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 CHAPTER ONE
Audit Sampling

ONE
Presentation outline:
Introduction
Rationale for Audit Sampling
Representative and Non-Representative Samples
Sampling Risk
Approaches of Audit Sampling
 Introduction
 Auditing is a systematic process of objectively
obtaining and evaluating evidence regarding assertions
about economic actions and events.
Obtain sufficient appropriate audit evidence.
Expression of an opinion
Systematic & independent examination of books,
accounts, documents & vouchers of an organization.
Ascertain that the financial statements present a true &
fair view of the concern.
Ensure that the books of accounts are maintained as
required by law.
Draw reasonable conclusion
 Cont….d

 Sampling – the process of selecting a group of items

from large characteristics of the items.
 Sampling is the process of selecting and examining a
portion of a group of related items for the purpose of
obtaining information or evaluation of some
characteristics about the group as a whole.
 The group as a whole is called the population.
 Population is the entire set of data from which a
sample is selected and about which the auditor wishes to
draw conclusion.
 Cont...d

Audit sampling – selecting less than 100%

of a population for testing to make inferences
about a population
Evaluating audit samples is often challenging
part of auditing.
When is a sample size sufficiently large to
evaluate a population?
Does a given sample accurately represent the
accounting information?
 Cont.…d

 In audit sampling, the population may be

represented by an account balance or a class of
transactions.
 The auditor examines only a representative
sample and draws his/her opinion.
 It is neither practicable nor necessary for the
auditor to check all the transactions in a client’s
accounting records or to verify or confirm all
individual items comprising the assets, liabilities,
revenues, equities, and expenses.
 Cont.…d
According to Statement on Auditing Standards (SAS) # 39,
Audit Sampling, must be met three conditions to constitute
audit sampling.
Or Features of Audit sampling
 First, less than 100% of the population must be examined.
 Second, the sample results must be projected as
population characteristic.
 Third, the projected sample results must be compared to
an existing client-determined account balance to determine
whether to accept or reject the client’s balance, or
 The projected sample results must be used to assess
control risk.
 1.3. Rationale for Audit Sampling
 The auditor examine all of the records of the company
being audited, when the size of company is manageable.
 However, as companies grew in size and complexity, it
became
 Uneconomical (costly & time consuming) to examine all the
accounting records and supporting documents.
 Thus, the auditor takes the sample to draw conclusion
about the entire population.
 The primary purpose of sampling is to draw inferences
about the whole population based on the results of testing
only a subset of the population.
 Cont.….d
The use of sampling widely adopted in audit because
1. Offers an opportunity to obtain minimum amount of audit
evidence that in turns, to form valid conclusions on the
population.
2. To reduce risk of over auditing in certain areas and enable a
much more efficient review of working papers at review stage
of the audit.
3. To obtain both sufficient and appropriate, audit evidence at
reasonable costly.
 As a result, the auditor provides reasonable, not absolute,
assurance that the financial statements are fairly presented.
Representative and Non-Representative Samples
Representative Sample
 Audit sampling is based on the theory of probability,
which say that a sample selected from a mass will by
and large have the same characteristics as are presented
in the mass.
 Whenever auditors select a sample from a population,
the objective is to obtain a representative one.
 “A representative sample implies a sample unit that can
represent relatively the characteristics of entire
population”. i.e. the sampled items are similar to the
items not sampled.
 Cont.….d
Four important decisions to ensure that the sample
is representative & to control against making an
incorrect inference:
Which population should be tested and for what
characteristics (population)?
How many items should be selected for audit testing
(sample size)?
Which items should be included in the sample
(selection)?
What inferences can be made about the overall
population from the sample (evaluation)?
 Non-Representative Samples
A sample result can be non representative due to
 Non sampling error or
 Sampling error.
 The risk of these two types of errors occurring is called non
sampling risk (factors unrelated to sampling) and sampling risk.
 Non-sampling risk is the risk that audit tests do not discover
existing exceptions in the sample.
 Sampling risk is the risk that an auditor reaches an incorrect
conclusion because the sample is not representative of the
population.
 A. Sampling Risk

Sampling risk: is the risk that an auditor reaches

an incorrect conclusion because the sample is
not representative of the population.
 Sampling risk is the probability that the sample results
are not representative of the entire population.
 Reducing Sampling Risk
Auditors have two ways to control (reduce)
sampling risk:
1. Increase sample size (taking larger size
samples) reduces sampling risk, and vice versa.
 A sample of all the items of a population has a
zero sampling risk.
 A sample of one or two items has an extremely
high sampling risk.
 Cont.…d
2.Using an appropriate method of selecting sample
items (size) from the population.
 Using an appropriate sample selection method increases the
likelihood of representativeness.
 This allow the auditor to measure the risk associated with a
given sample size.
eg.Statistical methods of sample selection and evaluation.
Non-Sampling Risk:
 Is a risk that the auditor forms wrong conclusions, which is
unrelated to sampling risk.
For example, most audit evidence is persuasive rather than
conclusive, the auditor might use inappropriate procedures, or the
auditor might misinterpret evidence and fail to recognize an error.
 Cont.…d
The two causes of non sampling risk are:
The auditor’s failure to recognize
exceptions (exclusion) and
Inappropriate or ineffective audit procedures.
 An auditor might fail to recognize an exception
because of exhaustion, boredom, or lack of
understanding of what to look for.
 Careful design of audit procedures, proper
instruction, supervision, and review are ways to
control non-sampling risk.
 Reducing Non-sampling Risk
Auditor can reduce the risk of non-sampling by:

1. Increase auditor competence through

continuing professional education.

2. Careful design of Audit procedure and

proper supervision and instruction.
 Approaches (methods) of Audit Sampling
Audit sampling methods can be divided into two:

1. Statistical Sampling and

2.Non-statistical Sampling
When properly used, either sampling approach can be
effective in providing sufficient audit evidence.
1. Statistical Sampling – uses the laws of probability
to compute sample size and evaluate the sample results
 Cont…d
1. Statistical Sampling permit the auditor to
 Use the most efficient sample size.
 Quantify the sampling risk for the purpose of reaching a
statistical conclusion about the population.
 Allows each sampling unit to stand an equal chance of
selection.
 Provide a reasonable basis for the auditor to draw valid
conclusions and ensuring that all samples are representative
of their population, will avoid bias.
2. The use of non-statistical sampling in audit sampling essentially
removes this probability theory and is wholly dependent on the
auditor’s judgment.
Statistical or probabilistic sample selection involves:

1. Simple Random Sampling

2. Systematic sampling
3. Stratified sampling
4. Cluster
1) Simple random sampling:
 This method of sampling ensures that all items in the
population have an equal chance of being selected.
 This is done using random number tables or
computer or calculator generated random numbers.
 The sampling unit could be the physical items such,
as sales invoices or monetary units.
 Cont.…d
2) Systematic sampling
 This method involves making a random start and then taking every nth
item thereafter.
Eg:If popn= 1000, expected sample size=100
Soln 1000/100 = 10 , if we select 3from 10 by using simple random, the next
3, 10+3, 13+3,16+3,19+3, 22+3, 25+3, 28+3, 31+3, 34 to 100
 provides for the selection of sample items in such a way that there is a
uniform interval between each item.
3) Stratified sampling:
 select the sample items by breaking the population down in to strata or
cluster.
 The population is divided into subpopulations by size and larger samples
are taken of the larger subpopulations.
 Auditors often stratify a population before computing the required sample
and selecting the sample.
 The objective of stratification is to reduce the variability of items within
each stratum.
 Cont.…d

