SUBSTANTIVE TESTING Notes

AUDIT SAMPLING Questions and Answers

AUDIT PLANNING, CONTROL & RECORDING Revision Questions and Answers

QUESTION ONE

Tasty ice cream employs thirty salesmen each with defined geographical area coverage. Each salesperson is supplied with a car which is changed every three years. at end of each week, each salesperson is submits claim on a preprinted form for expenses with supporting vouchers. Expenditure is on petrol, repairs and servicing the car, hotels, lunches and entertainment. Each claim is scrutinized by Beatrice who is the deputy chief accountant. She verifies that the claims are supported by the vouchers. She clears any inconsistencies with the salesperson concerned and makes out cheques for signatures by two company directors. The total amount paid in year ended 31/12/2019 was USD. 25,000,000. The company made a profit of USD. 125,000,000.

Required:

1. Discuss the short comings of this system and suggest ways of improving the system.
2. List and describe the tests of control the auditor would undertake in this system.
3. During the audit, the auditor discovered that a salesperson in one area was submitting false claims for entertaining customers. What actions should the auditor take?

QUESTION TWO

“Action must be specifically taken to prevent the occurrence of frauds involving the assets of the company”, Finance Director of Food All Limited addressing accounting staff of the company. Of particular interest to the directors are:

• The safety of unclaimed wages
• The receipt of cash from customers.
• The company’s cheque books
• Issue of credit notes to debtors.

Required:

1. For each of the above, explain how a fraud can occur in the area.
2. What controls should be in place to prevent the occurrence of each of the frauds described in (a) above?

QUESTION THREE

You have been asked by the manager in charge of the audit of Timab agencies to consider and describe various aspects of carrying out a debtor’s circularization at its year ending 31^st December 2006. The company sells its products on credit and the draft accounts show annual turnover of twenty five million shillings. The accounts also show debtors of five million shillings. Your compliance test on the sales system has shown that there is only satisfactory division of duties in the sales system and only minor errors were found in compliance tests.

Required

1. Consider the reliability of a debtor’s circularization in providing audit evidence and in verifying value of year end debtors.
2. Describe the work you will carry out in auditing the replies to debtors circularization where debtor does not reply to circularization

QUESTION FOUR

iaS 2 ‘inventories’ requires that inventories are measured at the lower of cost and net realizable value.

Required:

• Explain why the audit of inventory is important to auditors.
• Define ‘cost’ and ‘net realizable value’ according to IAS 2 ‘Inventories’.
• Describe the audit evidence that you would obtain for the cost and net realizable value of finished inventory in a company that manufactures household furniture.

QUESTION FIVE

(a) ISA 505, External Confirmations, states that ‘the auditor should determine whether the use of external confirmations is necessary to obtain sufficient appropriate audit evidence at the assertion level’.

Required:

1. List four examples of external confirmations.
2. For each of the examples in (i) above explain one audit assertion that the external confirmation supports, and one audit assertion that the external confirmation does not support.

(b) Jayne Co has a significant number of cash transactions and recent non-current asset purchases have been financed by a bank loan. This loan is repayable in equal annual installments for the next five years.

Required:

1. Explain the procedures to obtain a bank report for audit purposes from Jayne Co’s bank and the substantive procedures that should be carried out on that report.
2. list the further substantive procedures that should be carried out on the bank balances in Jayne Co’s financial statements.

Answers

QUESTION ONE

a)            Shortcomings

• There is no check that expenses claimed by salesmen claimed by salespersons were actually expended. invoices just need to be presented for payment to be made without a third party confirmation. This is appropriate because invoices can be falsified.
• There is no check that the expenses were properly incurred by salespersons in carrying out their duties.
• The deputy chief accountant could easily perpetrate fraud alone or with collusion with the salespersons as no one verifies her work.

improvements

• Each salesperson should complete a weekly log showing, mileage covered and calls made. The logs and expense claims should be submitted to sales manager who should check and sign the log before passing it to the deputy chief accountant.
• at intervals, a member of the accounts staff should verify that claimed mileage is consistent with mileage shown on the car’s odometer.
• The directors should verify that complete and signed documentation is attached to and is consistent with the cheques presented to the. They should then cancel the presented documents to prevent a second presentation.

b). Tests of control are those tests which seek to provide audit evidence that internal control procedures are being properly applied throughout the period under review. Tests of control that could be performed are;

• Select a sample of the payments and obtain the related documentation. verify that each claim is fully supported by vouchers and the additions are correct.
• Examine the cheques made to the salespersons and verify that they are made out properly and are properly signed. This may form part of the audit of the bank transactions. c)
• inform management verbally immediately and in writing in the management letter.
• Consider whether the discovery casts doubt on the effectiveness of the system hence whether further audit tests may be required.
• Consider whether the discovery casts doubt on the company records in general and hence whether further audit procedures may be necessary in selected areas.

