Module for Auditing Principles and Practices-II

JIGDAN COLLEGE
DEPARTMENT OF ACCOUNTING AND FINANCE
DISTANCE EDUCATION

AUDITING PRINCIPLES AND PRACTICES II

ACFN 4022

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 Module for Auditing Principles and Practices-II

Jigdan College
Lebu, Mebrat, Addis Ababa
First Published, 2020
Copyright © 2020 Jigdan College

All rights reserved. No part of this publication may be produced, stored in a retrieval system or
transmitted, in any form or by any means, without written permission from the College.

For further information, write to Jigdan College, Department of Accounting and Finance
/Distance Education.

P. O. Box 2217/1110
Call at Telephone: 01147106001/02
Addis Ababa, Ethiopia.

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 Module for Auditing Principles and Practices-II

Table of Contents
Principles and Practices of Auditing II..................................................................................... 1
Introduction .............................................................................................................................. 1
Chapter One .............................................................................................................................. 3
Sampling in Auditing ............................................................................................................... 3
Chapter 2 ................................................................................................................................ 39
Financial Statements Audit .................................................... Error! Bookmark not defined.
Chapter 3 ................................................................................................................................ 48
Audit of Receivables and Sales .............................................................................................. 48
Chapter 4 ................................................................................................................................ 63
Audit of Inventories and Cost of goods sold .......................................................................... 63
Chapter 5 ................................................................................................................................ 67
Audits over Property, Plant and Equipment ........................................................................... 67
Chapter 6 ................................................................................................................................ 75
Audit of current liabilities ...................................................................................................... 75
Chapter 7 ................................................................................................................................ 85
Audit of Long Term Debt and Equity capital......................................................................... 85
Answer keys for Self-Assessment Questions ....................................................................... 102

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 Module for Auditing Principles and Practices-II

Principles and Practices of Auditing II

Introduction
This course is the continuations of auditing I. your course material developer believes that you
understand basic concepts about audit and internal controls in auditing I. In Principles and
practices of Auditing II you will be equipped with advanced audit procedures that can make you
able to practice the role of auditors in the real practice. Auditing I is the prerequisite for this
course.

Dear learners, this course material are designed to enhance your competency in the auditing
profession. Your material writer, advises you to use this material well; to read it, to listen it, to
accept its instruction and implement accordingly, because it is your text book and your instructor.
This course is a three-credit hour course that requires you about 120 hours of study times
At the end of this course, you will be able to:
• Apply his knowledge of auditing theory, auditing standards, techniques and procedures to
practical situations commonly encountered relative to an opinion audit.
• Be acquainted the principles that underlie audit of Balance Sheet and Income
Statement accounts
• Enumerate and understand the audit objectives for the audit of major accounts;
• Develop audit procures for the audit of major accounts; and
• Comprehend the significance of professional competence, independence, and
mental integrity in the practice of accountancy.
• Be committed to bringing about a prevalence of good reporting practice and
contribute to the pursuit of social justice and fairness.

Study Guide
A dear learner, this course is module is classified into chapters and sections. The module
contains module objectives and chapter objectives. The module objective is presented at the
beginning of the module indicating over all goals to be addressed from the module. Chapter
objectives target specific objectives of that given chapter and are given at the beginning of each
chapter. You can understand or predict what the chapter or the section focuses on by looking into
those objectives. Hence, you need to set yourself to achieve those objectives.

In every chapter of module you may find activities, time to check your progress questions and
self assessment questions. Activities are included in most sections the aims are planned to make
you think, write and do before you continue to the next concepts. You will find the answers for
the self assessment questions at end of the module so that you can compare your answers with the
answer keys given. Do not open answer keys and questions as the same time

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 Module for Auditing Principles and Practices-II

At the end of each chapter you will find a chapter summary. The chapter summary briefly
provides the main points and issues in that specific chapter. We believe that the summary helps
you to get the over all ideas which are already discussed in the sections of the given chapter. At
the end of each section, you will find self assessment questions. It will help you to check yourself
about the chapters you read it and to prepare yourself to exam. You have answered those
questions means you understand the core ideas of the chapter as well as the module.
Enjoy reading to enhance your professional skills.

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 Module for Auditing Principles and Practices-II

Chapter One

Sampling in Auditing
1. Introduction
In practice 100% auditing is in appropriate in terms of time, human power and in cost. This chapter
will make you a competent auditor in practicing sample audit. The chapter provides you information
about what sampling is, why we need audit sampling, types of sampling in substantive testing. That
helps you to select an appropriate method from the others, how to make sampling and finally how to
evaluate results from sampling. What is expected from you is to read it and internalize it, by
investing your time and effort not only in reading but also in practicing the questions provided to test
yourself.
At the end of this chapter, you will be able to:-
• define substantive testing and control testing
• describe variable sampling
• explain the nature of different sampling methods
• discuss ways of sampling
• evaluate sample results
1.1. Rationale for and methods of Audit Sampling
Sampling refers to the process of selecting a group of items from a large group of items. The
assumption of sampling is that the sample is the representative of the population. Audit sampling
refers to the application of an audit procedure to less than 100% of the items within an account
balance and class of transactions for the purpose of evaluating some characteristic of the balance or
class. In practice 100% auditing is in appropriate in terms of time, human power and in cost.
Auditors may encounter two types of risk in evidence gathering process:
1. Sampling risk:
▪ The possibility that the sample drawn is not representative of the population and, as a
result, the auditor will reach an incorrect conclusion.
▪ It is a function of sample size. The larger the sample size, the lower the sampling
risk and vice versa.
▪ Can be quantified using statistical sampling.
▪ Can be reduced by increasing sample size
▪ Key issue: balance sampling risk- the cost of using large sample
2. Non-sampling risk: the possibility that the auditor uses inappropriate audit procedures, fail
to detect a misstatement when applying an audit procedure, or misinterpret an audit result. It

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can not be quantified using statistical sampling. The uncertainty related to such risk can be
controlled by:
▪ Adequate training
▪ Proper planning
▪ Effective supervision
1.2. Audit sampling for tests of controls
Generally, there are two types of audit tests:
1. Tests of controls
Test of controls are are procedures directed toward the evaluation of the effectiveness of the
design and implementation of internal controls.
Design issue: evaluate whether the control has been properly designed to prevent or detect
material misstatements
Implementation issue: evaluate whether the control is operating effectively at a point in time’

Audit procedures that can be used for tests of control include:

Inquiries of appropriate management, supervisory, and staff personnel
Inspection of documents, reports, and electronic files
Observation of the application of specific control
Walk-throughs (trace transactions from its origination to its inclusion in the financial statements
through inquiry, observation, & inspection.)
Re performance of the application of the control by the auditor.

1.3. Audit sampling for Substantive testing

Substantive testing defined: Substantive testing involves detailed examination of the monetary
value of the account balances to determine their accuracy and to draw conclusions about the
materiality of the error amounts in the accounts. The extent and nature of substantive testing,
depends upon the decision taken about the effectiveness of the systems of internal control.
The purpose of substantive procedures is to provide audit evidence as to the completeness,
accuracy and validity of the information contained in the accounting records or in the financial
statements.
In substantive testing, statistical sampling is used to obtain monetary estimates of the total error
amount or confidence limits for the total error amount in a particular account. The objective is to
obtain reliable confidence limits, (i.e. confidence limits with actual confidence levels never less
than their nominal levels) which are not conservative (i.e. the estimate of the total error amount
should not be very much greater than the true error amount) with sample sizes that are not too
large for practical audit applications.

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Substantive Procedures
Substantive procedures are tests performed to obtain audit evidence to detect material
misstatements in the financial statements, and are of two types: tests of details of transactions and
balances; and analytical procedures
Substantive tests of Balances: - Tests of balances are a substantive test that provide either
reasonable assurance of the validity of a general ledger balance, or identifies a misstatement in
the account.
Search for unrecorded liabilities a substantive test usually performed on accounts payable is a
search for unrecorded liabilities. This test provides evidence as to completeness and some
evidence as to valuation.

Activity 1: Substantive testing

Take 15 minutes time
The purpose of this activity aims to make familiar with the substantive testing.
What is substantive testing? Is there any other audit testing procedure you know?

Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following discussions.

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Comments: Read the above sections and compare your answers with the possible solutions given
in the sections

Audit risk
Before you read, try to jot down what you know about risk; now is time to read to acquire
more knowledge about risk and audit risk.

Audit risk consists of inherent risks, control risks and detection risks in an assertion or a balance
of an account.
Audit risk is made up of two components, the risk that a procedure is not effective and sampling
risk.
Sampling risk is the probability that the sample results are not representative of the entire
population.
Sampling risk - arises from the possibility that if a test is restricted to a sample, the conclusions
reached by the auditor may be different than the conclusions that may be reached if the test would

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be applied to the total population. A sample of specific or special design, sampling risk varies
inversely with sample size. The smaller the sample size is the greater the sampling risks.

In general, factors that may reduce sampling risk include:

• Taking larger size samples

• Using random sample selection methods
• Stratifying the sample
• Properly defining the test objective
• Properly defining a deviation
• Exclusion of non-recurring, non-systematic errors.
• Properly evaluating errors.

Non-sampling risk: - includes all aspects of audit risk that are not due to sampling. It is human
error due to lack of proper adherence in quality control standards, supervision of audit work, and
adequate planning of the audit. Examples of Non-sampling risk are:
✓ Failure to select appropriate audit procedures
✓ Failure to clearly define the audit population and audit requirements.
✓ Failure to define the nature of the audit exceptions
✓ Failure to recognize errors in the sample or in the documents examined
✓ Failure to evaluate sample results properly
✓ Failure in interpreting the results of audit tests or audit results.

1.3.1. Substantive Testing a Variable Sampling

Now it is time to come to the main part of this chapter, because we have acquired basic
knowledge about substantive testing in sub section of 1.5.

Sampling
Sampling is the application of an audit procedure to less than 100% of the items within an
account balance or class of transactions for the purpose of evaluating some characteristic of all
the items within the balance or class of transactions.

Sampling is a process of selecting a subset of a population of items for the purpose of making
inferences to the whole population. Accounting populations usually consist of a large number of
items (debtors, creditors), often totaling millions of birr, and a detailed examination of all
accounts is not possible.
It is also defined as “the application of audit procedures to less than 100% of the items within an
account balance or class of transactions to enable the auditor to obtain and evaluate evidence in
order assist in forming a conclusion concerning the population which makes up the account
balance or class of transactions” (Accounting professionals board, 1993).
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Why Sampling?
Audit sampling enables an auditor to gather audit evidence through the use of tests of control or
substantive procedures, on selected number of items and forming conclusion about the whole
population. The reasons for this are:
Economic: Audit becomes cost effective.
Time: Complete check would take so long time.
Practical: Users do not expect 100% accuracy. Materiality concept is important in accounting as
well as in auditing.
Psychological: A complete check would be boring for the audit staff.
Fruitfulness: A complete check would not add much to the worth of figures if few errors were
discovered. The emphasis in auditing should be on the completeness of record and the true and
fair view.

Variable sampling
It permits the auditor to determine an aggregate dollar amount of accounting data within
prescribed ranges of tolerable misstatement and sampling risk. Variable sampling permits
quantification of accounting data and yields an answer in dollars. Thus, the method is
sometimes called “dollar-value estimation.” Used for substantive testing

Sampling Risk
Risk - of incorrect rejections (alpha risk -type 1 error) This is the risk that the sample supports the
conclusion that there is a materially misstatement in the account, when in reality there is not a
materially misstatement. This type of risk causes the auditor to perform additional work, thus
increasing the time required for the audit. This risk relates to audit efficiency.
Risk of incorrect acceptance - (beta risk - type error) This is the risk that the sample supports the
conclusion that there is not a materially misstatement in the account, when in reality there is a
materially misstatements. This type of risk causes the auditor to not perform certain audit
procedures.

Steps involved in variable sampling - Substantive tests

1. Determine objectives of the test
2. Define the population: this requires definition of the sample chapter- the completeness of
the population- identification of individually significant items.
3. Select the sampling technique
4. Determine the sample size
5. Determine the method of selecting the sample
6. Perform the sample plan.
7. Evaluate the sample results
8. Document the sample procedures.

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Variables sampling relationship to sample size

Increases in Effect on Sample Size
Risk - Incorrect Acceptance Decrease
Risk- Incorrect rejection Decrease
Tolerable Misstatement ( Error) Decrease
Expected Misstatement (Error) Increase
Population Increase
Variation (std. deviation) Increase

Activity 2 Identify the role of sampling

Take 15 minutes time
Purpose: understanding sampling and its role
Define sampling and state how to use it

Comments: Read the above sections and compare your answers with the possible solutions given
in the sections.

In the first section of this chapter nature of substantive testing and sampling are explained. Let’s
elaborate more through example to develop sampling ability.

Example: Audit testing plan: substantive testing

Consider the substantive testing of retail inventory. Assume that:

• the audit objective is to gather evidence as to the accuracy of valuation of the inventory
items.
• the tolerable level of exceptions is $200,000, based on the value of planning materiality
for this account balance determined
• an exception, which in substantive testing is a misstatement, is defined as any item where
the recorded value of the chapter cost is different to the chapter selling price as at balance
date less 50%.
• the population is made up as follows:

Chapter cost Total recorded cost ($)

(Number of products)
> 2 months 2 months 1 month Total

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$10,000 + 300,000 600,000 1,700,000 2,600,000

(6) (12) (72) (90)

$5,000-$9,999 200,000 300,000 1,000,000 1,500,000

(12) (25) (65) (102)

$1,000-$4,999 150,000 250,000 700,000 1,100,000

(95) (120) (350) (565)

under $1,000 200,000 300,000 800,000 1,300,000

(320) (450) (1200) (1970)

Total 850,000 1,450,000 4,200,000 6,500,000

(433) (607) (1687) (2727)

Further assume the auditor has estimated that the different Risks of Material Misstatement
[RMM] applying to different strata in the population are as follows:

RMM Description Value No. of Avge

($) products chapter
value ($)
High Value > $10,000 per chapter and age > one 900,000 18 50,000
month
Moderate Value > $10,000 per chapter and age = one 1,700,000 72 23,611
month
Low to Value < $10,000 and age > 2 months 550,000 427 1,288
moderate
Low all others 3,350,000 2,210 1,515
Total 6,500,000 2,727

The auditor may then decide to select all 18 products rated "high" as key items and to stratify the
remaining population into three strata. Based on the guide to sample size, the auditor may decide
to select, for products rated "moderate", one product in ten, or 7 products; for products rated
"moderate to low", 20 products; and for products rated "low", 10 products. Thus the total number
of products selected for examination total 55 (18 key items and 37 by random selection). This
testing plan may be summarized as follows:

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Avge Total est'd

No. of
chapter value of
Stratum RMM products
value products
selected
($) selected ($)
Key items High 18 50,000 900,000
Stratum 1 Moderate 7 23,611 165,277
Stratum 2 Low to 20 1,288 25,760
moderate
Stratum 3 Low 10 1,515 15,150
Total to be selected 55 $1,106,187

The auditor then performs the relevant substantive testing on the 55 items selected. This
illustration is to show you how to do sampling, in chapter four of this module (audit procedures
and application for financial statement elements) you will learn about the substantive testing
procedures on selected accounts.

1.3.2. Drawing the Sample and Evaluating Sample Results

Dear learners, in the previous sections of this chapter you got skill of how to do variable
sampling. In this section, try to identify types of sampling methods and how to draw sampling
results.
Here we discuss some of sample selection types and how to evaluate results from evidences
found from selected samples. Some of sample selection types are random number selection,
systematic selection, haphazard selection and Probability-proportional-to-size (PPS) sampling
(also known as dollar chapter sampling). Some of the above sample selection types are both
statistical and non statistical sampling types. Now each of the above sample selection types are
discussed as follow:

Random number selection

Random number selection requires each item in the population to be individually numbered or be
capable of being assigned a unique identifying number. Random number tables, or computer
generated random numbers, are used to select the random numbers. Items in the population that
correspond to the random numbers are then selected from the population. This will help ensure
that every item in the population has an equal chance of Being selected.

For example, assume the auditor determines a sample size for a particular population, or stratum,
of retail inventory items, is 50 items. Assume also that every item has a unique four digit product
code with the smallest number being 1001 and the largest being 5999. The auditor may then use

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random number tables to select the items by choosing 50 numbers between 1001 and 5999,
ignoring any numbers outside that range, continuing until 50 different numbers have been chosen.
Alternatively, the auditor may use a random number generator. The random numbers selected are
used to identify the items of retail inventory to be selected for examination, by selecting 50 items
of inventory with the same product code as the 50 random numbers chosen.

Systematic Selection
A systematic selection of the sample items is made based on a fixed sampling interval. For
example, assume that a sample size (n) of 50 items of retail inventory are to be selected from a
population (N) of, say, 556 items. The sampling interval is equal to N/n or 11 (ignoring
fractions). The first item chosen in the population is determined by reference to random number
tables (based on the first random number selected between 1 and 11) and then after that, every
11th item is selected.

If this method is used, auditors ensure that the listing of the items in the population is not ordered
in some way, otherwise the selection of items may be biased. For example, if the payroll records
were organized in groups of 11 with every 11th record being the supervisor for the group, then in
the above example, either (i) only the payroll records for supervisors will be selected for
examination or (ii) the records for supervisors will never be selected for examination, depending
on the starting number.

Haphazard selection
Haphazard selection is where the auditor selects items haphazardly from the population, avoiding
any conscious bias (such as not selecting items that appear too time-consuming). The problem
with this method is that it does not avoid unconscious bias. When using haphazard selection,
auditors must be aware of the likelihood of increased sampling risk (the risk that a sample does
not reflect the true characteristics of the population) as haphazard selection is more likely than
other selection methods to produce a sample that does not properly represent the characteristics of
the population.

Stratification
Stratification is a process of dividing a population in subgroups each of which is a set of sampling
chapters with similar characteristics. Stratification of accounting populations is usually based on
the recorded book value amounts of the line items. The population is divided into groups (strata)
according to their book values and a sample is selected independently from each stratum. In the
guideline on audit sampling issued by the APB, stratification is advocated as an acceptable
sampling method on the basis that it enables the auditor to direct audit efforts towards the items
which, for example, contain the greatest potential monetary error. For example, the auditors may
direct attention to larger value items for accounts receivable to detect major overstatement errors.
Systematic sampling: In Systematic sampling, the sample is selected at regular intervals after a
random start.
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The following are examples of Systematic sampling

Monetary-Chapter Sampling
Monetary-chapter sampling selection views the population, not as a population of accounts of
different sizes, but as a population of monetary chapters. The size of the population is taken to be
the total number of monetary chapters in all the accounts and each monetary chapter is selected
with equal probability i.e., each monetary-chapter has an equal chance of selection. Monetary-
chapter sample selection gives each line item a probability of selection proportional to its stated
monetary value. This is the most commonly used statistical method for obtaining samples of line
items.

Estimation in Substantive Testing

Classical statistical methods, where a random sample is chosen and the central limit theorem is
invoked to use the normal distribution to estimate the total error amount, have been shown not to
work in substantive testing.

Two major problems are encountered when the classical sampling and estimation approach is
applied to auditing:

Zero-Error Sample: Accounting populations often have very low error rates and consequently the
selected sample may yield zero errors and hence fail to give any information on the population
total error amount.

Unreliable Confidence Bounds: The second problem pertains to the unreliability of confidence
intervals i.e. confidence intervals with actual confidence less than the nominal. The average line
item error amount is used as an estimate of the total error amount and the central limit theorem is
applied to obtain the confidence limits. Numerous studies have shown that using this estimator
leads to unreliable confidence intervals when the populations have low error rates and when the
line items are highly skewed.

To overcome these problems, new methods of estimation have been devised by auditors of which,
the Stringer rate bound is the most common method of estimating the total error amount in
substantive testing. It is calculated by obtaining an upper confidence limit for the line item error
rate using the poisson rate distribution and combining this with the relative errors observed in the
sample to get an upper bound for the total misstatement amount.

Sample Sizes for Variable Sampling: To calculate sample sizes for variable sampling, the
following information must be specified:
• Confidence level.
• Precision.
• Standard deviation.
• Population size.

