Sei sulla pagina 1di 121

Audit Objectives and


 Audit Objectives Related To Different Accounts
 Working Papers of Auditing
 Objectives and Procedures for Cash Audit
 Objectives and Procedures for Audit of
Receivables and Sales
 Objectives and Procedures to Audit Inventory
and Purchases
 Objectives and Procedures to Audit Fixed Assets

 After understanding the internal control structure of

the client, the auditor examines the transactions and
balances. In auditing transactions and account
balances, the auditor has to gather sufficient
competent audit evidence using different audit
procedures. The audit evidence you gather is the
function of audit objectives. That is, the type and
amount of evidence you collect is determined by the
specific audit objective the auditor intends to achieve.
 Similarly, auditing procedures are dependent upon
the nature and amount of evidence needed to satisfy
the specific audit objectives. Auditing objectives and
procedures are not necessarily related on a one-to-
one basis. Some audit procedures help to realize
many objectives.

 The auditing profession has identified five specific
audit objectives as being necessary in order to support
the fairness of financial statements. The audit
objectives emanate from financial statement
assertions. The general objective of financial statement
audit is expressing opinion on the fairness of financial
statements. To achieve this broad objective, you have
to develop specific audit objectives.

 existence or occurrence (validity),

 completeness,

 rights and obligations,

 valuation and allocation, and

 presentation and disclosure.


 The auditor uses different working papers for different

tests and gathering of data necessary to give audit
opinion. All working papers are important and they
should be kept properly for a certain period of time.
Since the audit working papers document a variety of
information gathered by the auditors, there are
numerous types of papers such as:-
1. Audit administrative work in papers: - as
Auditing is a sophisticated activity requiring planning,
supervision, control and coordination; certain working
papers are specifically designed to aid the auditors in
the planning and administration engagements. These
working papers include Audit plan and programs,
internal control questionnaires and flow charts,
engagement letters, and time budget.
2. Working trial balance;- the working trial balance is
a schedule listing the balance of the accounts in the
general ledger for the current and previous year, and
also providing columns for the auditors’ proposed
adjustments and reclassifications and for the final
amount that will appear in the financial statements.
Working trial balances is the “backbone” of the entire
set of audit working papers; it is the key schedule that
controls and summarizes all supporting papers.
3. Lead schedules: - it is also called grouping sheet or
summary schedules set up to combine similar general
ledger accounts, the total of which appears on the
working trial balances as a single amount. For
example, a lead schedule for cash might combine the
following general ledger accounts: petty cash, br. 500;
General bank account, br. 150,000; factory payroll
bank account br. 1000 and Dividend bank account br.
4. Adjusting journal entries and Reclassification
entries: - To correct material errors or irregularities
discovered in the financial statements and accounting
records, the auditors draft adjusting Journal
entries, which they recommended for entry on the
clients accounting records. In addition, the auditors
Develop reclassification Journal entries for items that,
although correctly recorded in the Accounting records,
must be reclassified for fair presentation in the client’s
financial statements. For example Account receivables
with the credit balance should be reclassified as a
liability in the balance sheet.
5. Supporting schedule
6. Analysis of a ledger Account: - the purpose of an
analysis is to show on one paper that all changes in an
asset, liability, equity, revenue, or expense accounts
are covered by the Audit.
7. Reconciliation: - frequently, auditors wish to prove
the relationship between amounts obtained from
Different sources. When they do so, they obtain or
prepare working papers known as reconciliations.
These reconciliation provides evidence as to the
accuracy of one or both of the amounts and are
important to the audit of many accounts, including
cash, Account – receivables, and inventories.
8. Computational working papers: - the auditors
Approach to verifying certain types of accounts and
other figure is to make an independent computation
and compare their results with the amount shown by
the client’s records. For example, amount that might
be verified by computation are interest expense,
depreciation, Payroll taxes, income taxes, pension
liabilities, and earning per share.
9. Collaborating documents: Audit is not limited to
the examination of financial records, and working
papers are not confined to schedule and analysis it
includes Documentation of copies of minutes of
directors and stockholders meeting, copies of articles of
incorporation and bylaws, and copies of important

 Cash consists of coins, currency, checks, money orders,

and money on hand or on deposit in a 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
characteristics, cash is the most susceptible asset to
improper use. Moreover, because of the large volume of
cash transactions, a number of errors may occur in
executing and recording cash transactions.

