Audit Problem (Auditing and Assurance Principle) PDF

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AUDIT PROBLEMOVERVIEW OF THE AUDIT PROCESS (RISK-BASED AUDIT) Client Continuance and Acceptance Considerations  PSA 220, Quality Control for an Audit of Financial Statements – “The engagement partner should be satisfied that appropriate procedures regarding the acceptance and the continuance of cli...

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AUDIT PROBLEM OVERVIEW OF THE AUDIT PROCESS (RISK-BASED AUDIT) 1. Client Continuance and Acceptance Considerations  PSA 220, Quality Control for an Audit of Financial Statements – “The engagement partner should be satisfied that appropriate procedures regarding the acceptance and the continuance of client relationships and specific audit engagements have been followed, and that conclusion reached in this regard are appropriate and have been documented”  PSQM 1, Philippine Standards on Quality Management – December 15, 2022 substantially the same as PSQC 1  PSQC 1, Philippine Standards of Quality Control (as a whole) – further explained that “the firm should establish policies and procedures for the acceptance and continuance of client relationships and specific engagements, designed to provide it with reasonable assurance that it will only undertake or continue relationships and engagements where it: a. has considered the integrity of the client and does not have information that would lead it to conclude that the client lacks integrity; b. is competent to perform the engagement and has capabilities, time and resources to do so; and, c. can comply with ethical requirements.” (independence) Note: Five types of threat on the Code of Ethics  Self-interest threat  Self-review threat  Intimidation threat  Advocacy threat  Familiarity threat Superseding Another Professional Accountant in Public Practice (Code of Ethics for Accountants in the Philippines, Part B – Section 13) o Communication shall be instigated by the accepting accountant after permission to do so is granted by the potential client o Inquiry shall be limited to the following: 1. Information on any professional reasons which should be known before deciding whether or not to accept the appointment and, if there are such matters (integrity) 2. To provide all the necessary details to be able to come to a decision

There (3) parts of Code of Ethics Part A – Fundamental Principles (Integrity, Objectiveness, Professional Skills and Competence, Confidentiality of Information) Part B – Accountants in Public Practice Part C – Employed Accountants Under PSA 210, Agreeing the Terms of Audit Engagement - for the interest of both parties and to help avoid misunderstandings with respect to the engagement, an engagement letter on any form of written material be prepared, agreed and signed by both parties once auditor decided to accept a client - in general terms, engagement letter, include: 1. The objective and scope of the engagement 2. The responsibilities of the auditor 3. The responsibilities of the management 4. The identification of the financial accounting framework for the preparation of FS 5. Reference to the expected form and content of any reports to be issued by the auditor 6. A statement that there may be circumstances in which a report may differ from its expected form and content 2. Audit Planning Under PSA 315, Identifying and Assessing the Risk of Material Misstatements through Understanding the Entity and its Environment (including Internal Control) Entity and Environment – enables the auditor to identify and understand events, transactions and practices that may have a significant effect on financial statements (basis of Inherent Risk – the risk that the subject matter may be potentially misstated in the absence of the interference of control as it influences the nature of the business and the industry) Entity (internal factors) – Nature of the entity, business operations, investment, financing, financial reporting; Environment (external factors) – industry conditions, regulatory environment, applicable financial reporting framework and other external factors Objectives and strategies and related business risks such as industry developments, new products and services, expansion, etc.

Measurement and review of entity’s financial performance (key ratios, key performance indicators, employee performance measures, trends and forecasts etc.) (Risk Assessment Procedure) Audit Risk = Inherent Risk x Control Risk (Risk of Material Misstatement) x Detection Risk – Sampling Risk and Non-sampling Risk

Sampling Risk – Type I Risk (Alpha) - risk of assessing control risk too high (ToC) Type II Risk (Beta) – risk of assessing control risk too low Substantive Test - Type I Risk (Alpha) - risk of incorrect rejection Type II Risk (Beta) – risk of incorrect acceptance

Internal Control – enable the auditor to: (used to assess Control Risk) a. Identify the types of potential misstatements in the financial statements b. Identify the factors that affect risk of significant misstatements in the financial statements c. Design the NATURE, TIMING and EXTENT of further audit procedures – test of controls and substantive testing Audit Planning Activities (ongoing) 1. Inquiry 2. Inspection 3. Observation 4. Analytical Procedures (Risk Assessment Procedure)