Activity 3: Identify the types of sampling methods and draw sampling results
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Take 15 minutes time

Purpose: this activity aims to equip you in identifying the types of sampling methods and draw
sampling results.
Mention sampling methods. Define each sampling methods and classify them as statistical and
non-statistical.how do you draw sample result?
_____________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

Comments: Read the above sections and compare your answers with the possible solutions given
in the sections.

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1.3.3. Probability-Proportional-to-Size Sampling /PPS

In your introduction to statistics lesson, what do you understand about probability?
Probability helps you to do sampling not only in statistics but also in auditing as well. The detail
of Probability-Proportional-to-Size sampling is discussed as follows. Read to acquire this new
concept.

Probability-Proportional-to-Size (PPS) sampling (also known as dollar chapter sampling) is a

variation of attribute sampling. In applying PPS, the auditor estimates the dollar amount of error
(rather than error percent) by examining a sample and calculating an upper error limit for the
population, based on ht sample results.

Probability-Proportionate-to-Size Sampling (PPS) is used with substantive tests. It requires the

use of a probabilistic sample selection method (random or systematic sampling). PPS allows the
auditor to estimate the total misstatement of a population. It is different from other sampling
approaches used by auditors in that each dollar in the population is treated as a separate sampling
chapter instead of each customer; invoice, check, vendor, etc.

Sample size for a PPS application can be determined by reference to a PPS sampling table. The
factors considered when determining sample size for substantive tests are:

• Risk of incorrect acceptance represents the risk that the auditor concludes that a material
misstatement does not exist when in fact a material misstatement does exist. The level
used for this risk is based on the auditor's planned detection risk and other planned
substantive tests. A higher risk of incorrect acceptance is used with a higher planned
detection risk and/or other planned substantive tests. This risk is inversely related to
sample size.
• Expected Number of Misstated Dollars represents the auditor's best estimate of the
number of sample dollars that will be misstated. This estimate is based on prior
experience with the client and is normally expected to be zero when PPS is used. This
estimate is directly related to sample size.
• Tolerable Misstatement represents the highest misstatement that could occur before the
population would be considered materially misstated. This amount has an inverse
relationship with sample size.
• Reported $ Balance represents the total recorded dollar balance in the population.

The risk of incorrect acceptance and expected number of misstated dollars are used to determine
the PPS Factor from the PPS table. The sample size is then determined using the following
formula:

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Obviously, substantive tests are not performed on individual dollars but rather are performed on
logical chapters (invoice, customer, check, vender, etc,) containing individual dollars. Therefore,
evaluation of sample results requires restatement of the logical chapter results in terms of the
sampling chapter (individual population dollars). Sample results are evaluated by comparing the
adjusted upper and lower limits on misstatements (error bounds) to tolerable misstatement. If the
adjusted upper and lower limits on misstatements are smaller than or equal to tolerable
misstatement, the auditor will conclude that a material misstatement does not exist. If either the
upper or lower limit on misstatement is greater than tolerable misstatement the auditor will
conclude that a material misstatement does exist.

The adjusted upper and lower limits on misstatements can be calculated using the PPS table. The
first step in calculating the adjusted upper and lower limits on misstatement is to divide misstated
dollars into over and understated dollars and then to rank them from the highest to lowest percent
misstatement. The percent misstatement for each misstated dollar is call tainting and is calculated
using the following formula:

The second step is to calculate an unadjusted upper and lower limit on misstatement using the
PPS table. These calculations require the auditor to know the risk of incorrect acceptance, sample
size, recorded dollars in the population (reported balance), sample dollars misstated, and tainting
of misstated dollars. The unadjusted upper limit on misstatement is based on the observed
overstated dollars and the lower limit on misstatement is based on the observed understated
dollars. The tainting are used in order of highest to lowest.

The third step is to calculate the estimated dollar overstatement and understatement in the
population. The estimated dollar overstatement is calculated based on the number of observed
overstated dollars. The estimated dollar understatement is calculated based on the number of
observed understated dollars. These amounts are calculated using the following formula:

The final step is to calculate the adjusted upper and lower limits on misstatement. The adjusted
upper limit on misstatement is calculated by subtracting from the unadjusted upper limit on

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misstatement the estimated dollar understatement in the population. The adjusted lower limit on
misstatement is calculated by subtracting from the unadjusted lower limit on misstatement the
estimated dollar overstatement in the population.

Advantages of PPS
PPS is easier to use than classical variables sampling, and therefore more cost effective. Some of
the advantages of PPS over classical variables sampling are the following:
The standard deviation calculation is not required, thereby eliminating the need for pilot
samples:
Because the population is automatically stratified, large dollar errors have a higher
probability of being detected; and
Sample size is usually smaller than either MPU or difference estimation.
A significant limitation of PPS sampling is that it is most applicable to populations for which the
auditor suspects few errors and those of overstatement only. Given automatic stratification of the
population, chapters that are understated (i.e. low book values have a much lower probability of
being included in a sample than chapters that are overstated.

The following situations are candidates for PPS sampling:

The auditor expects the inventory to contain few but significant overpricing errors;
- Analytical procedures and study of the business lead the auditor to suspect hat accounts
receivable are materially inflated; or
- Based on past experience with the client, the auditor believes that a substantial amount of
repair and maintenance expense has been capitalized

2.6. Non-Statistical Sampling

Again try to remind your introduction to statistics knowledge, what information do you have
about statistical sampling?

This section aims in introducing you what non statistical sampling is all about

Non-statistical sampling can be used with tests of controls or substantive tests. Non-statistical
sampling does not require the use of a probabilistic selection method. The main advantage of
non-statistical sampling is that it is less complex and less time consuming than statistical
sampling. The main disadvantage is that sampling theory cannot be used to quantify sampling
risk.

Sample size for non-statistical sampling is left entirely to the auditor’s professional judgement.
The factors considered when determining sample size for tests of controls using a non-statistical
approach are the same as those considered for attributes sampling. The factors considered when
determining sample size for substantive tests using a non-statistical approach are:

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• Risk of incorrect acceptance represents the risk that the auditor concludes that a material
misstatement does not exist when in fact a material misstatement does exist. The level
used for this risk is based on the auditor's planned detection risk and other planned
substantive tests. A higher risk of incorrect acceptance is used with a higher planned
detection risk and/or other planned substantive tests. This risk is inversely related to
sample size.
• Risk of incorrect rejection represents the risk that the auditor concludes that a material
misstatement exists when in fact a material misstatement does not exist. The level used for
this risk is based on the cost and difficulty of obtaining additional evidence. A lower risk
of incorrect acceptance is used when more costly or difficult evidence will be required if
expanded testing is needed. This risk is inversely related to sample size.
• Expected Misstatement represents the auditor's best estimate of the population
misstatement. This estimate is normally based on prior experience with the client. This
estimate is directly related to sample size.
• Tolerable Misstatement represents the highest misstatement that could occur before the
population would be considered materially misstated. This amount has an inverse
relationship with sample size.

Sample results for tests of controls are evaluated by comparing the sample deviation rate to the
tolerable deviation rate and calculating an allowance for sampling risk. The sample deviation rate
is calculated by dividing the number of sample deviations by the sample size. The allowance for
sampling risk is calculated by subtracting the sample deviation rate from the tolerable deviation
rate. If the allowance for sampling risk is large and positive the auditor would most likely
conclude that the design and operation of an internal control is effective. However, if the
allowance for sampling risk is small or negative; the auditor would conclude that the design and
operation of an internal control is not effective. What constitutes a large enough difference is a
matter for professional judgement. Generally, smaller allowances for sampling risk are tolerated
with higher risks of assessing control risk too low and larger sample sizes.

Sample results for substantive tests are evaluated in a similar manner. A projected population
misstatement is calculated based on the sample results and compared to the tolerable
misstatement. The projected population misstatement is computed by dividing the sample
misstatement by the dollar value of the sample and multiplying this amount by the dollar value of
the population. The difference between the projected population misstatement and tolerable
misstatement is called the allowance for sampling risk. If the allowance for sampling risk is large
and positive the auditor would most likely conclude that a material misstatement does not exist.
However, if the allowance for sampling risk is small or negative the auditor would conclude that
a material misstatement does exist. What constitutes a large enough difference is a matter for

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professional judgement. Generally, smaller allowances for sampling risk are tolerated with higher
risks of incorrect acceptance and larger sample sizes.

2.7 Analyze Exceptions/Misstatements

Regardless of whether a statistical or non-statistical approach is used to evaluate sample results,

you need to consider the nature and cause of every observed exception or misstatement.
Exceptions or misstatements that are intentional will normally affect the audit tests performed
even when the quantitative analysis supports effective controls or no material misstatement.
Additionally, the auditor may need to revise the original inherent risk and control risk
assessments based on subsequently performed substantive tests. Substantive tests can be
performed through PPS

The steps in a PPS sampling plan are:

Determine the sample size.

Determine the objectives of the plan.
Define the population and sampling chapter.
Determine the sample size.
Determine the sample selection method.
Evaluate the sample results.
The most common objective of PPS sampling plans is to obtain evidence that a recorded account
balance is materially correct (example, does not contain a material misstatement).
The sampling chapter in a PPS sample is the individual dollar (the population is considered to be
a number of dollars equal to the dollar amount of the population). The logical sampling chapter is
the account, document, transaction, etc., with which an individual dollar chapter selected for
inclusion in the sample is associated.

Since the individual dollar is the sampling chapter in PPS sampling, the more dollars associated
with a logical sampling chapter the greater its chance of selection. Conversely, logical chapters
with zero balances have no chance of selection. Therefore, they should be treated separately when
using PPS sampling. In testing accounts with credit balances, such as liabilities, the auditor is
usually primarily concerned with understatement. Since PPS sampling results in selection
proportional to size. The more an item is understated, the less its chance of selection.
Accordingly, the approach is incompatible with the objective The two major statistical sampling
approaches used in substantive testing are (1) probability-proportional-to-size (PPS) sampling
and (2) classical variables sampling.

The formula for calculating sample size in a PPS sample is:

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BV x RF
n=
TM − ( AM x EF )

Explanations of the factors in the above formula and their effect on sample size are:
Relationship to
Factor Explanation Sample Size

BV Book value of Direct

population tested

RF Reliability factor for Direct (1)

specified risk of incorrect acceptance

TM Tolerable misstatement Inverse

AM Anticipated misstatement Direct (2)

EF Expansion factor for anticipated Direct

misstatement

Note that while the relationship between RF and n is direct, the relationship between the risk of
incorrect acceptance (which is controlled through the RF factor) and n is inverse.
Note that while the relationship between AM and n is direct, the relationship between the risk of
incorrect rejection (which is controlled through the AM factor) and n is inverse.

The specification of anticipated misstatement provides the auditor with a means to control the
risk of incorrect rejection. The auditor uses prior experience and knowledge of the client and
professional judgment in determining an amount for anticipated misstatement, bearing in mind
that an excessively high anticipated misstatement will unnecessarily increase sample size while
too low an estimate will result in a high risk of incorrect rejection.

The three factors considered in evaluating the result of a PPS sample are (a) the projected
misstatement determined from the sample, (b) the allowance for sampling risk, and (c) the upper
misstatement limit.

The two components of the allowance for sampling risk for PPS samples are (a) basic precision
and (b) an incremental allowance resulting from any misstatements found.

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A tainting(infected) percentage and projected understatement are calculated for each logical
chapter with a book value less than the sampling interval that contains a misstatement. The
tainting percentage is calculated by dividing the difference between the book and audit values by
the book value. The tainting percentage is then multiplied by the sampling interval to project the
degree to which a logical chapter is tainted with misstatement to all of the dollars in the sampling
interval it represents.

For each logical sampling chapter with a book value greater than or equal to the sampling
interval, projected misstatement is simply the difference between the book value and the audit
value.

Three classical variables sampling techniques used in substantive testing are (a) mean-per-chapter
(MPU), (b) difference, and (c) ratio estimation.

The formula for determining sample size in mean-per-chapter sampling is:

2
 N  U R  S xj 
n =  
 A 

When the relationship between n and N is greater than .05, a finite correction factor is
recommended resulting in an adjusted sample size (n') calculated as follows:

n
n =
n
1+
N

The elements in the formula for n given above represent the following:
N= Population size
UR = The standard normal deviate for the desired risk of incorrect rejection
Sxj = Estimated population standard deviation
A= Planned allowance for sampling risk

The formula differs for difference and ratio estimation only in the term for the estimated standard
deviation. In difference estimation, Sdj (the estimated standard deviation of the differences) is
substituted for Sxj. In ratio estimation, Srj (the estimated standard deviation of the ratios) is
substituted for Sxj.

The risk of incorrect acceptance is controlled in classical variables sampling plans by specifying
the planned allowance for sampling risk (A) in the sample size formula. (A) is determined by
multiplying the auditor's specified tolerable misstatement (TM) by a ratio (R) of planned
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allowance for sampling risk to tolerable misstatement. The ratio is determined from a table based
on the auditor's specified risks of incomplete rejection and acceptance.

Three ways of estimating the standard deviation for a mean-per-chapter sampling plan are: (1) in
a recurring engagement, the standard deviation found in the preceding audit may be used, (2) it
may be estimated from available book values in the current year, and (3) it may be based on the
audit values found in a pre sample of 30 to 50 items selected from the current year's population.

Planned allowance for sampling risk in a classical variables sampling plan provides the means by
which the risk of incorrect acceptance is controlled. It is found by multiplying the auditor's
specified tolerable misstatement by a ratio determined from a table based on the specified risks of
incorrect rejection and acceptance.

The achieved allowance for sampling risk is calculated from the sample. When the achieved
allowance is not greater than the planned allowance used to determine sample size, it is used to
calculate a range, plus and minus, about the estimated total population value, if the recorded book
value falls within this range, the sample results support the conclusion that the book value is not
materially misstated at a risk of incorrect acceptance not exceeding that specified in designing the
sample.

An adjusted achieved allowance for sampling risk is calculated from a sample when the achieved
allowance is greater than the planned allowance. This adjustment is required so that the risk of
incorrect acceptance associated with the range calculated for the estimated total population value
will not exceed that originally specified by the auditor.

When sample results do not support the book value, the auditor must use professional judgment
in deciding on an appropriate course of action. If the auditor believes the sample is not
representative of the population, he or she may expand the sample and reevaluate. Also, if the
auditor believes the achieved allowance is larger than the planned allowance because the sample
size was too small (e.g., because the population standard deviation used to determine sample size
was underestimated), he or she may expand the sample and reevaluate. If the auditor believes the
population book value may be reinstated by more than tolerable misstatement, he or she may
have the client investigate, and, if warranted, adjust the book value. The auditor would then
reevaluate the sample results relative to the adjusted book value.

2.8. Difference and Ratio Estimation

Difference and ratio estimation is other statistical sampling method like PPS we discussed in the
previous section. Try to relate this method with PPS after you make a good reading.

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Difference and ratio estimation techniques generally produce more efficient samples than mean-
per-chapter estimation because the standard deviation of the differences or the standard deviation
of the ratios will be smaller than the standard deviation of the population items. This results in
smaller sample sizes. In order to use difference or ratio estimation, however, the book value of
each sample item must be known and a minimum number of differences (30 to 50) must exist
between the audit and book values.
In mean-per-chapter sampling, the estimated total population value is determined by multiplying
the average of the audit values of the sample items by the number of chapters in the population.

In difference estimation, the average difference between the audit and book values (AV - BV) of
sample items is multiplied by the number of chapters in the population to get the total projected
difference. This total is then added algebraically to the recorded total book value to get the
estimated total population value.

In ratio estimation, the ratio of the sum of the audit values to the sum of the book values of the
sample items is determined and multiplied by the recorded total book value to arrive at the
estimated total population value.
Consideration of the same factors in non statistical samples as in statistical samples may help to
produce more efficient and effective samples. However, in non statistical samples the factors
need not be explicitly quantified. The factors to be considered are: (1) population size, (2)
variation in the population, (3) tolerable misstatement, (4) expected misstatement. (5) risk of
incorrect acceptance, and (6) risk of incorrect rejection.

Two acceptable methods for projecting the misstatement found in non statistical samples to the
population are: (1) the ratio method which divides the total dollar amount of misstatement in the
sample by the fraction of total dollars from the strata of the population included in the sample; (2)
the difference method which multiplies the average difference between audit and book values for
sample items by the number of chapters in the strata of the population. In either case the results
of each strata should be added together to determine a estimated misstatement for the population.
In non statistical samples, the difference between the auditor's total projected misstatement and
tolerable misstatement may be viewed as an allowance for sampling risk.

2.9 Statistical Vs. Non-Statistical Sampling

In section 2.6 you have learned about non statistical sampling, how do you define it?
In previous sections we have seen types of sample selections which are part of Statistical and
Non-Statistical Sampling methods. Here an explanation is given about the two sampling
categories nature, similarities and their difference.

The difference between statistical and non-statistical sampling is that statistical sampling allows
the user to measure the sampling risk associated with the procedure. Statistical sampling applies

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the laws of probability to determine the percent likelihood that the sample does not accurately
reflect the population.

In essence, the laws of probability say that large, relatively homogeneous populations have
similar distributions and other features so that if a random sample is taken, it will consistently
reflect the population within certain limits. In order for the sample to be a “statistical" sample,
the results must be evaluated and two calculations made. These calculations tell the user how
likely it is that the sample results are within a given range of the actual population.
For instance, a statistical sample would not only tell you that disallowed deductions are estimated
at $5,000, but that you have a 95% likelihood (confidence) of being within $50 (precision) of the
actual disallowed deductions.

A properly designed and applied non-statistical sample can provide results that are accurate and
effective, but will not measure the sampling risk.

Generally, the decision to apply a statistical or non-statistical sampling application to a particular

audit test is a matter of cost effectiveness. Statistical applications usually require more training
for auditors and more time to apply. The department utilizes non-statistical random sampling
procedures.

In any sampling approach, the auditor must evaluate the population that is being tested, must
determine if any stratification should be done, must evaluate the cause of any exceptions and
must apply the results from the sample to the remaining portion of the population.

Activity 8: Identifying sample selection

Take 10 minutes time
The purpose of this activity is to help you to make various sample selection methods.
What are the different types of variable sampling selections? Do you understand their
difference? Compare weakness and strength of each method.
Give your answers on the space provided below. It will be helpful if you try this activity
before you proceed to the following discussions.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
Comments: Read the above sections and compare your answers with the possible solutions given
in the sections

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2.10 Designing a Sampling Application

Dear learners, many of the points discussed in this section are well discussed in the above section
of this chapter. It is designed to enable you to equip easily the application of sampling. It can be
considered as a practical guideline.
There are several steps in designing a sampling application for an audit or investigation. The
steps are discussed in detail in the next pages. Invest your effort and your precious time to be a
good auditor in making audit sampling.

1. Define the objectives of the test

The auditor must have a definite question to be answered by the test. Examples of questions to be
answered are.
Does the sales summary contain all invoices and is information recorded
accurately?
How often are invoices voided without explanation?
Does the taxpayer record all supplies pulled from inventory in the inventory log?
Does the sales supervisor correctly batch sales by destination so that they can be
recorded by state in the summary journal?
What is the percentage of sales of services to the government relative to total
sales?
What percentage of supplies are pulled from inventory held for sale each month?
What percentage of supplies purchased outside NM have not had tax paid or
accrued?

2. Determine the type of test to be performed

The type of sampling application, whether statistical or non-statistical, is usually defined by the
conclusion which the auditor is attempting to reach. "Variables sampling" is used to reach a
conclusion about a population in terms of an amount. Variables sampling is commonly used to
determine the dollar size of a population or to determine if the stated dollar size is correct.

Attribute sampling is used when the auditor is only concerned with acceptance or rejection of a
hypothesis. It is used to reach a yes or no answer about a question.

The reason that defining the type of application is so important is that sample size is dependent on
which type of application is being performed. Below is the same list of questions given on the
previous page, and an explanation of the type of application required for each.