4) Cluster sampling:
 This is useful when data is maintained in clusters
(= groups or bunches) as salary records are kept
in weeks or sales invoices in months.
 The idea is to select a cluster randomly and then
to examine all the items in the cluster chosen.
 The problem with this method is that this sample
may not be representative.
Non- statistical samplings (Judgment sampling)
 It uses the laws of non probability to compute
sample size and evaluate the sample results,
select the sample, and/or measure sampling risk
when evaluating results.
1) The auditor does not quantify sampling risk.
2) Those items that the auditor believes will
provide the most useful information are selected
3) Employs auditor’s professional experience and
judgment
 Cont.…d
There are three common approaches to
select non probabilistic samples from
accounting population.
1. Judgment/Direct Method
2. Block Sampling
3. Haphazard Sampling
 1. Direct Method
The selection of each item based on some judgmental
criteria by the auditor or the auditors deliberately select
each item in the sample based on their own judgmental
criteria instead of using random selection.
The criteria used may include:
 Items most likely to contain misstatements
 Items containing selected population characteristics
 Large dollar coverage
 Cont..d
 Auditors deliberately select each item in the
sample based on their own judgmental criteria
instead of using random selection.
 Is the use of professional judgment in selecting
sample items for test of transaction.
 When sample size is small, a random sample is
often unlikely to provide a representative
sample
 Cont.…d
Auditor should keep the following three things in
mind
1. Each major type of transaction in the cycle
should be included
2. Transactions prepared by each person or
group of person should be tested.
3. Population items with large balance should
be tested heavily than those with small
balances.
 2. Block (or sequence) Sampling
 In block sample selection, auditors select the first
item in a block, and the remainder of the block is
chosen in sequence.
 This method of sampling involves selecting a block
(or blocks) of contiguous items from within a
population.
 Block selection is rarely used in modern auditing
merely because valid references cannot be made
beyond the period or block examined.
 In situations when the auditor uses block selection as
a sampling technique, many blocks should be
selected to help minimise sampling risk.
 Cont.….d

Example 1:The selection of a sequence of 100 sales

transactions from the sales journal for the third week of
March is a block sampling.
Example 2:Where the auditor may examine all the remittances from
customers in the month of January. Similarly, the auditor may only
examine remittance advices that are numbered 300 to 340.

Example 3: Auditors can select the total sample of 100 by

taking 5 blocks of 20 items, 10 blocks of 10, 50 blocks of 2
or one block of 100.
 3.Haphazard/Convenience Sampling
The auditor selects population items without
regard to their size, source, or other distinguishing
characteristics - Sampling available units
When the auditor goes through a population and
selects items for the sample without regard to
their size, sources, or other distinguishing
characteristics, the auditors is attempting to select
without biases. This is called haphazard selection
When the auditor uses this method of
sampling, he does so without following a
structured technique.
 Cont..d

Similarities between Statistical and Non-statistical

samplings:
Both Approaches Requires:
Planning the sample,
Selecting the sample,
Performing the sample, and
Evaluating the results and drawings
conclusions.
 Cont.…d
Example: Assume that an auditor selects a sample of 100 duplicate
sales invoices from a population, tests each to determine whether a
shipping document is attached, and determines that there are three
exceptions.
Thus, those actions step-by-step:
 Plan the sample Decide that a sample size of 100 is needed

 Select the sample Decide which 100 items to select from the

popn.
 Perform the tests  Perform the audit procedure for each of

the 100 items and determine the exceptions exist

 Evaluate the results Reach conclusions about the likely

exception rate in the total population

 Cont….d

Statistical &Non-statistical Sampling are different in:

1. Statistical sampling:
 The sampling risk can be quantified
 Widely used
 While selecting a sample, each population item has a known probability
of being included in the sample.
Thus, statistical sampling may assist auditors in:
(1) Designing efficient samples.
(2) Measuring the efficiency of the evidence obtained, and
(3) Objectively evaluating sample results
2. Non-statistical sampling those items that the auditor believes will
provide the most useful information are selected
Audit Sampling for Test of Control and Substantive Test
of Transaction

Auditors use five types of tests to determine

whether the financial statements are fairly
presented.
I. Understanding of internal control
II. Tests of controls
III. Substantive tests of Transactions
IV. Analytical procedures (Tests)
V. Tests of Details of Balances
 Audit Sampling for Test of Controls

 Test of controls are used to determine whether

the client’s internal control is operating in a way
that could prevent or detect material
misstatements
 The auditor gathers evidence on the
effectiveness of the client’s internal control
system by examining the significant controls
over the financial reporting process.
 Cont.….d
When performing test of controls, the auditors are
concerned with two aspects of sampling risk. These are:
a. Risk of assessing control risk too high. when sample
results will cause the auditors to assess control risk at a
higher level than is warranted bases on the actual
operating effectiveness of the control.
b. Risk of assessing control risk too low- is the possibility
that the sample result will cause the auditors to assess
control risk at a lower level than is warranted based on
the actual operating effectiveness of the control.
 Substantive (practical) audit Test

 It is a procedure designed to test for birr

misstatements directly affecting the correctness of
financial statement balances (the technique used by
the auditor to obtain the audit evidence in order to
support auditor opinion).
 There are three types of substantive tests:
1) Substantive tests of transactions
2) Analytical procedures and
3) Tests of details of balances
 Substantive Tests of Transactions
 The purpose of substantive tests of transaction is to
determine whether all six transaction related audit
objectives have been satisfied for each class of
transactions.
Transaction related audit objectives are:
Existence Completeness
Accuracy Classification
Timing Posting and summarization
2. Analytical Procedures

 AP involve comparisons of recorded amounts to expectations

developed by the auditor
 They often involve the calculation of ratios by the auditor for
comparison with previous year’s ratio’s and other data

3. Tests of details balances

 Focus on the ending general ledger balances for both balance
sheet and income statement accounts, but the primary emphasis

in most tests of details of balance is on balance sheet

Application of Non statistical Audit Sampling Methods

Audit sampling is applied to tests of control and

substantive tests of transactions through a set of 14
well defined steps
The steps are divided in to three sections (phases):
A. Plan the sample.
B. Select the sample and perform the audit
procedures and
C. Evaluate the results
A. Plan the samples
1. State the objective of the audit test
2. Decide whether audit sampling applies
3. Define attributes and exception conditions
4. Define the population
5. Define the sampling unit
6. Specify the tolerable exception rate (TER)
7. Specify acceptable risk of assessing control risk too low
8. Estimate the population exception rate
9. Determine the initial sample size
 Cont….d

B. Select the sample and perform the Audit procedures

10. Select the sample
11.Perform the audit procedures

C. Evaluate the results

12. Generalize from the Sample to the population
13. Analyze Exceptions

14. Decide the acceptability of the population

What do you think???

Read the next slide ………………

1. The objectives of the audit Test
The overall objectives of tests of controls and substantive
tests of transactions are:
 To test the application of controls and determine
whether the transactions contain monetary misstatements
2. Decide whether audit sampling applies
 Audit sampling applies whenever the auditor plans to
reach conclusion about a population based on a sample.
 The auditor should examine the audit program and
decide those audit procedures for which audit sampling
applies.
 Cont…d
Consider the following audit programs:
Review sales transactions for large and unusual
amounts (analytical procedures)
Observe whether the duties of the accounts
receivables clerk are separate from handling cash
(an observation procedure)
Examine sample of credit approval sales invoice
Select a sample of shipping documents and trace
each to related duplicate sales invoice
3. Define Attributes and Exception Conditions
 When audit sampling is used, the auditor must carefully
define the characteristics (attributes) being tested and
the exception condition.
 Attributes of interest and exception conditions come
directly from the audit procedures for which the auditor
has decided to use audit sampling.
4. Define the population
 The population represents the body of data about which the
auditor wishes to generalize.
 The auditor must carefully define the population in advance
consistence with the object of the audit test.
 5