 the recorded cash is valid (existence and rights);

 all cash transactions are recorded (completeness);

 cash schedules are mathematically correct and agree

with general ledger accounts (clerical accuracy); and
 the presentation and disclosure of cash including
restricted funds is adequate (presentation and
 To achieve the above audit objectives, the auditor has
to first understand and evaluate the internal control
over cash transactions.
 Cash receipts may result from revenue
transactions, short and long-term borrowings,
issuance of capital stock, and the sale of
investments and other assets. The major source
of receivables of manufacturing and wholesale
businesses is credit sales- trade receivables. The
major functions in relation to cash handling are
receiving mail receipts, receiving over the
counter receipts, depositing cash in bank,
journalizing and posting cash receipt and
payment transactions, protecting cash on hand,
signing checks, and maintaining correctness of
cash balances.
These functions should be integrated to provide
assurance that:
 All cash that should have been received was
in fact received, recorded accurately, and
deposited promptly.
 Cash disbursements have been made only
for authorized purposes and have been
properly recorded.
 Cash balances are maintained at adequate.
To maintain a good cash handling practice, a company
has to develop an efficient internal control over cash.
Below are the general guidelines for good cash-
handling practices in all types of businesses
 Do not permit any employee to handle a transaction
from the beginning to the end.
 Separate cash handling from record keeping.

 Centralize receiving of cash as much as possible.

 Record cash receipts immediately.

 Encourage customers to obtain receipts and observe
cash register totals.
 Deposit each day’s cash receipts intact.

 Make all disbursements by check, with the exception

of small expenditures from petty cash.
 Have monthly bank reconciliations prepared by
employees not responsible for the issuance of checks or
custody of cash. The completed reconciliation should be
reviewed promptly by an appropriate official.
 The objectives of the Internal control over cash
receipts are to ascertain that all recorded cash receipts
represent transactions that occurred during the period
under audit (Validity), and that all cash receipts of
the period are recorded (completeness). Moreover,
the existence of strong internal control over cash
receipts assures that all recorded cash receipts
transactions are correct as to the amount, time period,
and classification and are correctly posted to the
general ledger and subsidiary ledger (documentation
and disclosure).
 The other objectives of internal control over cash
receipts are assuring that cash is properly secured
upon receipt and deposited in the bank daily
(safeguarding), and ascertaining that recorded cash
balances agree with cash on hand and in banks
(Subsequent accountability). In the paragraphs
that follow, you will have a look at the major internal
control over cash receipts.
 Internal control over cash disbursements: To
maintain a strong control over cash disbursements, all
payments should be made using checks. Moreover, the
petty cash fund from which small payments are made
should be established. In general, the internal control
over cash disbursements has the following objectives:
completeness, recording propriety, safeguarding
and subsequent accountability.
 Completeness: To ascertain that all cash payment
transactions are recorded, the client has to use pre-
numbered purchase orders, receiving reports, vouchers
and checks. For all documents, there should be
periodic follow up of unmatched documents such as
purchase orders or vendor’s orders without matching
receiving reports. Before preparing a check a voucher
is prepared and approved. To ensure that all vouchers
are recorded, the vouchers payable department should
prepare a daily voucher summary of the vouchers
 The summary is compared by an accounting
department supervisor to the total of the entries made
in the voucher register for that day. Similarly, the
treasurer’s office should prepare a daily check
summary. This summary should be compared by an
accounting department supervisor to the total of the
entries in the check register. This test helps you to
ensure that all cash disbursements are recorded.
 Recording propriety: The item description,
quantities, and prices on vouchers payable should be
verified with the receiving report, purchase order and
vendor’s invoice by another employee. The
mathematical accuracy of the vendor’s invoice and the
voucher should also be verified.
 The vouchers payable supervisor should monitor the
timelines of voucher preparation by comparing the
dates of vouchers with the dates of the receiving
reports. In addition, an accounting clerk should
monitor the timeliness of recording by comparing the
dates of voucher register entries with dates on
 There should be segregation of duties, which includes
assigning different individuals to maintain the unpaid
voucher file and to maintain the vouchers register.
This helps to have an independent internal
verification. Appropriate segregation of duties in
processing cash disbursements is provided by
preparing and issuing checks in the treasurer’s office
and recording the checks in general accounting.
 Safeguarding: The client has to have access controls
to protect records, documents and assets related to
cash disbursements. Unused checks and signed checks
that have not been mailed should be kept in secure
areas with restricted access. To ensure that signed
checks are not altered or diverted to an improper
payee, check signers should control their mailing.
Access to cash in bank is controlled by notifying the
bank the names of individuals authorized to sign
checks and having samples of their signatures on file
with the bank.
 Subsequent accountability: The independent
comparison of recorded bank balances with amounts
shown on bank statement is the principal control to
establish subsequent accountability. To this end, the
monthly bank reconciliations should be prepared by an
individual not involved in the processing or recording
of cash disbursements.
 You responsibility as an auditor is to evaluate if the
client internal control over cash receipts and
disbursement contains the aforementioned internal
control procedures. This helps you to determine the
level of reliance you should place on the client internal
control. The next task will be evaluating the account
balances. Hence, you have to prepare an audit
program that contains the appropriate audit
procedures of cash.
 Theaudit procedures you apply in auditing
cash are given below:
 Verify accuracy of cash schedules and agree
schedules to cash balances.
 Apply analytical procedures
 Count cash on hand
 Confirm bank balances
 Perform cash cutoff test
 Examine or prepare bank reconciliation
 Obtain and use bank cutoff tests
 Trace bank transfers
 Prepare proof of cash
 Compare statement presentation with GAAP.
 Most companies reconcile their bank and book
balances monthly. When the reconciliations are done
independently and reviewed by internal auditors, you
are only required to review the client’s at the end of
the year
 In reviewing the bank reconciliation prepared by the
client, you have to perform the following:
 Tracing bank balances to the bank confirmation
 Verifying the validity of the reconciling items such as
deposit in transit and outstanding checks.
 Scanning the bank statement for erasers and
alterations and investigating any occurrences.
 Establishing the propriety of any adjusting entries and
determining that the client has recorded them.
 If the client does not prepare bank reconciliation or if
the reconciliation is not made independently, you may
prepare the bank reconciliation yourself.
 The evidence provided by bank reconciliation alone is
not sufficient to verify the balance of cash in bank
because of the uncertainties concerning the two most
important reconciling items. These are the deposit in
transit and the outstanding checks. Such evidence is
obtained by tracing the deposit in transit and
outstanding checks to the next accounting period. To
this end, you have to obtain a cutoff bank statement.

