Assertions, objectives, and audit procedures

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AUDITING CHAPTER 11Accounts Receivable Cash
Balances

• TOPICS
• Assertions, objectives, and audit procedures
• Audit risk client strategies and substantive
  tests
• Substantive tests for assertions
• Revenue recognition, earnings manipulation,
  channel stuffing
• Audit sampling accounts receivable
• Computer-assisted audit techniques

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ASSERTIONS OBJECTIVES
Topic 1 Assertions, objectives, and audit
procedures

• Management assertions Recorded receivables
  cash balances
• Exist
• Include all transactions (completeness)
• Represent rights of entity
• Are valued appropriately
• Are presented disclosed properly

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RELATING ASSERTIONS AUDIT PROCEDURES
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OBJECTIVES PROCEDURES Existence/Occurrence

• Objective determine whether all recorded sales,
  receivables, cash balances actually exist and
  whether all recorded transactions actually
  occurred
• Procedures
• Existence
• Physical observation
• Confirmation
• Transactions occurred
• Cutoff testing for proper period

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OBJECTIVES PROCEDURES Completeness

• Objective determine whether all receivables,
  sales, cash of period are presented in financial
  statements
• Procedures
• Examine documents
• Apply analytical procedures
• Cutoff bank statements, bank reconciliations, etc.

• An auditor generally tests the completeness of
  credit sales transactions by
• Confirming receivables balances with debtors
• Reviewing the collectability of receivables
  outstanding
• Inquiring of management
• Performing analytical procedures

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OBJECTIVES PROCEDURES Rights/Obligations

• Objective determine whether entity has property
  rights to cash, accounts receivable
• Procedures
• Examine documentation
• Confirmations
• Inquiries

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OBJECTIVES PROCEDURESValuation, Allocation

• Objective determine whether entity has recorded
  items in correct amounts, accounts, time
  periods
• Procedures
• Confirm balances
• Verify mathematical accuracy
• Examine details of recording

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OBJECTIVES PROCEDURES Presentation, Disclosure

• Objective determine whether recorded
  transactions, balances properly classified,
  described, disclosed
• Procedures
• Compare presentation to GAAP
• Annual updates of AICPA guidelines

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AUDIT RISK MODEL
Topic 2 Audit risk client strategies and
substantive tests

• AR CR x IR x DR
• Detection risk (DR) likelihood that error could
  occur not be detected
• Based on
• Control risk (CR) Likelihood of material error
  not detected by internal control
• Inherent risk (IR) Strategies threats
• Nature, extent, timing substantive tests
• Nature more/less persuasive tests
• Extent larger/smaller samples
• Timing balance sheet date or interim

• 2. If tests of controls show that controls over
  shipping and billing are likely ineffective, the
  auditor would
• Assess control risk at the minimum
• Perform audit procedures at an interim date
• Increase the extent of testing on receivable
  balances
• Not rely on managements representations

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Topic 3 Substantive tests for assertions
ASSERTIONS PROCEDURESACCOUNTS RECEIVABLE
SALES
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ASSERTIONS PROCEDURESACCOUNTS RECEIVABLE
SALES

• 5. Positive accounts receivable confirmations
  are appropriate when
• There is reason to believe that a substantial
  number of accounts may be in dispute
• Control risk is low
• Accounts receivable consists of many small
  balances
• Confirmations are mailed during an interim period

• 6. Under which of the following conditions might
  an auditor justify not confirming receivables
  balances with debtors?
• The auditor accepted the engagement after the
  balance sheet date
• Prior-year confirmations revealed no errors in
  the receivables balance
• A small number of customers comprise almost all
  of the receivables balance
• The client is a government contractor

• How might an auditor proceed to address
  confirmations that customers do not return?
• Review customer purchase orders
• Interview billing employees
• Propose the customer balances as an audit
  adjustment
• Review subsequent cash collections

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ASSERTIONS PROCEDURESACCOUNTS RECEIVABLE
SALES

• 3. Which of the following might be detected by
  sales cutoff tests?
• Overstated receivables c. Kiting
• Overstated sales d. Misappropriates inventory