5. Define the sampling unit

 A sampling unit is any of the individual elements constituting

the population. Thus, the definition of the population and the
planned audit procedures usually dictate the appropriate
sampling unit
 The sampling unit is the physical unit that corresponds
to the random numbers the auditor generates.
 For the sales and collection cycle, the sampling unit is
typically a sales invoice or shipping document number.
For example, if the auditor wants to test the occurrence of
sales, the appropriate sampling unit is sales invoices
recorded in the sales journal
 6. Specify the Tolerable Exception Rate (TER)
 Tolerable exception rate is the exception rate that the
auditor will permit in the population and still be
willing to use the assessed control risk or
 The amount of misstatement in the transactions
established during planning.
For example:
Assume that the auditor decided TER for an attribute is
6%, which means the auditor has decided that even if
6% of the duplicate sales invoices are not approved for
credit, the credit approval control is still effective in
terms of the assessed control risk included in the audit
plan
 cont...d
 TER is the result of an auditor’s judgment and has a
significance impact on sample size.
 A large sample size is needed for a low TER than for a
high TER.
For example, a larger sample size is needed for the test of
credit approval (attribute 8) if the TER is decreased from
9 percent to 6 percent.
 7. Specify Acceptable Risk of Assessing Control Risk too Low
Acceptable risk of assessing control risk is the risk that
the auditor is willing to take of accepting a control as
effective when the true population exception rate is
greater than the TER.
ARACR is the auditor’s measures of sampling risk.
To illustrate, assume that TER is 6%, ARACR is 10%
and the true population exception rate is 8%. The
control in this case is acceptable, because the
exception rate of 8% exceeds TER (8%>6%)
 Cont…d

 The ARACR of 10% means that the auditor is willing

to take 10% risks of concluding that the control is
effective after all testing is completed, even when it is
ineffective

 A low ARACR/Acceptable Risk of Assessing Control Risk

implies that the tests of controls are important and
would correspond to a low assessed control risk and
reduce substantive test of detail balance.
 8. Estimate the population Exception Rate
 If the estimated population exception rate
(EPER) is low, a relatively small sample size
will satisfy the auditor’s tolerable exception
rate.
 This is because a less precise estimate is
required.
 In other word, to be more precise, estimates of
the population exception rate must be based
on more data, that is, a large sample
 9. Determine the initial sample size

Four factors determine the initial sample size for audit

sampling
Population size
TER
ARACR(Acceptable Risk of Assessing Control Risk)
and
EPER (Estimate the population Exception Rate)
 Cont…d

 Population size is not a significance factor and typically can be

ignored, especially for large populations.
 Auditors using non statistical sampling decide the sample size
using professional judgment rather than using a statistical
formula.
 Once the three major factors affecting sample size have been
determined, the auditor can decide an initial sample size.
 It is called an initial sample size because the exceptions in the
actual sample must be evaluated before auditors can decide
whether the sample is sufficiently large to achieve the objectives
of the tests.
B. Select the sample and perform the Audit procedures
10. Select the sample
11.Perform the Audit procedures
10. Select the sample
The auditor can use one of the sample selection
methods discussed above
 The sample exception rate (SER) can be easily
calculated from the actual sample result, SER equals the
actual number of exception divided by the actual sample
size. (i.e. actual no. of exception /actual SZ)
 Usually the sample exception rate (SER) is different
from the population exception rate
 Cont…d
11.Perform the Audit procedures
The auditor performs the audit procedures by
examining each item in the sample to determine
whether it is consistent with the definition of the
attributes and maintain a record of all the
exceptions found.
When audit procedures have been completed for
a sampling application, there will be a sample
size and a number of exceptions for each
attributes
 C. EVALUATE THE RESULTS
12. Generalize from the Sample to the population
 In order to generalize from the sample to the
population, subtract the sample exception rate
from the tolerable exception rate, which is
calculated sampling error
(TER- SER= Calculated sampling error), and
evaluate whether calculated sampling error is
sufficiently large to indicate the true population
exception rate is acceptable.
 Cont.…d
For example if an auditor takes a sample of 100
items for an attribute and finds no exception
(SER = 0) and TER 5%, calculated sampling
error is 5% (5% - 0%).
 On the other hand if there had been 4% sample
exceptions, calculated sampling error would have
been 1% (5% - 4%).
It is much more likely that the true
population exception rate is less than or
equal to the tolerable exception rate in the
first case than in the second case.
 Cont.…d

13 . Analyze Exceptions
Exceptions can be caused by many factors,
such as carelessness of employees,
misunderstood instructions, or intentional
failure to perform procedures
The nature of an exception and its causes
has a significance effect on the qualitative
evaluation of the system
 cont….d

14 . Decide the Acceptability of the population

 If the auditor concludes that TER – SER is sufficiently
large, the control being tested can be used to reduce
assessed control risk as planned, provided a careful
analysis of the cause of exception does not indicate the
possibility of other significant problems with internal
controls.
 Cont…d

 When the auditor concludes that TER – SER is too

small to conclude that the population is acceptable,
the auditor must take specific action
Four course of action can be followed
1. Revise TER or ARACR
2. Expand the sample size
3. Revise assessed control risk
4. Communicate with the audit committee or
management
1.7.2. Application of statistical Audit Sampling Methods

 The statistical sampling method most commonly

used for test of control and substantive tests of
transactions is attributive sampling.
 Both attributive and non statistical sampling
have attributes, which are the characteristics being
tested for the population, but attributive sampling
is a statistical method

63
 Attributive and non statistical sampling

Similarities
 Have attributes, which are the characteristics being tested for
the population
 All 14 steps discussed are used for both approaches and the
terminologies are essentially the same.
Differences
 The calculation of planned samples sizes using
tables developed from statistical probability
distribution and the calculation of estimated
upper exception rate using similar table.
END OF CHAPTER
1
THANK YOU!
 CHAPTER TWO
AUDIT OF CASH BALANCES

Presentation Outline:
Learning Objectives
Introduction to Cash
The Auditors Objectives in the Audit of
Cash
Types of Cash Accounts
Balance-related Audit Objectives
Fraud-oriented Procedures
Proof of Cash
 2.1. Introduction to Cash
 Cash is the only account included in every cycle except
inventory and warehousing.
 Cash consists of coins, currency, checks, money orders,
money on hand and deposit in bank.
 Cash is a type of asset that is readily convertible to any
other type of asset; it is easily concealed, transported and
is therefore highly desired.
 Because of these characteristic, cash is known as the most
susceptible asset to improper use.
 Moreover, because of the large volume of transactions, a
number of errors may occur in executing and recording
cash transactions
 Cont.…d
 Therefore, the internal control over cash should be
designed considering the special nature of cash.
 The cash balance of a business organization is
affected by both collections and payments.
 To maintain a good cash handling practices, business
organizations have to develop an efficient and
effective internal control over cash. How ????
 Control procedures
The following are general guideline for good cash
handling practices in all types of business
1. Handling cash transaction from beginning to end
should have to delegate to different employees.
2. Cash handling and recording should have to be
separated.
3. Cash receipts should be recorded immediately.
4. Deposit each day’s cash receipts intact.
 Cont.…d
5. Costumers should be encouraged to obtain
receipts and observe cash register totals.
6.There should be intact /unbroken deposit.
7. Any payment should have to be by check, except small
payments which have to be paid from petty cash fund.
8. Bank reconciliation statement should have to prepare by
employees not responsible for check issuance and custody
of cash.
9.Forecast expected cash receipts and disbursements and
investigate variances from forecasted amounts.
2.2. The Auditors Objectives in the Audit of Cash

The auditors` objectives in the audit of cash are to:

 Consider internal control over cash transactions
 Substantiate the existence of recorded cash
 Establish the completeness of recorded cash
 Determine that the clients has rights to recorded cash
 Establish the clerical accuracy of cash schedules
 Determine that the presentation and disclosure of cash
 INTERNAL CONTROL OVER CASH RECEIPTS

Cash receipts resulted from a variety of activities such as; cash received from revenue
transactions, short and long term borrowings, the issuance of stock, and the sale of
marketable Securities, long term investments, and other assets. The basic internal
controls over cash receipts include the following:
Authority to collect cash should be clearly defined.
Collections should be recorded when received.
The collector’s cash receipts should be reconciled to the
eventual banking.
Receipts should be banked immediately.
Each day receipts should be recorded promptly in the
cashbook.
Sales ledger account should have no access to the cash.
 Internal Control over Cash Disbursements

There are two cash disbursements functions:

