AUDITING AND ASSURANCE:

CONCEPTS AND APPLICATIONS 1

OVERVIEW OF THE RISK-BASED AUDIT PROCESS

1. *What is Auditing?

Auditing is the process of investigating information prepared by someone else in order to

determine whether the information is fairly stated.

If you’re a business owner, you’re responsible for the information being audited, which you
present in your financial records.

If you’re the auditor, you investigate the assertions made on the financial statements to make
sure you agree with what the company is saying about itself.

NOTE: Auditing involves gathering and evaluating evidence relating to

management’s assertions as reflected in the financial statements. It is a form of
“attestation” wherein the CPA communicates to the interested users whether the
representations of management regarding financial statements are fair or not.

2. *What are the Objectives of an Audit?

i. To obtain reasonable assurance about whether the FS as a whole are free from
material misstatements, whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are prepared, in all material
aspects, in accordance with an applicable financial reporting framework; and
ii. To report on the financial statements and communicate as required by the PSAs, in
accordance with auditor’s findings.

NOTE: Although the auditor’s opinion enhances the credibility of the financial
statements, the user cannot assume that the opinion is an assurance as to the future
viability of the entity nor the efficiency or effectiveness with which management has
conducted the affairs of the entity.

3. *What is meant by Reasonable Assurance?

Reasonable assurance is a high but not absolute level of assurance. It is obtained when the
auditor has obtained sufficient appropriate audit evidence to reduce audit risk (i.e., the risk
that the auditor expresses an inappropriate opinion when the FS are materially misstated)
to an acceptably low level.

The auditor cannot provide absolute assurance due to the inherent limitations in the work
carried out. This results from the majority of audit evidence (on which the auditor draws
conclusions and bases the auditor’s opinion) being persuasive rather than conclusive.
4. What is the difference between persuasive evidence and conclusive evidence?

Persuasive evidence tips the scale one way or the other and provides you with a basis
beyond a reasonable doubt for forming an opinion.

EXAMPLE: Your job is to verify the current accounts receivable balance of P50,000. To
accomplish this, you send confirmation letters to the client’s 20 largest customers. The sum
of these customers’ accounts receivable balances is P37,500, which is 75 percent of the
total — the percentage your senior associate told you to check. If all the customers reply
with positive responses (meaning they confirm that they owe your client the amounts
shown in accounts receivable), you have enough persuasive evidence to issue an opinion
on the accuracy of the overall accounts receivable balance.

Convincing evidence is perfectly reliable. You’d have to look at all the client’s records to
achieve this level of assertion — something that’s never done during an audit. Reaching
this level of evidence isn’t feasible, because you have to complete an audit during a limited
amount of time and for a reasonable cost. Convincing evidence would be if you sent
confirmation letters to all customers and pursued all customers until they responded.

5. *Who has the primary responsibility for the preparation of the FS?

The management.

NOTE: Many people outside the accounting profession think that the auditor
prepares both the financial statements and the audit report as part of the whole
process. This is definitely not true. The financial statements are the responsibility
of management. Though an auditor may give the client journal entries to correct
errors, omissions, and misstatements shown on the financial statements and
discovered during the course of the audit, the auditor doesn’t prepare any client
financial statements.

6. *What is a Risk-Based Audit Process?

• Assessment of the types and likelihood of misstatement in account balances
• Adjustment in the amount and type of audit work in relation to the likelihood of
material misstatement occurring in account balances.

NOTE: In risk-based audit, the audit team views all activities in the organization
first in terms of risks to strategies and objectives, and then in terms of
management’s plans and processes to mitigate the risk. The auditor obtain an
understanding of the client’s objectives. The risks are identified and the auditors
determine how management plans to mitigate the risk and whether those plans are
in place and operating effectively. (Cabrera, 2017)
 Stages of Risk-Based Audit:

Phase 1. Risk Assessment

Phase 2. Risk Response
Phase 3. Reporting

(See Figure 1.1 – Risk-Based Audit Process, Cabrera 2017, page 10.)

7. *What is Audit Risk?

Audit risk is the risk that the auditor may give an unqualified opinion on materially
misstated financial statements.

(Comment: This definition of audit risk does not include the risk that the auditor might
erroneously express an opinion that the financial statements are materially misstated.)

NOTE: The auditor always wants to minimize this risk but should take into account
the costs associated with gathering the evidence to minimize it. Hence, it is
intertwined with materiality.

NOTE: The amount and persuasiveness of audit evidence gathered should vary
inversely with audit risk; i.e., lower audit risk requires gathering more persuasive
evidence.

8. *What are the three components of Audit Risk?

a. Inherent Risk. This risk refers to the susceptibility of an account balance to material
errors assuming that the client does not have any related internal controls.

b. Control Risks. The risk that a material error in an account will not be prevented or
detected on a timely basis by the client’s system of internal control.

NOTE: The better the company’s internal controls, the lower the likelihood of
material misstatement.

c. Detection Risk. The risk that you won’t detect material errors, whether those errors are
intentional or unintentional. Detection risk occurs when you don’t use the right audit
procedures or you don’t use them correctly.

NOTE: Keep in mind that you can never completely eliminate detection risk
because you’ll most likely never look at each and every transaction. You’ll always
have some risk of a misstatement being missed, but your goal is to keep it to an
acceptable minimum.

NOTE: To reduce audit risk to an acceptable low level, the auditor is required to:
 1. Assess the risks of material misstatement (Inherent Risk and Control Risk);
and
2. Limit detection risk.

9. *What are the Limitations of the Audit Risk Model?

• Inherent risk is difficult to formally assess.
• The model treats each risk component as separate and independent when in fact the
components are not independent. It is also quite difficult to separate a client’s
material controls and inherent risk.
• Audit risk is judgmentally determined.
• Audit technology is not so fully developed that each component of the model can
be accurately assessed. Auditors can, however, make subjective assessments and
use the audit risk model as guide.