3. Sufficient and Appropriate Evidence Consideration Further Audit Procedures:

4. Wrap-up Procedures and Audit Report Preparation Wrap- Up procedures - The objective in rendering wrap-up is to ensure that correct conclusions were reached and are backed up by sufficient appropriate evidence a. Analytical procedures for overall review Note: Analytical Procedure is required for Risk Assessment Procedure, optional in Substantive Testing and required for final review tool b. Related party transactions review c. Subsequent events review 1. Type I – has an effect on the measurement on the accounting element as of accounting date 2. Type II (note disclosure) – no effect but should be disclosed d. Assessment of going concern assumption e. Obtaining management’s representation letter f. Review for commitments and contingencies Audit Report Preparation 1. Unqualified Opinion - issued if there is no material misstatement in the financial statement 2. Unqualified opinion with emphasis of a matter paragraph after the opinion - issued if there are uncertainties which are adequately disclosed in the financial statements (e.g. uncertainty about the appropriateness of the use of the going concern assumption) 3. Qualified opinion (w/ basis of opinion paragraph before the opinion paragraph) - issued if there is a scope limitation (unable to obtain sufficient and appropriate evidence) that is material but not pervasive to the financial statements taken as a whole - issued if there is a departure from the financial reporting framework that is material but not pervasive to the financial statements taken as a whole 4. Adverse opinion (w/ basis of opinion paragraph before the opinion paragraph) - issued if there is departure from the financial reporting framework that is both material and pervasive to the financial statement taken as a whole 5. Disclaimer of opinion (w/ basis of opinion paragraph before the opinion paragraph) - issued if there is a scope limitation (unable to obtain sufficient and appropriate evidence) that is both material and pervasive to the financial statements taken as a whole

TRANSACTION CYLCE REVIEW REVENUE 1. Customer/Sales Order Processing Control Objective: To ensure orders are authorized based on the credit worthiness of customers* To ensure orders are approved based on availability of goods What could go wrong (risk): Credit worthiness is not checked* Availability of goods not checked FS assertion affected: Valuation of receivables

2. Delivery Control Objective: Deliveries are done accurately Correct goods as to quantify and specifications To correct customers What could go wrong (risk): Error in delivery of goods

FS assertion affected: Existence/Occurrence of AR/Sales 3. Billing Control Objective: Billings are for goods actually delivered All deliveries are being billed Billings are accurate Sales Orders vs. Delivery Receipt Footings and extensions (computations) What could go wrong (risk): Billing for goods not delivered* Unbilled deliveries Inaccurate billings FS assertion affected: Existence/Occurrence of AR/Sales* Completeness of AR/Sales Valuation/Measurement of AR/Sales 4. Recording Control Objective: 5. Accurate recording of transactions 6. Completeness of recording transactions Sales Invoice – Daily Sales Summary – Sales Journal Accurate postings to General and Subsidiary (Customer Account)

Ledgers

What could go wrong (risk): Inaccurate &/or incomplete recording of transactions Posting errors (Type I – erroneous amount/double posting, Type II – correct amount/wrong ledger) FS assertion affected: Completeness and Existence/Occurrence of AR/Sales Valuation/Measurement of Sales/AR

RECEIPT (Audit of Cash) 7. Customer Remittance

Control Objective: Protection from CASH LOSS Use of Imprest System All collections should be deposited in-tact on a daily basis All disbursements should be made through checks Regular/Monthly reconciliation What could go wrong (risk): Cash Loss FS assertion affected: Existence of cash (if collection was recorded) Existence of AR (if collection was not recorded) 8. Collection Deposit 9. Recording Production/Conversion Control Objective – Risk/What could go wrong? – FS assertion affected FS Assertion 1. Assertion about account balances  Existence  Completeness  Rights and Obligation  Valuation 2. About transaction and events  Occurrence  Completeness  Cut-off  Accuracy  Classification 3. About Presentation and Disclosure  Existence, Rights and Obligation  Completeness  Valuation and Accuracy  Classification and Understandability Confirmation Important notes 1. Letter/Communication between client and confirming party

2. Handling (sending and receiving responses) controlled by auditor 3. Type of Confirmation Letters:

4. Replies received through the client are considered INVALID RESPONSES 5. For INVALID responses or no responses received (for positive letters) within a considerable period, another set of confirmation letter shall be sent. 6. If there is no response to second set send, auditor should determine alternative audit procedure necessary to validate the same assertion 7. Sample selection and assertion:

Account Balance: Trade Receivables

Audit of Accounting Estimate 1. Inquire about the policy of providing allowances 2. Recalculation based on policy 3. Test reasonableness of the policy through: a. Industry experience b. Past experience c. Subsequent events

Receivables

Note: Only Non-Trade Receivables can be classified as non-current BS Measurement: PFRS 9 (Financial Instruments) - Requires RECEIVABLES to be measured at the balance sheet date at AMORTIZED COST

Trade Receivable Initial Measurement: PFRS 9 (Financial Instruments) - Requires financial assets to be measured initially at Fair Value - For Trade Receivables (that don’t have significant financing component) initial measurement shall be at UNDISCOUNTED INVOICE PRICE (Transaction Price) Methods of Accounting for Cash Discounts (ECL Model) Gross Method – AR is recognized GROSS of cash discounts (List Price – Trade Discount = Invoice Price) Net Method – AR is recognized NET of cash discounts (List Price – Trade Discount – Cash Discount = Cash Price)

For Trade Receivables (Manufacturing/Merchandising)