4. To test whether all sales transactions have
been recorded, an auditor should test a sample
drawn from an entitys file of a. Receiving
reports b. Bills of lading c. Sales orders d.
Sales invoices

• 8. Which of the following procedures could
  reveal unrecorded sales at the balance sheet
  date?
• Comparing shipping documents with sales records
• Applying gross profit percentages to inventory
  shipped during the period
• Tracing payments received after the balance sheet
  date to accounts receivable records
• Sending accounts receivable confirmations

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Case 11-5 Analytical Procedures and Accounts
Receivable

• Martin Kline, engagement partner on RCT
  Manufacturing Company, a February 28, 2007,
  year-end client, is performing analytical
  procedures to better understand RCTs business
  and to determine where audit effort ought to be
  concentrated. The balance sheets and statements
  of operations for 2006 and 2007 follow.
• Refer to page 502 for balance sheets and income
  statements
• Additional information
• Cash sales are insignificant
• Year-end figures are comparable to the average
  for each respective year.
• Required For each year, compute accounts
  receivable turnover and, based on turnover,
  identify and discuss procedures Kline should
  include in the audit of accounts receivable

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ASSERTIONS PROCEDURES CASH
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• 10. A standard bank confirmation
• Requests information about indebtedness
• Is sent to the bank by the client
• Is signed by the clients chief executive and
  chief financial officers
• Requests information about account numbers

• 11. Assuming cash receipts from credit sales
  have been misappropriated, which of the following
  is likely to conceal the misappropriation and
  unlikely to be detected?
• Understating the sales journal
• Overstating the accounts receivable control
  account
• Overstating the accounts receivable subsidiary
  ledger
• Overstating the cash receipts journal

• 12. Which of the following interbank cash
  transfers misstates cash at December 31?
• Disbursement Receipt .
• Recorded in books Paid by bank Recorded in
  books Received by bank
• 12/31/06 01/04/07 12/31/06 12/31/06
• 01/04/07 01/05/07 12/31/06 01/04/07
• 12/31/06 01/05/07 12/31/06 01/04/07
• 01/04/07 01/11/07 01/04/07 01/04/07

• 9. An auditor requests a cutoff bank statement
  primarily to
• Verify the cash balance reported on the bank
  confirmation
• Verify reconciling items on the clients bank
  reconciliation
• Detect lapping
• Detect kiting

• 13. The purpose of a cutoff bank statement is to
• Reconcile cash on the books with cash in the bank
• Test deposits in transit and outstanding checks
• Reconcile accounts payable to cash disbursements
• Test subsequent cash receipts

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Case 11-9 Auditing a Client-Prepared Bank
Statement

• The following client-prepared bank reconciliation
  is presented to Kautz during an audit of the
  financial statements of Cynthia Company.
• Balance per bank (a) 18,375.91
• Deposit in transit (b)
• 12/30 1,417.10
• 12/31 2,840.69 4,311.79
• Subtotal 22,787.70
• Outstanding checks (c)
• 837 6,000.00
• 1941 671.80
• 1966 320.00
• 1984 1,855.42
• 1985 3,621.22
• 1987 2,576.89
• 1991 4,420.88 (19,466.21)
• Subtotal 3,221.49
• NSF check returned
• 12/29 (d) 200.00
• Bank charges 5.50
• Error, Check No. 1932 148.10

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REVENUE RECOGNITION EARNINGS MANIPULATION
Topic 4 Revenue recognition, earnings
manipulation, channel stuffing

• Increasingly, I have become concerned that the
  motivation to meet Wall Street earnings
  expectations may be overriding common sense
  business practices.
• Arthur Levitt, Jr., The Numbers Game. Speech
  NYU, 1998.