PHASE 1 – RISK ASSESSMENT:

PRELIMINARY ENGAGEMENT ACTIVITIES,
PLANNING THE AUDIT AND
PERFORMANCE OF RISK ASSESSMENT PROCEDURES

10. What are the steps an auditor should do prior to starting an

initial audit?

STEP 1: Meet with the client.

STEP 2: Review existing records.

NOTE: Many people outside the accounting profession think that the auditor
prepares both the financial statements and the audit report as part of the whole
process. This is definitely not true. The financial statements are the responsibility
of management. Though an auditor may give the client journal entries to correct
errors, omissions, and misstatements shown on the financial statements and
discovered during the course of the audit, the auditor doesn’t prepare any client
financial statements.

STEP 3: Assess whether the client can be audited.

NOTE: The condition of the financial statements offers clues as to their

auditability. Sometimes you can just look at the financial statements and realize
they’re a mess, which affects their auditability.

NOTE: Potential clients can also be rendered unauditable through no fault of their
own. Maybe their records were destroyed in a fire or flood. You must always query
the potential client as to the availability of records.

STEP 4: Interview the prior auditor.

 NOTE: If the potential client severed relations with its old CPA firm, you must get
the client’s permission to talk to the previous auditor to get the scoop on any
problems that the auditing firm may have encountered with client integrity,
disagreements about how the audit should be conducted, application of generally
accepted accounting principles, or lax internal controls.

11. *What is an engagement letter?

An engagement letter is one where the agreed terms of the audit engagement are recorded
or contained. It serves as the contract, detailing the duties and obligations of both the
auditor and the client. It includes:
 the objective and scope of the audit;
 the responsibilities of the auditor;
 the responsibilities of the management (client);
 identification of the applicable financial reporting framework for the preparation of
the financial statements; and
 reference to the expected form and content of any reports to be issued by the auditor
and a statement that there may be circumstances in which a report may differ from
its expected form and content.

NOTE: What not to include in the engagement letter? Don’t use jargon that only
CPAs understand. Doing so will make your client uncomfortable and may cause
the client to refuse to sign the letter. Also, don’t overstate what you can do. And
certainly don’t include any promotional or marketing information.

12. *What is audit planning?

Audit planning involves the establishment of the overall audit strategy for the engagement
and developing an audit plan, in order to reduce audit risk to an acceptably low level. It
generally involves the determination of the expected nature, timing and extent of the audit.

 Nature refers to the type of procedures you use during the audit and the method
you use to gather sufficient, competent evidence to support the company’s
information. (e.g., vouching, physical examination, etc.)

 Timing addresses when you do the audit procedures: before, on, or after the
balance sheet date.

 Extent refers to how deeply you have to dig in to the records.

NOTE: The higher the risk of error leading to material misstatements, the greater
the extent of your audit procedures.
13. What is materiality? When is it considered in planning an audit?

In accounting, materiality refers to the impact of an omission or misstatement of

information in a company's financial statements on the user of those statements. If it is
probable that users of the financial statements would have altered their actions if the
information had not been omitted or misstated, then the item is considered to be material.
If users would not have altered their actions, then the omission or misstatement is said to
be immaterial. (Source: https://www.accountingtools.com/articles/what-is-materiality-in-accounting-information.html)

In planning the audit, materiality should be considered by the auditor when:

a. Determining the nature, timing and extent of audit procedures;
b. Identifying and assessing the risks of material misstatement; and
c. Determining the nature, timing and extent of further audit.

NOTE: When planning the audit, the auditor considers what would make the
financial statements materially misstated. The auditor’s assessment of materiality,
related to specific account balances and classes of transactions, helps the auditor
decide such questions as what items to examine and whether to use sampling and
analytical procedures. This enables the auditor to select audit procedures that, in
combination, can be expected to reduce risk to an acceptably low level.

14. How does Materiality relate with Audit Risk?

There is an inverse relationship between materiality and the level of audit risk, that is, the
higher the materiality level, the lower the audit risk and vice versa.

EXAMPLE: If, after planning for specific audit procedures, the auditor determines that
the acceptable materiality level is lower, audit risk is increased. The auditor would
compensate for this by either:
• Reducing the assessed level of control risk, where this is possible, and supporting
the reduced level by carrying out extended or additional tests of control; or
• Reducing detection risk by modifying the nature, timing and extent of planned
substantive procedures.

15. What is meant by Risk Assessment Procedures?

This involves the identification and assessment of the risk of material misstatements
whether due to fraud or error at the financial statement and assertion levels, through
understanding the entity and its environment, including the entity’s internal control,
thereby providing a basis for designing and implementing the responses to the assessed
risks of material misstatement.

The following are the activities involved in the performance of risk assessment procedures:
a. Identification of Inherent Risks (Business and Fraud Risks) and Significant Risks
Step 1: Gather basic information about the entity.
• client-prepared information
 • external data
• relevant correspondence
• client’s key business procedures

Step 2: Design performance and document risk assessment procedures.

• Identify sources of risks of material misstatements
• Obtain appropriate understanding about the entity
• Obtain necessary audit evidence

Step 3: Relate the risks identified to material financial statement areas.

b. Understanding the Design/Implementation of Relevant Internal Controls

 Control environment – the auditor shall evaluate whether:
o management has created and maintain a culture of honesty and
ethical behavior
o the strengths in the control environment elements collectively
provide an appropriate foundation for the other components of
internal control, and whether those other components are not
undermined by deficiencies in the control environment

 Risk assessment – whether the entity has a process for:

o Identifying business risks relevant to financial reporting objectives
o Estimating the significance of the risks
o Assessing the likelihood of their occurrence
o Deciding about actions to address those risks

 Information system
o The classes of transactions in the entity’s operations that are
significant to the financial statements
o The procedures, within both IT and manual systems, by which those
transactions are initiated, recorded, processed, corrected as
necessary, transferred to the general ledger and reported in the
financial statements
o The related accounting records, supporting information and specific
accounts in the financial statements that are used to initiate, record,
process and report transactions; this includes the correction of
incorrect information and how information is transferred to the
general ledger.
o How the information system captures events and conditions, other
than transactions, that are significant to the financial statements
o The financial reporting process used to prepare the entity’s financial
statement, including significant accounting estimates and
disclosures
o Controls surrounding journal entries, including non-standard
journal entries used to record non-recurring, unusual transactions or
adjustments.
  Control activities
NOTE: An audit does not require an understanding of all the control activities
related to each significant class of transactions, account balance, and disclosure
in the financial statements or to every assertion relevant to them.