Sampling Application Analysis

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QUESTION TO BE TYPE OF
EXPLANATION
ANSWERED APPLICATION
Does the Sales Summary contain Attribute The auditor doesn’t want to
all invoices and is information know what percentage or how
recorded accurately? much, only yes or no.
How often are invoices voided Variables Here, the auditor wants to
without explanation? know a specific amount.
Does the taxpayer record all Attribute Presumably, if there are
supplies pulled from inventory in supplies not recorded, the
the inventory log? auditor will not “accept” the
inventory record.
Does the sales supervisor Attribute This is a yes or no question,
correctly batch sales by which will result in accepting
destination so that they can be or rejecting the data in the
recorded by state in the summary summary journal.
journal?

Sampling applications can also be classified by the type of audit procedure in which they are
used. “Compliance tests” are tests which determine whether controls are being complied with.
The answer to a compliance test is yes or no. “Substantive tests” are tests which determine the
amount of some class of items. Attribute sampling is most often used in compliance tests and
variables sampling is most often used in substantive tests.

Substantive Tests
Substantive tests are used to determine the amount, usually the dollar amount, of a specific group
of items. If the auditor seeks to determine the amount of disallowed deductions, for instance, the
result of the sample will be a dollar figure of disallowed deductions found in the sample. The
assumption is that the same proportion of disallowed deductions will exist in the population.
Therefore, the final result of the test will be a dollar amount of disallowed deductions for the
population which will be used as a basis for assessment.

Often, samples can be designed to serve both compliance and substantive tests. When it is likely
that records will be needed for both types of applications, the auditor should strive to pull one
sample. This is called dual-purpose testing.

3. Define the Deviation Conditions

If you are performing a substantive test, the item(s) you are picking up might not necessarily be
thought of as deviations. For instance, you may be trying to determine the average XX inventory
value over a period for testing the YY property factor. You need to define which items meet the

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criteria necessary to reach the objective of the test. In this example, that might be inventory
control log entries backed up by shipping and receiving reports.

Auditors should be careful not to include factors in the deviation, which do not affect the
objective of the test. For instance, in the first test described above, invoices where the customer
name was misspelled would not affect the objective of the test and should not be treated as
deviations. On the other hand, auditors should also be careful to include all factors, which may
affect the objective of the test.

4. Define the Population

The auditor should determine if the population from which the sample is selected is appropriate
for the specific audit objective, because sample results can be projected to only the population
from which the sample was selected. If a change in the business results in more than one distinct
population, then each needs to be tested separately. The auditor should also evaluate the
reliability of the data presented as the population:

Period Covered By the Test

Generally, a sample should be drawn from the entire period to which the test results will be
applied. However, there are many situations when this is not practical. In any test where the
auditor decides to limit the period from which the sample will be drawn, the auditor should
evaluate sample results, as well as the period outside the sample

Define the sampling chapter

A sampling chapter is any of the individual elements constituting the population. The auditor
should define the sampling chapter in light of what is being tested and the type of records kept by
the client. A sampling chapter may be, for example, a document, an entry in a journal, a line
item, or a single transaction.

Consider the Completeness of the Population

The population is physically represented by some form of record. For instance, sales invoices,
entries in a sales journal or summary entries in a ledger may represent total sales. The auditor
actually selects sampling chapters from this physical representation and so must confirm that all
sample chapters from this record are included in the entire population. If the physical
representation differs from the actual population, the auditor might make erroneous conclusions
about the population. A simple example of this is testing a depreciation schedule where a page of
the schedule is missing.

5. Determine the Method of Selecting the Sample

Sample items should be selected in such a way that the sample can be expected to be
representative of the population. Therefore, all items in the population should have an equal
opportunity to be selected.
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Random-Number Selection
The auditor may select a random sample by corresponding random numbers generated by a
computer or selected from a random number table with document numbers.
Examples of random selection:

When a listing is available, even if the items are unnumbered or have non-continuous or non-
systematic numbering systems, the random number sampling can be accomplished by making use
of the page and line number.

For instance, the auditor might want to obtain a random number sample of items sold to one
customer. Assume that a computer listing is available which consists of pages containing a total
of 20,000 items. The pages of the listing can be easily numbered or their numbers determined by
counting. There may be the same number of lines on most pages, with perhaps fewer on some.

Assume that there are 400 pages in the listing with 50 lines on most pages. The auditor would
draw two lists of random numbers, one for three digit numbers between 1 and 400 and one for
two digit numbers between 1 and 50. Items would then be selected by pairing numbers from the
first and second list to identify the page and line on which the item to be selected is located.

Systematic Selection
For this method, the auditor determines a uniform interval by dividing the number of physical
chapters in the population by the sample size then rounding up. A starting point is randomly
selected and each item after that is selected at the uniform interval. If the population is arranged
randomly, systematic selection is essentially the same as random number selection. However, if
the population is not randomly arranged, for instance, if sales are listed by item, rather than in the
order made, there may be problems with this method.

One way to ensure more randomness in a systematic sample is to re-compute the interval each
time by use of a random-number table. In this approach the auditor would select a list of random
numbers. The first number would be the starting point. The second number would tell the
auditor the interval to count to the next item to be selected. For instance, if the first two random
numbers are 503 and 219, the auditor would select item 503 to start, then item 722 (503 + 219).
In this approach, the auditor might have to go through the population more than once to finish
drawing all the items. The number of digits to be used for the random numbers should make
intervals that are large enough to go through the entire population a least once.

6. Determine the Sample Size Variables Sampling

A critical question must be answered before the sample size for a variables sample can be
computed. Is the population relatively homogeneous?

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Homogeneity is the tendency of items in a population to be similar, or closer to the same dollar
value. For instance, a population containing sales of three kinds of mid-priced property will be
far more homogeneous than a population containing all sales of a Department store.

If a population is non-homogeneous, the auditor can reduce the sample size through stratification
and identifying individually significant items. See Step 7 on performing the sample for an
explanation of how stratification should be done.

7. Perform the Sample

After the sampling plan has been designed, the auditor selects the sample and examines the
selected items to determine if they contain deviations. Test the viability of the sample plan using
approximately 25% of the items you intended to select. If the planned procedures work and the
results meet your expectations continue to sample the balance of the chapters. The sample should
also be evaluated to determine if it is representative of the population. The average value of the
sample should be similar to the average value of the population. If expectations are not met or if
the average values are not similar to the sample the plan may need to be modified or a new
sample may need to be selected.

The following problems may arise during the sample procedure.

Voided documents: If an auditor randomly or otherwise selects a voided item to be included in

the sample, and has reasonable assurance that the item was properly voided, it should be replaced
with another item selected in accordance with the sampling procedure. The rule here is not
absolute, the auditor or supervisor may make a judgment decision based on the circumstances
associated with the voided transaction.

Credits: Most populations will contain credits. It may be possible in certain situations to remove
the credits prior to sampling, but care should be taken to avoid inflating the population’s total
value. If the credits offset debits it is important to remove both. When stratifying a population it
is necessary to use absolute values in order to keep credits and matching debits within the same
strata. A credit will generally not produce a reduction in the exception total (the numerator in the
error calculation). One example of a credit that might generate a reduction in a compensating tax
exception total is the return of an item which had compensating tax accrued and paid at the time
of purchase. A reduction would be acceptable if a reversal of the accrual did not take place and if
the auditor has reasonable assurance that the return is not an unusual event.

Unused Or Inapplicable Documents: The auditor's consideration of unused or inapplicable

documents is the same. For example, a sequence of vouchers might include unused vouchers or
an intentional omission of certain numbers. If the auditor selects such a document, he should

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obtain reasonable assurance that the voucher number actually represents an unused voucher and
does not represent a deviation. The unused voucher may then be replaced with an additional
voucher.

Errors in random-number selection: In a situation where the auditor generates a random number
that is not part of the population, that number should be replaced with another random number
which is part of the population.

Stratification
In order to make a population more homogeneous for variables sampling, the auditor can use
stratification. Described below are some ways to stratify a population. This list is not all-
inclusive and auditors may find other appropriate ways to stratify a population.

It is important to note that generally, stratification requires that the sample results be extrapolated
to each strata separately. In other words, if an auditor divides the population into two groups,
sales of tangibles and sales of services, to make both groups more homogeneous, then the results
of the sample from the tangible group should only be extrapolated to the total tangible sales and
the results of the sample from the services group should only be extrapolated to the service sales.

Where the sample is limited to specific time periods, the auditor will need to confirm that the data
from the entire population can be stratified before the resulting error rates can be applied.

Stratification is most often performed during computer assisted audits. Computer software
applications can easily segregate a population and provide subtotals. It is required that auditors
contact the Computer Assisted Audit Team when working with a high volume of transactions or
with large data files.

A minimum of three errors per strata is necessary for extrapolation to strata population.

The following are some methods of stratification:

by dollar amount – This is the most common type of stratification used by auditors. The auditor
needs to identify the number of different ranges, and their dollar values, into which the population
most usually falls.

For instance, if the auditor is testing sales of equipment and the taxpayer sells several low-priced,
several medium-priced and two high-priced models, the auditor may decide to make strata from
$7,000 to $12,000, $12,001 to $18,000 and $18,001 to $25,000. Remember, the results of the
sample pulled from each strata would be extrapolated only to the total of that strata.

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By nature of the items: An easy way to stratify a total population is to stratify based on the nature
of the transactions, such as sales of tangibles and sales of services.

Any relevant attribute can be used so long as stratifying by that attribute tends to make the
population more homogeneous in dollar amounts.

By nature of the test – another way to stratify a population is to divide the items into groups
according to the nature of the test to be performed. For instance, if the auditor is testing
deductions for supporting documentation, the population could be divided into groups where an
NTTC is required and where one is not required.

The methods for stratifying described above may be used separately or in combination. For
instance, the auditor may stratify first by the nature of the items, then by dollar amount.

Stratification example:
Taxpayer A sells three types of computer equipment: laptops, desktops and network servers. The
auditor decides to stratify the total population of sales by type of computer equipment, since that
tends to create more homogeneous sub-populations. Since this is still a non-homogeneous,
stratified population the sample size computed from the Sampling Size Table is 100 per strata.

There were $2,000,000 total laptop sales during the period, $3,000,000 total desktop sales and
$5,000,000 server sales. The auditor should allocate the total sample size as follows:
100 from laptop sales
100 from desktop sales
100 from network sales
The results were as follows:
5% under-reported laptop sales X $2,000,000 = $100,000
5% over-reported desktop sales X $3,000,000 = ($150,000)
10% under-reported network sales X $5,000,000 = $500,000

8 Evaluating The Sampling Results

Whether the sample is statistical or non-statistical, the auditor uses judgment in evaluating the
results and reaching an overall conclusion.
Interpreting results
The auditor must determine how the outcome of the sample affects the test conclusions and the
overall audit approach. If the auditor is testing the reliability of a certain record, the outcome of
the attribute sample will either show deviations or no deviations. If there are deviations, the
auditor must expand the sample as described under Step 6 for attribute sampling or reject the
record as unreliable. This in turn may affect the audit approach.
Extrapolating results:

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If the test is a variables sample and five or more errors are found, the auditor must extrapolate the
results to the remainder of the population. This procedure calculates the percentage of error
(POE) found in the sample and applies that result to the population tested. To calculate the POE,
take the dollar value of the deviations (or other sample result), divide by the dollar value of the
total sample. Then multiply that POE times the dollar value of the population.
$Deviations (or sample results) X $Population= $Total Sample
There are three rules for extrapolating:
The numerator should be the sample representation of what the auditor is trying to determine
about the population (or strata). The denominator should be the sample representation of the
population (or strata). The population should be complete and should not include items that do
not represent the population as defined by the test.

9. Document the Sample Procedures

Working papers that document the audit should be prepared by the auditor. These documents
should record the information obtained and the analyses made and should support the basis for
the findings and recommendations to be reported.
Purpose of working papers:
Provide evidential support for the internal auditor’s report.
Aid in the planning, performance, and review of audits.
Document the achievement of audit objectives and completion of all audit procedures.
Facilitate third-party reviews.
Provide a basis for evaluating the Internal Audit Department’s quality assurance.
Provide support in circumstances such as insurance claims, fraud cases, and lawsuits.
Aid in the professional development of the audit staff.

Demonstrate compliance with the Standards.

Audit working papers should be complete and include support for audit conclusions reached. Among
other things, working papers may include the following:

Planning documents and audit programs.

System analysis flowcharts or narratives.
Notes and memoranda resulting from interviews.
Auditee organizational charts and job descriptions.
Copies of contracts.
Department and institution-wide policies and procedures.
Analyses and tests of transactions.
Results of analytical reviews.

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Activity 9: Identifying sampling steps

Take 10 minutes time

The purpose of this activity is to help you to make various audit sampling.
Enumerate the steps to make sampling for your audit work.
Give your answers on the space provided below. It will be helpful if you try this activity
before you proceed to the following discussions.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
Comments: Read sections 2.10 and compare your answers with the possible solutions given in
the section

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 Summary

Substantive testing involves detailed examination of the monetary value of the account balances
to determine their accuracy and to draw conclusions about the materiality of the error amounts in
the accounts .In substantive testing, statistical sampling is used to obtain monetary estimates of
the total error amount or confidence limits for the total error amount in a particular account.
Audit risk is made up of two components, the risk that a procedure is not effective and sampling
risk. Sampling risk is the probability that the sample results are not representative of the entire
population. Sampling is performed because it is more efficient than testing 100% of a population.
PPS is used with substantive tests and it requires the use of a probabilistic sample selection
method (random or systematic sampling). In difference estimation, the average difference
between the audit and book values (AV - BV) of sample items is multiplied by the number of
chapters in the population to get the total projected difference. This total is then added
algebraically to the recorded total book value to get the estimated total population value.

In ratio estimation, the ratio of the sum of the audit values to the sum of the book values of the
sample items is determined and multiplied by the recorded total book value to arrive at the
estimated total population value. Selection for Substantive Testing are stratification, Stratification
is a process of dividing a population in subgroups each of which is a set of sampling chapters
with similar characteristics.
The steps in designing a sampling application for an audit or investigation are:
1. Define the objectives of the test
2. Determine the type of test to be performed
3. Define the deviation conditions
4. Define the population
5. Determine the method of selecting the sample
6. Determine the sample size
7. Perform the sample
8. Evaluating the sampling results
9. Document the sample procedures

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 Self Assessment Question 1.1

Write true if the statement is correct and false if incorrect.
___1.Sampling risk consists of Inherent and Control risks in an assertion or a balance of an
account
___2.Audit risk is the probability that the sample results are not representative of the entire
population
___3.it is the application of an audit procedure to less than 100% of the items within an account
___4. Failure to select appropriate audit procedures is an examples of Non-sampling risk
___5. Proper definition of tests can minimize sampling risk
___6. Materially concept is important in accounting but not in auditing.
___7. Risk of incorrect acceptance is a Sampling Risk, where as risk of incorrect rejection is non
Sampling Risk
___8.The first step involved in variable sampling in case of substantive tests is, document the
sample procedures.
___9. Random number tables, or computer generated random numbers, are used to select the
random numbers.
____10. confidence levels are determined by auditor judgment

____11.When the acceptable detection risk is high, it means that the auditor is prepared to accept
a high risk that material errors will not be picked up by substantive audit tests
____12. Inherent risk relates to the nature of the entity's business

PART II Give short answer

1. What are the purposes of substantive procedures?
_________,________________________________________________________
2. List sample selection methods._________________________________________
_________________________________________________________________
_________________________________________________________________

Self Assessment Question 1.2

Write true if the statement is correct and false if incorrect.
____1. PPS allows the auditor to estimate the total misstatement of a population.
____2. Tolerable Misstatement has an inverse relationship with sample size.
____3. A significant limitation of PPS sampling is that it is most applicable to populations for
which the auditor suspects few errors and those of overstatement only
____4. Sample size for non-statistical sampling is left entirely to the auditor’s professional

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judgments.
____5. The formula have no difference for difference and ratio estimation only in the term for the
estimated standard deviation.
____6. Determine the sample size is the first steps in a PPS sampling plan.
____7. Risk of incorrect acceptance represents the risk that the auditor concludes that a material
misstatement does not exist when in fact a material misstatement does exist.
____8. In PPS, Sample size is usually larger than either MPU or difference estimation.

 Self-Assessment Questions 1.3

Part I Write true if the statement is correct and false if incorrect.
_____1. Taking larger size samples lessen sampling risk.
_____2. Failure to recognize errors in the sample or in the documents examined is examples of
sampling risk.
_____3. Zero Percent Examination occurs when the auditor determines that a type of receipt,
deduction, exemption or other item does not need to be tested.
_____4. Risk of incorrect rejections the risk that the sample supports the conclusion that there is
not a materially misstatement in the account, when in reality there is a materially
misstatements.
_____5. The main disadvantage of non statistical sampling is that sampling theory cannot be
used to quantify sampling risk.
_____6. When sample results do not support the book value, the auditor must use professional
judgment in deciding on an appropriate course of action.
_____7. In ratio estimation, the ratio of the sum of the audit values to the sum of the book values
of the sample items is determined and multiplied by the recorded total book value to
arrive at the estimated total population value.
_____8. Statistical Sampling is an acceptable method of selection provided the auditor is
satisfied that the sample is not unrepresentative of the entire population.
_____9. Monetary-chapter sample selection views the population, not as a population of
accounts of
different sizes, but as a population of monetary chapters.
_____10. Substantive tests are used to determine the amount, usually the dollar amount, of a
specific group of items.
_____11. Sample items is any of the individual elements constituting the population.
_____12. If a population is homogeneous, the auditor can reduce the sample size through
stratification and identifying individually significant items.

Part II choose the correct answer and write the letter of your choice on the space provided
__1. Which of the following is not an important consideration in determining the sample size
of confirmations?
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A. Total annual credit sales.

B. Tolerable misstatement.
C. The types of confirmations being sent; that is, positive or negative.
D. The results of related analytical procedures.
___2. The following statements relate to the process of selecting items to include in the
confirmation sample. Which of the following is not a true statement?
A. With most confirmations, some type of stratification is desirable.
B. In most audits, the emphasis should be on sampling equally throughout the population.
C. It is important that the auditor have complete independence in choosing the accounts to be
confirmed.
D. It is important to sample some items from every material stratum of the population.
___3. While performing a substantive test of details during an audit, the auditor determined that
the sample results supported the conclusion that the recorded account balance was
materially misstated. It was, in fact, not materially misstated. This situation illustrates the
risk of
A. incorrect rejection.
B. incorrect acceptance.
C. assessing control risk too low.
D. assessing control risk too high.
____4. Which of the following is not an example of non sampling risk?
A. Failing to evaluate results properly.
B. Use of an audit procedure inappropriate to achieve a given audit objective.
C. Obtaining an unrepresentative sample.
D. Failure to recognize an error.
___5. Which of the following best illustrates the concept of sampling risk?
A. An auditor may select audit procedures that are not appropriate to achieve the specific
objective.
B. The documents related to the chosen sample may not be available for inspection.
C. A randomly chosen sample may not be representative of the population as a whole.
D. An auditor may fail to recognize deviations in the documents examined
___6. The advantage of using the negative form of confirmations is that
A. larger sample sizes can be used without increasing the costs above what would have been
required for positive confirmations.
B. customer's silence proves that the balance is correct.
C. follow-up procedures are scheduled automatically.
D. it is appropriate in all circumstances.
___7. When monetary-chapter sampling has been concluded and the population is not
considered acceptable, which one of the following courses of action would not be appropriate
for the auditor?

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A. Increase the sample size to see if this may satisfy the auditor's tolerable misstatement
requirements.
B. Increase the tolerable misstatement amounts so that the error bounds are acceptable.
C. Request the client to correct the population.
D. Refuse to give an unqualified opinion.
___8. Which of the following is a disadvantage of the monetary-chapter sampling method?
A. It automatically increases the likelihood of selecting high dollar items from the
population being audited.
B. It always gives the statistical conclusion as a dollar amount.
C. Computer assistance is needed to select monetary-chapter samples from large
populations.
D. If one large item makes up 10% of the total recorded dollar value of the population and
the sample size is 100, approximately 10% of the sample items will come from that one
large population item.
____9. In selecting the items to include in the sample, the auditor must
A. use a method that will guarantee that all items in the population are represented in the
sample.
B. have reasonable assurance of obtaining a representative sample.
C. be assured of the randomness of the population.
D. be assured that each item chosen in the sample is a material amount.
____10. In a probability-proportional-to-size (PPS) sample, all population physical audit chapters
with an amount equal to or greater than the amount of the interval will automatically be
included in the sample if the auditor uses
A. random selection.
B. systematic selection.
C. block selection.
D. stratified selection.
____11. The method used to measure the estimated total error amount in a population when there
is both a recorded value and an audited value for each item in the sample is
A. difference estimation.
B. mean-per-chapter estimation.
C. ratio estimation.
D. monetary-chapter sampling.