QUESTION TWO

a)

1. Safety of unclaimed wages.
   1. misappropriation of unclaimed wages.
   1. The money being used to write off debtors accounts.
   1. Use of the cash as petty cash and buying office items not authorized.
   1. Double payments to already paid workers through collusion with clerk.
2. receipt of cash from customers
   1. Teeming and lading.
   1. Misappropriation of cash received.
   1. Writing off bad debts for customers who have paid.
   1. Crediting other debtor’s accounts with the cash after colluding.
3. Company’s cheque books
   1. Writing cheques for personal purposes.
   1. Paying for expenses that are non-existent to suppliers after colluding.
   1. Duplication of cheques such that the clerk has a cheque book for his own purposes that is identical to the company’s businesses.
4. issue of credit notes to debtors
   1. Issue of credit notes when no goods are returned or when there is no justification.
   1. overstated credit notes. •         Understated credit notes

QUESTION THREE

 The most common type of circularization is where auditor writes a letter to the debtor or clients audited paper asking them to reply directly to the auditor whether he agrees, disagrees or can not confirm the balance on client’s sales ledger. The client is asked to reply under all circumstances i.e. positive circularization.

 With negative circularization, a similar procedure is carried out but the debtor is asked to reply only if he disagrees with the balance.

 Frequently with circularization of debtors, the percentage of debtors who reply is low. With negative circularization, the percentage is even lower.  However, negative circularization leads to an invalid conclusion as many debtors never reply to any circularization and some of them will disagree with the balances. Negative circularization provides weak evidence of the reliability of debtors figure in the sales ledger as many debtors who do not agree with the balance will not reply.

 Where client and debtor are independent of each other, replies to circularization are quite good evidence. however, there are some limitations in reliability

• Some debtors reply agreeing balance for any circularization even when there is a difference. in some cases they sign the reply that they agree with the balance without checking the purchases ledger. if the reply is from junior members of debtor staff, it is less reliable from senior’s e.g. chief accountant.
• Sometimes the debtor will disagree with the balance on clients sales ledger is correct. Usually this arises through cash and goods in transit. in most businesses, the ledger is more reliable than the purchases ledger, as sales invoice is posted to sales ledger at the same time as the goods are dispatched to customer and cash is posted to sales ledger when it is received usually within a day. However with purchases ledger, there will be a considerable delay between receiving the goods and posting the invoice to the purchase ledger because there may be delay in receiving purchase invoice and delays in checking invoice to goods received note and purchase order. This creates inaccuracies in customers purchase ledger.
• Some debtors reply saying that they cannot confirm the balance because of accounting records they keep. In this case, only the existence of debtor is confirmed.
• Agreement of balance by debtor does not confirm that it is recoverable e.g. the debtor may confirm the balance but because of cash flow problems, he is unable to pay it and becomes a bad debt. Also, debtors who are experiencing cash flow problems may not reply to the circularization. Nevertheless, this is a serious weakness of debtor’s circularization. Checking cash received at the year end is best way of verifying the recoverability of a debt.
• Although the great advantage over debtor’s circularization is to confirm existence of debtor, it is time consuming to carry out and because of limitations above. it is a less efficient way of verifying debtors than other techniques such as looking at aged debtors at the year end and checking cash received after year end.
• It is carried out only on a small sample of debtors which could be a very small percentage of the total valuation of debtors. Therefore there is a problem of sampling risk.

b. Where a debtor does not reply to circularization, a number of techniques are used to confirm the existence of such a debtor.

• Check sales invoices, dispatch notes and order confirmations generated by the company. This evidence is weak in reliability because it is generated by the company.
• The best evidence of the existence of the debtor which is available within the company is correspondence from the debtor such as orders from the debtor which can be found in sales department and in the credit control.
• Cheques received are further evidence of existence of debtors. Only the most recent cheques will be available for auditor to inspect but there should be remittance advices from customers showing invoices each cheque pays.
• Other evidence can be obtained from trade directories and telephone directories. This confirms existence of the business on client’s sales ledger but does not confirm that the business is a debtor of the client i.e. the debtor balance on the sales ledger could either be made of fictitious sales invoices or invoices posted to wrong accounts.
• A further letter could be sent to the debtor to confirm that he received goods from the client but in the same way the debtor did not reply to the circularization, he could also not reply to the letter.
• The debtor could be telephoned and asked if he purchased goods from the client. in using the telephone, one must be careful that the call is not intercepted by the client.