A bank cutoff statement is a bank statement as of a date

subsequent to the date of balance sheet. The date should
be a point in time that will permit most of the year-end
bank statements to clear the bank. Usually the date is
seven to ten business days following the end of the
client’s fiscal year.
 The client requests the bank to send the cutoff bank
statement directly to the auditors. Upon receipt of the cutoff
statement, you should:
 Trace all prior year dated checks to the outstanding checks
listed on the bank reconciliation.
 Trace deposit in transit on the bank reconciliation to deposits
on the cutoff statement.
 Examine the cutoff statement and enclosed data for unusual
 Tracing the checks helps you to verify the list of
outstanding checks. When you trace the checks, you
may find that a prior period checks not on the list of
outstanding checks has cleared the bank. This may be
indicative of fraud known as kiting.
 In tracing checks, you may also find that some of the
checks listed as outstanding have not cleared the
bank. This may be due to delays in mailing the checks
by the payer, depositing the checks by the payee, and
processing the checks by the bank.
 If the aggregate effect of uncleared checks is material,
it may be indicative of fraud known as window
dressing. Window dressing is a deliberate attempt to
overstate a company’s short-term solvency. In such a
case, you have to trace the uncleared checks to the
check register (or to the cash payment journal) and
supporting documentation.

 In tracing deposit in transit, you have to check that

the first deposit in the cutoff bank statement is the
deposit in transit shown on the bank reconciliation. If
this is not the case, you have to obtain explanation
from the concerned person of the client staff.
 In scanning the cutoff statement for unusual items,
you have to be alert for such items as unrecorded bank
deposits and credits and bank errors and corrections.
Since the cutoff bank statement is sent directly to the
auditor by an independent party (the bank), it provides
a high degree of competent supporting evidence about
the validity of the year-end bank reconciliation and the
existence, completeness, rights and valuation
 Perform cash cutoff test
 A proper cutoff of cash receipts and cash
disbursements at the end of the year is important to
examine the proper statement of cash on the balance
sheet and the overall fairness of the client’s financial
statements. To this end, you have to apply cash
receipts cutoff tests to year-end cash transactions. You
have to examine cash receipts on the last business day
by reference to cash receipts listings, remittance
advices, and deposit tickets
 Perform cash cutoff test
 . If the cash is deposited before year-end, you should
trace it to the bank statement. If the cash receipts
were not deposited before year-end, you must trace
them to the bank reconciliation and to the cutoff bank
statement. For deposits in transit, you should
determine that the bank credited the deposit within
one or two working days after year-end. Credits dated
later than this may be indicative of faulty cutoff
procedures and, possibly, inflated year-end cash
 If customer remittances have been misappropriated by
one or more employees with access to customer
accounts, a form of concealment known as lapping may
have been applied. Lapping involves crediting current
remittances to the accounts of customers who have
remitted previously. The purpose is to keep all
accounts current in order to avoid auditor suspicion
and unusual customer exceptions to confirmation
 For example, assume that Customer A remitted Birr
5,000 on November 10, and the remittance was
misappropriated by an accounts receivable clerk.
Assume further that Customer B remitted Birr 8,000
on December 30, and that the company closes its book
on December 31. The dishonest clerk may elect to
credit Birr 5, 000 of B's remittance to Customer A, and
only Birr 3, 000 to Customer B's account in the
subsidiary ledger. The effect is to lessen the
probability of detection by transferring the fraudulent
debit from a past due to a current customer's account.
 The auditor is less likely to confirm Customer A's
balance, given its current status. In addition to
confirming customer accounts and clearing all
exceptions, an auditor who suspects lapping should
consider tracing the details of year-end cash receipts to
remittance advices and the accounts receivable
subsidiary ledger. Any credits to accounts other than
the customer remitting will thereby be detected. This
procedure may also be applied to cash receipts for the
first couple of days following year-end.
 Many companies maintain accounts with more than
one bank. A company with more than one bank