Part II Fill the blank space

1.___________ used to obtain monetary estimates of the total error amount or confidence limits
for the total error amount in a particular account.
2. ________________is the probability that the sample results are not representative of the entire
population.

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3. Define audit sampling

____________________________________________________________
_________________________________________________________________________
________________________________________________________
4. write the steps in a PPS sampling plan
__________________,____________,_____________________,________________,

Part IV mach column B to column A

Column A column B
___1.The purpose of substantive procedures A. Risk of incorrect acceptance
B. tests performed to obtain audit evidence
___2. Substantive procedures C. process of selecting a subset of a
population of items
___3. Audit risk D. inherent risk
___4. Sampling
___5. Sampling risk E. providing audit evidence

Part V describe the following shortly

A. What is the effect of assessing control risk too low? How should the auditor avoid such step?
B. Why are substantive tests performed by the auditor?
C. List the advantages and disadvantages of statistical sampling?
D. What is the advantage of a substantive test sample?
E. List the procedures for determining a sample for a substantive test?
F. Discuss why sampling and why not to sample.
G. Explain Probability-proportional-to-size /PPS /
H. Difference and ratio estimation techniques generally produce more efficient samples than
mean-per-chapter estimation. What do you think the reason behind? What difference do you
observe from other sampling techniques?

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Chapter 2

Audit of Cash and Marketable Securities

2. Introduction
Financial statement audit involves a thorough review of a department’s records and reports, in
order to check that assets and liabilities are properly recorded on the balance sheet, and, all profits
and losses are properly assessed. Financial statement audit involves verification of revenue, sales,
bank deposits, bank reconciliation, accounts payable, accounts receivable, disbursements, petty
cash transactions, loans and advances and assets.
Audit of current assets, audit of long term assets, audit of current liabilities, audit of long term
liabilities and audit of owners’ equities are some of the topic discussed in this module from
chapter 2 to chapter 7.

Dear learners, financial statement audit is a highly practiced audit area in our country in both
public and privates sectors. Chapters covered from 2 to 7 tries to provide you with an insight and
the techniques on how to make audit of accounts.
At the end of these chapters, you will be able to:
• state the components of financial statement audit
• identify nature and internal control procedures of cash
• describe the nature of appropriate procedures to accomplish the objectives of cash audit
• conduct audit of cash
• explain the audit objective, procedures and programs of audit of receivables
• describe the nature of the audit procedures to accomplish the auditors’ objectives for the
audit of receivables and sales
• identify fundamental internal controls over inventories and purchases.
• describe the auditors’ objectives for the audit of inventories
• identify fundamental internal controls over Property, Plant and Equipment assets
• audit Property, Plant and Equipment assets
• conduct audit of cash payment and cash collection

Dear learners after completing this chapter 2, you will be able to:
• Describe the nature of cash and marketable securities
• Discuss the fundamental internal control over cash and marketable securities
• Identify the auditors’ objectives for the audit of cash and marketable securities
• Identify the appropriate audit procedures for cash and marketable securities
•

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2.1. Internal Control over cash transactions, Receipts and Disbursements

2.1.1. The Nature of cash

• Cash includes cash on hand (petty cash, change fund) and cash at bank (general checking
account, payroll fund, branch accounts).
• Cash is highly liquid and sensitive to misuse and theft.
• Cash increases due to cash sales, collections on receivables, additional cash investment
etc.
• Cash decreases due to business expenditures, and cash withdrawals.

2.1.2. Objective for Auditing Cash

a. Consider internal control over cash

b. Substantiate the existence of recorded cash
c. Determine the rights to cash
d. Establish the completeness of cash balances
e. Establish the clerical accuracy of cash schedules
f. Evaluate balance sheet presentation & disclosure

2.1.3. Internal control over cash

a. What are Cash handlings functions?
• Handling and depositing cash receipts
• Signing checks
• Investing idle cash
• Maintaining custody of cash & cash equivalents
• Forecast cash requirements
b. Who is responsible for cash handling functions?
• Finance department under the direction of the treasurer
c. What are the purposes of cash handling functions? To ensure:
• The proper collection of cash
• The recording of cash transactions accurately and timely
• Prompt cash deposit
• Proper authorization of cash payments
• The adequacy of cash balances
• Investment of idle cash on a timely basis
d. General internal control over cash
• Do not allow one employee to handle a transaction from beginning to end
• Separate cash handling from recording
• Centralize receiving of cash as much as possible

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• Record cash receipts immediately

• Encourage customers to obtain receipts & observe cash register totals
• Deposit each day’s cash intact
• Make all disbursements by check, except small payments
• Have monthly bank reconciliation prepared by employees not responsible for the
issuance of check and cash custody
• Forecast expected cash receipts & disbursements, & investigate variances

2.1.4. Internal control over cash receipts

1. Control over cash sales

• Separation of duties
• Use of serially numbered tickets or sales checks & account for them

•
Use cash registers, electronic point-of-sale (POS) system or form writing
machines.
✓ Custody and depositing of cash receipts

2. Potential misstatements in cash receipts

• Recording fictitious cash receipts
• Failure to record receipts from cash sales
• Failure to record receipts from As/R
• Early or late recognition of cash receipts

2.1.5. Internal control over cash payments

a. potential misstatements for cash payments

• Inaccurate recording of a purchase
• Duplicate recording and payment of vouchers
• Failure to record disbursements
b. Possible controls
• Proper segregation of duties
• Payments by check or electronic fund transfers
• Use pre-numbered checks
• Mutilate, preserve, & file void checks
• Match purchase order & receiving documents with vendor’s invoices
• Review of supporting documents by authorized check signer
• Perforate or cancel supporting documents to avoid reuse
2.1.6. Internal control over petty cash
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• Approval of the establishment by the concerned party

• Review the supporting documents of each disbursement
• Deface the documents to prevent reuse
• Emphasize the transaction instead of the year-end balance
• Verify numerical accuracy

Activity 1: Understanding the audit and internal control of cash

Take 20 minutes time

The following activity will help you to learn about nature of cash and internal control over cash
balance.
At any stage of maintaining cash it need a special control. What would you think the control
objective? Try to assess the internal control over cash balance in your organization and list the
weakness and strengths.
Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following
discussions.____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________
______________________________________________________________________________

Comments: Read sections 2.1.3 and compare your answers with the possible solutions given in
the sections

2.2. Audit Program for Cash

The following audit program indicates the general pattern of work performed by the auditors in
the verification of cash.
• Consider internal control for cash.
• Obtain an understanding of internal control for cash.
• Assess control risk and design additional tests of controls for cash.
• Perform additional tests of control for those controls, which the auditors plan to consider
in their assessment of control risk:
• Test the accounting records and reconciliation by re-performance.
• Compare the detail of a sample of recorded disbursements in cash payments journal to
accounts payable postings, purchase orders, receiving reports, invoices, and paid checks.
• Compare the detail of a sample of recorded cash receipts listings to the cash receipts,
journal, accounts receivable postings, and authenticated deposit slips.
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• Re-assess control risk and design substantive tests for cash.

2.2.1.1. Perform substantive tests of cash transaction and balances:

• Obtain analysis of cash balances and reconcile to the general ledger.
• Send standard confirmation forms to banks to verify amounts on deposit.
• Obtain or prepare reconciliation of bank accounts as of the balance sheet date and
consider the need to reconcile bank activity for additional months.
• Obtain a cutoff bank statement containing transactions of at least seven business days
subsequent to balance sheet date.
• Count and risk cash on hand.
• Verify the client’s cutoff of cash receipts and disbursements.
• Trace all bank transfers for last week of audit year and first week of following year.
• Evaluate proper financial statement presentation and disclosure of cash.
2.2.1.2. Cash Count Procedures
1.Review cash handling related policies, regulations, rules, and guidelines:
System Regulation of Receipt, Custody, and Deposit of Revenues
Guidelines for Cash Handling Procedures
2. Obtain a copy of the Custodian Receipt Form for the fund to be counted.
3. Review prior cash count reports for the fund.
4. Begin the cash count:
Request access to the fund,
Ensure proper ID is presented to the fund custodian, and
Request that the fund custodian remain present during the count.
5. Perform the cash count of the fund.
For a working fund:
• If a cash register is in use, obtain a copy of the “X” reading for the day’s sales and
verify “Z” totals to the prior day’s activity.
• Document the count on a cash count form.
• Reconcile the funds on hand with the working fund amount according to the
Custodial Receipt Form.
• Have the fund custodian sign the cash count form verifying that all funds were
returned to him/her intact.
• For permanent working funds, document the amount of times the fund was
replenished in the last 12 months. Assess the appropriateness of the fund amount
based on the times replenished and through discussion with the fund custodian.
• For a petty cash fund:
• List the receipts (or run a tape) for all expenditures made from the fund that have
not been reimbursed.

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•
Verify that the fund is being used for the purpose listed on the Custodial Receipt
Form and that all expenditures are allowable.
• Ascertain that the fund is being reimbursed in a timely manner.
• Verify that the amount of the fund is appropriate based on the frequency of
reimbursement.
6. Observation made during the cash count:
• observe if the area is orderly and has adequate security
observe if there are any lists or notes which could be used to track fund
“borrowed”
from the fund, etc.
• for all checks, observe that they have been restrictively endorsed

7. Inquire of the fund custodian(s) and/or observe to determine if:

• there are written policies and procedures for cash operations
• the funds are kept in a safe or locked drawer during temporary placement as well
as long-term and overnight storage
• the combination of the safe is changed periodically and record when it was last
changed.
• duplicate keys and combinations to the safe are submitted to department head or
designee for use if fund custodian(s) are out. Document with whom and how are
they secured.
• cash register tapes and counts of cash are reconciled daily
• cash receipts are deposited daily (observe dates on checks)
• person who makes deposits does not post to customer accounts and/or prepares
monthly reconciliation (bank account)
• personal checks are not cashed from the fund
• checks are restrictively endorsed upon initial receipt
• returned checks are collected by the fund custodian
• cash register receipts are given to customers
• handwritten receipts are pre-numbered
• not more than one person operates the cash register during a shift (using the same
cash drawer)
• shortages are recorded and not made up from personal funds
• overages are immediately deposited not held
• cash handling areas are secured from entry by unauthorized persons
• cash handlers are trained in the event of an emergency (i.e., natural disaster, power
outage, robbery, etc.)
• the fund custodian information and job descriptions are current

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•
voids or adjustments are approved by someone who does not have access to the
funds. If not, ensure that voids are independently reviewed for appropriateness
and analyzed for possible trends.
8. Prepare report of cash count
• complete cash count form (include signature of the counter and fund custodian).
• include recommendations for enhancing the accountability, security, segregation
of duties, and/or documentation/reconciliation process
• include any suggestions to improve effectiveness of subsequent cash counts

2.3. Internal Control Over Marketable Securities

1. Characteristics of marketable securities

• Includes commercial paper, marketable equity securities, and marketable debt securities
• Represent secondary cash reserve
• Capable of quick conversion to cash at any time
• Produce a steady rate of return
• Do not include investments in securities made for the purpose of maintaining control or
influence over affiliated companies
2. Auditors’ Objectives for marketable securities
• Consider internal control over marketable securities
• Determine the existence and rights to marketable securities
• Establish completeness
• Determine the proper valuation of marketable securities
• Determine clerical accuracy
• Evaluation the presentation and disclosure of marketable securities
3. Overall audit approach to marketable securities
• Assess control risk for securities
• Inspect certificates
• Confirmation of securities held by 3rd parties eg. Banks
• Determine appropriate valuation of securities
4. Internal control over marketable securities
• Separation of duties among:
a. Authorization of purchases & sales of marketable securities
b. Custodian (safekeeping agents or bank safe deposit box)
c. Recordkeeping
• Detailed records (subsidiary records) of all securities owned & the related revenues.
• Registration of securities in the name of the company
• Periodic physical examination or inspection of securities by an internal auditor or another
official
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2.4. Audit Program for marketable securities

Consider Internal control for securities
1. Obtain an understanding of internal control for securities
2. Assess control risk and design additional tests of controls for securities
3. Perform additional tests of controls
✓ Trace several transactions for purchases & sales through the accounting system
✓ Inspect reports by internal auditors on their periodic inspection
✓ Inspect monthly reports on securities owned, purchased & sold, and amounts of
revenue earned and budgeted
4. Reassess control risk and modify substantive tests

B. Substantive Tests for securities

B. Substantive Tests for securities Audit Objectives
a. Obtain analysis of securities & related accounts & reconcile to Clerical accuracy
ledger
b.Inspect securities on hand Existence & rights
c. Obtain confirmation of securities held by others
d. Vouch selected purchases and sales of securities during the year Existence, rights, &
valuation
e. Perform analytical procedures Existence,
f. Make independent computations of revenues from securities Rights
g. Verify the client’s cutoff of securities transactions Completeness
h. Determine market value of securities Valuation, disclosure,
i. Evaluate the method of accounting Presentation
j. Evaluation of financial statement presentation and disclosure Presentation &
disclosure

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Check Time to check your progress 4.5/Self Assessment Question 2

Write true if the statement is correct and false if incorrect on space provided
____1 financial auditor is not concerned with propriety of business transactions.
____2 If company’s cash is used personally by the cashier and is made up on demand by the
Managements, it can be said that the financial statements are misstated
____3 The auditor of a company has a right to carry out surprise checks of transactions beyond
the end of the accounting year for which he is reporting.
____4. For good cash control, the custody of cash should be included with the record keeping of
cash
____5. An analysis prepared to explain the difference between the balance of the chequing
account of the depositor and the balance as shown by the bank statement is called a bank
reconciliation
____6. Cash is considered to be a liquid asset
____7. The balance sheet figure for cash should include all cash received on the final day of the
year.
____8. Separation of duties is really not a critical item of control procedures

Part II. Write the related audit objectives on the each transaction
1. Recorded cash receipts are for funds actually received by the company __________________.
2. Cash received is recorded in the cash receipts journal (completeness).
3. Cash receipts are deposited and recorded at the amounts received ______________________
4. Cash receipts transactions are properly classified__________________________
5. Cash receipts are recorded on the correct dates ______________________.
6. Cash receipts are properly included in the accounts receivable master file and are correctly
summarized _____________________

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Chapter 3

Audit of Receivables and Sales

3. Introduction
Dear Lerner! Well come to the third chapter of the course. We have discussed what receivables
are and how they are presented in the financial statements in the previous courses. Its importance
is; to one degree or another, many business transactions result in the extension of credit.
Purchases of inventory and supplies will often be made on account. Likewise, sales to customers
may directly (by the vendor offering credit) or indirectly (through a bank or credit card company)
entail the extension of credit. So, it is necessary to understand and manage properly ‘receivables
and temporary investments’ to be successful in business and in your carrier as accountant.
Receivables represent claims for money, goods, services, and non-cash assets from other firms
and can be categorized as current or non-current depending on the expected collection date.

Dear Learner, after completing this chapter successfully, you will be able to:
✓ Describe the nature & sources of receivables
✓ Describe the nature of revenue and collection cycle
✓ Explain the fundamental internal controls over sales transactions and receivables
✓ Identify the auditors’ objectives for the audit of receivables & sales
✓ Identify appropriate audit procedures for receivables and sales

3.1. Internal Control Over Sales Transactions, and Account recivables

In this section, two broad areas of audit, audit over sales and collection cycle are discussed. These
are day to day activities of any organization. You, as an auditor need to understand the nature of
the above activities since you will use them in your audit operations. What can you recall about
sales transactions of merchandise business in your study of principle of accounting?

3.1.1. Audit over sales

i. Cash sales and Controls over Cash Sales
Cash sales should be recorded at the point the sale is made. Usually this is by means of Cash till
or the use of cash sale invoices or receipts. If cash sale invoices or receipts are used they should
be pre-numbered, a register should be maintained of cash sale books and copies should be
retained. Cash received should be reconciled daily with either the till roll or the invoice totals.
Cash should be banked promptly. This reconciliation should be carried out by someone
independent of those receiving the cash and recording the sale.

Daily banking should be checked against the till roll or invoice total and differences investigated.
A responsible official should sign cancelled cash sale invoices at the time of cancellation. All
such invoices should be checked periodically for sequential numbering.

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Control over cash sales is strongest when two or more employees participate in each transaction
with a customer. Tickets or sales invoices if they are serially numbered and if all numbers are
accounted for, separation of responsibility for the transaction is an effective means of preventing
fraud.
In many establishment the nature of the business is such that one employee must make over the
counter sales, deliver the merchandise, received cash, and record the transaction.

In this situation dishonesty may be discovered by proper use of cash registers and form writing
machines with locked in copies. The protective features of cash registers include (1) visual
display of the amount of the sale in full view of the customer (2) a printer receipt, which the
customers is urged to take with the merchandise (3) accumulation of a locked in total of the day’s
sales.

Many stores use various types of electronic cash registers including online computer terminals.
With some of these registers an electronic scanner is used to read the sales prices and other data
from especially prepped price tags. Thus the risk of a salesperson recording sales to erroneous
prices is substantially reduced. Besides, providing strong control over cash sales, electronic
registers often may be programmed to perform numerous other control functions.

Many business making sales over the counter find that internal control is strengthened by use of a
machine containing triplicate sales invoices. As each sales invoice is written two copies are
ejected by the machine and a third copy is retained in a locked compartment. The retention of
third copy, which is not, available to the sales clerk, tends to prevent a dishonest employee from
changing the stores copy of the sales invoice amount less than that shown on the customer’s copy.

After evaluating the effectiveness of the internal controls, the auditor carries out substantive
procedures in aspect of receipts. These producers involve (a) test of individual transactions which
are often carried out on a sampling basis, depending on the auditor’s assessment of the
effectiveness of internal controls and (b) analytical producers. In examining the copies of receipt
the auditor should pay special attention if the date on the audit tallies with that in the cash book, if
the amount has been recorded correctly and if there is no over writing.

The auditor’s comparison of the date, name of the payee and amount as stated on the copy of
receipt with the corresponding particulars entered in the cash book also helps in detecting cases of
teeming and lading or lapping.

Teeming and lading is one of the common methods of frauds retaliation got cash receipt and
involves postponing the entries of cash receipts to conceal a cash shortage. Where identical
amounts are received from various customers periodically, the amount received form the first

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customer is defalcated.

Lapping means the concealment of a cash shortage by delaying the recording of cash receipts.
Comparison of the daily entries in the cash receipts journal with bank despites may disclose this
type of fraud. Unless the money used by cashier is replaced the accounts receivable as a group
remain overstated. However, overstatement from one account receivable to another may avert to
protest from customers receiving monthly statements. It involves abstracting receipts from one
customers and convening the shortage with receipts form another customer which in turn are
covered with receipts from other customers received a day or so later.

Kiting. Manipulation causing an amount of cash to be included simultaneously in the balance of

two or more bank accounts is referred to as kitting. Auditors can detect kitting by preparing and
verifying a schedule of bank transfers for a few days before and after the balance sheet date. This
working paper lists all bank transfers and shows the dates that the receipt and disbursement of
cash journals and one bank statements.

ii. Special types of sales

In this section, we will discuss the specific audit procedures for certain special types of sales.
The audit procedures discussed below are procedures applicable in audit of sales. It may also be
noted that the specific audit procedures described in this section are also basically suggestive in
characters. The nature; timing and extent of audit procedures to be applied in a particular case
depend upon the facts and circumstances of the case.

iii. Consignment sales

Many companies or enterprise send goods on consignment to their agents, called consignees. An
invoice is sent to the consignee in respect of each consignment of goods sent to him. The
particulars of goods sent on consignments are entered in the consignment sales book. A separate
account is maintained for each consignee. The consignee sells the goods on behalf of the
enterprise and sends a period account of the transactions relating to the consignments through a
statement called account sales. This statement shows the value of sales made and the expenditure
incurred by the consignee during the period.