NOTE: In understanding the entity’s control activities, the auditor shall obtain an
understanding of how the entity has responded to risks arising from IT.

 Monitoring

c. Concluding the Risk Assessment Phase. (Refer to page 84 for the fundamental
questions that you, as auditor, must address to determine the optimal amount of
audit work)

PHASE II – RISK RESPONSE: DESIGNING OVERALL RESPONSES AND FURTHER

AUDIT PROCEDURES

16. What are the steps in the Risk Response Phase? (See Figure 4.1, page 101)

The Risk Response Phase in the Risk-Based Audit Approach includes the following steps:
a. Designing the overall audit responses and further audit procedures. This will
require:
i. Updating overall audit strategy
ii. Developing response to assessed risks
iii. Briefing team on audit plans as required

b. Performance of further audit procedures. This step will involve:

i. Performing planning procedures
ii. Assessing results and evidence obtained
iii. Documenting findings and conclusion

NOTE: The starting point for designing an effective audit response is the listing of
assessed risks that we developed at the conclusion of the risk assessment phase of
the audit.

NOTE: The auditor shall design and implement overall responses to address the
risks identified and assessed at the financial statement level and assertion level for
financial statement areas and disclosures.

17. How do audit firms tailor their audit to a low-risk situation?

Many audit firms assign less experienced auditors to work low-risk engagements and save
the big guns for the tough cases. That means that as a staff associate, you’ll more than
likely have the pleasure of working these easier engagements early in your career.
 Also, in low-risk situations, sample sizes (the number of records you look at) will be set at
normal levels. Normal levels of any audit criteria are usually set as firm policy, meaning
that your senior associate will tell you what size samples to use.

Professional skepticism is also set at normal levels, which simply means you’ll be more
apt to take transactions at face value. In other words, you assume the transactions are
correct unless you discover otherwise.

18. How does an auditor respond to a High-Risk Assessment?

If an audit engagement is high-risk, you have to sit back, evaluate how the company does
business, and think about how material misstatements may slip through the cracks. You
then design an extended audit to provide as much assurance as possible that you’ll detect
those misstatements.

Actions you take during a low-risk engagement are flip-flopped for a high-risk one. More
experienced staff associates work on the engagement. The senior associates become more
hands-on. Your firm may hire outside specialists who have knowledge and skills relating
to the business’s specific needs that are lacking in the CPA firm.

Professional skepticism increases, as does the number of items selected for sampling. You
may use more extensive analytical procedures, which compare the business’s financial data
with your expectations of how the data should look.

NOTE: As you do your investigative work getting to know your client, following
your risk assessment procedures, and assessing the risk of material misstatement,
you must extensively document everything you do. You use this documentation to
provide a clear audit trail of what steps you took so you have written substantiation
for the various levels of risk you’ve assessed for the financial statement accounts
and transactions.

19. What is meant by Audit Procedures? What are the types of audit procedures?

Audit procedures are the methods or acts that auditors use to gather evidence to determine
the validity of financial statement assertions.

NOTE: An effective audit program will be based on an appropriate mix of

procedures that collectively reduce audit risk to an acceptably low level.

The various types of an audit procedures available to the auditor are categorized as follows:
1. Test of Controls or Compliance Tests – designed to evaluate the operating effectiveness of
controls in preventing, or detecting and correcting, material misstatements at the assertion
level.
 Types:
a. No Trail – this does not leave a visible trail in the supporting documents of
the performance of control procedure by the client’s employee. The auditor
makes inquiries and observation of office personnel and routines to
determine how control procedures are performed and who perform them.
b. Documentary Trail – this leaves a visible trail in the supporting documents.
Hence the auditor inspects the documents supporting a particular type of
transaction to see whether a control procedure, such as approval or other
checking, was performed and who performed it as indicated by signatures
or initials.

2. Substantive Procedures – designed to detect material misstatements at the assertion level.

Types:
a. Tests of Details – involves obtaining evidential matter on the items (or
details) involved in an account balance or class of transactions.
i. Tests of Transactions – tests of the processing of individual
transactions by inspection of the documents and accounting records
involved in processing.
ii. Tests of Balances – applied directly to the details of balances in
general ledger accounts. Their objective is to establish the monetary
correctness of the accounts they relate to.
b. Analytical Review Procedures – involve study and comparison of
relationships among accounting data and related information. They identify
unusual fluctuations for investigation and focus on the rationale of
relationship.

NOTE: Auditing standards require the application of analytical procedures at the

planning and overall final review stages of audit. The auditor may also decide to
use them during the audit as substantive tests to provide evidence as to the
reasonableness of the specific account balances.

NOTE: The auditor applies compliance tests when the purpose is to see whether
prescribed accounting control procedures are being followed. This evaluation
identifies the control procedures that can be relied on in performing restricted
substantive tests. Substantive tests are applied when the auditor’s purpose is to see
whether the peso amount of an account is properly stated.