1.
Paying the liability
2.
Recording the cash disbursements.
These functions should not be performed by the same department or
individual person. The basic internal controls over cash disbursements
include:
Unused checks should be held in a secure place.
The person who prepares checks should have no responsibility over
purchase ledger or sales ledger.
Checks should be signed only when evidence of a properly approved
transaction is available.
These checks should be evidenced by signing the supporting documents .
 Cont..d

 Check signatories should be restricted to the minimum practical

number.
 Two signatories at least should be required except perhaps for
checks of small amounts.
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent
their use to support further check payments.
 Checks should preferably dispatch immediately
 INTERNAL CONTROL OVER CASH RECEIPTS

 The basic internal controls over cash receipts

include the following:
Authority to collect cash should be clearly
defined.
Collections should be recorded when received.
Receipts should be banked immediately.
Each day receipts should be recorded
promptly in the cashbook.
Sales ledger account should have no access to
the cash.
 Cont.…d
 The processing of receipts from cash and credit
sales involves the following cash receipts
functions:
Receiving cash receipts.
Recording the receipts.
Depositing cash in bank.
 Segregation of duties in performing these
functions is an important internal control
activity.
 Internal Control over Cash Disbursements
 There are two cash disbursements functions:
1. Paying the liability
2. Recording the cash disbursements.
The basic internal controls over cash disbursements
include:
 Unused checks should be held in a secure place.
 The person who prepares checks should have no
responsibility over purchase ledger or sales ledger.
 Cont…d
 Checks should be signed only when evidence of a
properly approved transaction is available.
 These checks should be evidenced by signing the
supporting documents.
 Check signatories should be restricted to the minimum
practical number.
 Two signatories at least should be required except
perhaps for checks of small amounts
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent
their use to support further check payments.
 Checks should preferably dispatch immediately.
 Control Over Petty Cash
 The level and location of cash fund should be laid down
formally.
 Cash should securely hold.
 There should be restricted access to the floats.
 All expenditure should require a voucher system signed by a
responsible official, not the petty cashier.
 Vouchers should be produced before the check is signed for
reimbursement.
 A maximum amount should be placed on a petty cash
payment to discourage normal purchase procedures being by
past.
 Periodically the petty cash should be reconciled by an
independent person.
 Auditing Cash Receipts
 Cash receipt audit is a significant aspect of financial
statement audit.
 This is because
 Cash receipts affect almost all accounts relating to
balance sheet and income statement.
 This area is prone to error and fraud
 When a cashier may take the money without
recording the transactions unless the customer
requests written receipts.
 This is very difficult for auditors to detect. But such
deflections can be prevented if the client establishes
strong internal control.
Auditing Cash Receipts: Evaluation of accounting and internal controls

 Examining whether the authority to execute sales,

receive the payment, and deliver the goods is assigned to
different persons;
 Examining whether there is a system of maintaining up
to date price lists and of verifying the prices to be
charged with such price lists;
 Examining whether there is a system of proper
authorization of discounts and refunds to be given to
customers; and
 Examining whether cash receipt vouchers are pre –
numbered, and whether the unused cash receipt vouchers
are kept under the custody of a responsible official.
 Auditing Cash Receipts: Substantive Procedures
You have to apply the following substantive procedures in auditing
cash sales:
 Check the prices charged, discounts allowed, and rates of sales tax
charged, as shown in the cash receipt vouchers to ensure that they are
proper and duly authorized;
 Check the arithmetical accuracy of cash receipt vouchers
 Compare the copies of the cash receipt vouchers with the daily cash
sales summary sheet;
 Check the arithmetical accuracy of the daily cash sales summary
sheets and the entries in the cash receipt journal;
 If the cash sales are recorded through mechanical cash registers,
compare the licked-in totals provided by the cash register with the
recorded receipts in the cash receipt journal; and
 Examine the classification of cash sales to ensure that the credit is
recorded to correct accounts.
 Auditing Cash Payments

 Organization make payments using checks and petty cash for

small payments.
 Using check is helpful
 To obtain evidence of receipt from the payee in the form of an
endorsement on the check.
 For the centralization of disbursement authority in the hands of
a few designated officials
 a permanent record of disbursements; and
 a reduction in the amount of cash kept in hand.
 To maximize the benefits of using checks:

 All checks should be pre-numbered

 Un issued checks should be adequately kept against theft
or misuse:
 Voided checks should be defaced to eliminate any
possibility of further use filed in the regular sequence of
paid checks; and
 Officials authorized to sign checks should review the
documents supporting the payment and deface these
documents at the time checks to prevent them from being
submitted a second time.
 Standard Audit Procedures for Petty Cash Payments

 As an auditor, perform the following procedures to

examine petty cash transaction:
 Evaluate the internal control over petty cash to know
petty cash is normally under the charge of only one
individual and is, therefore, prone to defalcation.
 In evaluating the relevant internal controls, you have to
examine the following aspects:
• Is the amount of petty cash fund fixed?
• Are items or expenditure which can be reimbursed
from the petty cash well defined?
 Cont.…d

 Is there a limit on the amount that can be reimbursed from the

petty cash in respect of a single transaction?
 Is the petty cash kept separate from other receipts?
 Is the disbursements form the petty cash fund made only
against the petty cash expense vouchers duly approved by a
responsible official?
 Is the petty cash in hand periodically examined by the internal
auditor or another responsible official? is the petty cash
reconciled with book records periodically?
 Is the reimbursement of petty cash only for the exact amount
of petty cash expense during the period as supported by petty
cash vouchers?
 Are petty cash vouchers marked as” paid after payments to
prevent duplicate payments the same?
What Do U Think?
 AUDIT OF CASH BALANCE ON HAND

The audit procedures applied in audit of cash on hand

are given below:
 Verifying accuracy of cash schedules and agrees
schedules to cash balances.
 To verify the accuracy of cash balance, you should
have to ascertain that the schedules agree with the
related cash balance in the general ledger.
 Count cash on hand: includes un deposited cash
receipts, change funds, and petty cash funds.
 Cont…d
To ascertain the existence of cash the following
should be applied:
Controlling all cash and negotiable instruments
held by the client until all funds have been
counted. This prevents the client from
transferring counted funds to uncounted funds.
Counting cash in the presence of the custodian.
Obtain signed receipt from the custodian on
the return of funds of the client.
 AUDIT OF CASH AT BANK AND TRANSACTION CYCLE

Audit procedures applied in auditing cash at bank is

given below:

 Auditors must distinguish between verifying the client’s

reconciliation of the balance on the bank statement to the
balance in the general ledger, and

 Whether recorded cash in the general ledger correctly

reflects all cash transactions that took place during the
year.
 Cont…d

Generally, auditor discovered the following types of

misstatements as part of the test of bank reconciliation.
 Failure to include a check that has not cleared the bank
on the outstanding check list, even though it has been
recorded in the cash disbursements journal.
 Cash received by the client subsequent to the balance
sheet date but recorded as cash receipts in the current
year.
 Cont.…d
 Deposits recorded as cash receipts near the end of the
year, deposited in the bank in the same month, and
included in the bank reconciliation as a deposit in
transit.
 Payments on notes payable debited directly to the bank
balance by the bank but not entered in the client’s
records.
 Cont…d

 Confirm bank balance:- an auditor must able to confirm

cash deposit with banks as of the balance sheet date.

 Bank confirmation provides evidence of existence and

valuation of the accounts. It is also useful in reconciling
bank and book balance.