The auditor verifies the transactions relating to consignment sales through normal audit
procedures related ales.

iv. Contracts of construction

A number of enterprises undertake contracts involving construction of assets like bridge, dam or
building or a combination of assets. Normally, the construction activity under these contracts is
spread over more than an accounting period, i.e. the date on which the work on the contract
beings and the date on which it is completed fall into different accounting periods. The amount of

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each installment is based on the stage of completion of the work which in turn is determined and
certified by the engineers.

The audit of revenue from construction contracts is conducted through an appropriate

combination of compliance and substantive procedures applicable in the case of audit revenue
from sales of goods and from rendering of services. An important aspect to which the auditor has
to pay special attention in an audit of construction contracts is the recognition of revenue from
such contracts. The auditor has to examine whether the recognition of revenues is in accordance
with the recognized accounting principles as laid down in accounting standards. Two commonly
followed methods of accounting for construction contracts are the percentage of completion
method, and the completed contract method. Under the percentage of completion method,
revenue is recognized as the contract authority progress, based on the stage of completion
reached. The costs incurred in reaching the stage of completion are matched with the revenue.
Under the completed contract method, revenue is recognized only when the contracts completed
or substantially completed.

Activity 1. Understanding audit of sales

Take 10 minutes time
Purpose: Identify and describe internal control and audit over sales.
Describe the internal controls required in sales. What do you test in audit of sales?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
__________________________________________________________________
Comments: Read the above section/4.2.1/ and compare your answers with the possible solutions
given in the section

3.1.2. Audit of cash collection

The complete cash collection procedure includes the following steps.
1. Receipt of cash
2. Preprint of deposit
3. Recording cash receipts
4. Depositing
5. Bank reconciliation
Access to cash includes any activity that permits an employee to convert enterprise or company
receipts to his personal use. The employee proposing such and activity must not only have access
to cash but must have some expectation of getting it without detection. An irregularity once
committed may be either open or concealed. Open irregularities or shortage will be discovered if

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any one takes the trouble to ascertain whether the cash supposed to be present is actually there.
Concealed shortages will appear only if the method of concealment is detected.

Concealment of interruptions of cash receipts may be effected by:

Omission of entry
Manipulation of the records
Manipulation of documents
Evasion of control procedures
Internal control over cash is obtained by getting a record of the cash and then holding each
employee responsible for the amount shown by the recorded. Omission of entry of receipts is
often an effective way concealing a fraud.

ii) Manipulation of records

Two kinds of record manipulation are noted. Manipulation to reduce accountability for cash and
manipulation to reduce accountability for other assets without recoding an increase in the cash
account.

Any manipulation of the records that reduces the apparent accountability will serve to reduce the
discrepancy between the records and the cash actually on deposit and thereby conceal the
difference.

iii) Manipulation of documents

If an employee is able to initiate fictitious credit memorandum for sales returns and allowances he
can then pass credits to accounts receivable to cover irrigates of remittances. Authorization to
write off amounts of receivables as uncollectible may be used in the same way.

iv) Evasion of control procedures

Certain irregularities might be detected by control procedures as perpetuation of bank
reconciliation, reconciliation of subsidiary accounts with controlling account and sending
monthly statements to customers.

v) Preventing concealment
Concealment typically requires either access to the records or evasion of control producers. Those
employees who have access to cash should not record or post cash receipts, post accounts.
Receivable, prepare customers statements, authorize credit memorandums and reconcile the bank
account.

3.1.3. Controls over collection

Receipts should be banked daily. The receipts should be banked intact - for example no cash
payments should be made out of cash receipts. Banking intact allows control (d) below to operate.
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Each day's receipts should be recorded promptly in the cash book.

Sales ledger personnel should have no access to the cash or the preparation of the paying-in slip.
Periodically a comparison should be made between the split of cash and cheques:
Received (and recorded in rough cash book)
Banked (and recorded on paying-in slip).
The principal objectives of the auditors in their examination of receivable are to determine.
✓ The adequacy of internal control for receivables and sales transactions.
✓ The validity or geniuses of he recorded receivable.
✓ That all receivables are recorded.
✓ The approximate realizable value of group of assets.
✓ The accuracy of the year and cutoff sales and collection.
✓ The adequacy of disclosure and classification of receivables in the balance sheet,
including
✓ the separation of receivables in to appropriate categories and reporting of any pledging of
receivables and any related party transactions.

3.1.4. Audit procedures

The following audit procedures and substantive tests are typical of the work done in the
verification of notes and accounts receivables and sales transactions.
• Prepare a description of internal control for receivables and sales.
• Examine key controls for a sample of sales transactions.
• Compare at sample of shipping documents to related sales invoices.
• Review the use and authorization of credit memorandum.
• Reconcile selected cash register tapes and sales invoice or tickets with sales
journals.
• Review and confirm accounts and notes written off as uncollectible.
• Evaluate internal control for receivables and sales.
• Obtain or prepare aged trial balance of trade accounts receivables and analysis of
other accounts receivable.
• Obtain or prepare an analysis of notes receivable and related interest.
• Confirm accounts and notes receivable by direct communication with debtors.
• Determine adequacy of allowance for doubtful accounts and notes.
• Review the year end cut-off sales transaction

Activity 2. Understanding audit over cash collection

Take 10 minutes time
Purpose: Identify and describe internal control and audit over cash collection.
Describe the internal controls required in cash collection from cash sales and credit sales. how do
you test internal control over cash collection?
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___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
__________________________________________________________________
Comments: Read the above section/4.2.2/ and compare your answers with the possible solutions
given in the section

3.2. Internal Control over receivables

3.2.1. Nature of receivable
In section 2.1 we have discussed audit of one current asset type. The other current asset is
receivables, what do you know about it? Let’s see it together.

The sales and collection cycle including the receiving of orders from customers are delivery and
billing of merchandise to customers, and the recording and collection of receivables. Receivables
from customers include both accounts receivable and various types of notes receivable. The basic
sequence of activities and accounting in a receivable and collection cycle is:
✓ Receiving and processing customer orders: Entering data in an order system and obtaining
a credit check.
✓ Delivering goods and services to customers: Authorizing release from storekeeping to
shipping to customer. Entering shipping information in the accounting system
✓ Billing customers, producing sales invoices. Accounting for customer trade accounts
receivable.
✓ Collecting cash and depositing it in the bank.
✓ Accounting for cash receipts.
✓ Reconciling bank statements.

3.2.2. Internal Control Objectives for the sales accounts receivable:

✓ Each customer has a satisfactory credit rating.
✓ Invoice preparation for credit sales is based on authorized sales order.
✓ Goods cannot be dispatched without a properly authorized sales order.
✓ All appropriate records are updated.
✓ Overdue accounts are promptly followed up.
✓ Receipts from credit sales and cash sales are properly controlled.
✓ Receipts are adequately protected from theft and misappropriation.
✓ There are no unauthorized credit entries to the accounts receivable account.

3.2.3. Account receivable audit objectives:

Reasonableness:
✓ Compare the current accounts receivable balance to the prior year and
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investigate any significant fluctuations.

✓ Compare the accounts receivable turnover ratio to the industry average and
investigate any significant fluctuation.
Accuracy:
✓ Foot/base/ the accounts receivable subsidiary ledger.
✓ Test the accuracy of the aged accounts receivable schedule.
Completeness:
✓ Trace a sample of shipping documents to the sales journal to determine that
shipped goods were recorded as sales and to the accounts receivable subsidiary
ledger to determine that shipments were recorded as receivables.
✓ Account for the numerical sequence of shipping documents and sales invoices
to determine that all sales were recorded.
Disclosure:
✓ Determine that the direct write-off method is not used to recognize bad debts
expense.
✓ Obtain a client representation letter indicating that any accounts receivables
from affiliates, officers or employees are properly reported and disclosed in the
financial statements.
Ownership:
✓ Inquire of management whether discounted or pledged accounts receivables
exist and are properly disclosed in the financial statements.
✓ Examine bank confirmation forms to determine if accounts receivables have
been pledged as collateral for a bank loan.
Validity:
✓ Vouch a sample of accounts receivables subsidiary ledger accounts to shipping
documents to determine that recorded receivables are for goods actually
shipped.
✓ Confirm a sample of accounts receivables by direct communication with the
debtors.
Arrange with client personnel to select all large accounts (over $XX amount) and a representative
sample of other accounts (e.g., every 30th account) for confirmation.
Have the client print out confirmation requests and monthly statements, in triplicate, for all
accounts selected.
Review the client selection of accounts and agree data on confirmation form with accounts
receivable subsidiary ledger.
Mail the confirmation requests in self-addressed, stamped envelopes in the firm’s envelopes.
Mail second requests to those customers not replying after ten business days.
Retain the third copy of the confirmation requests and statements for control purposes and for use
in follow up of “no replies.”
For all returned confirmation requests:

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• Note postmark on reply envelope is appropriate.

• Investigate any discrepancies noted.
• Trace any payments indicated by customers to the cash receipts journal and accounts
receivable subsidiary ledger.
• Investigate all differences noted by customers.
For all “no replies”
• Trace the addresses to which we mailed confirmations to D & B, trade journals, or the
telephone directory.
• Substantiate the balances as described under “B” below.
Valuation:
• Agree the accounts receivable subsidiary ledger to the general ledger and the Balance
Sheet.
• Determine that accounts receivables are presented in the financial statements at net
realizable value.
• Review the adequacy of the Allowance for Doubtful Accounts.

Activity 3: Explain internal control of receivables and its audit

Take 20 minutes time
The aim of this activity is to help you to learn about internal control of receivables and its audit.
Credit sales is the sources of account receivable, in your organization list the sources of
receivables and internalize the system launched to control and test it. List and describe the audit
objective of receivables in your institution.

Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following
discussions.__________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Comments: Read the above sections and following section (for audit objectives) compare your
answers with the possible solutions given in the sections.

3.3. Audit program for receivable

Dear learners in above sub section internal control of receivables and its audit objectives are
explained. After you set an objective the next task is to formulate the audit programs. Let’s see it
how it can be done.

Risks
• the accounts receivable listing or individual balances may be inaccurate.
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• Accounts receivable balances may not exist.

• Accounts receivable may not be collectible.
• Bad debts write-offs may not be valid.
• Sales transactions may be processed in the wrong period.

Steps
1. Agree a detailed listing of accounts receivable to the summary
Obtain a detailed listing of accounts receivable balances (aged by customer, if possible) and: trace
totals to the comparative summary of accounts receivable balances; select reconciling items in
order to obtain a moderate to low level of assurance that accuracy is achieved and trace these
items to supporting documentation; and determine whether the results of the client's
investigations have been reviewed and approved by a responsible official; test, to an extent to
obtain a moderate to low level of assurance, the mathematical accuracy of the detailed listing; and
if appropriate, examine support for any significant adjustments made throughout the year in
reconciling detailed accounts receivable records with the account(s) in the general ledger.

2. Positively confirm selected accounts receivable balances

Select customers' account from the detail accounts receivable listing for positive confirmation in
order to obtain a moderate to low level of assurance that the aforementioned audit objectives are
achieved. Perform the following:
first send positive confirmation requests under our control. Where appropriate, send itemized
statements to customers to facilitate responses. Second requests and, where warranted, third
requests should be mailed when responses to positive confirmation requests have not been
received within a reasonable time. When management requests us not to confirm certain
accounts receivable balances, consider whether there are valid grounds for such a request. Before
accepting a refusal as justified, examine any available evidence to support management's
explanations. Finally summarize confirmation coverage.

3. Review confirmation replies

For confirmations returned:
a) Agree account information and account balance to detail listing;
b) Reconcile the account detail between the returned confirmation and the detail listing,
where applicable; and
c) Investigate all reconciling items and determine whether any adjustments are necessary.

4. Test accounts where there is no confirmation

When confirmation is not carried out, or where it is not possible to confirm a selected amount
(including where confirmation requests are unanswered), select customer accounts from the
detail accounts receivable listing for verification and perform the steps outlined below in
order to obtain a moderate to low level of assurance that the aforementioned audit objectives

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are achieved.
Compare subsequent remittances credited to accounts with remittance advices or other
receipts (e.g. deposit slips and bank statement) and ascertain that payments relate to the
account balances;
Examine documentation such as shipping documents, copies of sales invoices, customer sales
orders, and other relevant correspondence supporting the unpaid portion of the account balances.
Coordinate this test with the review of the collectability of overdue accounts
Consider whether it is necessary to verify further the existence of the customer.

5. Assess adequacy of allowance for doubtful accounts

To an extent based upon materiality and inherent risk, assess the adequacy of allowance for
doubtful accounts by performing the following procedures:
Obtain a list of accounts for which an allowance has been established. Review and test the
process used by management to develop their estimate of collectability;
Where provisions are made by the use of formulae based on the aged listing, determine by
reference to the details in the notes of the client's procedures whether the basis is:
✓ Consistent with prior years
✓ Appropriate to the circumstances of the business
✓ In accordance with the accounting policy
✓ determine the effect, if any, of the client's policies and experiences regarding the timing of
the passage of title, sales returns and allowances where right of return exists, and bill and
hold situations; and
✓ Discuss collectability with management and review other documentation supporting
collectability as necessary.

6. Review bad debt write offs

Review, in order to obtain a moderate to low level of assurance that valuation is achieved, bad
debt write offs by performing the following:
✓ consider the reasonableness of bad debt expense in light of the levels of bad debt write-
offs compared with prior years; and
✓ examine documentation relating to write-offs during the period and determine whether the
write-offs were properly authorized.

7. Test sales/accounts receivable cutoff

Accounts receivable cutoff testing is typically performed in conjunction with testing inventory
cutoff and may be tested in the Inventory audit area. If cutoff is tested in the Accounts receivable
audit area, perform the following:
✓ Select sales and credit memoranda to obtain a moderate to low level of assurance that
cutoff is achieved by reviewing the cutoff at the time of inventory taking and at year-end
(if different) and performing the following:

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• for selected sales for periods before and after the cutoff date, examine the related
records of goods shipped and services performed to determine that the sales invoices
are recorded as sales in the proper period;
• For selected credit (debit) memoranda for periods before and after the cutoff date,
examine the elated records of returns and claims from customers to determine that the
credit (debit) memoranda are recorded in the proper period;
• Determine whether there are unusually high volumes of returned goods after year-end;
and
• Consider unusual fluctuations in sales or return patterns before and after year-end and,
if present, review for possible cutoff errors.
3.3.1. Internal Control Questionnaires (ICQ)
Completion of an ICQ during the fieldwork may assist the auditor in identifying control
weaknesses.
General and specific questions are advisable in the questionnaire. When all questions and
answers have been evaluated, weaknesses in the adequacy of the systems controls may become
apparent. If any audit procedures identify that initial answers to the ICQ are not accurate, work
paper schedules should document reasons for the difference.
Items to be considered in each questionnaire are organizations, procedures and regulations. The
organization should have adequate segregation of duties. Procedures should describe the
authority and responsibilities, accounting data, data flow and reports
Assertion Transaction class Account balance
Category Audit objective Audit objective
recorded sales transactions represent goods Accounts receivable include all amounts
existence or shipped during the period. recorded cash owed by the customers exists at the balance
occurrence receipts transactions represent cash received sheet date.
during the period.
all sales, cash receipts sales adjustments that Accounts receivable include all claims on
Completeness occurred during the period have been customers at the balance sheet date.
recorded.
the entity has rights to the receivables and Accounts receivable at the balance sheet
rights and cash resulting from sales transactions. date represents legal claims of the entity.
obligations
Valuation all sales, cash receipts and sales adjustments Accounts receivable represent gross claims,
transactions are correctly journalized, on customers at the balance sheet date. the
summarized, and posted. allowance for uncollectible accounts
represent a reasonable estimate.
presentation ad the details of sales, cash receipts and sales Accounts receivables are properly identified
disclosure adjustments support their presentation in the and classified.
financial statements.
 Self Assessment Question 3.
Choose the correct answer and write the letter of your choice on space provided
____1. Which of the following can be used as substantive test for receivables and sales
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transactions?
A. Confirm receivable with debtors.
B. Perform analytical procedures.
C. Review the year-end cutoff of sales transactions.
D. All of the above.
____2. Which of the following is (are) primary audit objective for receivables/sales?
Clerical accuracy D. Statement Presentation
B. Existence E. All of the above
C. Valuation
______3. Which assertions relating to receivables/sales are addressed when auditors select a
sample of sales invoices and compare details to shipping documents?
A. Existence
B. Ownership
C. Valuation
D. All
_____4. The most important test of details of balances to determine the existence of recorded
accounts receivable is
A. tracing sales entries to shipping documents.
B. tracing the credits in accounts receivable to bank deposits.
C. tracing sales returns entries to credit memos issued and receiving room reports.
D. the confirmation of customers' balances.
_____5.The use of the positive form of receivables confirmation is preferred when
A. internal control surrounding accounts receivable is considered to be effective.
B. there is reason to believe that a substantial number of accounts may be in dispute.
C. a large number of small balances are involved.
D. there is reason to believe a significant portion of the requests will be made.
_____6. Most tests of accounts receivable and the allowance for uncollectible accounts are based
on
A. the general ledger balance of each account.
B. the results of analytical procedures.
C. the results of confirmations.
D. the aged trial balance.
_____7. The most important test of details of balances for accounts receivable is
A. confirmations.
B. recalculation of the aged receivables and uncollectible accounts.
C. tracing credit memos for returned merchandise to receiving room reports.
D. tracing from shipping documents to journals to the accounts receivable ledger.

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Chapter 4

Audit of Inventories and Cost of goods sold

4. Introduction
Dear Learners, stocks are often also known as inventories. They are anything which a firm has
which is not currently being used for one of the firm's functions. Most departments in the
company will have stocks of something. The factory may have stocks of raw materials ready to
produce, the office may have stocks of stationery and the warehouse may have stocks of finished
goods.

Stocks are vital to a company to help it function smoothly. If production had to be stopped every
time the firm ran out of raw materials, the time wasted would cost the firm a fortune. If a shop
had no stock on the shelves, customers would soon desert them. The same is true of most areas
the firm operates in. I am sure you can appreciate the importance of planning ahead and having
suitable levels of stocks.

After completing this chapter successfully, you will be able to:

✓ Describe the nature of inventories

✓ Explain the fundamental internal controls over inventories and cost of goods sold
✓ Identify the auditors’ objectives for the audit of inventories and cost of goods sold
✓ Identify appropriate audit procedures for inventories and cost of goods sold

Nature of Inventories

Inventories are Goods on hand at specific point of time which is held either for:
✓ Resale in the normal course of business
✓ Use in the manufacture of finished goods
✓ Use in the normal course of business
There are different types of inventories in different organizations. Raw materials inventories,
Work in process inventory, finished goods inventory, Supplies, are inventory types in
manufacturing businesses. Merchandise inventories and supplies are inventories held by
merchandising businesses.

4.1. Internal control over inventory and Cost of Goods Sold

You will be aware that there is a close link between inventory on the one hand and sales and
purchases on the other hand. in the light of this, you will not be surprised that many of the points
in this section have already been dealt with in covering sales and purchases

4.1.1. Control objectives

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Although inventory records may vary considerably from client to client, the controls are the
same in all cases, namely:
✓ Authorization and purchase procedures
✓ Control over goods inwards
✓ Inventory records supported by physical inventory counts
✓ Control over dispatches and goods outwards
✓ Adequate steps should be taken to identify all inventory for which provisions may be
required on the grounds that their net realizable value is below cost
✓ Inventory levels should be controlled so that materials are available when required but
that inventory is not unnecessarily large

4.1.2. Control procedures over inventory

Approval and control of documents
• Issues from inventories should be made only on properly authorized requisitions.
• Reviews of damaged, obsolete and slow moving inventor/ should be carried out. any
write-offs should be authorized.

