©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts Chapter 20

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 1 Recognize the many accounts in the acquisition and payment cycle.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accounts Associated with the Acquisition and Payment Cycle  Cash  Inventory  Supplies  Property, plant, and equipment  Patents, trademarks, and copyrights  Prepaid rent  Prepaid taxes  Prepaid insurance

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accounts Associated with the Acquisition and Payment Cycle  Cost of goods sold  Rent expense  Property taxes  Income tax expense  Insurance expense  Professional fees  Retirement benefits  Utilities

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accounts Associated with the Acquisition and Payment Cycle  Accounts payable  Rent payable  Accrued professional fees  Accrued property taxes  Other accrued expenses  Income taxes payable

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Identify client business risks affecting other accounts. Methodology for Designing Tests of Details of Balances for A/P Phase I Set tolerable misstatement and assess inherent risk for accounts. Assess control risk for accounts.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Methodology for Designing Tests of Details of Balances for A/P Design and perform tests of controls and substantive tests of transactions for the acquisition and payment cycle. Phase II

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Timing Items to selectSamplesizeAuditprocedures Methodology for Designing Tests of Details of Balances for A/P Design and perform analytical procedures for the acquisition and payment cycle. Phase III Design tests of details of account balances to satisfy balance-related audit objectives.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 2 Design and perform audit tests of property, plant, and equipment and related accounts.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Classifications of Property, Plant, and Equipment Accounts  Land and land improvements  Buildings and building improvements  Manufacturing equipment  Furniture and fixtures  Autos and trucks  Leasehold improvements  Construction-in-process for property, plant, and equipment plant, and equipment

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Manufacturing Equipment and Related Accounts Manufacturing Manufacturing Equipment EquipmentAccumulatedDepreciatedBeginningbalanceBeginningbalance DepreciationExpense Gain or Loss on Disposals Current period depreciation Ending balance DisposalsDisposals Acquisitions Endingbalance

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Auditing Manufacturing Equipment and Related Accounts Analytical procedures Current year acquisitions Current year acquisitions Current year disposals Current year disposals Ending balance in the asset account Ending balance in the asset account Depreciation expense Depreciation expense Ending balance in accumulated depreciation Ending balance in accumulated depreciation

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Manufacturing Equipment Compare accumulated depreciation divided by gross manufacturing equipment cost with previous years. Misstatement in accumulated depreciation. Analytical Procedure Compare depreciation expense divided by gross manufacturing equipment cost with previous years. Misstatement in depreciation expense and accumulated depreciation. Possible Misstatement

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Manufacturing Equipment Compare gross manufacturing cost divided by some measure of production with previous years. Idle equipment or equipment that was disposed of but not written off. Analytical Procedure Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years. Expensing amounts that should be capitalized. Possible Misstatement

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Verifying Current Year Acquisitions The proper recording of current year additions is important because of the long-term effect the assets have on the financial statements. Because of the importance of current period acquisitions, seven of the nine balance-related audit objectives are used as a frame of reference.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Major Balance-Related Audit Objectives Current acquisitions agree with the master file. Detail tie-in 1.Foot the acquisition schedule. 2.Trace the individual acquisitions to the master file. to the master file. 3.Trace the total to the general ledger.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Major Balance-Related Audit Objectives Current acquisitions as listed exist. Existence 1.Examine vendors’ invoices and receiving reports 2.Physically examine assets.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Major Balance-Related Audit Objectives Existing acquisitions are recorded. Completeness 1.Examine vendors’ invoices of closely relatedaccounts to uncover items that should be manufacturing equipment. 2.Review lease and rental agreements.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Major Balance-Related Audit Objectives Current year acquisitions as listed are accurate. Accuracy 1. Examine vendors’ invoices.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Major Balance-Related Audit Objectives Current year acquisitions as listed are properly classified. Classification Examine: 1. Vendors’ invoices in mfg. equipment account. 2. Vendors’ invoices of closely related accounts. 3. Rent and lease expense for capitalizable leases.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Current year acquisitions are recorded in the proper period. Major Balance-Related Audit Objectives Cutoff 1.Review transactions near the balance sheet date for proper period.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder The client has rights to current year acquisitions. Major Balance-Related Audit Objectives Rights 1. Examine vendors’ invoices.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Verifying Current Year Disposals Review whether newly acquired assets replace existing assets. Analyze gains and losses on disposal. Review documents for indications of deletion of equipment. Make inquiries about the possibility of the disposal of assets.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Verifying Ending Balance of Asset Accounts 1. All equipment owned is recorded. 2. All recorded equipment physically exists on the balance sheet date. exists on the balance sheet date.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Verifying Depreciation Expense The most important objective is accuracy. Consistent depreciation policy Correct calculations