 To check the recoverability of a debt at the year end, the auditor should check its aging. The auditor should also check cash received between year end and the time of audit visit after year end. Any year end invoices cleared by cash received since year end can be considered good as it is unusual for a debtor to request repayment. If some paid since year end is large, one should check that the cheque has cleared particularly for debtors who have been outstanding for a long period. The auditor will discuss all old outstanding amounts because there is likely to be a dispute between the debtor and the client over the amount.

QUESTION FOUR

Inventories

• importance of inventory
  • Inventories are important to the financial statements because the inventory figure, particularly for manufacturing companies, may be material to the balance sheet and income statement, both in the current year and as a comparative figure.
  • Inventories may be high risk if they are valuable, and/or easily portable. The valuation of inventories is a matter requiring the exercise of judgment, which means that inventories are sometimes used to manipulate the appearance of both the income statement and the balance sheet.
  • In the income statement, there is a direct relationship between the inventory figure and the profit for the period. If closing inventories are overstated, profits will be overstated.
  • Many key accounting and performance ratios are calculated using the inventory figure. These include inventory turnover, inventory days, the current ratio and working capital ratios. Many companies use these ratios for internal purposes and many third parties, such as investment analysts, also use these figures to assess performance.
  • Poor inventory control will be reflected in inventory figures at the period-end. For many companies, excess inventory is a sign of serious problems.
  • Some significant cases of litigation against auditors have involved the alleged overstatement of inventories in financial statements of companies where the auditors have issued an unqualified audit report before the company has been taken over.
  • There is sometimes relatively little audit evidence for the inventory figure, particularly for small companies and it is therefore important for auditors to scrutinize the evidence available carefully and consider the scope for misstatement or deliberate manipulation of the inventory figure.
• Cost and net realizable value
  • iaS 2 requires that cost comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
  • Costs of purchase include the purchase price, import duties and other taxes, transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and similar items are deducted.
  • Costs of conversion include costs directly related to units of production such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials to finished goods.
  • Fixed production overheads are indirect costs of production that remain relatively constant regardless of the volume of production such as depreciation, the maintenance of factory buildings and equipment and the cost of factory management and administration. The allocation of fixed overheads is based on a normal level of production.
  • variable production overheads vary directly, or nearly directly, with the volume of production and include indirect materials and labour. The allocation of variable overheads is based on actual levels of production.
  • Other costs might include the costs of designing products for specific customers and borrowing costs, which may be included in certain circumstances.
  • Costs not included are storage costs, unless these are necessary to the production process prior to completion, general administrative overheads and selling costs.
  • net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale, such as advertising costs.
• audit evidence
  • The costs of purchase for a furniture manufacturing company will include purchase costs such as the cost of timber, metals, fabrics, fillings and adhesives.
  • These costs can be checked on a sample basis from the inventory records through to the daybooks, ledgers and purchase invoices, ensuring that the correct amounts have been recorded in the correct period.
  • The variable production overheads will include direct labour costs (including tax and social insurance costs), the cost of power for factory machinery, the cost of small tools and similar items that are directly related to the level of production.
  • Direct labour costs can be checked to payroll records, production records, timesheets or clock cards, and payment records, including entries in the bank statements. it is likely that the cost of power for machinery will have to be allocated, but if this is not possible it may be necessary to include such costs in fixed overheads. In either case, the cost can be traced to utility invoices and accruals. The costs of small tools can be checked in the same way as purchase invoices, ensuring that capital items are not included in the revenue accounts and vice versa.
  • Fixed production overheads will include depreciation of machinery, the cost of heat and light in the factory, factory administration overheads and storage space for work in progress. it is important to establish that the factory is operating at a normal level of activity. if it is not, it is not appropriate to include overheads on the basis of an abnormal level of activity.
  • Depreciation can be checked to asset registers. it is important that auditors examine both the accuracy of calculations, and the reasonableness of the depreciation rates applied as costs may be inappropriately included as assets, otherwise.
  • Factory administration may include the wages and salaries of those administering the factory payroll for example, and the costs of the offices in which such staff work. It may be necessary to split such costs out from general administration overheads that should not be included. The attributable payroll and overhead costs can be checked in the same way as for direct factory costs.
  • analytical procedures can also be performed on all of the costs noted above and compared with prior periods and budgets, as well as production levels, profits and factory capacity where they vary directly with production or sales.
  • analytical procedures on gross margins will also provide audit comfort on costs.
  • Cut-off tests may include checks between inventory records, the inventory itself, and purchase and sales records for a period just before and just after the period-end. it may also be necessary to examine provisions for goods dispatched or received but not invoiced before the period-end.
  • The net realizable value of finished goods will only be relevant if it is likely to be lower than cost, i.e. if furniture is to be sold at a loss. auditors should review inventory counting results and inventory records for old or slow-moving inventory and form an opinion, in discussion with directors, as to whether any such inventories need to be reduced to net realizable value.
  • Evidence from post year-end sales or contracts is a good source of evidence in relation to net realisable value. if these are not available, it is important to review the entity’s previous experience of having to sell furniture below cost. Current market conditions are relevant as is the existence of a high level of inventories, which may indicate problems.