Arithmetical accuracy
• All receipts and issues should be recorded on inventory cards, cross-referenced to the
appropriate GRN or requisition document.
• The costing department should allocate direct and overhead costs to the value of work-
in progress according to the stage of completion reached.
• To do this standard costs are normally used. such standards must be regularly
reviewed to ensure that they relate to actual costs being incurred.
• if the value of work-in-progress is directly comparable with the number of chapters
produced checks should periodically be made of actual chapters against work-in-
progress records.
Control accounts: Total inventory records may be maintained and integrated with the main
accounting system; if so they should be reconciled to detailed inventory records and
discrepancies investigated.
Comparison of assets to records:
• Inventory levels should be periodically checked against the records by a person
independent of the stores personnel, and material differences investigated.
• Where perpetual inventory records are not kept adequately a full inventory count should
be held at least once a year.

Activity 1: Understanding inventory audit.

Take 10 minutes time

This activity will help you to be familiar with internal control and audit of inventories.
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What are the internal Control objectives of inventories? List control procedures over inventory.
Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following
discussions.____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Comments: Read sections 4.2 and compare your answers with the possible solutions given in
the sections

4.2. Audit Program for Inventories & CGS

I. Obtain an understanding of internal control structure

o Assess control risk and design additional tests of controls for Inventories & CGS.
o Perform additional tests of controls for those controls necessary to support the
planned level of control risk
▪ Examine significant aspects of a sample of purchase transactions
▪ Test the cost accounting system
o Reassess control risk and modify substantive tests for Inventories & CGS.

II. Substantive Procedures for Inventories

Substantive Tests Audit Objectives
✓ Evaluate the client’s planning of physical inventory Existence & rights
✓ Observe the taking of physical inventory Completeness
✓ Review the year-end cut-off of purchases & sales
transactions
✓ Obtain a copy of the completed physical inventory, test
Existence & rights
its clerical accuracy and trace test counts
Completeness
✓ Review inventory condition and quality
valuation
✓ Evaluate the bases & methods of inventory pricing
✓ Test the pricing of inventories
✓ Perform analytical procedures.
Existence, Rights
Completeness, Valuation
✓ Determine whether any inventories have been pledged &
Valuation, disclosure, Presentation
review commitment
✓ Evaluation financial statement presentation and
Presentation & disclosure
disclosure

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 Self Assessment Question 4

Say true or false
1. Inventories play significant role in the preparation of both balance sheet and income statement.
2. The financial statement assertion of valuation is not related to inventories.
3. Adjustments to inventory records should be authorized.
2. Efficient and effective inventory taking requires careful planning in advance.
5. Auditors should not observe the quality or condition of inventories

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Chapter 5

Audits over Property, Plant and Equipment

5. Introduction
Fixed asset is an asset held with the intention of being used for the purpose of producing or
providing goods or services and is not held for sale in the normal course of business.

Acquisition of Property, Plant and Equipment is usually large in amount but concentrated in only
a few transactions. Individual items of plant and equipment may remain unchanged in the
accounts for many years. Because of these characteristics the auditors' approach is to emphasize
changes during the current year. In other words, the auditors verify the acquisitions and the
retirements of current period. The beginning balance of the plant and equipment accounts are
readily determinable from the prior year's audit working papers. If the auditors are satisfied with
the beginning balance and they verify fully the acquisitions and disposal of the current year, then
the ending balances will have fully established.

Dear Learner, after completing this chapter successfully, you will be able to:
✓ Describe the nature of inventories
✓ Explain the fundamental internal controls over Property, Plant and Equipment .
✓ Identify the auditors’ objectives for the audit of Property, Plant and Equipment .
✓ Identify appropriate audit procedures for Property, Plant and Equipment .

5.1. Internal control over Plant and Equipment

Control objectives:
The control objectives are to ensure that:
✓ Property, Plant and Equipment assets are correctly recorded, adequately secured and
properly maintained
✓ Acquisitions and disposals of Property, Plant and Equipment assets are properly
authorized
✓ Acquisitions and disposals of Property, Plant and Equipment assets are for the most
favorable price possible
✓ Property, Plant and Equipment assets are properly recorded, appropriately depreciated,
and written down where necessary.

5.2. The Property, Plant and Equipment Budget.

• Annual capital expenditure budgets should be prepared by someone directly responsible to
the board of directors.
• Such budgets should, if acceptable, be agreed by the board and put in the minutes.
• Applications for authority to incur capital expenditure should be submitted to the board
for approval and should contain reasons for the expenditure, estimated cost, and any
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Property, Plant and Equipment replaced.

• A document should show what is to be acquired and be signed as authorized by the board
or an authorized official.
• Property, Plant and Equipment manufactured or constructed by the company itself should
be separately identifiable in the company's costing records and should reflect direct costs
plus relevant overhead but not include any profit. This might apply where, for example, a
building company constructs its own office block.
• Disposal of Property, Plant and Equipment should be authorized and any proceeds from
sale should be related to the authority.
• A register of Property, Plant and Equipment should be maintained for each major group of
assets. The register should identify each item within that group and contain details of cost
and depreciation.
• A physical inspection of Property, Plant and Equipment should be carried out periodically
and checked to the Property, Plant and Equipment register. Any discrepancies should be
noted and investigated.
• Assets should be properly maintained and adequately insured.
• Depreciation rates should be authorized and a written statement of policy produced.
• Depreciation should be reviewed annually to assess the need for changes in the light of
profits or losses on disposal, new technology etc.
• The calculation of depreciation should be checked for accuracy.
• Property, Plant and Equipment should be reviewed for the need for any write-down.

Tests of controls:
• Check authorization of purchase to board minutes, capital expenditure budgets and capital
expenditure form.
• Check authorization for disposals of significant assets.
• Confirm existence of Property, Plant and Equipment register which adequately identifies
assets and comments on their current condition. Ensure register reconciles to nominal
ledger.
• Test evidence of reconciliation of register to physical checks of existence and condition of
assets.
• Check authorization of depreciation rates, and particularly changes in rates.
• Examine evidence of checking of correct calculations of depreciation.

5.3. Audit Program for Property plant and Equipment

While conducting an auditing of fixed asset the auditor aims at collecting sufficient appropriate
audit evidence to reasonably assure him regarding the following assertions.
Existence:
Property, Plant and Equipment included in the balance sheet exist on the balance sheet date.
Rights and Obligations
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The enterprise owns or otherwise has a legal right to all Property, Plant and Equipment
included in the balance sheet.
Completeness
Property, Plant and Equipment which are owned by the enterprise, or to which the enterprise
otherwise has a legal right on the balance sheet date, are included in the balance sheet.
Valuation
Property, Plant and Equipment are stated in the financial statements at appropriate amounts
in accordance with recognized accounting principles and relevant requirements.
Presentation and Disclosure
Property, Plant and Equipment are properly classified and disclosed in the financial statement
in accordance with the recognized accounting principles and relevant requirements.

5.4. Disposal of Property, Plant and Equipment

Subsequent expenditure relating to an item of fixed asset should be added to its cost only if it
increases the future benefits from existing asset beyond its previously assessed standard of
performance.
Important items retired from active use and held for disposal should be stated at the lower of their
net book value and net realizable value and shown separately in the financial statements.

5.4.1. Profit or Loss on Disposal

Any profit or loss on retirement to disposal of Property, Plant and Equipment should be dealt
with:
Any gain or loss arising from disposal or retirement of a fixed asset with is carried at cost should
be recognized in the profit and loss account.
When revalued item of fixed asset is disposed of or retired any gain or loss should be credited or
charged to the profit and loss account.

5.5. Evaluation of Internal Controls

The auditor studies and evaluates the internal controls relating to Property, Plant and Equipment
that cover:-
Segregation and rotation of duties
There should be a proper segregation of various duties in regards to Property, Plant and
Equipment . The following duties should be assigned to different persons:
• Authorization of acquisition and disposals
• Execution or transaction relating to acquisitions and disposals
• Recording of transaction
• Physical custody of items
Authorization of acquisition, transfer and disposal
The following aspects are particularly examined in this regard:
• Proposal of capital expenditure

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•
Proposal about the financial, commercial and technical aspects should be properly
laid down.
• Approval of the budget should be examined
Maintenance of records and documents:
The enterprise should maintain proper records of all Property, Plant and Equipment
Property, Plant and Equipment register should be maintained
Accountability for and safeguarding of Property, Plant and Equipment:
Property, Plant and Equipment should be given an identification number, location etc.
Property, Plant and Equipment should be adequately safeguarded
Property, Plant and Equipment should be properly insured

Substantive Procedures Relating to Property, Plant and Equipment

Based on the evaluation of the effectives of internal controls, the auditor determines the nature,
timing and extent of his substantive procedures relating to Property, Plant and Equipment.

These procedures usually include the following:

• Examination of records and documents
• Observation of physical verification carried out by management
• Examination of valuation and disclosure
• Carrying out analytical procedures
• Obtaining management representation
The above procedures are discussed as follows:

Examination of Records and Documents: an auditor should verify opening balances of fixed
asset from the schedules of Property, Plant and Equipment ledger of the previous year.
• Auditors should verify approval of appropriate authority, copies of purchase order
invoices, receiving reports and bank statements.
• Auditors should verify assets constructed and additions to Property, Plant and
Equipment during the year by examining work order records, statements of allocation
and apportionment of costs, certificate of work performed, contractor's bill, invoices
of supplies of materials and bank statement.

Observation of Physical Verification: it is the responsibility of the management of an enterprise

to carry out physical verification of Property, Plant and Equipment. The auditor, however,
observe, such verification, whenever possible. In any case he reviews the documents related to
such verification considered reasonable.
Examination of Valuation and Disclosure: the auditor should examine to detect whether the
Property, Plant and Equipment have been valued according to recognized accounting principles
and examine if depreciation has been provided properly keeping in view the recognized
accounting principles relating to depreciation.

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Analytical Procedures: the analytical procedures employed in an audit of Property, Plant and
Equipment includes additions or disposal, repair and maintenance expenses, tools written off and
deprecation.

Obtaining management Representations: the auditor should receive appropriate representation

from the management concerning Property, Plant and Equipment. Usually the auditors obtain
from the management a letter confirming that the net book values at which Property, Plant and
Equipment are stated in the balance sheet have been arrived at after additions and depreciation are
recognized.

Depreciation
Property, Plant and Equipment are disclosed in the balance sheet at their cost less accumulated
depreciation. The auditor examines whether depreciation had been provided in respect of all
depreciable assets.
The depreciable amount of depreciable assets should be allocated on a systematic basis to each
accounting period during useful life of the asset.
Depreciable asset should comprise items which
Is expected to be used for more than one accounting period
Has a limited useful life
Is held by the enterprise
Depreciable amount of depreciable assets refers to its historical cost or the revalued amount as
reduced by the estimated residual value. When an enterprise has revalued any of its Property,
Plant and Equipment, depreciations in respect of those assets should be changed on the revalued
amounts.

Activity 1: Audit of Property, Plant and Equipment assets.

Take 15 minutes time
The following activities will help you to familiarize with internal control over and audit of
Property, Plant and Equipment assets.
What are the control objectives of Property, Plant and Equipment ? List assertions in case of
plant asset audit. How do you evaluate your institution internal control over Property, Plant and
Equipment assets? What are the objectives of audit over Property, Plant and Equipment ?
Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following
discussions.__________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________

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Comments: Read sections4.6 and compare your answers with the possible solutions given in the
sections

Internal Control Questionnaire of Property, Plant and Equipment Over

Internal Control Questionnaire Property, Plant and Equipment
Audit objectives and Internal Control Questionnaire Date
Yes No N.A Remark
I. Existence assuring questions
1) Are Property, Plant and Equipment physically
safeguarded?
2) Are Property, Plant and Equipment adequately covered by
insurance?
3) Are physical inventories of Property, Plant and Equipment
taken periodically, by or under the supervision of,
employee not responsible for physical custody or record
keeping of such properties?
4) Does management in respect of assets reported as missing
or damaged take adequate follow-up action?
5) Are documents of title kept in safe custody and controlled
by register?
II. Acquiring of Property, Plant and Equipment
1. Is all capital expenditure subject to budget sanction by the
supervising authority?
2. Is expenditure in excess of that approved in the budget
submitted to the supervising authority for approval?
3. Is there an adequate procedure for ensuring that all Property,
Plant and Equipment ordered are received?
4. Are proper procedures in force for identifying and recording
own lab our and materials used in construction projects?
5. Is the progress on construction and capital works projects
regularly monitored and compared with budget by senior
management?
6. Are completed capital projects cleared promptly from
capital works in progress to completed fixed accounts?
7. Are there adequate procedures of distinguishing between
capital additions and repairs and maintenance expense?
Depreciation and disposal
1. Is depreciation calculated consistently in accordance with
laws?

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2 .Do the depreciation rates used accord with those prescribed

by the income tax regulations, or if not is it reasonable
under the circumstances?
3. Are adequate records maintained to ensure that depreciation
is not charged on assets that are already fully depreciated?
4. Is written authorization of management required for
disposals of Property, Plant and Equipment?
5. Are there written procedures as to how such disposals shall
be effected e.g. sale by public tender?
6. Are there adequate procedures to ensure that the accounts
department is promptly informed of all Property, Plant and
Equipment sold or scrapped?
7. Do procedures exist for canceling insurance coverage in
respect of fixed asset disposals?

 Self Assessment Question 5

Choose the correct answer and write the letter of your choice on space provided
_____1. The specific account balance audit objective, the entity owns or has rights to all
recorded plant assets at the balance sheet date, relates to the:
A. Rights and obligations
B. Completeness
C. Existence or occurrence
D. Valuation or allocation
E. Presentation or disclosure
_____2. Which of the following procedures would an auditor most likely perform in searching for
unrecorded payables?
A. Reconcile receiving reports with related cash payments made just prior to year-end.
B. Contrast the ratio of accounts payable to purchases with the prior year's ratio.
C. Vouch a sample of creditor balances to supporting invoices, receiving reports, and
purchase orders.
D. Compare cash payments occurring after the balance sheet date with the accounts
payable trial balance.
_____3. In the examination of property, plant, and equipment, the auditor tries to determine all of
the following except the
A. Adequacy of internal control.
B. Extent of property abandoned during the year.
C. Adequacy of replacement funds.
D. Reasonableness of the depreciation

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_____4. A normal audit procedure is to analyze the current year's repairs and maintenance
accounts to provide evidence in support of the audit proposition that
A. Expenditures for Property, Plant and Equipment have been recorded in the proper
period.
B. Capital expenditures have been properly authorized.
C. Non capitalizable expenditures have been properly expensed.
D. Expenditures for Property, Plant and Equipment have been capitalized.
______5. Determining that proper amounts of depreciation are expensed provides assurance
about management's assertions of valuation or allocation and
A. Presentation and disclosure.
B. Completeness.
C. Rights and obligations.
D. Existence or occurrence.

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Chapter 6

Audit of current liabilities

6. Introduction
Dear Learners, an accounts payable is short term obligations arising from the purchase of goods
and services in the ordinarily course of business. Transactions that create accounts payable
include the acquisition on credit of merchandise, raw material, plant assets, and office supplies.
Other sources of accounts payable include the receipts of services, such as legal and accounting
services, advertising, reports, and utilities. Interest bearing obligations should not be included in
accounts payable but shown separately as notes payables, bonds, and mortgages like sales and
collection cycle, purchase and payment cycle are day to day activities of any organizations. You
as an auditor try to understand the nature of those activities as you did in section

Since in a similar fashion like sales and collection cycle you will face in your audit operation.
Again try to recall about purchase transactions of merchandise business in your principle of
accounting?

At the end of this chapter, you will be able to:

✓ Describe the nature of accounts payable and accrued liabilities
✓ Discuss fundamental internal control over accounts payable and accrued liabilities
✓ Identify auditors’ objectives for accounts payable and accrued liabilities
✓ Discuss audit procedures for accounts payable and accrued liabilities
✓ Describe the purchasing process

Nature of account payable

An accounts payable is short term obligations arising form the purchase of goods and services in
the ordinarily course of business. Transactions that create accounts payable include the
acquisition on credit of merchandise, raw material, plant assets, and office supplies. Other sources
of accounts payable include the receipts of services, such as legal and accounting services,
advertising, reports, and utilities. Interest bearing obligations should not be included in accounts
payable but shown separately as notes payables, bonds, and mortgages.

6.1. Internal control over payable

The first essential of adequate control is the segregation of duties so that a cash disbursement to a
creditor will be made only upon approval of purchasing, receiving, accounting and finance
departments. All purchase transactions should be evidenced by serially numbered purchase
orders, copies of which are sent to the account payable department for comparison with vendors’
invoices receiving reports.
The receiving department should be independent of purchasing department. Receiving reports
should be prepared for all goods received. These documents should be serially numbered and
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prepared in a sufficient number of copies to permit notification of the receipt of goods to the
account payable department, purchase department and stores department.
The separation of the function of invoice verification and approval from the function of cash
disbursement is another step that tends to prevent error or fraud. Before invoices are approved for
payment, written evidence must be presented show that all aspects of the transaction have been
verified.

Another control procedure that the auditors may expect to find in a well managed accounts
payable department is regular monthly balancing of the detailed records of payables to the
general ledger controlling account. Monthly statements from vendors should be recounted with
payables ledger of list of open vouchers and any discrepancies fully investigated.
The auditors’ evaluation of internal controls is based on tests of transactions making up the
acquisition and payment cycle. These transactions involve the issuance of purchase orders, the
receiving of goods services, the recognition of the liability, and the issuance of cheques in
payment.

Audit objectives of accounts payable

Consider internal controls over accounts payable.
• Determine the existence of accounts payable and that the client has obligation to pay them
• Establish the completeness of account payable.
• Determine that accounts payable are valued appropriately.
• Establish the clerical accuracy of schedules of accounts payable.
• Determine that the presentation and disclosure of payable is appropriate. Payments affect
almost all account relating to expenses, assets and liabilities. Thus audit of payment is a
significant part of an independent and internal audit.

The audit of payables

• Prepare a description of the internal control for accounts payable and conduct a system
audit.
• Verify posting to the payables controlling account for a test period.
• Vouch to supporting documents entries in the voucher register or inspected accounts
payable subsidiary ledger.
• Review cash discounts.
• Evaluate internal controls.
• Determine proper balance sheet presentation of account payable.
6.2. Audit Program for Account Payables and other Liabilities

Audit Over Payroll and Personnel Expenditure/Accrued Liabilities

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The payroll in many enterprises is by far the largest operating cost and therefore, deserves the
close attention of the auditors. In the past payroll frauds were common and often substantial.
Today, payroll frauds are more difficult to conceal for several reasons.

Internal control over payroll

Control objectives
The control objectives in respect of a wages and salaries system are as follows:
Payment of wages and salaries should be made only in respect of the client's authorized
employees.
Payment should be made at authorized rates of pay.
Wages and salaries payments should be in accordance with records of work performed, e.g. time,
output, commissions on sales.
Payroll and payroll deductions (tax and social security) should be calculated accurately.
Payment should be made to the correct employees.
Liabilities to the tax authorities for tax and social security should be properly recorded

Control procedures - wages and salaries

Approval and control of documents
• There should be written authorization to employ or dismiss any employee.
• Changes in rates of pay should be authorized in writing by an official outside the
wages department.
• Overtime worked should be authorized in advance by a manager/supervisor,
• An independent official should review the payroll and sign it.
• The wages cheque should be signed by two signatories and agreed with the signed
payroll.
• Where weekly pay relates to hours at work, clock cards should be used. There
should be a supervision of the cards and the timing devices, particularly when
employees are clocking-on or off.
• Where a piece work system operates, payment should only be made for work of
an appropriate quality which has been inspected and approved.
• Personnel records should be kept independently of the payroll department for
each employee
• giving details of engagement, retirement, dismissal or resignation, rates of pay,
holidays etc, with a specimen signature of the employee.
• A wages supervisor should be appointed who could perform some of the
authorization duties listed above.
Arithmetical accuracy
• Where appropriate, payroll should be prepared from clock cards, job cards etc, and
a sample checked for accuracy against current 'rates of pay.
• Payroll details should be checked for '.he accurate calculation of deductions e.g.
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tax, social security, pensions, trade union subscriptions etc Control accounts
• Control accounts should be maintained in respect of each of the deductions
showing amounts paid periodically to the inland Revenue, trade unions etc.
• Overall analytical checks should be carried out to highlight major discrepancies
e.g. check
• against budgets, changes in amounts paid over a period of time, check against
personnel records.
• Management should exercise overall review and control.