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Verifying Ending Balance in Accumulated Depreciation 1.Accumulated depreciation as stated in the property master file agrees with the general ledger. 2.Accumulated depreciation in the master file is accurate.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 3 Design and perform audit tests of prepaid expenses.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit of Prepaid Expenses Prepaid rent Prepaid rent Organization costs Organization costs Prepaid taxes Prepaid taxes Patents Patents Prepaid insurance Prepaid insurance Trademarks Trademarks Deferred charges Deferred charges Copyrights Copyrights

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Prepaid Insurance and Related Accounts Prepaid Insurance Beginning balance balance Acquisitions Ending Current period insurance insurance expense expense Insurance Expense

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Internal Controls 1. Acquisition and recording of insurance 2.Insurance register 3.Insurance expense

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit Tests Compare total prepaid insurance and insurance expense with previous years. Compute the ratio of prepaid insurance to insurance expense and compare it with previous years. Compare the individual insurance policy coverage on the schedule of insurance obtained with the preceding year’s schedule.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit Tests Compare the computed prepaid insurance balance for the current year on a policy-by-policy basis with that of the preceding year. Review the insurance coverage listed on the prepaid insurance schedule with an appropriate client official or insurance broker.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Balance-Related Audit Objectives Existence and completeness Insurance policies in the prepaid insurance schedule exist and existing policies are listed. Rights The client has rights to all insurance policies in the prepaid insurance schedule.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Balance-Related Audit Objectives Accuracy and detail tie-in Prepaid amounts are accurate and the total is correctly added and agrees with the general ledger. Classification Insurance expense is properly classified.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Balance-Related Audit Objectives Cutoff Insurance transactions are recorded in the proper period. Presentation and disclosure Prepaid insurance is properly presented and disclosed.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 4 Design and perform audit tests of accrued liabilities.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit of Accrued Liabilities Accrued income taxes Accrued income taxes Accrued interest Accrued interest Accrued pension costs Accrued pension costs Accrued professional fees Accrued professional fees Accrued rent Accrued rent Accrued warranty costs Accrued warranty costs

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accrued Property Taxes and Related Accounts Accrued Property Taxes Beginning balance balance Current period property tax property tax expense expense Ending balance balance Property Tax ExpensePayments (property taxes)

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 5 Design and perform audit tests of income and expense accounts.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Approach to Auditing Income and Expense Accounts Analytical procedures Tests of controls and substantive tests of transactions Tests of details of account balances

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Income and Expense Accounts Compare individual asset and liability balances with previous years. Overstatement or understatement of a balance sheet account that would also affect an income statement account. Analytical procedure Compare individuals expenses with previous years. Overstatement or understatement of a balance in an expense account. Possible misstatement

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Income and Expense Accounts Compare gross margin percentage with previous years. Misstatement of cost of goods sold and inventory. Analytical procedure Compare individual expenses with budgets. Misstatement of expenses and related balance sheet accounts. Possible misstatement

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Income and Expense Accounts Analytical procedure Possible misstatement Compare inventory turnover rate with previous years. Misstatement of cost of goods sold and inventory. Compare prepaid insurance expense with previous years. Misstatement of insurance expense and prepaid insurance.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Analytical Procedures for Income and Expense Accounts Analytical procedure Possible misstatement Compare commission expense divided by sales with previous years. Misstatement of cost of goods sold and inventory. Compare individual manufacturing expenses divided by total manufacturing expenses with previous years. Misstatement of individual manufacturing expenses and related balance sheet accounts.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Tests of Controls and Substantive Test of Transactions Understanding internal control and the related tests of controls and substantive tests of transactions to determine the appropriate assessed control risk are appropriate assessed control risk are the most important means of verifying many of the income statement accounts in each of the transaction cycles.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Tests of Details of Account Balances – Expense Analysis Expense account analysis

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Tests of Details of Account Balances – Allocation Several expense accounts result from the allocation of accounting data rather than discrete transactions. These include depreciation, depletion, and the amortization of copyrights and catalog cost. The allocation of manufacturing overhead between inventory and cost of goods sold is an example of a different type of allocation that affects expenses.

©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder End of Chapter 20