1. Exam Focus and Strategic Maneuvering
This chapter deals with the practical application of audit principles, and it's a frequent topic in exams. The key is to move beyond general knowledge and apply your understanding to a specific scenario.
Strategic Maneuvering: The "ACTION, SOURCE, OBJECTIVE" Rule
To write a good audit procedure in an exam, remember to include three key components:
- ACTION: What the auditor will do (e.g., inspect, recalculate, observe).
- SOURCE: The document or record the action will be performed on (e.g., a purchase invoice, the non-current asset register).
- OBJECTIVE: The reason for the procedure (e.g., to verify existence, to confirm valuation).
A weak answer might say, "Check some invoices." A strong answer would say, "Select a sample of invoices from the purchase day book and inspect them to confirm the correct amount and date, verifying accuracy and cut-off."
2. Directional Testing
Directional testing is a powerful concept that uses the principles of double-entry bookkeeping to make audit testing more efficient. It is particularly useful for focusing your testing efforts on the areas most at risk.
- To test for understatement (Completeness): The auditor selects a sample from outside the accounting system (e.g., a Goods Received Note) and traces it into the system to ensure it has been recorded. This confirms that all transactions that should have been recorded have been.
- To test for overstatement (Existence, Valuation, Occurrence): The auditor selects a sample from within the accounting system (e.g., the sales day book) and traces it back to supporting documentation (e.g., the Goods Despatch Note) to confirm that the transaction or balance is valid.
3. Auditing Key Balances
Bank and Cash
The key assertions are existence and valuation. The most reliable source of evidence is the bank confirmation letter, which provides independent, third-party verification of balances. Auditors also review and reperform the client's bank reconciliation to account for timing differences.
Test your understanding 1 - Bank and cash: Murray Co
Bank reconciliation as at 31 December 20X4
| Item | Amount ($) |
|---|---|
| Balance per cash book | (180,345.22) |
| Add: Unpresented cheques | 2,223.46 |
| Less: Outstanding lodgements | (1,600.34) |
| Difference | 1.34 |
| Balance per bank statement | (179,720.76) |
Required: Describe the substantive procedures the auditor should perform to verify the bank and cash balance of Murray Co.
Substantive procedures for bank and cash:
- Obtain and cast the bank reconciliation to confirm its arithmetical accuracy.
- Obtain a bank confirmation letter from the bank and agree the balance per bank statement.
- Agree the balance per the cash book on the reconciliation to the year-end cash book and financial statements.
- Trace all unpresented cheques and outstanding lodgements to post-year-end bank statements.
- For any cash in hand, perform a cash count to verify its existence.
Non-current Liabilities and Non-current Assets
For non-current liabilities, the key assertions are completeness and valuation. Evidence is obtained from loan agreements and bank confirmation letters. Procedures focus on verifying outstanding balances, recalculating interest, and checking for compliance with loan covenants.
For non-current assets, the key assertions are existence, valuation, and rights and obligations. The auditor will perform procedures on additions, disposals, and depreciation, and physically inspect a sample of assets to verify their existence.
Test your understanding 2 - Non-current assets: Murray Co
Non-current assets: Property, plant and equipment note
| Land & buildings ($000) | Fixtures, fittings & equipment ($000) | Motor vehicles ($000) | Total ($000) | |
|---|---|---|---|---|
| Cost at 1 January 20X4 | 3,000 | 2,525 | 375 | 5,900 |
| Additions | 1,050 | 75 | 1,125 | |
| Disposals | (300) | (300) | ||
| Cost at 31 December 20X4 | 3,000 | 3,275 | 450 | 6,725 |
| Accumulated depreciation at 1 January 20X4 | 386 | 489 | 125 | 1,000 |
| Charge for the year | 97 | 338 | 56 | 491 |
| Disposals | (116) | (116) | ||
| Accumulated depreciation at 31 December 20X4 | 483 | 711 | 181 | 1,375 |
| Carrying value at 31 December 20X4 | 2,517 | 2,564 | 269 | 5,350 |
| Carrying value at 31 December 20X3 | 2,614 | 2,036 | 250 | 4,900 |
Required: Describe the substantive procedures the auditor should perform to confirm the non-current assets included in Murray Co's financial statements.
Substantive procedures for non-current assets:
- Obtain and cast the non-current asset register and agree totals to the financial statements.
- For a sample of assets from the register, physically inspect them to verify existence.
- For a sample of additions, agree the cost to supplier invoices and inspect them to ensure they are capital in nature, not repairs.
- Recalculate the depreciation charge for a sample of assets to verify accuracy and valuation.
- Inspect title deeds or other ownership documents for land and buildings to verify rights and obligations.
4. Auditing Inventory, Receivables, and Payables
Inventory is often a high-risk area. The key assertions are existence and valuation. The auditor's attendance at the inventory count is crucial. The auditor does not perform the count but observes and performs test counts to gain assurance over the client's process.