account may make authorized transfer of money
between bank accounts. When a bank transfer occurs,
several days will elapse before the check clears the
bank on which it is drawn. This period is known as
floating period. Thus, cash on deposit per bank records
will be overstated during this period because the check
will be included in the balance of the bank in which it
is deposited and will not be deducted from the bank on
which it is drawn. Bank transfers may also result in
misstatement of the bank balance per books if the
disbursement and receipt are not recorded in the same
accounting period.
 If the client has more than one bank account, the
auditor should analyze inter-bank transfers for one or
two weeks before and after year-end. The purpose of
this analysis is to detect errors or irregularities
involving year-end checks in transit between banks.
 Analyzing inter-bank transfers helps you to detect
kiting. Kiting is a type of misrepresentation fraud used
to conceal bank overdrafts or cash misappropriations.
Kiting occurs when a company draws a check on one
bank for deposit in another bank but does not record
the transaction or records only a part of the
transaction before year-end. A journal entry is made to
record the receipt, and the check is listed as a deposit
in transit to conceal the overdraft. The disbursement
side of the transaction is not recorded until after year-
end, and the check is not listed as outstanding in the
reconciliation of the disbursing bank.
 To examine the validity of bank transfers, you have to
prepare a schedule of the checks issued at or near the
end of the client’s fiscal year. You may obtain data for
the schedule from an analysis of the cash entries per
books, bank statements, and bank cutoff statements.
The schedule lists all transfer checks and shows the
dates the checks were recorded by the client and the

 Kiting is possible when one individual is allowed to
issue and record checks. Kiting is also possible if there
is collusion between the individuals who are
responsible for the two functions—issuing and
 In addition to tracing bank transfers, you may detect
kiting by obtaining and using bank cutoff statement
because the kited check clearing in January will not
appear on the list of outstanding checks for December.
You may also detect kiting by performing a cash cutoff
test since the last check issued in December will not be
recorded in the check register or cash payment journal.
Tracing of bank transfers provides you with reliable
evidence concerning the existence and completeness of

 If you conclude that the internal control over cash

transactions is weak you may prepare a proof of cash
for one or more of the year under audit. A proof of
cash is a simultaneous reconciliation of bank
transactions and balances with corresponding data per
books for a specified period of time. The time period
may be for one or more interim months or for the last
month of the fiscal year. Proof cash performs the same
function as the bank reconciliation and, in addition,
reconciles the client-recorded receipts and
disbursements with bank statement credits and debits.
This audit procedure helps you to detect errors in
recording cash receipts or disbursements. It will also
assist you in detecting omitted entries.
You have to follow the steps below in preparing a proof
of cash.
 Obtain the bank and book totals from the bank
statement and cash in bank account respectively.
 Obtain the beginning and the ending balance of
reconciling items from the bank reconciliations at the
designated dates.
 Determine the reconciling items for the two middle
columns by analysis.
 The term “receivables” refers to the amount due from
individuals and other companies. Receivables are
claims that are expected to be collected in cash.
Receivables may be classified as accounts receivable,
notes receivable and other receivables. Accounts
receivables are amounts owed by customers on
account. They result from sale of goods or services on
 The principal source of receivables for many companies
is sale of goods or services on account- accounts
receivable. In addition, a company may have accounts
for notes, interest, and loans receivable. The
importance of accounts and notes receivable to specific
enterprise varies with the volume of credit sales and
the length of credit period. For many businesses, the
revenue from sales of their products on a credit basis is
the largest factor influencing the amount of net
income. This is the reason why both receivables and
sales are discussed together in the subsequent

The auditor’s objectives in auditing receivables and sales are
to determine that:
 The recorded receivables are valid (existence and rights).

 All receivables are recorded (completeness).