• 15. Which of the following is most likely to
  provide management with incentives to overstate
  earnings?
• Projected quarterly dividends
• Issuance of preferred stock
• Unbudgeted increases in materials prices
• A projected stock split

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REVENUE RECOGNITIONSAB 104

• Criteria
• Persuasive evidence of arrangement exists
• Delivery has occurred or services rendered
• Sellers price fixed or determinable
• Collectibility reasonably assured

• 17. Under which of the following circumstances
  does management have some discretion in timing
  the recognition of revenue?
• The timing of revenue is not reasonably
  determinable and the earnings process is not
  complete
• The amount and timing of revenue is reasonably
  determinable
• The earnings process is complete or reasonably
  complete
• The transaction is at arms length

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COMMON MEANS TO MANIPULATE EARNINGS - 1

• Method Revenue Recognition
  Error

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COMMON MEANS TO MANIPULATE EARNINGS - 2

• Method Revenue Recognition Error

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COMMON MEANS TO MANIPULATE EARNINGS - 3

• Method Revenue Recognition Error

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MANIPULATED EARNINGSChannel Stuffing

• Definition incentives to induce incremental
  demand
• Examples
• Bausch Lomb
• Told distributors to buy large amount of
  inventory to maintain distributorship
• BL recognized extra 22 million
• Sunbeam
• Used price discounting to encourage customers to
  hold 80 weeks of inventory

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MANIPULATED EARNINGSAsset Swaps

• Definition companies trading right to use others
  asset
• Examples
• Global Crossing
• Treated underseas cables as real estate
• Recognized revenue by treating swap as sale

• 20. Global Crossing exploited capacity swaps to
• Understate telecom assets c. Overstate net cash
  flow
• Recognize revenue prematurely d. Defer revenue

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MANIPULATED EARNINGSOther

• Improper expense capitalization
• Chambers Development
• Capitalized landfill expenses after determining
  earnings necessary to meet analysts expectations
• MicroStrategy
• Recognized revenue before all services provided
  for software sales

• 16. A vendor sold software to an engineering
  company, recorded revenue of 15,000, and
  included in the price end-user support for a
  number of hours the vendor and company have yet
  to determine. This is an example of
• A side agreement c. A kickback sale
• A consignment sale d. A conditional sale

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AUDIT SAMPLING ACCOUNTS RECEIVABLE
Topic 5 Audit sampling accounts receivable

• Update assessment of control risk
• Planning confirmations selecting plan
• Identify population, sampling unit, anticipated
  error
• Estimate tolerable error risk incorrect
  acceptance
• Calculate sample size
• Choose sample selection method
• Evaluate results

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COMPUTER ASSISTED TESTS
Topic 6 Computer-assisted audit techniques

• AR Accuracy
• Foot, crossfoot recorded amounts within master
  file
• Total balances
• Display/print exceptions
• AR Aging
• Trace individual balances from master file to
  sales journal
• Classify balances by invoice dates/age
• Display/print aged trial balances
• AR Credit Balances
• Scan master receivables file for net credit
  balances
• Display/print listing credit balance accounts

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Case 11-10 Computer-Assisted Audit Tests

• After determining that computer controls are
  valid, Hastings is reviewing the sales system of
  Rosco Corporation to determine how
  computer-assisted audit techniques may be used to
  assist in performing tests of Roscos sales
  records. Rosco sells corns from one central
  location. All orders are received by mail or fax
  and indicate that pre-assigned customer
  identification number, desired quantity, proposed
  delivery date, method of payment, and shipping
  terms. Since price fluctuates daily, orders do
  not indicate a price. Price sheets are printed
  daily, and details are stored in on computer. The
  details of orders also are maintained on
  computer.
• Each morning the shipping clerk receives a
  computer printout that indicates details of
  customers orders to be shipped that day. After
  the orders have been shipped, the shipping
  details are entered in the computer, which
  simultaneously updates the sales journal,
  perpetual inventory records, accounts receivable,
  and sales accounts. The details of all
  transactions, as well as daily updates, are
  maintained on computer and are accessible by
  Hastings.
• How man Hastings use computer-assisted audit
  techniques to perform substantive tests of
  Roscos sales records?
• What other auditing procedures should Hastings
  perform in order to complete the audit of Roscos
  sales records?