Receivables testing focuses on valuation (are they recoverable?) and existence. A receivables circularization provides reliable, external evidence for existence. Auditors also inspect post-year-end cash receipts and review aged receivable listings for old debts that may need to be written off.
Payables and accruals are tested primarily for completeness. Auditors are concerned with understatement. Procedures include reconciling supplier statements to the payables ledger and inspecting post-year-end payments and invoices to ensure all liabilities have been recorded.
Test your understanding 3 - Inventory: Murray Co
Murray Co's inventory count instructions are as follows:
(1) A finance manager must supervise the inventory count.
(2) No goods are to be received or despatched during the inventory count.
(3) Each team will consist of two members of staff from the finance department. One person must count the items. The second person will record the count on sequentially numbered count sheets.
(4) The teams will be allocated a team number and will be provided with a map of the warehouse. Each area of the warehouse is marked on the map with the number of the team that is to count inventory in that area. The warehouse manager will be in attendance to ensure each team is clear about which area they are counting, before it is counted.
(5) Once a section is counted it must be tagged to confirm it has been counted. Yellow tags are to be used by the first counting team to confirm the count has been performed.
(6) Once the first count is complete, a second count will take place, with each team counting an area that they were not responsible for on the first count (according to the warehouse map). Any discrepancies should be notified to the finance director immediately. Green tags are to be used to confirm the count has been checked by a second team.
(7) Sequentially numbered count sheets will contain the product description from the inventory system but no system quantities.
(8) Any items of inventory in the warehouse that are not listed on the count sheets should be recorded on a blank, sequentially numbered count sheet.
(9) Inventory count sheets must be recorded in ink. If a mistake is made, it should be crossed out neatly and the correct information written next to it.
(10) Any damaged or obsolete items will be moved to a designated area. After the count, an assessment of the goods will be made by the finance manager with advice from a sales manager and the warehouse manager, to determine the allowance appropriate for the condition of the items.
(11) After the count, the finance manager should review the warehouse to ensure all sections have been tagged with both yellow and green tags to confirm the count is complete.
(12) The count sheets must be signed by each team member responsible for completing the sheets and returned to the finance manager who will perform a sequence check to confirm all count sheets have been returned.
(13) The finance manager will compare the inventory count sheets to the inventory records and any adjustments will be updated by another finance manager not involved in the count.
Required:
- Describe the procedures that should be performed by the auditor before attending the inventory count of Murray Co.
- Describe the audit procedures that should be performed whilst in attendance at the inventory count of Murray Co.
- Describe the substantive procedures that should be performed during the final audit of Murray Co.
Solution:
- Before the count: Obtain and review the client's inventory count instructions, consider the need for an expert, and request confirmation of inventory held at third-party locations.
- During the count: Observe that the client's instructions are followed (e.g., no inventory movements, teams of two), perform test counts (from floor to sheet for completeness, and from sheet to floor for existence), and inspect for damaged or obsolete items.
- At the final audit: Trace items from the count sheets to the final inventory listing. Inspect post-year-end sales invoices to test NRV, and recalculate valuations for WIP or finished goods.
5. Auditing Accounting Estimates and Specific Balances
Accounting estimates, such as provisions, are inherently risky due to their reliance on management judgment. The auditor must apply a high degree of professional skepticism, test management's assumptions, and may even develop an independent estimate to compare against the client's figures.
Share capital, reserves, and directors' emoluments are material by nature. Procedures involve inspecting board minutes for authorizations, recalculating dividends, and agreeing emoluments to payroll records and contracts to verify that they are completely and accurately disclosed.
6. Audits of Smaller Entities and Not-For-Profit Organizations
Smaller entities often have simpler systems and a lack of segregation of duties, which can increase audit risk. The auditor may rely more on a substantive approach and less on controls. However, direct owner control can sometimes compensate for these weaknesses.
Not-for-profit (NFP) organizations have unique risks, such as the completeness of donation income and the proper use of restricted funds. The auditor's procedures will be similar to a commercial audit but tailored to these specific risks.
Illustration 6 - Not-for-profit organization: Thames Pool Trust (TPT)
The Thames Pool Trust (TPT) is a not-for-profit organisation. TPT owns a large area of park space. Within the park is an open-air pool which locals can pay to use. TPT does not employ any staff directly. Day-to-day operations are run by a local organisation, EmCA, under a management agreement, and TPT receives a share of EmCA's operating surplus.