 Receivable records and supporting schedules are

mathematically correct and agree with general ledger
accounts (clerical accuracy).
 The valuation of receivables approximates their realizable
values. (Valuation)
 The presentation and disclosure of receivables is adequate,
including the separation of receivables into appropriate
categories, and adequate reporting of any receivables
pledged as collateral and related party
receivables.(Presentation and disclosure)
 As an auditor, your objective to determine the validity
of the recorded receivables involves (1) determining
the genuineness of customers' accounts and notes and
(2) determining whether generally accepted accounting
principles have been followed in the establishment of
the receivables. You can evaluate the genuineness of
receivables by examining client controls over issuance
of sales invoices, shipping documents, and other
evidence of claims against customers. To examine
whether the client follows generally accepted ac-
counting principles, you should analyze estimates
made by management in areas such as the
capitalization of leases and the sale of franchises.

 When internal controls over sales on account are
inadequate, large credit losses are almost inevitable.
For example, merchandise may be shipped to
customers whose credit standing has not been
approved. Shipments may be made to customers
without notice being given to the billing department.
Consequently, no sales invoice is prepared. Sales
invoices may contain errors in prices and quantities;
and if sales invoices are not controlled by serial
numbers, some may be lost and never recorded as
accounts receivable. To avoid such difficulties, strong
internal controls over credit sales are necessary.
To strengthen internal control over credit sales, the
following functions should be performed by different
individuals or departments:
 Preparation of the sales order,
 Credit approval,
 Issuance of merchandise from stock,
 Shipment,
 Billing,
 Invoice verification,
 Maintenance of control accounts,
 Maintenance of customers' ledgers,
 Approval of sales returns and allowances, and
 Authorization of write-offs of uncollectible accounts.
 If the above functions are separated, errors can easily
be detected by comparing documents and amounts
obtained from independent units of the company, and
thus the opportunity for fraud is reduced.
 These rules show that there should be separation of
the authorization and recording functions from the
custodial function, especially for cash and receivables.
This reduces the likelihood of creating fictitious notes
receivable to offset a theft of cash. The same review
and approval should be required for renewal of a note;
otherwise, an opportunity is created for the diversion
of cash when a note is collected and the concealment of
a shortage by unauthorized renewal of the paid note.
To strengthen the control over notes, it is advisable
that the internal auditor confirm notes directly with
makers of the notes periodically.
 An employee may conceal cash shortage by not recording
receipt of a partial payment of a note. The client should
have control procedures for recording partial payments that
require writing the date and amount of the payment, and
the new unpaid balance should be entered on the back of
the note, with proper credit being given the debtor in the
note register. Moreover, any notes written off as
uncollectible should be kept under accounting control
because occasionally debtors may attempt to re-establish
their credit in later years by paying old dishonored notes.
Any credit memoranda or journal vouchers for partial
payments, write-offs, or adjustment of disputed notes
should be authorized by proper officials and kept under
numerical control.
 In many companies, internal control is strengthened
by the preparation of monthly reports summarizing
notes receivable transactions during the month and
the details of notes owned at the end of the reporting
period. These reports are often designed to focus
management attention immediately upon any
delinquent notes and to require advance approval for
renewals of maturing notes. In addition, the client
should prepare a monthly report on notes receivable to
show the amounts collected during the month, the new
notes accepted, notes discounted, and interest earned.
The person responsible for reporting on note
transactions should be someone other than the
custodian of the notes.

 In auditing receivables and sales, you should first
understand and then evaluate the internal control of
the client in the light of the internal control procedures
discussed so far. Then, you have to develop audit
procedures for receivables and sales, which you will
use as guide during the examination of the account

Below are the audit procedures applied by auditors to achieve the

audit objectives of receivables and sales.
 Verify accuracy of accounts receivable trial balance
and agreement with general ledger control.
 Apply analytical procedures.
 Confirm accounts receivable.
 Vouch recorded receivables to supporting
 Perform sales cutoff test
 Examine subsequent collections
 Vouch aged trial balance to supporting documentation.
 Evaluate whether the financial statements are
presented in accordance to GAAP.


 Inventories include goods held for sale to customers,

goods in the process of production, and materials and
supplies expected to be used or consumed in
production. The term merchandise inventory is usually
applied to goods held for sale by a retailer or
wholesaler when such goods have been acquired in a
condition for resale. The terms raw materials, work in
process, finished goods, and factory supplies are
generally used in referring to the inventories of a
manufacturing company. Our discussion in this unit
refers to all types of inventories.
Inventories have received much attention in both the
fields of accounting and auditing. The reasons for the
special significance attached to inventories include the
 Inventories usually constitute the largest portion of
current asset of an enterprise and are very susceptible
to major errors and irregularities.
 The existence of numerous alternative methods for
valuation of inventories which results in different
values of inventory and cost of goods sold.
 The complexity of determination of inventory quality,
condition, and value.
 The examination of inventories requires careful
planning and significant amount of time, cost, and
effort. Therefore, you have to identify the specific audit
objectives of inventory and purchases as part of your
As an auditor, your objectives in inventories and
purchases audit are to determine the following:
 The recorded inventories are valid (existence and
 All inventories are recorded (completeness).