 Obtaining cut-off statement:- is obtaining a bank

statement as of a date subsequent to the date of the
balance sheet.
 Cont.…d
After obtaining bank cut-off statement, perform the
following tests:
 Trace deposit in transit to subsequent period bank
statement.
 Record the last check number issued in the last day of the
year and subsequently trace to the outstanding checks and
the cash disbursement journal.
 Trace outstanding check to subsequent period bank
statement.
 This provides high degree of evidence about the validity of
the year end bank reconciliation and the existence,
completeness, rights and assertions.
 Cont…d
 Trace bank transfer: - a business organization may
maintain accounts with more than one bank. If the
businesses have more than one bank account, the
auditor should have to analyse inter-bank transfer.
 Preparing proof of cash: - cash proof is a
simultaneous reconciliation of bank transaction and
balance with corresponding data per book for
specific time of period.
 Types of Cash Accounts

Before dealing with audit tests of the client’s bank

reconciliation, it is helpful to learn all types of cash
accounts commonly used by most companies.
The major types of cash accounts are:
General Cash Account
Imprest Accounts
Branch Bank Account
Imprest Petty Cash Fund
 A. The general cash account:

It is the focal point of cash because all cash

receipts and disbursements flow through this
account.
The disbursements for the acquisition and
payment cycle are normally paid from this
account, and the receipt of cash in the sales and
collection cycle are deposited in this account.
 B. Imprest Payroll Accounts
It is established to record payroll payments made for
employees.
In an imprest account, a fixed balance is maintained in a
separate account and this amount should always be shown
as a balance. The use of imprest payroll account can
improve internal control and reduce the time needed to
reconcile bank accounts.
In testing the payroll bank account balances, auditors must
obtain:
• The bank reconciliation
• Bank confirmation and
• Cutoff bank statement.
 C. Branch Bank Account

 For a company operating in multiple locations, it

is often desirable to have a separate bank balance
at each location.
 Branch bank accounts are useful for building
public relations in local communities and
permitting the centralization of operations at the
branch level.
 D. Imprest Petty Cash Fund
 Petty cash is a unique account. Although it is
often immaterial in amount, many auditors verify
petty cash primarily because of the potential for
embezzlement and the client’s expectation that
auditors will examine the account, even when the
amount is immaterial.
 An imprest petty cash fund is not a bank account,
but it is sufficiently similar to cash in the bank to
merit inclusion.
 Cont…d

 A petty cash account is often something as simple as a

preset amount of cash set aside in a cash box for
incidental expenses.
 It is used for small cash acquisitions that can be paid
more conveniently and quickly by cash than by
check, or for the convenience of employees in cashing
personal or payroll checks.
 Cash Equivalents
Cash equivalents are short-term, highly liquid
investment assets meeting two criteria:
(i) Readily convertible to a known cash amount
(ii)Sufficiently close to their maturity date so that market
value is not sensitive to interest rate changes
 Cash equivalents, which can be highly material, are
included in the financial statements as a part of the cash
account only if they are short-term investments that are
readily convertible to known amounts of cash, and there
is insignificant risk of a change of value from interest
rate changes.
 Marketable securities and longer-term interest-bearing
investments are not cash equivalents.
 A. Audit of the General cash account
The methodology for auditing year-end cash is
essentially the same as that for all other balance sheet
accounts.
 Identify Client Business Risks Affecting Cash
 Set Tolerable Misstatement and Assess Inherent Risk
 Assess Control Risk:
 Design and Perform Tests of Controls and Substantive
Tests of Transactions
 Design and Perform Analytical Procedures
 Design Tests of Details of Cash Balance
 Balance-related audit objectives
 Detail tie-in: Cash in the bank as stated on the
reconciliation foots correctly and agrees with the general
ledger.
 Existence: Cash in the bank as stated on the
reconciliation exists.
 Completeness: Existing cash in the bank is recorded
(that there are no unrecorded cash and bank balances).
 Accuracy: Cash in the bank as stated on the
reconciliation is accurate.
 Cut-off: Cash receipts and cash disbursements
transactions are recorded in the proper period.
 Fraud-Oriented Procedures

 A major consideration in the audit of the general cash

balance is the possibility of fraud.
 The auditor must extend the procedures in the audit of
year-end cash to determine the possibility of a material
fraud when there are inadequate internal controls,
especially the improper segregation of duties between
the handling of cash and the recording of cash
transactions in the accounting records and the lack of an
independently prepared monthly bank reconciliation.
 Fraud oriented procedures include:
1. Extended tests of the bank reconciliation
2. Proofs of cash and
3. Tests of interbank transfers
1. Extended Tests of the Bank Reconciliation
 It is performed when the auditor believes that the year-end bank
reconciliation is intentionally misstated.
 The purpose of this procedure is to verify whether all
transactions included in the journal for the last month of the
year were correctly included in or excluded from the bank
reconciliation and to verify whether all items in the bank
reconciliation were correctly included.
2. Proof of cash
 Is a four-column working paper prepared by the auditor
to reconcile the bank’s record of the client’s beginning
balance, cash deposit, cleared checks and ending
balance for the period, with the client’s records.
The auditor uses a proof of cash to determine whether
the following were done.
 All recorded cash receipts were deposited
 All deposit in the bank were recorded in the accounting records
 All recorded cash disbursements were paid by the bank
 All amounts that were paid by the bank were recorded
 A proof of cash includes the following

 A reconciliation of the balance on the bank

statement with the general ledger balance at the
beginning of the proof-of-cash period.
 A reconciliation of cash receipts deposited per the
bank with the cash receipt journal for a given
period.
 A reconciliation of cancelled checks clearing the
bank with the cash disbursements journal for a
given period.
 A reconciliation of the balance on the bank
statement with the general ledger balance at the
end of the proof of-cash period.
 3. Test of Inter bank transactions

 This procedure is helpful in preventing

embezzlements that may occur when the client
has accounts in more than one bank
 Embezzlers’ occasionally cover a defalcation of
cash by transferring money from one bank to
another and improperly record the transaction, such
practice is known as kiting.
 A useful approach to test for kiting, as well as for
errors in recording interbank transfers, is to list all
inter-bank transfers made a few days before and
after the balance sheet date and to trace each to the
accounting records for proper recording.
 There are several things that should be audited on the
interbank transfer schedule:
 The accuracy of the information on the interbank transfer
schedule should be verified.
 The interbank transfers must be recorded in both the
receiving and disbursing banks.
 The date of the recording of the disbursements and
receipts for each transfer must be in the same fiscal year.
 Disbursements on the interbank transfer schedule should
be correctly included in or excluded from year-end bank
reconciliations as outstanding checks.
 Receipts on the interbank transfer schedule should be
correctly included in or excluded from year-end bank
reconciliations as deposits in transit.
 Audit of the Imprest payroll Bank account

 It is a bank account to which the exact amount of

payroll for the pay period is transferred by check
from the employer’s general cash account.
 The audit includes reconciliation like those
described in the general cash account to reconcile
outstanding checks.
In testing the payroll bank account balances, auditors
must obtain:
• The bank reconciliation
• Bank confirmation and
• Cut-off bank statement.
 Audit of Imprest Petty Cash
 Petty cash is a unique account. Although it is
often immaterial in amount, many auditors
verify petty cash primarily because of the
potential for embezzlement and the client’s
expectation that auditors will examine the
account, even when the amount is immaterial.
 AUDIT FOR MARKETABLE SECURITIES

Marketable securities are

 Debt or equity securities that are readily marketable
 That management intends to hold for a short time
 Includes commercial paper, marketable equity
securities, and marketable debt securities
 Relevant Financial Statement Assertions
Existence or Occurrence: Securities exist at balance sheet
date.
Completeness: Securities balances include all securities
transactions taken place during the period.
Rights and obligations: Company has title to such
securities accounts as of balance sheet date
Valuation or allocation: Recorded balances reflect true
underlying economic value of those assets
Presentation and disclosure: Properly classifying the
securities on balance sheet and disclosing in notes to
financial statements
 Control Risks
Risk of theft of securities if:
 They are not physically controlled
 Authorization and monitoring over their trade is not
effective
 Lack of policies over purchase or sale of securities
 Lack of monitoring of changes in securities balances
 Lack of policies over valuation or classification of
securities
 Lack of segregation of duties between those responsible
for: Making investment decisions and Custody of securities
• Lack of involvement or oversight by internal audit in
relation to securities
INHERENT RISK ANALYSIS QUESTIONNAIRE - MARKETABLE SECURITIES
 Cont.…d

Are the written policies and

guidelines approved by the board?

Is there a clear policy for

classification of marketable
securities?