To raise funds to pursue its charitable objective, TPT stages six summer picnic concerts each year. Each event has an audience capacity of 1,200 with a ticket price of $40, and is entirely staffed by volunteers.
| Income and expenditure account | Notes | 20X8 ($000) | 20X7 ($000) |
|---|---|---|---|
| Income: | |||
| Share of operating surplus from EmCA | 1 | 49 | 38 |
| Summer concerts | 2 | 268 | 275 |
| Total income | 317 | 313 | |
| Expenditure: | |||
| Operation of pool | 3 | (27) | (57) |
| Summer concerts | 4 | (242) | (203) |
| Surplus for year | 48 | 53 |
Statement of financial position
| Notes | 20X8 ($000) | 20X7 ($000) | |
|---|---|---|---|
| Non-current assets | 5 | 38 | 55 |
| Current assets: | |||
| Amount due from EmCA | 89 | 102 | |
| Cash at bank | 877 | 805 | |
| Total assets | 1,004 | 962 | |
| Funds | 1,000 | 952 | |
| Non-current liabilities | 4 | 10 | |
| Total funds and liabilities | 1,004 | 962 |
Required: Outline the audit strategy and plan, including specific audit procedures for TPT.
Audit Strategy & Plan: The audit approach will be substantive due to the risks of understatement of income and potential detection risk with volunteer staff. The audit team should include staff with experience in NFP and grant-funding regulations. Materiality should be set at a lower level to compensate for the higher risks.
Procedures:
- For EmCA Surplus: Obtain direct confirmation from EmCA of the amount due. Agree after-date cash receipts to the year-end balance.
- For Concert Income: Obtain ticket sale data and reconcile to recorded income. Perform a reasonable test by comparing total income to the maximum potential revenue ($288,000).
- For Concert Expenses: Inspect invoices for fees paid to bands. Compare costs by category to the prior year and investigate significant differences.
Test Your Understanding: Summary Questions
Aged receivables analysis at 31 December 20X4 ($000)
| Ref | Customer Name | Total | Current | 30-60 days | 60-90 days | 90-120 days | >120 days |
|---|---|---|---|---|---|---|---|
| A001 | Anfield United Shop | 176 | 95 | 76 | 5 | 0 | 0 |
| B001 | Bibs and Balls | 0 | 0 | (24) | 0 | 24 | 0 |
| B002 | The Beautiful Game | 84 | 62 | 0 | 20 | 0 | 2 |
| B003 | Beckham's | 42 | 32 | 10 | 0 | 0 | 0 |
| C001 | Cheryl & Coleen Co | 12 | 12 | 0 | 0 | 0 | 0 |
| D001 | Dream Team | 45 | 0 | 31 | 14 | 0 | 0 |
| E001 | Escot Supermarket | 235 | 97 | 65 | 0 | 0 | 73 |
| G001 | Golf is Us | 211 | 0 | 0 | 0 | 100 | 111 |
| G002 | Green Green Grass | 61 | 50 | 11 | 0 | 0 | 0 |
| H001 | HHA Sports | 59 | 40 | 0 | 19 | 0 | 0 |
| J001 | Jilberts | 21 | 11 | 10 | 0 | 0 | 0 |
| J002 | James Smit Partnership | 256 | 73 | 102 | 34 | 45 | 2 |
| J003 | Jockeys | 419 | 278 | 120 | 21 | 0 | 0 |
| O001 | The Oval | 92 | 48 | 44 | 0 | 0 | 0 |
| P001 | Pole Vaulters | 76 | 0 | 0 | 76 | 0 | 0 |
| P002 | Polo Polo | 0 | 0 | 0 | 0 | 0 | 0 |
| S001 | Stayrose Supermarket | 97 | 24 | 23 | 23 | 27 | 0 |
| T001 | Trainers and More | 93 | 73 | 20 | 0 | 0 | 0 |
| T002 | Tike Co | (54) | 0 | 0 | 0 | 0 | (54) |
| W001 | Wanderers | 89 | 60 | 29 | 0 | 0 | 0 |
| W002 | Whistlers | (9) | 645 | (654) | 0 | 0 | 0 |
| W003 | Walk Hike Run | 4 | 0 | 0 | 0 | 0 | 4 |
| W004 | Winners | 31 | 21 | 10 | 0 | 0 | 0 |
| Total | 2,040 | 1,621 | (127) | 212 | 196 | 138 |
Required:
- Identify, with reasons, FOUR trade receivables balances from the aged receivables analysis that should be selected for further testing.
- Describe substantive procedures that should be performed to confirm the receivables balance of Murray Co.
Solution:
1. Balances for testing:
- Jockeys: The outstanding balance of $419,000 is material, representing over 20% of the total receivables balance. This requires detailed testing.
- Golf is Us: The balance of $211,000 is old and large. This may be irrecoverable, requiring a specific allowance to be made.
- Tike & Co: This has a large credit balance. This may be an error, a payment misallocation, or an overpayment, requiring further investigation and possible reclassification as a trade payable.
- Escot Supermarket: The balance of $235,000 is large, with a significant portion over 120 days old, indicating potential recoverability issues.
2. Substantive Procedures:
- Perform a positive receivables circularization.
- Inspect the aged receivables report for slow-moving balances and discuss with management.
- Inspect post-year-end bank statements for cash receipts.