NOTE: Audit procedures vary according to the risks associated with the client and
the methods used to record transactions. (See page 105, Selecting the Audit
Procedures that Will Be Applied)

20. Guidelines – Summary of Relevant PSAs [PSA 300 and 330] (See page 108)
  design and implement overall responses to address the assessed risks of material
misstatements at the FS level
 design and perform further audit procedures (FAP) whose nature, timing and extent
are based on and are responsive to the assessed risks at the assertion level
o consider the reasons for the assessment, including:
 likelihood of material misstatement due to the particular
characteristics of the relevant class of transactions, account
balances, or disclosure (i.e., inherent risk); and
 whether the assessment takes account of relevant controls (i.e.,
control risk), thereby requiring the auditor to obtain audit evidence
to determine whether such controls are operating effectively

o obtain more persuasive audit evidence the higher the assessment of risk
 develop an audit plan which include a description of
o the nature, timing, and extent of planned risk assessment procedures;
o the nature, timing and extent of planned FAP
o other planned audit procedures so that the engagement complies with PSAs.
 when designing and performing audit procedures, consider the relevance and
reliability of the information to be used as audit evidence
 when designing tests of controls and tests of details, determine means of selecting
items for testing that are effective in meeting the purpose of the audit procedure

Test of Controls
 design and perform test of controls to obtain sufficient appropriate audit evidence
as to the operating effectiveness of relevant controls if:
o assessment of risks of material misstatement at the assertion level includes
an expectation that the controls are operating effectively; or
o substantive procedures alone cannot provide sufficient appropriate audit
evidence at the assertion
 In designing and performing test of controls,
o obtain more persuasive audit evidence the greater the reliance the auditor
places on the effectiveness of a control
o perform other audit procedures in combination with inquiry to obtain audit
evidence about the operating effectiveness of the controls
o determine whether the control to be tested depend upon other controls and,
if so, whether it is necessary to obtain audit evidence supporting the
effective operation of those indirect controls.
 If the auditor plans to relay on controls over a risk the auditor has determined to be
a significant risk, the auditor shall test those controls in the current period.

Substantive Tests
 Irrespective of the assessed risks of material misstatements, auditor shall design
and perform substantive procedures for each material class of transactions, account
balances and disclosure
 Consider whether external confirmation procedures are to be performed as
substantive audit procedures
  The auditor’s substantive procedures shall include the following audit procedures
related to the financial statement closing process:
o Reconciling the financial statements with the underlying accounting
records;
o Examining material journal entries and other adjustments made during the
course of preparing the financial statements
 If the auditor has determined that an assessed risk of material misstatement at the
assertion level is a significant risk, the auditor shall perform substantive procedures
that are specifically responsive to that risk. When the approach to a significant risk
consists only of substantive procedures, those procedures shall include tests of
details
 If substantive procedures are performed at an interim date, the auditor shall cover
the remaining period by performing:
o Substantive procedures, with test of controls for the intervening period;
o If the auditor determines that it is sufficient, further substantive procedures
only,
that provide a reasonable basis for extending the audit conclusions from the interim
date to the period end
 Perform audit procedures to evaluate whether the overall presentation of the
financial statements, including the related disclosures, is in accordance with the
applicable financial reporting framework.

AUDIT OF THE REVENUE AND COLLECTION CYCLE:

TESTS OF CONTROLS
AND
SUBSTANTIVE TESTS OF TRANSACTIONS

21. In performing an audit of the revenue and collection cycle,

what are the things that the auditor should do?

 Identify the activities and types of transactions that occur in a company’s revenue
cycle;
 Relate the effect of controls on the assertions embodied in the FS, sales adjustments,
and cash receipts transactions;
 Determine the essential features of internal control over the transactions in the
revenue and collection cycle;
 Prepare and perform the audit procedures for compliance test of controls over these
transactions;
 After evaluating the effectiveness of internal control, perform substantive tests of
transactions to meet transaction-related audit objectives for revenue and collection
cycle; and
 Design tests of details of accounts affected by the revenue and collection cycle and
analytical procedures to satisfy balance-related audit objectives.
22. What is the nature of the Revenue and Collection Cycle?

The revenue and collection cycle of an entity consists of the activities relating to the
exchange of goods and services with customers and the collection of the revenue in cash.

For a trading concern, the classes of transactions in the revenue and collection cycle
involve:
a. Sales (cash and credit);
b. Sales adjustments (discounts, returns and allowances and uncollectible accounts
provisions and write-offs); and
c. Cash receipts (collections on accounts and cash sales).

23. What are the documents used in the Revenue and Collection Cycle and their Audit
Significance?

Documents Audit Significance

Customer’s purchase order – a A written purchase order from a customer
request for merchandise by a customer. provides evidence that a customer actually
ordered the goods. Purchase order numbers are
generally recorded on sales invoices so that an
auditor can determine the purchase order to
which an invoice relates. Sellers generally
maintain a file of each customer’s purchase
orders.
Sales order – a prenumbered A sales order contains the seller’s
document for recording the understanding of the sales terms. A seller
description, quantity, and related should account for the numerical sequence to
information for goods ordered by a help ensure that shipments are made for sales
customer. This is frequently used to orders and that all sales are billed.
show credit approval and
authorization.
Shipping document or Bill of lading The signature of the carrier or the customer on
– a prenumbered document prepared to the shipping document provides externally
initiate shipment of the goods, created evidence that goods have been
indicating the description of the shipped. Sellers should account for the
merchandise, the quantity shipped, and numerical sequence to help ensure that all
other relevant data. shipments are recorded as sales.
Sales invoice – a prenumbered A sales invoice indicates credit terms, shipping
document indicating the description terms, and price charged for merchandise.
and quantity of goods sold, the price Sellers should account for the numerical
including freight, insurance, terms, and sequence to help ensure that all sales are
other relevant data. recorded.
Credit memo – a prenumbered A credit memo provides evidence that a seller
document indicating a reduction in the has reduced the amount previously billed to a
amount due from a customer because customer. Sellers should account for the
of returned goods or an allowance
 granted. It often takes the same general numerical sequence to help ensure that all
form as a sales invoice, but it supports credit memos are recorded.
reductions in account receivable rather
than increases.
Remittance advice – a document that A remittance advice usually indicates the date
a customer attaches to a check in and amount of payment and the invoices paid.
payment of an invoice. The document Sellers generally file remittance advices by
may be a turnaround document, a part date.
of a check, or a statement identifying
the invoices being paid. Remittance
advices facilitate recording cash
receipts. If a customer does not return a
remittance advice, the employee
opening the mail generally prepares
one.
Uncollectible account authorization Sellers should account for the numerical
form – a prenumbered document used sequence to ensure that all write-offs are
internally, indicating authority to write recorded.
an account receivable off as
uncollectible.
Monthly statement – a document sent A statement mailed to a customer reporting a
to each customer indicating the beginning balance and transactions that
beginning balance of accounts occurred during eh period. If the statement is
receivable, the amount and date of each inaccurate, many customers would contact the
sale, cash payments received, credit seller.
memos issued, and ending balance due.