If classification has changed, are

the amounts significant and
reviewed by audit committee?
 Cont..d
How is value of marketable
securities estimated if a liquid
market does not exist?

Is there an effective segregation

of duties?

Is there a regular audit of the

controls and review of recent
reports?
 Cont.…d
Auditing in Practice - Common Fraud Schemes
Relating to Investments
• Securities purchased, not authorized
• Securities purchased, not recorded as purchased
• Securities recorded as purchased, not purchased
• Securities sold, not recorded as sold
• Securities recorded as sold, not sold
• Investment income is stolen
• Investments are purposely valued inaccurately
• Investment classifications are purposely inaccurate
Analytical Procedures for Marketable Securities
• Developing expectations about level of amounts
in ending balances
– Based on purchase or sales activity reported
• Developing expectations about relationship
between balances in marketable securities
accounts
• Reviewing changes in:
– Balances
– Risk composition
– Classification types of marketable securities
 Tests of Controls
• Reviewing policies for authorization
– To purchase, sell, and manage such securities
• Inquiring of board of directors about board’s
oversight of process and examining related
documentation
• Examining documentation of authorization
– For selected purchases and sales
• Reviewing minutes of board meetings
– For reference to investment policies and
associated oversight
 Cont.…d
 Examining evidence of authorization controls
– For changes in classification of such securities
 Inquiring of management about its process for
– Establishing valuation
– Reviewing related documentation
 Inquiring about process for reclassifications and
review related documentation
 Examining documentation for selected
marketable securities transactions
 Reviewing reports of internal audit
Assertions and Related Substantive Tests of Details - Marketable
Securities

Existence or occurrence
• Requesting for a schedule of securities and verifying their existence

Completeness
• Footing schedule of marketable securities and examining them

Rights and obligations

• Examining selected documents to determine any restrictions

Valuation or allocation
• Determining current market value
• Re-computing interest and proper recording of accrued interest

Presentation and disclosure

• Determining whether securities are properly classified
Auditing in Practice - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments

• Employing specialist to assist in fair value

measurements
• Conducting background checks of employees
having access to investment accounts
• Requiring original documents of securities
• Tracing:
– Dividend payments
– Interest payments
– Sales of securities
• Tracing purchases of securities to cash disbursements on
the bank statement
• Reviewing any unusual journal entries in investment
accounts
 Documentation related to substantive procedures for
marketable securities
 Schedule of marketable securities as:
– Prepared by client
– Reviewed by auditor
 Documentation of any confirmation of securities
 Documentation of securities transactions scrutinized
 Memo containing rationalization for judgments about
management’s:
– Classification of securities
– Valuation of securities
 Reports of any outside valuation experts
 Documentation of calculation of potential
impairments
END OF CHAPTER
2
THANK YOU!
 CHAPTER THREE
RECEIVABLE AND SALES AUDIT

Learning Objectives
After studying this chapter, students should be able
to:
Describe the sources and nature of receivable
Illustrate financial reporting standards for receivables
and sales
Evaluate internal control over receivables according to
accepted standards
Understand audit Program for receivables and sales
Transactions
Describe audit objectives for the receivables and sales
 Sources and Nature of Receivable
 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 or
 Receivables include amounts due from customers,
employees, and affiliates on open accounts, notes, and loans
and accrued interest on such balances.
 Financial Reporting Standards
Financial reporting standards for receivables require:
 Separation of trade from non – trade receivables.
 Assurance of ownership disclosure.
 Assurance of collectability of receivables.
 Assurance of consideration for returns and
allowances.
 Appropriate classification of current and non -
current.
 AUDIT OBJECTIVES

 The audit objectives for the receivables and sales

relate to obtain to sufficient competent evidence
about each significant financial statement assertion
that pertains receivables and sales transactions and
balances.
 To achieve each of these specific audit objectives,
the auditors employ various parts of the audit
planning and audit testing methodology.
 The auditors’ objectives in the examination of receivables and sales are :

1. To consider internal control over receivables and sales

transactions.
2. To determine the existence of receivables, the clients ownership
of these assets, and the occurrence of sales transactions.
3. To establish the completeness of receivables and sales
transactions.
4. To establish the clerical accuracy of records and supporting
schedules of receivables and sales.
5. To determine that the valuation of receivables is at appropriate
net realizable values.
6. To determine that the statement presentation of receivables and
sales is adequate.
Selected specific audit objectives for receivables and sales
 3.5 INTERNAL CONTROL OVER SALES AND RECEIVABLES

The objectives of internal controls over receivables are to ensure:

a. All goods dispatched/Shipped are invoiced.

b. Invoicing is at correct price and discount.

c. Goods are only dispatched on credit to approved customers.

d. Invoices are recorded and related to subsequent cash receipts.

e. Receivables are controlled and bad debts pursued.
f. Credit notes approved.
 Cont.….d
Control procedures, over sales and receivables
include the following.

a.Orders
- The orders should be checked against the
customer’s account.
- All orders received should be recorded on
pre-numbered sales order documents.
- All orders should be authorized before goods
are dispatched.
 Cont…d

b. Dispatch

- Dispatch notes should be pre-numbered and

a register kept of them to relate to sales
invoices and orders.
- Goods dispatch notes should be authorized
as goods leave.
 Cont.…d

C. Invoicing
- Sales invoices should be authorized by a responsible
official.
- Sales invoices should be checked for prices and
calculations by a person other than the one preparing the
invoice.
- All invoices should be pre-numbered consecutively.
- Copies of cancelled invoices should be retained/booked.
 Cont.…d

D. Receivables.
 A receivable ledger control account should be
prepared and checked to individual sales ledger
balances.
 Receivables ledger personnel should be
independent of dispatch and cash receipt functions.
 Statements should be sent regularly to customers.
 Cont…d

E. Bad debts.
- The authority to write off a bad debt should be
given in writing and adjustments made to the
accounts receivable ledger.
- The use of court action or write-off of a bad debt
should be authorized by an official independent of
the cash receipts function.
 3.6 AUDIT PROGRAM FOR RECEIVABLES AND SALES TRANSACTIONS

The following audit procedures are typical of the work

done in the verification of notes, accounts receivable,
and sales transaction.
A. Consider internal control for receivables and
sales.
 Obtain an understanding of internal control for
receivables and sales.
 The auditors’ consideration of internal controls over
receivables and sales may begin with the preparation
of a written narrative or flow chart and the completion
of an internal control questionnaire.
 Cont…d

 As the auditors’ confirm their understanding of the sales and

collection cycle, they will observe whether there is
appropriate segregation of duties, and enquire as to who
performed various functions throughout the year.
 Assess control risk and design additional tests of controls for
receivables and sales. After obtaining an understanding of
the client’s internal control for receivables and sales
transactions, the auditors perform their initial assessment of
control risk for the variant financial statement assertions.
 Cont..d
Perform additional tests and controls: Tests
directed towards the effectiveness of control
help to evaluate the client’s internal control,
and determine the extent to which the
auditors are justified in reducing their
assessed levels of control risk for the
assertion about the receivables and sales
accounts.
 Cont..d
The following are examples of additional tests:
1.Examine significant aspects of a sample of
sales transactions.
2.Compare a sample of shipping documents to
related sales invoices.
3.Review the use and authorization of credit
memoranda.
4.Reconcile selected cash register tapes and
sales invoices with sales journals.
 Cont…d
• Reassess control risk and design substantial tests.
When auditors have completed the procedures
described in the preceding sections, they should
assess the extent of control risk for each
financial statement assertions regarding
receivables and sales transactions. The
assessment will determine the nature, extent, and
timing of auditors’ substantive tests for
receivables and sales.
 Cont…d

B. Substantive tests
1. Obtain an aged trail balance of trade accounts receivable and analyses
of other accounts receivable and reconcile to ledgers. When trial
balances or analyses of accounts receivable are furnished to the auditors
by the client’s employees, some independent verification of the listings
is essential.