Access to assets and records. Ideally, payment should be made by cheque or by direct transfer
into the employees’ bank account. If payment is made in cash, the following procedures should
be in place:
• Employees should sign for their wages.
• No employee should be allowed to take the wages of another employee.
• When wages are claimed late, the employee should sign for the wage packet and
the release of the packet should be authorized.
• The system should preferably allow the wages to be checked by the employee
before the packet is opened, by using specially designed wage packets.
• The wages department should preferably be a separate department with their
personnel not involved with receipts or payments functions.
• The duties of the wages staff should preferably be rotated during the year, and
ensure that no employee is responsible for all the functions in respect of any
particular department.
• The employee making up the pay packets should not be the employee who
prepares the payroll.
• A surprise attendance at the pay-out should be made periodically by an
independent official.
• Unclaimed wages should be recorded in a register and held by someone outside
the wages department until claimed or until a predefined period after which the
money should be re-banked.
• An official should investigate the reason for unclaimed wages as soon as possible.

Tests of Controls - Wages and Salaries

A suggested program of tests of control is set out below. This can, of course, be modified to suit
the particular circumstances of the client.
• Test sample of time sheets, clock cards or other records, for approval by responsible
official. Pay particular attention to the approval of overtime where relevant.
• Test authority for payment of casual labor, particularly if in cash.

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• Observe wages distribution for adherence to procedures ensuring employees sign for
wages, that unclaimed wages are re-banked etc.
• Test authorization for payroll amendments by reference to personnel records.
• Test control over payroll amendments.
• Examine evidence of checking of payroll calculations (e.g. a signature of the financial
• controller).
• Examine evidence of approval of payrolls by a responsible official.
• Examine evidence of independent checks of payrolls (e.g. by internal audit).
• Inspect payroll reconciliations.
• Examine explanations for payroll expense variances.
• Test authorities for payroll deductions.
• Test controls over unclaimed wages

Audit objective of payroll audit

The principal objectives of the auditors in the examination of payroll are
• To determine that he authorized records and procedures are so designed and
operated as to provide adequate internal control.
• To determine that the client and enterprise have complied with government
regulation concerning pension plan, wages, income tax withholdings etc.
• To suggest methods of simplifying and improving payroll procedures.

Activity 4. Understanding audit over payroll and personnel expenditure

Take 15 minutes time
Purpose: Identify and describe internal control and audit over payroll.
Describe the internal controls required in payroll and personnel expenditure. How do you test
internal control over payroll and personnel expenditure?
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
___________________________________________________________________
__________________________________________________________________
Comments: Read the above section/6.3/ and compare your answers with the possible solutions
given in the section

Standard audit procedures for wages and salaries

Wages and salaries constitute major items of expenses in the case of most enterprises. As wages
and salaries involve payments to a large number of persons and the supporting document is

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generally internal, this area is susptible to fraud and error. Audit of wages and salaries, therefore,
has to be given special attention.
Audit of wages and salaries is carried out by the auditor in the following two sages:
• Study of the accounting system and internal controls relating to wages and salaries and
their evaluation through compliance procedure; and
• Application of standard audit procedures for wages and salaries

Study and evaluation of accounting system and internal controls

You have to study and evaluate the accounting system and internal controls relating to wages and
salaries to determine the nature, timing and extent of the procedures to be applied in this area. In
evaluating the effectiveness of internal controls, you have to examine the adequacy of segregation
and rotation of duties, procedures for authorization of transactions, adequacy of records and
documents maintained in support of transactions, procedures for securing accountability and
safeguarding of related assets, and independent checks on performance.

Standard audit procedures for wages and salaries

On the basis of your evaluation of the internal controls relating to wages and salaries, you have to
decide the nature and timing of the audit procedures to be used in this area. The standard audit
procedures for wages and salaries consist of the following:
• Detailed examination of the payroll
• Detailed examination of the wages and salaries of a few selected employees; and
• Application of analytical procedures.
Detailed examination of the payroll: payroll of selected month is checked as follows:
• Examine the primary employee data. This includes name, wage rate, record of
o attendance, etc with reference to the records kept by the personnel department.
o Check the computation of wages and salaries payable on the basis of the verified
o primary data and other relevant factors such as contribution to saving and credit
o associations and contributions to pension funds.
• Check the arithmetical accuracy of the payroll, i.e., additions, subtraction.
• Examine the receipts/acknowledgements by employees. (See whether the employees
o have signed on receipt of their salary and wages.)
• Examine the deductions made in respect of income tax, contributions to pension
o funds, and others with reference to the returns submitted to the authorities
concerned.
• Examine whether the amounts remaining undisbursed (unclaimed wages and salaries)have
been deposited. Examine the vouchers relating to subsequent disbursement of unclaimed
wages and salaries.
• Examine the statement of unclaimed wages as well as the list of persons to whom wages
were paid on the basis an authority letter. If certain names are repeated this may be an
indication that they are fictitious, dummy or retired workers. In such a case, the auditor

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may decide to carry out further audit procedure; for example, the auditors may examine
the detailed attendance records in respect of such workers.

Detailed examination of wages and salaries of selected employees:

• Select a few employees using sampling techniques (it could be random or based on the
auditors judgment)
• Examine the wages and salaries paid to the selected employees during the year in
depth with reference to their personnel records, detailed attendance records, and other
supporting data. This procedure helps you to evaluate whether wages and salaries are
accurately determined and properly disbursed.
Application of analytical procedures: Salaries and wages usually have consistent pattern over
several years, Applying analytical procedures helps an auditor to identify unusual fluctuations of
wages and salaries. The most common analytical procedures in auditing wages and salaries are
presented below:

• Compute the ratio of total wage bill for the year to the wage bill of the previous year.
• Compare the ration of the total wages and salaries to total sales and cost of goods sold
for the current year with corresponding fingers for the previous year.
• Compare the ratio of contributions to pension fund to total wages and salaries for the
current year with the corresponding figures for previous years as well as with the rates
of contribution specified in the relevant law.

6.3. Audit over Purchase and Payment Cycle

Audit over purchase

Internal control
Purchase transaction usually begins with a purchase reacquisition being generated by department
or support function. The purchasing department prepares a purchase order for the purchase of
goods or services from a vender when the goods are received or the services are been rendered,
the entity records a liability to the vender. Finally, the entity makes payment to the vender.
The three major types of transactions are processed through the purchasing cycle.
• Purchase of goods and services for cash or credit
• Payment of the liabilities arising from such purchases.
• Return of goods to suppliers for cash or credit.

The types of documents and records involved in the purchasing cycle Include.
Purchase requisitions – this document is a request for goods or services by authorized individual
department within the entity. Example of such requests includes an order for raw materials for
production from the production management department, an order for newspaper advertising
space from a marketing manager.
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Purchase order – this document includes the description, quality and quantity of and other
information as date of delivery, credit terms means of transportation, the purchase order also
indicates the person who approved the acquisition and represents the authorization to purchase
the goods or services.

Receiving report - this document is used to record the receipts of goods. Normally, the
receiving report is a copy of the purchase order with the quantities omitted. This procedure
encourages receiving department personnel to make adequate, independent count of the goods
received. Receiving department personnel records the date, description, quantity and other
Information or this document.

Vender invoice – this document is the bill from the vender. The Vender invoice or purchase
invoice includes the description and quantity of goods shipped or services rendered the prices
including freight costs, insurance the terms of trade including cash discounts and date billed.

Voucher – this is a document that is frequently used by entities to control payment for acquired
goods and services. This document serves as basis for recording a venders invoices into voucher
register or purchase journal the voucher is attached to the purchase reacquisition, purchase order,
receiving report, and vender invoices to create a voucher packet – this vouch example Include
check payment voucher,
Accounts payable – is an account used to record all vender invoices, cash disbursements and
adjustment in individual vender accounts.

General ledger – proper accumulation, classification and summarization of purchases, cash

disbursement and payable in the general ledger.

Control procedures and tests of controls

There are seven control procedures applied for control of purchase Transactions.

Validity - the Auditors concern in testing of the validity of purchase transaction is that factious or
non-existent purchase may have been recorded in the clients records. If fraudulent transactions
are recorded, assets or expenses will be overstated. A liability will also be recorded and a
resulting payment made, usually to the individuals who initiated the factious purchase
transactions proper segregation is the control test for preventing factious purchases. The critical
segregation of duties is the separation of the reacquisition, and purchasing functions from the
accounts payable and disbursement functions.

Completeness of purchase transaction- If the client fails to record a purchase that has been
made assets or expenses will be understated and the corresponding accounts payable will also

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understate. Control Test that provides assurance that the completeness objective is being met
includes accounting or checking the numerical sequence of purchase orders, receiving Reports,
and Vouchers; matching receiving vouchers with vender invoices, etc.

Timeliness of recording of purchase transaction - the client should have controls to ensure that
purchase transactions are recorded or timely basis (in a proper time). For example, the client’s
procedure should require that all receiving reports should be forwarded to the accounts payable
department or section on daily basis.

Authorization of purchase transaction - possible misstatements due to improper authorization

includes the purchase of unauthorized goods and the purchase of goods or services at
unauthorized price or terms. The major control procedure to prevent these misstatements is the
use of authorization schedule or table which shows the amount that different levels of employees
(personnel) are authorized to purchase.

Valuation of purchase transactions - The possible misstatements for valuation of Internal

control objective is that purchase transactions may be recorded at in correct amounts due to
improper pricing or erroneous calculation.

Classification of purchases - Proper classification of purchase transactions is an important

internal control objective for the purchasing cycle. If purchase transactions are not properly
classified, asset and expense accounts will be misstated. A control test for this objective is proper
documentation and records for example having chart of accounts.

Segregation of duties – the major segregation of duties to control purchasing transactions

including the following

The purchasing function should be separated from the requisitioning and Receiving functions
(that is separate Individuals should involve in each functions.
The invoice (vender invoice) processing function should be segregated from the accounts payable
function.
The account payable function should be segregated from the general ledger function.

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Self Assessment Question 6

Part I: Write true if the statement is correct and false if incorrect on the space provided
______1. An accounts payable is short term obligations
______2. Transactions that create accounts payable include the acquisition on credit of
merchandise, raw material, plant assets, and office supplies
______3. The auditors’ evaluation of internal control over receivables is based n tests of
transactions making up the acquisition and payment cycle
______4. Establish the completeness of account payable is not audit objectives of accounts
payable

Part II: Fill the Blank Space

1. The first essential of adequate control over payable is ______________
2. In examination of payables what are the considerations?
____________,____________,__________________________,

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Chapter 7

Audit of Debt and Equity capital

7. Introduction
Dear learners, try to recall what liabilities and equity capital are from your accounting courses.
Long term liability represents financial obligation of an enterprise of a long term payment and
Equity capital is the net asset or the net worth.

At the end of this chapter you will be able

✓ Describe internal control over interest bearing debt
✓ Discuss audit programs for interest bearing debt
✓ Discuss internal control over equity capital and dividends
✓ Identify audit program for capital stock
✓ Identify Disclosure of contingencies

Auditing Interest-Bearing Debts

Sources and Nature of Interest-Bearing Debts

• May include debentures, secured bonds, notes payable, and mortgages
• Supported by formal documents such as indenture or trust indenture
• Substantial in amount
• Usually involve covenants as a means of protecting the creditors
• May be convertibles, callable
• May be secured or unsecured
• May require establishment of sinking funds
• Debt covenants may contain various restrictions such as prohibiting:
• dividend declaration
• Acquisition of plant assets
• Additional loans
• Increasing managerial salaries
• Maintenance of certain financial rations
• Maintenance of defined working capital & tangible net worth
The Auditors’ Objectives for Interest-Bearing Debts
• Consider internal control over Interest-Bearing Debts
• Determine the existence of recorded interest-bearing debts
• Determine that the client has the obligation to pay liabilities in the future

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• Establish the completeness of recorded interest-bearing debts

• Valuation as per IFRS
• Clerical accuracy of schedules
• Presentation and disclosure
• In auditing interest-bearing debt, the auditor should also deal with related items such as
interest expense, interest payable, and bond discount and premium.
• The primary concern of the auditor in auditing interest-bearing debt is understatement of
debts.
7.1. Internal control over Interest-Bearing Debts

a. Financing proposal by the treasurer, containing:

• Explanation for the need for funds
• Effect of borrowing on future borrowing
• Estimated financial position before and after borrowing
• Alternative method of financing
b. Authorization by the Board of Directors
• Authorization to incur the debt
• Review and approval of the following
• The choice of a bank or trustee
• Type of security
• Registration with concerned authority (eg. SEC)
• Compliance with requirements of the state of incorporation
• Listing of bonds on a securities exchange
c. Use of independent trustee (large banks)
• Protection of the creditors’ interest
• Monitor the issuing company’s compliance with the provisions of the
indenture
• Maintains the detailed records of the names and addresses of the registered
owners
• Cancel old bond certificates
• Issue new bonds
• Distributes interest & principal payments
The use of independent trustee largely solves the problem of internal control over interest bearing
debts, specially bonds in that it:
• Limits the trustee's access to the issuing company’s assets or records
• Provides legal responsibility for its actions

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7.2. Audit Program for Interest Bearing Debt

Substantive tests Primary Audit Objectives
✓ Obtain analysis of interest-bearing debt and related Clerical accuracy
accounts
✓ Examine copies of Ns/P and supporting documents Completeness, existence and
✓ Confirm interest-bearing debt obligations
✓ Vouch borrowing & repayment transactions
✓ Perform analytical procedures Completeness
✓ Test computations of interest expense, interest payable, & Existence & obligation,
amortization of discount & premium Valuation
✓ Evaluate whether debt provisions have been met Presentation & disclosure
✓ Trace authority for issuance of debt to corporate minutes
✓ Review notes payable paid or renewed after the balance sheet
date
✓ Perform procedures to identify Ns/P to related parties
✓ Send confirmation letters about financing arrangements
✓ Evaluate financial statement presentation & disclosure

Auditing Equity Capital

Sources and Nature of Equity Capital

• Consists of capital stock accounts and retained earnings

• Changes capital stock originates from issuance of new stock and repurchase of
stock
• Few transactions affect owner’s equity, but material in amount
• Requires less audit time as compared to other financial statement items

Auditors’ Objectives for Equity Capital

• Consider internal control over equity capital
• Existence of recorded equity
• Completeness of recorded equity
• Valuation as per IFRS
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• Clerical accuracy of schedules

• Presentation and disclosure

7.3. Internal Control for Equity Capital and Dividends

1. Proper authorization of transactions by BOD & Corporate officers
• No. of shares to be issued
• Stock price
• Terms for installment payments (if any)
• Exchange & valuation of shares for plant assets (if any)
• Transfers from retained earnings to capital stock & paid in capital accounts for
stock dividend
• Stock split
• Changes in par or stated value of shares
• Resolution with respect to:
• Signing stock certificate
• Maintaining records of stockholders
• Custody of unissued certificate
• Signing dividend checks
• Dividend authorization
• Dividend amount
• Date of record
• Date of payment

2. Segregation of duties for related transactions

3. Maintain adequate records
4. Use independent agent as stock registrar and stock transfer agent
Responsibilities of Stock Registrar:
• Control over issuance of stock
• Verify the issuance of stock certificate as per the Article of
Incorporation or BOD authorization
• Maintain records of total shares issued & canceled

Responsibilities of stock transfer agent:

• Maintain detailed stockholders records, including names and
addresses of each stockholder
• Carryout transfer of stock ownership
•
7.4. Audit program for stockholders equity
The following are the appropriate audit procedure for stockholders equity

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• Obtain an understanding of internal control over capital stock transactions

• Review the articles of incorporation, by laws, and minutes of provision relating to
capital stock
• Obtain and prepare analysis of the capital stock account
• Check authorized capital limit to legislation and company constitution documents
• Check changes to issues capital in year and agree in board minute
• Trace all transactions involved stockholders equity
• Ensure that any necessary registration have been made and that the company’s register
of members has been updated
• For a corporation acting as its own stock register and transfer agent, reconcile the
stock holders records with the general ledger
• Ensure appropriate disclosure as their debt or equity
• Ensure that all transactions are legal and that premiums in particular have been
accounted for properly
The stock holder equity of a corporation consists contributed capital, retained earnings,
and dividend. We have seen audit about contributed capital. Now let’s see about audit
procedure for retained earning and dividend briefly.

7.5. Retained earning and dividend

Audit work on retained earning and dividend includes: a) the analysis of retained earning and any
appropriation of it, and b) the review of dividend procedure for all types of dividend.
You should analyze the retained earnings and any appropriation of retained earning by looking in
to the history of these accounts. Appropriation of retained require specific authorization of the
board of directors. Thus you have to verify whether the dates and amounts of these entries
correspond to the action of the board of directors.
In audit of cash dividend perform the following:
• Determine the date and amount of dividend authorized
• Verify the amount paid
• Determine the amount of any preferred dividend in arrears
• Review the treatments of unclaimed dividend checks
When you review minutes of board of directors meeting, you should note the date and the amount
of each dividend declaration. These serve to establish the authority for dividend disbursement.
The dividend payment may be verified by multiplying the total number of shares by the dividend
per share.

When you review dividend declaration, you may discover the existence of cash dividend declared
but not paid. This must be shown as liability in the balance sheet.
The final procedure in auditing in auditing stockholders equity is ensuring presentation in
financial statement.
The presentation of capital stock in the balance sheet should include a complete description of
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each issue, par or stated value, dividend rate, dividend preference, number of shares authorized or
issued, in treasury, dividend in arrears and shares reserved for stock option and conversions.

Activity 1: Understanding the audit and internal control of equities and retained
earnings.

Take 20 minutes time

The following activity is designed to make you familiar with internal control over equity and
retained earning.
Mention appropriate audit procedure for stockholders equity. What are the steps you use in audit
of cash dividend?
Give your answers on the space provided below. It will be helpful if you try this activity before
you proceed to the following
discussions.____________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________
______________________________________________________________________________

Comments: Read sections 7.2.3 and compare your answers with the possible solutions given in
the sections
7.6. Disclosure of Contingencies
Nature of Loss contingencies
• A probable that will be resolved as to existence and amount by some future events
• Stems from past events
• Characterized by uncertainty as to the amount & whether any loss has been incurred
• May be classified in to three categories:
1. Loss contingencies that can be accrued
✓ Criteria: Probable & reasonably estimated
✓ May involve the recognition of a liability or reduction of an asset
✓ Disclosure required: description of the nature of contingency in notes to
financial statements, & exposure to loss in excess of the amount accrued
2. Loss contingencies that should be disclosed only
✓ Criteria: Reasonably possible
✓ Disclosure needed: description of the nature of contingency, estimate of
the possible loss (single or range of values), or a statement that an
estimate cannot be possible
3. Loss contingencies those are neither accrued nor disclosed
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✓ Criteria: The chance of occurrence is remote

✓ The common examples of loss contingencies include pending or
threatened litigation, income tax disputes, guarantees, & accounts
receivable sold with recourse.
✓

7.6.1. Audit Procedures for Loss contingencies

1. Review the minutes of the directors’ meetings
✓ Information to be obtained: contracts,, law suits, & dealings with subsidiaries
2. Send confirmation letters to financial institutions to request information on contingent
liabilities & guarantees
3. Obtain a representation letter from the client indicating that all liabilities have been
recorded
4. Send a letter of inquiry (lawyer's letter) to the client’s legal counsel
What should be requested?
✓ Description (evaluation of management’s description) of loss contingencies and
unasserted claims (legal actions to be initiated)
✓ An evaluation of the likelihood of an unfavorable outcomes of the contingencies
✓ An estimate of the probable loss or range of loss, or a statement that an estimate cannot be
made.
✓ An evaluation of management’s description of unasserted claims
✓ A statement of the amount of any unbilled legal fees

7.7. Audit of Accounting Estimate

Accounting estimate means an approximation of the amount of an item in the absence of a
precise means of measurement. Some examples are set out below:
✓ Allowances to reduce stocks and debtors to their estimated realizable value.
✓ Depreciation provisions.
✓ Accrued revenue.
✓ Provision for deferred taxation.
✓ Provision for a loss from a lawsuit.
✓ Profits or losses on construction contracts in progress.
✓ Provision to meet warranty claims.
Management is responsible for making accounting estimates included in financial statements.
These estimates are often made in conditions of uncertainty regarding the outcome of events that
have occurred or are likely to occur and involve the use of judgment. As a result, audit evidence
obtained is generally less conclusive when accounting estimates are involved. Consequently, in
assessing the sufficiency and appropriateness of audit evidence on which to base the audit
opinion, auditors are more likely to need to exercise judgment in their consideration of
accounting estimates than in other areas of the audit.