24. What are the Accounting Records in the Revenue and Collection Cycle?

 Sales journal
 Sales returns and allowances journal
 Cash receipts journal
 General journal
 Accounts receivable master file/subsidiary ledger
 Accounts receivable trial balance

25. Audit of Sales Transactions

I. Evaluation of Internal Control Over Sales Transactions

II. Tests of Controls overs Sales and Receivables
III. Audit Program for Tests of Controls: Sales
IV. Substantive Tests of sales Transactions

26. Audit of Sales Adjustments Transactions

 I. Evaluation of Internal Control Over Sales Adjustments Transactions
II. Tests of Controls overs Sales Adjustments Transactions
III. Audit Program for Tests of Controls: Sales Adjustments Transactions
IV. Substantive Tests of Sales Returns and Allowances

27. Audit of Cash Receipts Transactions

I. Evaluation of Internal Control over Cash Receipts Transactions

II. Tests of Controls over Cash Receipts Transactions
III. Audit Program for Tests of Controls: Cash Receipts Transactions
IV. Substantive Tests of Cash Receipts Transactions

AUDIT OF THE EXPENDITURE CYCLE:

TESTS OF CONTROLS AND SUBSTANTIVE TESTS
OF TRANSACTIONS

28. What are the activities that should be undertaken by the auditor in relation to audit
of the expenditure cycle?

 Diagram the flow of transaction in a typical expenditure cycle, the specific accounts
affected and the elements of control within the cycle
 Relate the effects of controls on the assertions embodied in the FS
 Determine the essential feature of internal control over the transactions in the
expenditure cycle
 Prepare an audit program to gather evidence regarding compliance with control
procedures that reduce control risk
 Evaluate effectiveness of controls and perform the substantive tests of transactions
to gather evidence to determine whether financial statement assertions are
materially correct on accounts affected by the expenditure cycle
 Design test of details of account balances and analytical procedures to satisfy
balance-related audit objectives

29. What is the nature of the Expenditure Cycle?

The expenditure cycle involves the activities associated with the acquisition and payment
of goods and services, plant assets and labor.

For a trading concern, the major classes of transactions in this cycle are:
a. Acquisitions
b. Cash disbursements
c. Payroll

For a manufacturing firm, production cycle transactions and inventory warehousing

transactions are included in the expenditure cycle in addition to the above-mentioned major
classes of transactions.
 NOTE: Transactions in the expenditure cycle often affect more financial statement
accounts than other cycles combined.

30. What are the Documents used in the Expenditure Cycle and their Audit Significance?

Documents Audit Significance

Purchase Requisition – a prenumbered A purchase requisition provides evidence that
document that originates in the inventory the purchasing department was authorized to
stockroom or an operating department and initiate a purchase.
indicates to the purchasing department that
goods should be ordered.
Purchase Order – a prenumbered document A purchase order contains the signature of the
recording the description, quantity, and related employee who authorized a purchase from a
information for goods and services the vendor.
company intends to purchase.
Receiving Report – a prenumbered document This report is prepared within the entity and
prepared at the time tangible goods are provides evidence that goods were received.
received that indicates the description of
goods, the quantity received, the date received,
and other relevant data.
Vendor’s invoice – a document that indicates This document is created externally and
the description and quantity of goods and provides evidence about a purchase of goods
services received, price, including freight, cash or services.
discount, terms and date of the billing.
Debit memo – a prenumbered document
indicating a reduction in the amount owed to a
vendor because of returned goods or an
allowance granted.
Voucher – a prenumbered document to A voucher provides documentation for the
establish a formal means of recording and recording of a transaction.
controlling acquisitions prepared by a payables
clerk for each payment.
Check – a prenumbered written authorization A check that has been presented for payment is
to a bank to transfer funds to the payee. referred to as paid or canceled check. A paid
check provides evidence about payments that
an entity has made, such as date, payee, and
amount.
Vendor’s statement – a statement prepared by Vendor’s statements may be used to determine
the vendor indicating the beginning balance, that all transactions recorded on the statements
acquisitions, returns and allowances, payments have been recorded in the books.
to the vendor and ending balance.

31. What are the Accounting Records involved in the Expenditure Cycle?

 Purchase Journal
  Cash Disbursement Transaction File/Journal
 Accounts Payable Master File/Subsidiary Ledger

32. Audit of Acquisitions

I. Evaluation of Internal Control over Acquisitions

II. Tests of Controls: Acquisitions
III. Audit Program for Tests of Controls: Acquisitions
IV. Substantive Tests of Transactions: Acquisitions

33. Audit of Cash Disbursements

I. Evaluation of Internal Control over Cash Disbursements Transactions

II. Tests of Controls: Cash Disbursements Transactions
III. Audit Program for Tests of Controls: Cash Disbursements Transactions
IV. Substantive Tests of Transactions: Cash Disbursements

34. What is the Nature of Payroll Transactions?

Payroll transactions involve the events and activities relative to executive and employee
compensation. This class of transactions includes salaries of personnel, wage earner
(factory workers); sales persons’ commissions, bonuses to executives, payroll taxes,
pensions and profit-sharing plans and other employees’ fringe benefits.