2. Obtain analyses of notes receivable and related interest.

3. Inspect notes on hand and confirm those note on hand with holders.
4. Confirm receivables with debtors.

5. Receive the year-end cutoff/limit of sales transactions.

 Cont.…d
6. Perform analytical procedures for accounts receivable, sales,
notes receivable, and interest revenue.
7. Verify interest earned on notes and accrued interest receivable.
8. Evaluate the propriety/correctness of the client’s accounting for
receivables and sales.
9. Determine adequacy of allowance for uncollectible accounts.
10. Ascertain whether any receivables have been pledged.
11. Investigate fully any notes or accounts receivable from related
parties.
12. Evaluate financial statement presentation and disclosure.
 CHAPTER FOUR

INVENTORIES AND COST OF GOODS SOLD

Presentation outline:
 Introduction
 Auditors’ objectives in the examination of
inventories and purchases
 Internal Controls Expected for Inventory
 Internal Control Principles for Inventories
Performing Audit for Inventory:
 Audit Objectives Relating to Inventories
 Audit Procedures for Inventories
 Introduction
 Inventories are major items on the balance sheet, i.e.
in total assets, especially in the current asset section.
 Inventories play also a very significant and
important role in preparation of income statement
and determination of net income or loss.
 The audit of inventory, especially test of the year-end
inventory balance is often the most complex and time
consuming part of the audit.
 Lack of information held on stock holdings resulting in
poor decision and inability to meet the demands and
objectives of the business.
 Factors affecting the complexity of the audit of
inventory include:-
 Inventory is generally a major item in B/sheet, and is often
the largest item making up the accounts included in
working capital.
 The inventory may be in different locations, which makes
physical control and counting difficult.
 The density of the items in inventories create difficulties
for the auditor.
 Valuation of inventory is also difficult because of such
factors as obsolescence and the need to allocate
manufacturing cost to inventory.
 Application of different valuation methods for different
parts of the inventory.
 Difficulty in identifying obsolete or defective inventory.
Auditors’ objectives in the examination of inventories and purchases

i. To consider internal control over inventories and

purchases.
ii.To determine the existence of inventories, and the
client’s ownership of these assets.
iii.To establish the completeness of inventories and
purchase transaction.
iv.To establish clerical accuracy of records and
supporting schedules for inventories and
purchases.
 Cont.…d
V. To determine that the valuation inventories is based on
appropriate methods.
VI. To determine the statement presentation of inventories is
adequate, including disclosure of classification of inventories,
accounting records and any inventories pledged as collateral for
loans.
Internal Controls Expected for Inventory
 The controls should be appropriate to manage the
risks associated with inventory.
 For companies heavily reliant on inventory
holding, there can be significant levels of risk and
therefore very robust controls are required.
 Cont…d
Both internal and external auditors will be involved
in audits of inventory and will need an
understanding of risks and the following internal
controls:
 Formal, documented procedures for inventory
controls that are monitored regularly to ensure
compliance.
 Trained and experienced staff, familiar with inventory
control requirements
 Inventory control planning processes
 Active records of inventory control and of future
requirements, with regular verification of such records
 Cont….d
 Regular liaison with other areas of the business to
maintain an awareness of future needs
 Authorization procedures for inventory changes,
including purchases
 Controls over inventory inwards, including logging and
recording and reconciliation of expected versus actual
inventory received

 Regular inventory valuations and reconciliation's

to accounting records
 Cont.…d
 Ccontrols over dispatches and goods outwards ,including
authorization of dispatch and physical check to ensure the correct
type and number of inventory items is released
 Inventory held in a secure site

 Inventory takes, including physical checks on level and type of

inventory
 Identification and physical tracking of raw materials, items in
production and finished goods
Internal Control Principles for Inventories
The auditor reviews the following aspects of internal
controls relating to inventories:
 Segregation and Rotation of Duties
 Authorization of Purchases, Receipts and Issues
 Maintenance of Records and Documents
 Accountability for and Safeguarding of Inventories
 Approval and control of documents
 Arithmetical accuracy
 Comparison of assets to records
 Assess to assets and records
 Performing Audit for Inventory
A. Audit Objectives Relating to Inventories:
The auditor aims at obtaining sufficient appropriate audit
evidence regarding the following assertions:
1. Existence - Inventories included in the financial statements
exist on the date of the balance sheet.
2. Rights and Obligations
 The entity has right of ownership to the inventories.
 Inventories exclude items billed to customers or those owned by
others.
3. Completeness - inventories include all raw materials and
components, work-in-process, finished goods, maintenance
supplies, and stores and spares on hand as well as those,
which are in transit or stored at third party locations (e.g.,
in public warehouses).
 Cont.…d
4. Valuation - Inventories are stated in the financial
statements at appropriate amounts in accordance with
the recognized accounting principles. This implies,
inter alias, that slow-moving, excess, defective,
damaged and obsolete items included in inventories are
properly identified and valued.
5. Presentations and Disclosure - Inventories are
properly classified and disclosed in the financial
statements in accordance with recognized accounting
principles and relevant statutory requirements.
 Audit Procedures for Inventories

On the basis of his/her evaluation of the effectiveness

of the internal controls, the auditor carries out
substantive procedures in relation to inventories.
These substantive procedures include the following:
a)Examination of records and documentation;
b)Review / observation of physical verification carried out
by management
c)Examination of valuation and disclosure of inventories;
d)Carrying out analytical procedures; and
e)Obtaining confirmation from third parties and
representations form management.
 Examination of Records and Documents
 The auditor's examination of records relating to
inventories depends upon the nature of records
maintained by the enterprise under audit.
 Where the enterprise maintains inventory records
showing quantities and values of inventories on a
perpetual basis, the auditor examines such records (on a
sampling basis).
 Where such records are not maintained, the auditor
suitably extends his other procedures, i.e., review /
observation of physical verification and analytical
procedures.
Review/ Observation of physical Verification carried out by Mgt

 The auditor needs to review the procedures, work

sheets and the follow-up action on the physical
verification of inventories carried out by the
management.
END OF CHAPTER FOUR
 CHAPTER-FIVE
AUDIT OF FIXED ASSETS
 Property, plant, and equipment are assets that have
expected lives of more than one year, are used in
the business, and are not acquired for resale.
 The intent to use the assets as part of the operation
of the client’s business and their expected lives of
more than one year are the significant
characteristics that distinguish these assets from
inventory, prepaid expenses, and investments.
 Cont…d
There are four types of property, plant, and equipment
transactions in fixed assets.
 Acquisition of capital assets for cash, or other non-monetary
considerations (exchange by other fixed assets)
 Disposition of capital (fixed assets) through sale, exchange,
retirement, or abandonment.
 Depreciation of capital assets over their useful economic
life
 Leasing of capital assets
 Cont.….d

 The property, plant and equipment subsidiary ledger is record of

all capital assets owned by the entity.
 It contains information of the cost of the asset, the date acquired,
the method of depreciation, and accumulated depreciation.
 The subsidiary ledger also includes the calculation of
depreciation expense for both financial statements and income
tax purposes.
 The subsidiary ledger should be reconciled to the general ledger
control account on a monthly basis.
Evaluating Internal Control over Fixed Assets
The important controls applicable to plant and equipment
are as follows:-
 A subsidiary ledger consisting of a separate record for
each unit of property.
 A system of authorizations requiring advance executive
approval of all plant and equipment acquisitions,
whether by purchase, lease, or construction.
 Cont.…d

 A reporting procedure assuring prompt disclosure and analysis of variances

between authorized expenditures and actual costs.
 A policy requiring all purchases of plant and equipment to be handled
through the purchasing department and subjected to standard routines for
receiving, inspection and payment.
 Periodic physical inventories designed to verify the existence, location, and
condition of all property listed in the accounts and to disclose the existence
of any unrecorded units.
 The reconciliation of detailed records with control accounts.