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7.7.1. The nature of accounting estimates

The determination of an accounting estimate may be simple or complex depending upon the
nature of the item. For example, accruing a charge for rent may be a simple calculation, whereas
estimating a provision for slow-moving or surplus stock may involve considerable analyses of
current data and a forecast of future sales. In making complex estimates, there may be a high
degree of special knowledge and judgment required.

Accounting estimates may be determined as part of the routine accounting system operating on a
continuing basis, or may be non routine, determined only at the period end. In many cases,
accounting estimates are made by using a formula based on experience, such as the use of
standard rates for depreciating each category of Property, Plant and Equipment or a standard
percentage of sales revenue for computing a warranty provision. In such cases, the formula needs
to be reviewed regularly by management, for example, by reassessing the remaining useful lives
of assets or by comparing actual results with the estimate and adjusting the formula when
necessary.

If the uncertainty associated with an item, or the lack of objective data makes it incapable of
reasonable estimation, auditors would consider its impact on the auditors' report in accordance
with SAS 600 "Auditors' reports on financial statements".
a. Auditors would consider whether the circumstances surrounding the uncertainty are adequately
disclosed in the notes to the financial statements and, if so, to include a paragraph of added
emphasis in the basis of opinion section of their report.
b. Alternatively, if the auditors conclude that disclosure is inadequate their report would be
qualified for disagreement.

7.7.2. Audit procedures

Auditors should obtain sufficient appropriate audit evidence to conclude as to whether an
accounting estimate is reasonable in the circumstances and, when required, is appropriately
disclosed.
The evidence available to support an accounting estimate will often be more difficult to obtain
and less conclusive than evidence available to support other items in the financial statements. An
understanding of the procedures and methods, including the accounting and internal control
systems, used by management in making the accounting estimates is often important for auditors
to plan the nature, timing and extent of the audit procedures.

Auditors should adopt one or a combination of the following approaches in the audit of an
accounting estimate:
A. review and test the process used by management to develop the estimate;
B. use an independent estimate for comparison with that prepared by management; or

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C. review subsequent events.

7.7.3. Review and testing the process used by management

The steps ordinarily involved in reviewing and testing the process used by management are:
A. evaluation of the data and consideration of assumptions on which the estimate is based;
B. testing of the calculations involved in the estimate;
C. comparison, when possible, of estimates made for the purposes of the preparation of prior
period financial statements with subsequent actual outcomes;
D. consideration of management's approval procedures; and
E. obtaining management representations.

7.7.4. Evaluation of data and consideration of assumptions

Auditors evaluate whether the data on which the estimate is based is accurate, complete, relevant
and consistent with other information obtained in the course of the audit. For example, in
substantiating a warranty provision, auditors may obtain audit evidence that the data relating to
products still within the warranty period at period end agrees with the sales information within
the accounting system.

Auditors may seek evidence from sources outside the entity. For example, when examining a
provision for stock obsolescence calculated by reference to anticipated future sales, auditors may,
seek evidence from industry-produced sales projections and market analyses. Similarly when
examining management's estimates of the financial implications of litigation and claims, auditors
may seek direct communication with the entity's lawyers in accordance with SAS 401. Auditors
evaluate whether the data collected is appropriately analyzed and projected to form a reasonable
basis for determining the accounting estimate. Examples are the analysis of the age of debtors and
the projection of the number of months of supply on hand of an item of stock based on past and
forecast usage.
Auditors evaluate whether the entity has an appropriate base for the principal assumptions used in
the accounting estimate. In some cases, the assumptions will be based on industry or government
statistics, such as future inflation rates, interest rates, employment rates and anticipated market
growth. In other cases, the assumptions will be specific to the entity and will be based on
internally generated data.

In evaluating the assumptions on which the estimate is based, auditors may consider, among other
things, matters set out below.
Whether they are reasonable in light of actual results in prior periods.
Whether they are consistent with those used for other accounting estimates.
Whether they are consistent with management's plans.

Auditors would pay particular attention to assumptions which are sensitive to variation,

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subjective or susceptible to material misstatement and carry out sensitivity analyses to provide a
quantitative understanding of any exposure to variation.

In the case of complex estimating processes involving specialized techniques, it may be necessary
for auditors to use the work of an expert. For example, engineers can estimate quantities in stock
piles of mineral ores in accordance with SAS 520 "Using the work of an expert".
Auditors review the continuing appropriateness of formulae used by management in the
preparation of accounting estimates. Such a review would reflect the auditors' knowledge of the
financial results of the entity in prior periods, practices used by other entities in the industry and
the future plans of management as disclosed to the auditors.

Testing of calculations
Auditors test the calculation procedures used by management. The nature, timing and extent of
the auditors' testing depend on such factors as the complexity involved in calculating the
accounting estimate, the auditors' evaluation of the procedures and methods used by the entity in
producing the estimate and the materiality of the estimate in the context of the financial
statements.

7.7.5. Comparison of previous estimates with actual results

When possible, auditors compare accounting estimates made for the purposes of the preparation
of prior period financial statements with subsequent actual outcomes to assist in:
A. obtaining evidence about the general reliability of management's estimating procedures;
B. considering whether adjustments to estimating formulae may be required; and
C. evaluating whether differences between actual results and previous estimates have been
quantified and that, where necessary, appropriate adjustments or disclosures have been made.

7.7.6. Consideration of management's approval procedures

Material accounting estimates are ordinarily reviewed and approved by management. Auditors
would consider whether such review and approval is performed by the appropriate level of
management and is evidenced in the documentation supporting the determination of the
accounting estimate.

7.7.7. Management representations

Auditors would consider seeking specific written representations from management in respect to
material accounting estimates and in respect to the assumptions which underline them.

7.7.8. Use of an independent estimate

Auditors may make or obtain an independent estimate and compare it with the accounting
estimate prepared by management. When using an independent estimate auditor would ordinarily
evaluate the data and consider the assumptions, and may test the calculation procedures used in

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its development. It may also be appropriate to compare accounting estimates made for prior
periods with actual results of those periods.

7.7.9. Review of subsequent events

Transactions and events which occur after the period end, but prior to completion of the audit,
may provide audit evidence regarding an accounting estimate made by management. Auditors'
reviews of such transactions and events may reduce, or even remove, the need for the auditors to
review and test the process used by management to develop the accounting estimate or to use an
independent estimate in assessing the reasonableness of the accounting estimate.

7.7.10. Evaluation of results of audit procedures

Auditors should make a final assessment of the reasonableness of the estimate based on the
auditors' knowledge of the business and whether the estimate is consistent with other audit
evidence obtained during the audit.

Because of the uncertainties inherent in accounting estimates, evaluating differences can be more
difficult than in other areas of the audit. When there is a difference between the auditors' estimate
of the amount best supported by the available audit evidence and the estimated amount included
in the financial statements, auditors would determine whether such a difference requires
adjustment. If the difference is reasonable, for example, because the amount in the financial
statements falls within a range of acceptable results, it may not require adjustment. However, if
the auditors believe the difference is unreasonable, management would be requested to revise the
estimate.

Auditors also consider whether individual differences which initially were accepted as reasonable
are biased in one direction, so that, taken in aggregate, they may have a material effect on the
financial statements. In such circumstances, auditors evaluate the accounting estimates on an
overall basis in determining whether the differences are reasonable and whether to request
management to adjust the estimates.

If the auditors consider that the estimates need to be adjusted and management refuses to revise
them, the differences would be considered misstatements and would be considered with all other
misstatements identified in the course of the audit in assessing whether the effect on the financial
statements is material. Where the auditors consider that the effect on the financial statements is
material, they would consider whether the auditors' report would be qualified for disagreement, or
whether they would express an adverse opinion, in accordance with SAS 600 "Auditors' reports
on financial statements".

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 Self Assessment Question 7

Write true if the statement is correct and false if incorrect on space provided
____1 financial auditor is not concerned with propriety of business transactions.
____2 If company’s cash is used personally by the cashier and is made up on demand by the
Managements, it can be said that the financial statements are misstated
____3 The auditor of a company has a right to carry out surprise checks of transactions beyond
the end of the accounting year for which he is reporting.
____4. For good cash control, the custody of cash should be included with the record keeping of
cash
____5. An analysis prepared to explain the difference between the balance of the chequing
account of the depositor and the balance as shown by the bank statement is called a bank
reconciliation
____6. Cash is considered to be a liquid asset
____7. The balance sheet figure for cash should include all cash received on the final day of the
year.
____8. Separation of duties is really not a critical item of control procedures

Part II. Write the related audit objectives on the each transaction
1. Recorded cash receipts are for funds actually received by the company __________________.
2. Cash received is recorded in the cash receipts journal (completeness).
3. Cash receipts are deposited and recorded at the amounts received ______________________
4. Cash receipts transactions are properly classified__________________________
5. Cash receipts are recorded on the correct dates ______________________.
6. Cash receipts are properly included in the accounts receivable master file and are correctly
summarized _____________________

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 Summary
Control over cash sales should be strong in each transaction with a customer. If tickets or sales
invoices are serially numbered and if all numbers are accounted for, separation of responsibility
for the transaction is an effective means of preventing fraud.
In many establishments the nature of the business is such that one employee must make over the
counter sales, deliver the merchandise, received cash, and record the transaction.
The primary objectives for the auditors' substantive tests of receivables and revenue are to (a)
substantiate the existence of receivables and the occurrence of revenue transactions, (b) establish
the completeness of receivables and revenue, (c) determine that the client has rights to the
recorded receivables, (d ) determine that the valuation of receivables and revenue is at an
appropriate net realizable value, and (e) establish that the presentation and disclosure of
receivables and revenue are appropriate. The auditors' consideration of internal control over
revenue and cash receipts provides them with a basis for assessing control risk for the related
financial statement assertions.
The audit of inventories presents the auditors with significant risk because: (a) they often
represent a very substantial portion of current assets, (b) numerous valuation methods are used for
inventories, (c) the valuation of inventories directly affects cost of goods sold, and (d) the
determination of inventory quality, condition, and value is inherently complex. Effective internal
control over inventories requires appropriate controls over purchasing, receiving, and issuing,
supplies and materials, producing and shipping products, and cost accounting. The auditors'
objectives in the audit of inventories and cost of goods sold are to: (a) consider inherent risks; (b)
consider relevant controls; (c) establish the existence of, and the client's rights to, inventories; (d)
establish the completeness of inventories. The primary substantive test for inventory accounts is
observation of the client's physical inventory. Other substantive procedures include price tests of
the valuation of inventory items, cutoff tests, analytical procedures, and tests of the financial
statement presentation and disclosure.
In the audit of property, plant, and equipment for a continuing client, the emphasis of the testing
is on transactions that occurred during the year, as contrasted to an emphasis on ending balances.
Depreciation expense is often tested by re-computation or through the use of analytical
procedures.
The auditors' objectives for the audit of natural resources and intangible assets are similar to those
for property, plant, and equipment. The audit of intangible assets typically involves vouching the
cost of the assets and evaluating and testing the allocation methods used by the client.
Audit objectives of accounts payable are consider internal controls over accounts payable,
determine the existence of accounts payable and that the client has obligation to pay them,
establish the completeness of account payable, determine that accounts payable are valued
appropriately, establish the clerical accuracy of schedules of accounts payable and, determine that
the presentation and disclosure of payable is appropriate.

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 Self-Assessment Questions 4
Part I
___1. Kiting A. Overdue accounts are promptly followed up
___2. Lapping B. Manipulation causing an amount of cash
to be included simultaneously in the balance of
two or more bank accounts
___3. Omission of entry C. The concealment of a cash shortage by delaying the
recording of cash receipts
___4. Controls over collection D. Obtain an understanding of the internal control
structure for cash the Sales Accounts Receivable
___5. Type of audit program for cash E. way of concealing a fraud
___6. Internal Control Objectives for F. Receipts should be banked daily
___7. Audit objectives of
accounts payable G. review of dividend procedure for all types of dividend
___8. Validity H. Confirm a sample of accounts receivables by direct
communication with the debtors
___9. Audit work on retained earning I. Consider internal controls over accounts payable
and dividend

PART II. In respect of each of the following objectives of internal control over Property, Plant
and Equipment , state one internal control procedure that is likely to achieve the given
objective.

A. Acquisitions of Property, Plant and Equipment are properly

authorized______________________________________________________________
B. There is adequate segregation of incompatible functions relating to Property, Plant and
Equipment
.___________________________________________________________________
C. Disposals of Property, Plant and Equipment are properly
authorized________________________________________________________________
D. In the case of self-constructed Property, Plant and Equipment , the cost is properly
determined
________________________________________________________________________
E. Property, Plant and Equipment are protected against misappropriation,
encroachment_____________________________________________________________

Part III choose the correct answer

____1. Which of the following is the most common audit procedure for verification of ownership
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of land held by an enterprise?

A. Examination of correspondence with the solicitors of the company concerning acquisition
of land
B. Examination of title deeds
C. Examination of minutes of meeting of the board of directors concerning acquisition of the
land
D. Physical verification of the eland
____2. Which of the following audit procedures is most likely to enable an auditor to discover
unrecorded disposals of Property, Plant and Equipment ?
A. Examination of capital budget
B. Review of repairs and maintenance expenses
C. Examination of invoices relating to additions to Property, Plant and Equipment
D. Examination of insurance policies
____3. Which of the following procedures is most likely to enable an auditor to discover
unrecorded additions to Property, Plant and Equipment ?
A. Examination of capital budget
B. Review of repairs and maintenance expenses
C. Examination of invoices relating to additions to Property, Plant and Equipment
_____4. Which of the following statements best describes the duties of an independent financial
auditor with regard to physical verification of Property, Plant and Equipment ?
A. It is the responsibility of the management to carry out physical verification of Property,
Plant and Equipment . The auditor has no duty in this regard
B. It is the responsibility of the management to carry out physical verification of Property,
Plant and Equipment . However, the auditor should satisfy himself that the method and
frequency of verification are reasonable in the circumstances of the case. It is no part of
an auditor’s duty to attend the verification being conducted by the management.
C. It is the responsibility of the management to carry out physical verification of Property,
Plant and Equipment . However, the auditor should satisfy himself that the physical
verification was carried out properly by observing the verification being conducted by
the management, wherever possible, and by examining the written instructions issued by
the management to the staff responsible for verification and the relevant working
papers.
D. It is the responsibility of the auditor the conduct physical verification of Property, Plant
and Equipment
_____5. The auditor’s attendance at physical stock-taking is one of the audit procedures often
employed in an audit of inventories. What, in your view, is the role of the auditor in
stock-taking, where the auditor decides to attend the stock-taking?
A. He conducts physical stock-taking himself
B. He supervises the stock-taking while it is conducted by personnel who are specially
assigned by the management for this task

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C. He observes the stock-taking conducted by personnel who are specially assigned by

the management for this purpose.
D. He observes the stock-taking as at above and also performs test counts himself in
appropriate cases.
_____6. while-auditing wages and salaries, the auditors often examines entries in the payroll with
reference to the time cards of the employees concerned. what evidence does this
procedure provide to the auditor?
A. the employees concerned were actually in the services of the enterprise
B. the allocation of wages to various jobs on which the employees concerned worked
during the relevant period is reasonable
C. the employees concerned actually worked for the number of hours for which the
wages were paid to them.
_____7. Which of these would not be considered an important control in the cash disbursements
function?
A. signing of checks by an individual with proper authority.
B. separation of check signing from the accounts payable function.
C. examination of the supporting documents by the controller at the time the check is
signed.
D. physical control over the blank, voided, and signed checks.
_____8. The major balance sheet account in the acquisition and payment cycle is
A. purchases.
B. common stock.
C. accounts payable.
D. merchandise inventory.
_____9. When auditing accounts payable, auditors are usually especially concerned about the
A. existence and completeness objectives.
B. completeness and cutoff objectives.
C. existence and cutoff objectives.
D.existence and accuracy objectives.

Part IV Answer the following

1. Assume you have assigned to audit cash balance. What steps you do to make cash count?
2. As an independent auditor lets say you accept a client to audit account receivable. Exhaustively
list what audit objectives to set and what audit procedures you plan to apply.

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Reference
1. Kamal Gupta & Ashok Arora (2004) Fundamentals of auditing. Tata McGraw-hill
publishing company limited.
2. larry F. Konrath (2002) auditing a risk analysis approach. South western
3. Leung, P., Coram, P., Cooper, B.J. & Cosserat, G.W, Modern Auditing & Assurance Services
4. K H Spencer Pickett (2005) the essential handbook of internal auditing. John Wiley &
Sons Ltd
5. Alvin A. Arens and Ronald J. Elder(2002) auditing and assurance services. prentice Hall
companion
6. Arens and loebbecke (2000) auditing an integrated approach. prentice Hall

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 Answer keys for Self-Assessment Questions

Chapter One
Self Assessment Question 1.1.

1. F 4. T 7. F 10. T
2. F 5. T 8. T 11. F
3. T 6. F 9. T 12. T
I. to provide audit evidence as to the completeness, accuracy and validity of the information
contained in the accounting records or in the financial statements
II. Random sampling, stratification …..( fill the rest)

Self Assessment Question 1.2.

1. T 4. T 7. F
2. T 5. F 8. F
3. T 6. F
Self assessment questions 1.3
1. T 4. F 7. F 10. T
2. F 5. T 8. F 11. F
3. T 6. T 9. T 12. F

Part II
1. B 2. B 3. A 4. C 5. C
5. A 7. D 8. B 9. A 10. B 11. A
Part III
1. substantive testing
2. Sampling risk
3. audit sampling is the application of audit procedures to less than 100% of the items within an
account balance or class of transactions to enable the auditor to obtain and evaluate evidence
4.
Determine the objectives of the plan.
Determine the objectives of the plan.
Define the population and sampling chapter.
Determine the sample size.
Determine the sample selection method. o Execute the sampling plan
Evaluate the sample results
Part IV
1. E 2. B 3. D 4. C 5. A
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Part V describe the following shortly

Refer sections
Chapter Two
Self Assessment Question 2.
Part I
1. F 4. F 7. T
2. T 5. T 8. F
3. T 6. T

Part II
1. Existence 5. Classification
2. Completeness 6. Timing
3. Classification 7. Posting and authorization
4. Accuracy

Chapter Three
Self Assessment Question 3
1. D 4. D 7. D
2. E 5. A
3. C 6. A

Chapter Four
1. T 2. F 3. T 4.T 5. F
Chapter 5
Self Assessment Question 5
1. A 2. C 3. C 4. D 5. A

Chapter Six
Self Assessment Question 6

Part I
1. T 2. T 3. F 4. F

Part II
1. segregation of duties
2. Prepare a description of the internal control for accounts payable and conduct a
system audit.
✓ Verify posting to the payables controlling account for a test period.
✓ Vouch to supporting documents entries in the voucher register or inspected
accounts payable subsidiary ledger.

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Chapter 7
Answer keys for over all Self-Assessment Questions
Part I
1. B 4. F 7. I
2. C 5. D 8. H
3. E 6. A 9. G

Part II
(a) and effective system of capital budgeting and a requirement of obtaining prior written
authorization of a manager at a sufficiently senior level before a fixed asset is actually acquired.
(b) proper segregation of duties relating to (a) authorization of acquisition and disposals, (b)
execution of transactions, (c) recording of transactions, and (d) physical custody of various items
(c) Disposals to be authorized by a committee of senior managers on the basis of proper
quotations
(d) a proper system of maintenance of detailed records of Property, Plant and Equipment under
construction including assignment of job numbers, identification of direct costs and
allocation/apportionment of overheads.
(e) Assigning a identification number to each fixed asset, restricting access, proper insurance and
periodic physical verification

Part III
1. B 4. D 7. D
2. D 5. D 8. C
3. B 6. C 9. B

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