 Inventory records and supporting schedules are

mathematically correct and agree with the general
ledger accounts (clerical accuracy).
 Inventories are properly valued (valuation).

 The presentation and disclosure of inventories is

 The importance of adequate internal control over
inventories and purchases from the viewpoint of both
management and the auditors can scarcely be
overemphasized. Good internal control is a means of
providing accurate cost data for inventories and
purchases as well as accuracy in reporting physical
quantities. Inadequate internal control may cause
losses by permitting erroneous cost data to be used by
management in setting prices and in making other
decisions based on reported profit margins. If the
accounts do not furnish a realistic picture of the cost of
inventories on hand, the cost of goods manufactured,
and the cost of goods sold, the financial statements
may be grossly misleading both as to earnings and as
to financial position.
 Internal control procedures for inventories and
purchases affect almost all the functions involved in
producing and disposing of the company's products.
Purchasing, receiving, storing, issuing, processing, and
shipping are the physical functions directly connected
with inventories; the cost accounting system and the
perpetual inventory records comprise the recording
functions. As an auditor, you will be interested in the
final products of the recording functions.
 Thus, you have to understand and appraise the cost
accounting system and the perpetual inventory records
as well as the various procedures and original
documents underlying the preparation of financial
data. The important functions in inventory and
purchase are purchasing, receiving, storing, issuing,
production, and shipping. To prevent errors and fraud
in inventory and purchases, the client has to have a
strong internal control over these functions. As an
auditor, you need to be aware of the nature of each
 The cost accounting system: An adequate cost
accounting system is necessary to account for the usage of
raw materials and supplies to determine the content and
value of goods in process inventories, and to compute the
finished goods inventory. In a manufacturing company, the
cost accounting system comprises all the records, orders,
requisitions, time tickets, and the like needed in a proper
accounting for the disposition of materials as they enter the
flow of production and as they continue through the factory
in the process of becoming finished goods. The cost
accounting system also serves to accumulate labor costs and
indirect costs that contribute to the goods in process and
the finished goods inventories. The cost accounting system
is therefore an integral part of the internal control for

 The figures produced by the cost system should be
controlled by general ledger accounts. Two general
types of systems are widely used. Under one, all
transactions in a factory are passed through a factory
ledger. The net balance of this ledger is represented by
a factory ledger controlling account in the general
ledger. The other system records the cost of materials,
labor, and factory overhead in individual goods in pro-
cess accounts for each production order or process.
These goods in process accounts are controlled by
single general ledger goods in process inventory
account. In effect, a subsidiary goods in process ledger
is produced by the cost system, which must at all times
be represented in the general records.
 Underlying this upper level of control between the
factory records and the general ledger is found a
system of production orders, material requisitions, job
tickets or other labor distributions, and factory
overhead distributions. To exercise strong internal
control over factory records, each production order
should be properly authorized, recorded, and followed
up. Payroll records are compiled only after all time
tickets have been verified for accuracy. Indirect costs
are distributed to the various job orders or processes
through predetermined rates which are adjusted to
actual cost at the period's end. In addition, many cost
systems have introduced methods of determining
spoilage, idle labor, and idle machine time
 These systems, known as standard costing, provide for
the prompt pricing of inventories and for a control over
operations through a study of variances between
actual and standard figures. All these various types of
cost accounting systems are alike in that all are
designed to contribute to effective internal control by
tracing the execution of managerial directives in the
factory, by providing reliable inventory figures, and by
safeguarding company assets.
 The perpetual inventory system: Perpetual
inventory records constitute the most important part
of internal control. These records show the quantity of
goods on hand which provide relevant information for
purchasing, sales, and production-planning policies.
Perpetual inventory records also serve as a guide for
purchasing by establishing points of minimum and
maximum quantities for each standard item stocked.
 To exercise strong internal control from perpetual
inventory records, the subsidiary records should be
maintained both in quantities and dollars for all stock;
the subsidiary records should be controlled by the
general ledger, the trial balances should be prepared
at reasonable intervals; and both the detailed records
and the general ledger control accounts should be
adjusted to agree with physical counts whenever
 Perpetual inventory records discourage inventory theft
and waste since store keepers and other employees are
aware of the accountability over goods established by
this continuous record of goods received, issued, and on
hand. The records, however, must be periodically
verified through the physical counting of goods.
 The above discussion aims at providing you with the
major internal control procedures over inventories and
purchases. This helps you to evaluate the internal
control procedures of the client in the light of these
internal control procedures. The other test you have to
perform is testing the account balances (substantive
testing). This is performed by developing audit
procedures for inventory and purchases.
Audit procedures for inventory and purchases
 To meet the audit objectives of inventory and purchase, you
have to do the following:
 verify accuracy of inventory schedules and agreement of
perpetual records with inventory balances.
 apply analytical procedures.
 observe client's inventory taking.
 confirm inventories in public warehouses.
 vouch recorded purchases to supporting documentation.
 perform purchases cutoff test.
 inquire of management regarding ownership.
 review data pertaining to inventory quality.
 vouch and test inventory pricing.
 compare statement presentation with GAAP.
 The primary source of evidence about inventory on
hand is obtained from observing the client's inventory
taking. Substantive tests of inventory balances result
in reliable evidence concerning management's
financial statement assertions.
 The term fixed assets includes all tangible assets with
a service life of more than one year that are used in
the operation of the business and are not acquired for
the purpose of resale
Three major subgroups of such assets are generally
 Land, such as acres of property used in the operation
of the business, has the significant characteristic of not
being subject to depreciation.
 Buildings, machinery, equipment, and land
improvements, such as fences and parking lots, have
limited service lives and are subject to depreciation.
 Natural resources (wasting assets), such as oil wells,
coalmines, and tracts of timber, are subject to
depletion as the natural resources are extracted or
 Acquisitions and disposals of property, plant, and
equipment are usually large in dollar amount, but
concentrated in only a few transactions. Individual
items of plant and equipment may remain unchanged
in the accounts for many years. In auditing any
financial statement items, you have to first set the
specific audit objectives. Consequently, you have to
identify the audit objectives for 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
 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.
 The principal purpose of internal controls relating to
plant and equipment is to obtain maximum efficiency
from the dollars/Birr invested in plant assets. The
amount invested in fixed assets represents a large
portion of the total assets of many industrial concerns.
The expenses of maintenance, rearrangement, and
depreciation of these assets are a major factor in the
income statement. Thus, there has to be a strong
internal control over fixed assets so as to the produce
reliable financial statements.
 Errors in measurement of income will be material if
assets are scrapped without their cost being removed
from the accounts or if the distinction between capital
and revenue expenditures is not maintained
consistently. The losses that inevitably arise from
uncontrolled methods of acquiring, maintaining, and
retiring fixed assets are often greater than the losses
from fraud in cash handling.