35. What are the Documents used in the Payroll and Personnel Cycle and their Audit
Significance?

Documents Audit Significance

Trial Card – prenumbered record for each Provides evidence about the validity of the
employee indicating the number of hours hours an employee is paid for working.
worked each day during a pay period. Many
entities use a time clock that automatically
records a starting and stopping time.
Deduction Authorization – a form that Indicates that the employee authorized an
employees sign to authorize their employer to amount to be withheld from a paycheck for a
withhold taxes and various optional payments specific purpose.
from their paychecks.
Certificate of Taxes Withheld – A report Indicates that taxes withheld were reported to
prepared every year for each employee to the various taxing authorities.
report the gross amount of earnings, income
taxes withheld, and Social Security taxes
withheld.
Labor Ticket – a prenumbered form on which Records the specific activity of a laborer.
time worked on a job is recorded
Labor ticket Summary – a form that Records labor used in production on any given
summarizes the daily labor tickets by job or by day.
process.
Payroll Tax Returns – forms the entity files Provide evidence that amounts withheld have
with governmental agencies reporting wages been paid to the appropriate authorities.
and taxes withheld.
Other Personnel Records
• Employment applications Provide evidence that employees exist
• Reports on reference checks Provides evidence that employees exist
• Authorizations for employment Provide evidence that employees work for
entity
• Authorizations for pay or pay changes
• Performance evaluation reports Provide evidence that pay rate is approved
• Records of sick and vacation days Provide evidence that employees exist
Provide evidence in testing accrued payroll

36. Audit of Payroll Transactions

I. Evaluation of Internal Control over Payroll Transactions

II. Tests of Controls: Payroll
III. Audit Program for Tests of Controls over Payroll Transactions
IV. Substantive Tests of Transactions: Payroll Transactions

37. What is the nature of the Production Cycle?

The production cycle involves the conversion of raw materials into finished goods. It
includes the production planning and control of the types and quantities of products to be
manufactured, the inventory levels (raw materials, finished goods) to be maintained, and
the activities pertaining to the manufacturing process. This cycle interfaces with both the
revenue and expenditure cycles.

38. Audit of Production Transactions

I. Evaluation of Internal Control over Production Transactions

II. Tests of Controls: Production Transactions
III. Audit Program for Tests of Controls over Production Transactions
IV. Substantive Tests of Transactions: Production Transaction

39. Audit of Inventory Warehousing

I. Tests of Controls: Inventory Warehousing

II. Audit Program for Tests of Controls over Inventory Warehousing Transactions
III. Substantive Tests of Inventory Warehousing Transactions
AUDIT OF THE FINANCING AND INVESTING CYCLE:
TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS

40. In conducting an audit of the financing and investing cycles, what are the activities
that the auditor should undertake?

i. Identify the activities and types of transactions that occur in a company’s financing
and investing cycles;
ii. Relate the internal accounting control objectives to financing and investing
activities;
iii. Determine the essential features of internal control over the above-mentioned
transactions;
iv. Perform compliance tests of controls over these transactions;
v. Perform substantive audit procedures to determine whether financial statement
assertions are materially correct on accounts affected by the financing and investing
cycles; and
vi. Design tests of details of account balances and analytical procedures to satisfy
balance-related audit objectives

41. What is the nature of financing and investment cycles of a business?

Such cycles include the responsibilities of planning the cash needs, raising capital, and
investing funds. These cycles embrace the major non-operating activities of many
companies.

42. Financing Cycle

An entity’s financing cycle consists of transactions pertaining to the acquisition of capital

funds through borrowings from others, short-term and long-term excluding trade credit,
and share capital and the subsequent redemption and reacquisition of these securities. This
cycle includes the sequence of procedures for authorizing, executing and recording
transactions that involve bank loans, mortgages, bonds payable and share capital. The
payments of interest and dividends are also an integral part of the financing cycle.

43. What are the possible errors that may occur in relation to the financing cycle?

• Failing to make interest accruals, or making them twice

• Accruing interest in the wrong period
• Making incorrect estimates of allowance for obligations
• Failing to recognize that the entity violated a debt agreement
• Failing to record dividends that were declared
 44. Auditing the financial cycle.

I. Internal control over financing cycle transactions

II. Study and evaluation of internal control over financing cycle transactions
III. Tests of control and substantive tests of transactions

45. Auditing the investing cycle.

I. Internal control over investing cycle transactions

II. Study and evaluation of internal control over investing cycle transactions
III. Tests of controls and substantive test of transactions

SUBSTANTIVE TESTS OF CASH

46. Audit Objectives and Procedures

Assertions Audit Objectives Audit Procedures

I. Existence or occurrence A. To determine whether cash 1. Obtain analysis of cash
exists at year-end and cash- balance and reconcile to the
related transactions occur general ledger.
within the year. 2. Confirm bank balances as
B. To determine that all cash of SFP date.
balances of the client are 3. Perform cash count
reflected on the SFP at procedures for cash on
year-end. hand.
4. Obtain (prepare) bank
reconciliations as of the
SFP date.
5. Trace all transfers occurring
between banks near year-
end
II. Completeness C. To determine whether all 6. Obtain a cutoff bank
cash transactions are statement containing
recorded in the proper transactions several days
accounting period. subsequent to the SFP date.
Examine items returned
with the cutoff bank
statements.
7. Prepare proof of cash and
reconcile cash transactions
occurring during a specified
period as they are recorded
by the bank and the client.
 8. Verify the client’s cutoff of
cash receipts and cash
disbursements.
III. Rights and obligations D. To determine that cash 9. Review bank statements
balances are available for and the bank replies to
use without restrictions or confirmation letters.
if with restrictions,
properly indicated in the
SFP.
IV. Valuation or allocations E. To determine if cash is 10. Verify existence of
recorded and presented at cash in banks under
the proper amount. receivership, cash subject to
court’s restraining order, in
foreign banks and in foreign
currency. This is in addition
to the foregoing procedures
which will enable the
auditor to verify proper
valuation of cash.
V. Presentation and F. To determine whether cash 11. Investigate any checks
disclosure is presented in accordance representing large or
with GAAP. unusual payments to related
parties.
12. Evaluate proper FS
presentation and disclosure
of cash.

