptions.
AUDIT PROGRAM: Accounts
Receivable & Sales (4/4)

Perform analytical procedures &

calculate significant ratios, trends.
Scan for and investigating the unusual.
Analyze for fraud if control absent or
weak, or as deemed necessary.
Clear all exceptions; project sampling.
Write a memo with your opinion.
COMPUTER AUDITING &
SAMPLING in SALES TESTS
Sales orders input, with price & terms,
postings by computer; Exceptions Reports.
Control weaknesses noted--auditor’s test
data may be used, exceptions investigated
for cause & potential effects.
Testing/Vouching continues (random sales
invoices verified, support examined,
posting traced to A/R & Inventory details).
AUDIT PROGRAM: Allowance
for Uncollectibles

Verify authorizations for write-offs;

trace recordings, postings.
Compare statistical data from past
years; make forecast.
Scan for the unusual, as collateral;
discuss with officials.
Write memo with
your opinion.
Audit Program Summary for
Cash Receipts Transactions

Prepare a Proof of Cash for test month(s).

Trace cash receipts from/to A/R subsidiary
records, deposit list detail, bank
statements, Cash Receipts tabulations.
Tie-in details’ totals to General Ledger.
Test for kiting, lapping, window dressing.
Verify authorizations for non-cash credits
to Accounts Receivable.
Write memo with your opinion.
AUDIT PROGRAM:
Cash (1/4)

Test prescribed controls for legal,

procedural & policy compliances.
Observe counts of all cash funds &
signed receipt for same (workpaper
in ink); tie-in to G/L.
Prove all Bank Reconciliations for all
accounts of the year & tie-in to G/L.
Test mathematics of Reconciliations.
AUDIT PROGRAM:
Cash (2/4)

Request cut-off bank statements &

compare details to reconciliations.
Test year-end cut-off procedures &
consistency with accounts receivable.
Test for inactive accounts, lapping,
kiting & window dressing, using Interbank
Transfers work papers.
Verify pre-numbering where applicable.
AUDIT PROGRAM:
Cash (3/4)

Mail positive confirmations to all banks

used during the year.
List and investigate all exceptions.
Tie-in all non-cash details (e.g., notes)
to appropriate work papers.
Calculate related accruals.
Consider second, third requests.
Consider an FYE “Proof of Cash.”
AUDIT PROGRAM:
Cash (4/4)

Perform analytical procedures &

calculate significant ratios, trends.
Scan for and investigating the unusual.
Analyze for fraud if control absent or
weak, or as deemed necessary.
Clear all exceptions; project sampling.
Write a memo with your opinion.
STATISTICAL SAMPLING &
SUBSTANTIVE TESTS in A/R

The population in Accounts Receivable is

The List of Claims against Customers.
The lower the [revised] Control Risk, the
fewer the [positive] Confimations.
Consider PPS sampling.
Consider “Bayesian” (subjective)
quantifications in assessing CR.
 Audit Programs = Verbs!
(Can you define these 28?)
Confirm; Reconcile Inspect; Observe
Trace; Prepare Sample; Test count
Verify; Substantiate Investigate; Clear
Foot; Crossfoot Compare; Review
Vouch; Prove Inquire; Assess
Calculate; Recalculate Suggest; Draft
Schedule; Analyze Scan; Scrutinize

“CHECK” is not a verb -- it’s too vague!

A Summary Observation, often
misunderstood...
An auditor may, in general, see what the
client has done, then decide if such is
acceptable to the auditor, OR
An auditor may derive what s/he believes
to be the proper answer, then decide if the
client’s amount (however derived by the
client) is tolerable.
AFTER ALL CAPITONS, the
In-charge CPA will…
Review for GAAP consistency and/or
violations.
Consider materiality, potential for
fraud, misleading data.
Make decisions as to Presentations,
Footnotes, Disclosures.
Draft the Audit Report.
CRITICAL KEY TERMS
Aged analyses Proof of cash
Cutoff procedures Bank cutoff
Positive statements
confirmations Interbank transfers
Negative Kiting
confirmations Lapping
Bank confirmations Window dressing
Substantive testing Revenue cycles
End of Chapter 11