 The plant and equipment budget: In large
enterprises, you may expect to find an annual plant
budget used to forecast and to control acquisitions and
retirements of plant and equipment. Many small
companies also forecast expenditures for plant assets.
Successful utilization of a fixed assets budget
presupposes the existence of reliable and detailed
accounting records for plant and equipment. A detailed
knowledge of the kinds, quantities, and condition of
existing equipment is an essential basis to forecast the
need for replacements and additions to the plant.
 Other major control devices
 Other important controls applicable to plant and equipment
are as follows:
 A subsidiary ledger consisting of a separate record
for each unit of property. An adequate plant and
equipment ledger facilitates your work in analyzing
additions and retirements; in verifying the depreciation
provision and maintenance expenses; and in comparing
authorizations with actual expenditures.
 A system of authorizations requiring advance executive
approval of all plant and equipment acquisitions, whether
by purchase, lease, or construction. Serially numbered
capital work orders are a convenient means of recording
 A reporting procedure assuring prompt disclosure
and analysis of variances between authorized
expenditures and actual costs.
 An authoritative written statement of company
policy distinguishing between capital and revenue
expenditures. A dollar minimum ordinarily will be
established for capitalization; any expenditures of
lesser amount are automatically classified as charges
against current revenue.
 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.
 A system of retirement procedures including
serially numbered retirement work orders, stating
reasons for retirement and bearing appropriate
Audit procedures for fixed assets
 You have to apply the following audit procedures to achieve
the audit objectives of fixed assets.
 Verify accuracy of schedules and agreement of subsidiary
ledger with plant asset balances.
 Apply analytical procedures.
 Inspect plant additions.
 Examine title documents and lease contracts.

 Vouch plant asset additions.

 Vouch plant asset disposals.
 Analyze entries to repairs expense.

 Review entries to accumulated depreciation.

 Compare statement presentation with GAAP .
 In what follows, each audit procedure is discussed in
 Verify Accuracy of Schedules and Agreement of
Subsidiary Ledger with Plant Asset Balances

 Before undertaking any of the subsequent steps in the

audit procedures, you should test the mathematical
accuracy of schedules and the agreement of the
subsidiary plant ledger with general ledger plant asset
balances. It is also important that you compare
beginning balances with the balances shown on the
prior period's working papers. This comparison is
made to ascertain whether the client booked the
adjustments proposed by the auditor at the conclusion
of the prior audit.
 This test helps you to check the clerical accuracy fixed
asset records.