SUBSTANTIVE TESTS OF RECEIVABLES AND SALES

47. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine that 1. Obtain schedule of aged
II. Rights and Obligations receivables exist and trade accounts receivable
represent bona fide and notes receivable
obligations owed to the schedule and reconcile to
company as of the SFP ledgers.
date. 2. Confirm receivables with
debtors.
3. Inspect notes on hand.
4. Perform analytical
procedures to determine
whether recorded sales and
receivables balances
appear reasonable.
III. Completeness B. To determine that all 5. Test cutoff of sales and
transactions relative to sales returns to determine
receivables have been whether receivables are
recorded in the proper recorded in the proper
accounting period. accounting period.
IV. Valuation or allocation C. To determine that 6. Review collectability of
receivables are recorded receivables and determine
and presented at proper the adequacy of allowance
amounts in accordance for doubtful accounts.
with PAS/PFRS 7. Recalculate the interest
income from the notes
receivable.
V. Presentation and D. To determine that the 8. Evaluate FS presentation
Disclosure receivables are properly and disclosures of
presented and classified in receivables.
the SFP. 9. Obtain written client
representations regarding
pledge, discount or
assignment of receivable,
and about receivables from
officers, directors,
affiliates or other related
parties.

SUBSTANTIVE TESTS OF INVENTORIES AND COSTS OF GOODS SOLD

48. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine whether 1. Obtain listings of
inventories exist at year- inventory and reconcile to
end and represent items ledgers.
held for sale in the ordinary 2. Observe the taking of
course of business. physical inventory and
conduct test counts
3. Confirm inventories in
public warehouse and with
consignees.
II. Completeness B. 1. To determine whether 4. Obtain a final inventory
all transactions related to listing from the client.
inventory are recorded in A. Trace test counts made
the proper accounting during the inventory
period. observation into inventory
listing.
 2. To determine that B. Test the clerical accuracy
inventory listings are of the final inventory
accurately compiled and listing.
inventory quantities 5. Review the year-end
include all items on hand cutoff of purchases and
and in transit. sales transactions.
6. Test numerical sequence
of inventory purchase
requisition.
7. Review entries to cost of
goods sold.
8. Perform analytical review
related to inventories and
cost of goods sold.
III. Rights and Obligations C. To determine whether the 9. Make inquiries of
company has legal title or management regarding
ownership rights to inventory ownership and
inventory items and examine consignment
inventories exclude items agreement.
billed to customers or
owned by others.
IV. Valuation or Allocation D. To determine whether the 10. Evaluate the bases and
inventories are properly methods of inventory
stated with respect to pricing.
• Cost determined by 11. Vouch and test inventory
an acceptable pricing.
method consistently 12. Check inventory for
applied. quality and/or
• Slow-moving, obsolescence.
excess, defective,
and obsolete items
identified and
reduced to
replacement cost or
net realizable value
if lower than cost
V. Presentation and E. To determine that the 13. Determine the existence of
Disclosure inventories and cost of pledged inventory.
goods sold are presented 14. Evaluate financial
and classified in the statement presentation of
financial statements in inventories and cost of
accordance with goods sold, including the
PAS/PFRS. adequacy of disclosure.
SUBSTANTIVE TESTS OF INVESTMENTS

49. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

1.Existence or Occurrence A. To determine that 1. Obtain or prepare a listing
investments in securities of securities and
(share, bonds, notes) investments owned by the
physically exist and in company and related
loans and advances exist. revenue accounts and
reconcile to the general
ledger.
2. Inspect securities on hand
3. Obtain confirmation of
securities held by others.
2.Completeness B. To determine that 4. In addition to audit
investments are all procedure 2 and 3, vouch
included in the statement selected purchases and sales
of financial position transactions of securities
during the year.
3.Rights and Obligations C. To determine that the 5. In addition to audit
company owns or has procedures 2 and 3, verify
ownership rights to all the clients’ cutoff of
investments securities transactions.
6. Perform analytical
procedures.
7. Compute independently
revenue from securities.
4.Valuation D. To determine that 8. Determine market value of
investments are valued securities at statement of
properly in accordance financial position date.
with generally accepted 9. Evaluate the method of
accounting principles. accounting for securities.
5.Presentation and E. Investments are properly 10. Evaluate financial
Disclosure described and classified in statement presentation and
the statement of financial related revenue or loss
position and related accounts.
disclosures are adequate.
SUBSTANTIVE TESTS OF PROPERTY, PLANT AND EQUIPMENT

50. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine whether 1. Obtain or prepare a
property and equipment summary of property and
included in the statement equipment transactions
of financial position and analysis of the
physically exist. Additions accumulated depreciation
include only the during the year and
capitalizable cost of assets reconcile to ledger.
purchased, constructed, or 2. Conduct physical
leased and retirements are inspection of major
removed. acquisition of plant and
equipment.
II. Completeness B. To determine that property 3. Vouch additions to
and equipment include all property and equipment
capitalizable costs and during the year.
capitalizable costs are not 4. Investigate disposals and
expensed. retirements of property and
equipment during the year.
III. Rights and Obligations C. To determine that the 5. Examine evidence of legal
company has legal title or ownership of property and
equivalent ownership equipment.
rights to property and 6. Examine lease agreement
equipment included in the on property and equipment
statement of financial leased to and from others.
position and the statement 7. Review rental revenue
of financial position and from land, buildings and
the related lease obligation equipment owned by the
of capitalized leased assets client but leased to others.
is recognized.
IV. Valuation or Allocation D. To determine that property 8. Analyze repair and
and equipment is stated at maintenance expense
cost and allowance for accounts.
depreciation or depletion 9. Investigate status of
are computed on the basis property and equipment
of acceptable and not in current use.
consistent methods. 10. Test client’s computation
of depreciation.
11. Perform analytical
procedures for property
and equipment.
V. Presentation and E. To determine that property 12. Review financial statement
Disclosure and equipment are presentation and disclosure
 properly described and for property and
classified in the statement equipment and for related
of financial position and revenue and expense.
related disclosures are
adequate.