 Physical security over fixed assets and, if appropriate, the title to fixed assets
recorded in the accounts.
Internal control questionnaires for fixed assets
 5.2 Performing Audit for Fixed Assets

5.2.1 Audit Objectives of Fixed Assets

The auditors' objectives in fixed assets audit are to determine
that:
 The recorded property, plant, and equipment is valid (existence
and rights).
 All property, plant, and equipment is recorded (completeness)
 Property, plant, and equipment records and supporting
schedules are mathematically correct and agree with general
ledger accounts (clerical accuracy).
 The valuation of property, plant, and equipment is proper
(valuation).
 The presentation and disclosure of property, plant, and
equipment, including disclosure of depreciation methods, is
adequate. ( Disclosure)
 5.2.2 Audit Procedures for Fixed Assets

To ascertain that validity of the records of fixed assets,

 Examine the fixed asset register, and trace the balances to the ledger
accounts and the balance sheet.
 Trace the purchase invoices during the year to the fixed asset register,
the ledger accounts and the balance sheet.
 Examine purchase invoices to verify that all the fixed assets
acquisitions recorded in the books are for transactions that have
occurred.
 Review minutes of the executive committee for approval of
acquisitions.
 Physical observation of assets to ascertain existence of fixed assets.
 Cont….d

To verify the completeness of fixed asset records, apply

the following audit procedures:
 Examine the fixed asset register, and trace the balances
to the ledger accounts and the balance sheet.
 Trace the purchase invoices during the year to the fixed
asset register, the ledger accounts and the balance sheet.
 Examine plant asset acquisitions and disposals to make
sure that these transactions are in the right period.
 Cont….d
To verify the clerical accuracy of records reconcile the figures
of cost, accumulated depreciation and book value with the
corresponding figure in the previous year end:
 Verify calculation of depreciation.

 examine the valuation of assets at acquisition

 Verify arithmetic accuracy of addition.

 Examine sales invoices and accounting records for disposals

and check that depreciation is calculated to date of disposal.
Perform Analytical procedures - According to Qualified
Advice and Audit Partners, analytical procedures
encompass the investigation of identified fluctuations and
relationships that are inconsistent with other relevant
information or deviate significantly from predicted
amounts.

Analytical Procedures Commonly Used to Audit Plant

Assets
 Cont.…d
Inquiry and Observation - The auditor asks the client
about the location of fixed assets and any changes in
value of existing assets.
– The client's response helps the auditor determine which
fixed assets he/she selects to physically observe.
– While observing an asset, the auditor determines that the
asset existences and condition that is comparable to the
remaining life listed on the depreciation schedule.
 Cont…d

Verify Current Year Acquisitions

• Companies must correctly record current year additions
because the assets have long-term effects on the financial
statements.
• The failure to capitalize a fixed asset, or the recording of an
acquisition at the incorrect amount, affects the balance
sheet until the company disposes of the asset.
• The income statement is affected until the asset is fully
depreciated.
 Cont…d

Verify Current Year Disposals

 Transactions involving the disposal of fixed assets are often misstated when
company internal controls lack a formal method to inform management of the
sale, trade-in, abandonment, or theft of recorded machinery and equipment.
 If the client fails to record disposals, the original cost of the equipment
account will be overstated indefinitely, and net book value will be overstated
until the asset is fully depreciated.
 Formal methods of tracking disposals and provisions for proper authorization
of the sale or other disposal of equipment help reduce the risk of misstatement.
 There should also be adequate internal verification of recorded disposals to
make sure that assets are correctly removed from the accounting records.
Verify Depreciation Expense
•  Depreciation expense is one of the few expense accounts not verified as part of tests of controls and
substantive tests of transactions.
• The recorded amounts are determined by internal allocations rather than by exchange transactions with
outside parties.
• When depreciation expense is material, more tests of details of depreciation expense are required than for an
account that has already been verified through tests of controls and substantive tests of transactions.
• The most important balance-related audit objective for depreciation expense is accuracy.

• Auditors focus on determining whether the client followed a consistent depreciation policy from period to
period, and the client’s calculations are correct.
• In determining the former, auditors must weigh four considerations:
 The useful life of current period acquisitions
 The method of depreciation
 The estimated salvage value
 The policy of depreciating assets in the year of acquisition and disposition
 Cont…d
Verify Ending Balance in Accumulated Depreciation
• The debits to accumulated depreciation are normally tested as a part of
the audit of disposals of assets, while the credits are verified as a part of
depreciation expense.
• Two objectives are usually emphasized in the audit of the ending
balance in accumulated depreciation:

1.Accumulated depreciation as stated in the property master file agrees

with the general ledger.
 This objective can be satisfied by test-footing the accumulated depreciation in
the property master file and tracing the total to the general ledger.

2. Accumulated depreciation in the master file is accurate.

 Natural Resources

• The audit procedures for determining the cost of natural resources

are similar to those for other fixed assets.
• The auditor should test the capitalization of all new natural
resources and should verify the costs by examining documents,
including the client’s own process of documenting all the costs of
exploration and drilling.
• Depletion expense should be based on the items extracted during
the year using the units of production method.
• The company should have production records of daily extractions.
 Cont…d
• In addition, the auditor will be able to substantiate the amount of
items sold during the year.
• Further, the company should have procedures to estimate any
changes in reserves in order to update the depletion procedures.
• All costs associated with restoring the property to its original state
should be estimated and accrued.
• The auditor should examine the reasonableness of the procedures
used by management to estimate such expenses.
• Reclamation expenses should be amortized against the use of the
natural resources as part of the depletion expense
 CHAPTER SIX

AUDIT APPROACH IN RELATION TO

LIABILITY AND CAPITAL ACCOUNTS
 Introduction
 Liabilities are the financial obligations of an enterprise
other than owners’ funds.
 Liabilities include loans and borrowings, trade creditors
and other current liabilities, deferred payment credits,
installments payable under hire purchase agreements, and
provisions.
 Current liabilities include
 trade liabilities (accounts payable and notes payable),
 accrued charges,
 short term borrowings and
 currently matured portion long-term liabilities.
 Introduction………

 Trade liabilities constitute the major part of

current liabilities.
 Thus, trade payable is the item requiring most work

which will be tested by extracting appropriate sample.

 To ensure that trade liabilities reported in the

balance sheet are valid, complete and accurate,

the client should establish strong internal control.
 Internal Controls over Trade Payables
The client should establish strong internal control over
trade payable to ensure that:
1. Purchased goods /services are ordered under proper
authorities and procedures;
2. The order made as necessary for the proper conduct of
business operations and are ordered from suitable
suppliers;
3. Good / services received are effectively inspected for
quality, quantity and condition
 Cont….d
4. Invoices and related documentation are properly checked and
approved as being valid before being entered as trade payables
5. All valid transactions relating to trade payable (suppliers' invoices,
credit notes and adjustments), should be accurately recorded in the
accounting records.
6. Separation of duties (like approvals of vendors
invoice, recording of payables, preparation of checks,
and control over checks already prepared).
7. Ascertaining proper authorization for creation of
liability.
8. Ensuring that unauthorized liabilities are not recorded
and paid.
9. Ascertaining that all proper liabilities are recorded
promptly.
 Cont…d

 Reviewing the individual account balance.

In reviewing the individual account balance
consider;
- Is the balance made up of specific item
outstanding within a reasonable period?
- Have all items been authorized for payment?
- Does the amount agree with the
supplier’s statement?
- Is confirming for account balance required?
 Current Liabilities Audit Objectives

In carrying out an audit of trade liabilities, the auditor aims

are to reasonably assure him/her self regarding the
following assertions:
1. Existence: the amounts recorded in respect of creditors
are actually outstanding
• Recorded acquisitions are for items that were acquired
2. Rights and Obligations: creditors represent obligations
of the enterprise
• The client has an obligation to pay
3. Classification - payables in the listing are properly classified
 Cont….d
4. Completeness: the creditors as shown by ledger
accounts are complete
• To ensure that existing accounts payable
• Search for unrecorded liabilities
5. Valuation: the creditors' balances are stated at
appropriate amounts
 Acquisitions are recorded for the proper amounts
6. Presentation and Disclosure: to check creditors'
accounts are properly classified and disclosed in the
financial statement in accordance with GAAPs.
7. Cut-off - to determine if the transactions are recorded
in the correct period