Apply Analytical Procedures

 The following financial relationships are often used in
applying analytical procedures to plant assets:
Financial Relationship Formula

Plant asset turnover Net sales /Average plant assets

Rate of return on plant assets Net income / Average plant

Plant assets to stockholders' Plant assets / Stockholders'
equity equity
Repairs expense to net sales Repairs expense / Net sales
 When comparisons of these relationships with other
data reveal normal or expected results, you can
conclude that the fixed assets exist, and the account
balances are complete and properly valued. However,
an abnormal result should be investigated. For
example, an extreme decrease in the ratio of repairs
expense to net sales may indicate that some
maintenance expenditures have not been recorded.
 You may obtain information on plant additions from an
analysis of fixed asset accounts, an examination of
fixed asset schedules, a review of the minutes of board
of directors' meetings, and inquiry of management. The
inspection of plant assets acquired during the year
enables you to obtain direct personal knowledge of
their existence. Physical inspection also allows you to
acquire other corroborating information. For example,
during the inspection, you can make inquiries
concerning the disposition of retired asset, if any, and
the incurrence of installation, testing, and other costs
to make a new asset.
 This test also relates to the valuation assertion.
 Examine Title Documents and Lease Contracts

 You may determine the ownership of vehicles by

examining certificate title, registration certificates,
and insurance policies. For equipment, furniture and
fixtures, the "paid" invoice may be the best evidence of
ownership. Verification of ownership in real property
can be substantiated by a review of public records.
When this form of additional evidence is desired, you
may seek the help of an attorney.
 The examination of ownership documents contributes
to the existence and rights assertions for plant assets.
Lease agreements convey to a lessee the right to use
property, plant, or equipment, usually for a specified
period of time. For accounting purposes, leases may be
classified as either capital leases or as operating
leases. You should read the lease agreement to
determine the proper accounting classification of the
lease in accordance with Financial Accounting
Standards Board pronouncements.
 When a capital lease exists, both an asset and a
liability should be recognized in the accounts and
statements. In addition to the existence and rights
assertions, the examination of lease contracts pertains
to the statement presentation assertion due to the
disclosures that are required under GAAP.

 All additions should be supported by documentary

evidence in the form of authorizations in the minutes,
vouchers, invoices, contracts, and canceled checks. You
have to vouch the recorded amounts to supporting
documentation. If there are numerous transactions,
you may vouch the recorded amounts on test basis.
Performing this test helps you to determine that
appropriate accounting recognition has been given to
installation, freight, and similar costs.
 For construction in progress, you may review the
contract and documentation in support of construction
 When plant assets are acquired under a capital lease,
the cost of the property and the related liability should
be recorded at the present value of the future
minimum lease payments. You should also verify the
accuracy of the client's determination of the present
value of the lease liability.
 The vouching of additions provides evidence about the
existence, rights, and valuation of fixed assets.

 Evidence of sales, retirements, and trade-ins should be

available to the auditor in the form of cash remittance
advices, written authorizations, and sales agreements.
Such documentation should be carefully examined to
determine the accuracy and propriety of the
accounting records including the recognition of gain or
loss, if any.

You may also find the following procedures useful in
determining whether all retirements have been recorded:
 Analyze the miscellaneous revenue account for proceeds
from sales of fixed assets plant assets.
 Investigate the disposition of facilities associated with
discontinued product lines and operations.
 Trace retirement work orders and authorizations for
retirements to the accounting records.
 Review insurance policies for termination or reductions of
 Make inquiry of management as to retirements. This
substantive test relates to the existence and valuation
 Analyze entries to repairs expense.
 The auditor's objectives in performing this test are to
determine the propriety and consistency of the charges
to repairs expense. Propriety involves a consideration
of whether the client has made appropriate
distinctions between capital and repair expenditures.
Accordingly, you should examine the individual
charges to identify those that are sufficiently material
to be capitalized.
 For these items, you should examine supporting
documentation, such as the vendor's invoice, company
work order, and management authorization to
determine the propriety of the charge or the need for
an adjusting entry. Consistency involves a
determination of whether the company's criteria for
distinguishing between capital and revenue
expenditures is the same as in the preceding year.
 This substantive test provides important evidence
concerning the completeness of fixed asset account
balances. You can also obtain evidence about the
valuation of the fixed assets by analyzing the entries
to repairs expense. In addition, the analysis may
reveal misclassifications in the accounts that relate to
the statement presentation assertion.
 Property pledged as security for loans should be
disclosed. Information on pledging may be obtained
from reviewing the minutes and long-term contractual
agreements, by confirming debt agreements, and
through inquiries of management.
 ..\..\audit 2008 ECSu
The End