SUBSTANTIVE TESTS OF INTANGIBLE ASSETS

51. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

I. Existence or A. To determine that 1. Obtain an analysis of
Occurrence intangibles exist and are ledger accounts for
represented by contractual intangibles.
rights, privileges or 2. Examine documentation
earning power owned by supporting intangibles.
the company.
II. Completeness B. To determine that all 3. Vouch additions to or
transactions related to acquisitions during the
intangibles have been year.
properly recorded 4. Evaluate dispositions and
write offs during the year.
III. Rights and C. To determine that the 5. In addition to audit
Obligations intangibles are owned by procedure no. 2, perform
the company. analytical procedures.
IV. Valuation or D. To determine that 6. In addition to audit
Allocation intangibles are stated at procedure nos. 3 & 4,
cost less amortization. evaluate amortization
policy and verify
computation of
amortization.
V. Presentation and E. To determine whether 7. Evaluate financial
Disclosure presentation and statement presentation and
disclosures concerning disclosure for intangibles.
intangibles are adequate
and in accordance with
PAS/PFRS.
SUBSTANTIVE TESTS OF LIABILITIES.

52. Audit Objectives and Procedures for Current Liabilities.

Assertions Audit Objectives Audit Procedures

I. Existence or A. To determine that 1. Obtain from the client a
Occurrence payables exist as of the listing of accounts and
statement of financial notes payable as of year-
position date. end and reconcile to the
general ledger.
2. Vouch recorded liabilities
to vendor’s statements.
3. Confirm recorded
liabilities directly with
suppliers and creditors.
Investigate differences in
liabilities reported in the
confirmations with the
recorded book amounts.
4. Examine bank
confirmations for loans.
II. Completeness B. To determine that all 5. Perform purchases cutoff
transactions relating to examination.
payables have been 6. Test for unrecorded
properly recorded. liabilities.
7. Perform analytical
procedures.
III. Rights and C. To determine that 8. In addition to audit
Obligations payables represent valid procedure no. 3, review
and legal claims of third documentation in client’s
parties from the client. files.
9. Examine subsequent
payments to creditors.
IV. Valuation or D. To determine that 10. Vouch accounts payable
Allocation payables are recorded at schedule.
the proper amount 11. Test computation of
accrued or prepaid interest.
V. Presentation and E. To determine that 12. Scan list of payables to
Disclosure payables are presented and determine that each major
disclosed according to type of obligation is
PAS/PFRS. properly described and
classified. Determine that
contingent liabilities are
properly disclosed.
13. Obtain client’s
representation letter.
 53. Audit Objectives and Procedures for Non-Current Liabilities.

Assertions Audit Objectives Audit Procedures

I. Existence or A. To determine that long- 1. Obtain an analyses of long-
Occurrence term debts exist at year- term debt accounts and
end. related interest, premium
and discount accounts.
2. Review debt agreements
and confirm with payees
the principal amount,
maturity date, interest rate,
etc.
3. Inspect bonds redeemed,
retired or surrendered
during the period.
II. Completeness B. To determine that all 4. Trace authorization for
transactions relating to issuance of debt to credits
long-term debts are to the long-term debt
properly recorded. account.
5. Vouch borrowing and
repayment transactions
and review transactions to
supporting documents
occurring near year-end.
III. Rights and C. To determine that long- 6. Review minutes of board
Obligations term debts represent valid of directors’ meetings.
obligations of the entity. 7. Review payments and
renewals after the
statement of financial
position date.
IV. Valuation or D. To determine that the 8. Recalculate interest
Allocation long-term are recorded at expense and amortization
the proper amount of premium or discount, if
any.
9. Ascertain the amount of
long-term debt maturing
within one year.
V. Presentation and E. To determine that long- 10. Evaluate presentation in
Disclosure term debts are presented the financial statement of
and disclosed according to the long-term debt.
PAS/PFRS. Examine classification of
obligation as either
secured or unsecured.
SUBSTANTIVE TESTS OF OWNERS’ EQUITY ACCOUNTS

54. Audit Objectives and Procedures.

Assertions Audit Objectives Audit Procedures

I. Existence or A. To determine the validity 1. Obtain schedules of
Occurrence of recorded shareholders’ shareholders’ equity
equity balances and accounts and reconcile to
whether the transactions the general ledger
actually occurred. balances.
2. Review authorizations and
terms of share issues.
3. Confirm shares
outstanding with registrar
on share and transfer agent.
4. Inspect share certificate
book.
5. Inspect certificates of
shares held in treasury.
II. Completeness B. To determine whether 6. In addition to the above
recorded shareholders’ mentioned procedures,
equity accounts reflect all perform analytical review
data that should be procedures.
recorded.
III. Rights and C. To determine whether the 7. Review articles of
Obligations entity has the authority incorporation and by-laws.
and execute the 8. Make inquiries of legal
shareholders’ equity counsel.
transactions, e.g., whether
share capital was legally
issued and shareholders
have a legal claim on
corporate assets at the
statement of financial
position date.
IV. Valuation or D. To determine whether the 9. Vouch share capital
Allocation shareholders’ equity entries, dividend entries
balances are shown in the and entries to retained
proper statement amount earnings.
in accordance with
PAS/PFRS.
V. Presentation and E. To determine that the 10. Review minutes of board
Disclosure shareholders’ equity directors’ and
accounts are properly shareholders’ meetings for
presented in the statement share options and dividend
of financial position. restrictions.
11. Evaluate financial
statement presentation and
disclosure for
shareholders’ equity
accounts.