QUESTION FIVE

• ( i) Four examples of external confirmations are :
  • accounts receivable letter
  • Solicitor letter
  • bank report letter
  • inventory held by third parties.

(ii)

Accounts receivable letter

• This letter provides evidence of the existence of the receivable when a reply is returned from that receivable direct to the auditor.
  • The letter provides evidence on cut-off because sales or cash receipts recorded in the incorrect accounting period will have to be reconciled to the balance provided by the receivable.
  • The letter does not provide evidence of completeness of the receivables balance because receivables may not query balances which are understated.
  • The letter does not provide evidence of the valuation of the receivables balance because the receivable cannot be expected to list all outstanding balances and confirmation of the debt does not mean it will be paid.

Solicitor letter  a solicitor letter provides evidence as to the existence of claims at the period end as the solicitor will confirm specific claims.

 However, the letter does not necessarily confirm the valuation of claims due to uncertainty about the future or the completeness of any legal claims as solicitors do not normally provide a list of all claims but they prefer to comment only on claims they are actually asked about.

Bank report letter

 A bank confirmation letter provides good evidence on the existence of the company’s bank accounts as the bank has confirmed this information in writing.

 a bank letter cannot necessarily be relied on to provide complete or accurate information. most banks place a disclaimer on the letter of ‘errors and omissions exempted’ indicating that the auditor must review this evidence against other cash and bank evidence obtained. Inventory held by third parties  a letter from the third party holding the inventory will provide evidence of the existence of that inventory because the third party has confirmed this in writing.

 However, the letter does not provide evidence regarding the valuation of the inventory; confirming something exists does not necessarily mean it is in good condition.

• (i) procedure for obtaining a bank letter
  • The auditor should consider if a bank letter is required. For the audit of Jayne Co the letter is required as the company has significant cash transactions and a loan from the bank.
  • The auditor will produce a confirmation letter in accordance with local audit regulations and practices.
  • The letter will be sent to the client to sign and authorize disclosure and then it will be forwarded on to Jayne’s bank.
  • alternatively, the client may already have provided a standard authority for the bank to respond to a bank letter each year. in this case separate authority would not be required.
  • ideally the letter should be sent before the end of the accounting period to enable the bank to complete it on a timely basis e.g. at the year-end.
  • The bank will complete the letter and send it back directly to the auditor.
  • audit procedures on the bank letter include:
  • Agree the balances for each bank account to the relevant bank reconciliation and the year end balance in the financial statements.
  • Agree total interest charges on the letter to the interest expense account in the general ledger.
  • For any details of loans, ensure repayment terms are correctly disclosed in the financial statements between current and non-current liabilities.

                (ii) Substantive procedures for the audit of bank balances.

• Obtain a copy of the year end trial balance.

 Agree the bank balance on the trial balance to the year end bank balance on the computer system and the balance on the financial statements.

• Obtain a copy of Jayne Co’s bank reconciliation. •        Cast the reconciliation
  • Agree the bank balance to the trial balance.
  • Agree the bank statement balance to the year end bank statement.
  • Agree any unpresented lodgements to the bank statement after the end of the year
  • Agree any unpresented cheques or similar expenses to the cash book before the end

FRAUD & ERROR (iSA 240) Questions and Answers