Risk Assessment and other Procedures

Transaction Cycle Review Expenditure/Purchasing 1. Requisitioning (Requisition Slip by Operating Department) Purchasing Department Control Objective: To ensure that only items needed are being requested to be purchased Authorization done by head of operating department requesting the item/s For inventories for instance, used of EOQ or JIT system ensures items requested are needed What could go wrong (risk): Overstocking of inventories Requesting/purchasing items not needed FS assertion affected: Valuation of inventories 2. Purchase Order Control Objective: To ensure that transactions are done in the best available terms Prelisting of pre-approved multiple potential suppliers (Specific authorization) First time suppliers – product testing and background check (General authorization) For significant purchases – canvassing and bidding policies What could go wrong: The purchase is not best term FS assertion affected: Valuation of inventory 3. Receiving Control Objective: To ensure that items received are inspected and counted A receiving report should be fully accomplished to manifest that goods received are in fact inspected and counted Blank/blind purchase order given to receiving department ensures that items received are in fact counted and inspected

What could go wrong: Goods are not inspected and/or counted appropriately FS assertion affected: Existence/Occurrence of trade liabilities Existence and Valuation of inventories 4. Voucher Preparation and Recording (AP Voucher - request to pay a liability) Control Objective: To ensure that only valid purchases are requested payments for and recorded Compare documents in the voucher package 1. Purchases Order vs. Supplier’s Sales Invoice 2. Purchase Order vs. Receiving Report 3. Receiving Report vs. Supplier’s Sales Invoice To ensure that all valid purchases are requested payments for recorded as liability

What could go wrong: *Goods received were not ordered (P.O. vs. R.R.) *Suppliers’ charges are not for goods received (S.I. vs. R.R.) *Suppliers’ charges are not according to what has been agreed upon (S.I. vs. P.O.) (*EXISTENCE/OCCURRENCE) Valid purchases are not requested for payments and not recorded (Completeness) *Requesting payment for an invalid purchase transaction Recording errors – classification errors, slide and transposition errors, posting errors FS assertion affected: Existence/Occurrence of trade liabilities Completeness of trade liabilities Classification of purchases Cut-off of Purchases

Disbursement 5. Payment Approval; Check preparation and release (Treasury Department) Control Objective: To ensure that only valid purchases are being approved for payment Agreeing documents in the voucher package (PO, RR, SI) Use imprest system All disbursements should be made through checks (Set-up of Petty Cash Fund) Designating 2 signatories for significant disbursements Check release by the person who last signs the checks Cancellation of the voucher documents by the one who signs the checks last and releases checks What could go wrong: Misappropriation of disbursements Unauthorized payments Payments made for invalid purchases Payment of vouchers twice Vouchers being paid after cash discount period and even after due dates Unrecorded disbursements FS assertion affected Existence of cash Completeness; Existence of payables 6. Recording Control Objective: To ensure that all valid disbursements are recorded accurately and completely What could go wrong: Recording errors – classification errors, slide and transposition errors, posting errors FS assertion affected: Existence of cash Completeness; Existence of payables

Substantive Testing Cycle: Expenditure/Disbursement Account Balance: Payables/Accrued Liabilities

Cut-off Procedures: 1. Purchase Cutoff (PFRS 15)

Purchase Cut-off: Inventories

2. Cash Disbursements’ Cut-off (Search for unrecorded liabilities)

Audit of Accounting Estimate (Test of Reasonableness) 1. Inquire about the estimation policy of the company 2. Recompute balances based on the company’s estimation policy 3. Determine reasonableness of the estimation policy through: a. Past/historical experience (based on accounting records) b. Industry experience (bench marking) c. Subsequent event

Presentation of Liabilities in the SFP (As per PAS 1, Presentation of Financial Statements)

Current vs. Noncurrent presentation of Assets and Liabilities

4. No right to defer settlement for another 12 months Long-term Refinancing Currently Maturing Obligation (CMO) GENERAL RULE: CURRENT LIABILITY EXCEPTION: (NONCURRENT LIABILITY) 1. Right to refinance EXISTS AND as of the BS DATE 2. Long-Term Refinancing - Extend maturity for another 12 months - Issuance of another LT debt security proceeds DIRECTLY USED to pay the CMO (Subsequent event) Breach of Contract (Failure to comply with certain debt agreements) GENERAL RULE: Due and demandable CURRENT LIABILITY EXCEPTION: (NONCURRENT LIABILITY 1. RIGHT over the LT grace period AND EXISTS as of the BS DATE 2. Long-term Grace Period - For another 12 months (payment will not be demanded)

Presentation of Liabilities in the SFP

(As per PAS 1, Presentation of Financial Statements)

(PAS 37: PROVISIONS, CONTINGENT LIABILITIES AND ASSETS) Provisions – liabilities of uncertain timing or amount

NOTE: PAS 37 notes that it is only in extremely rare cases that a reliable estimate will not be possible

Contingent Liability – a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity

Problem 3: Page 4 Possible Scenarios

REIMBURSEMENTS Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party (Examples: through insurance contracts, indemnity clauses or suppliers’ warranties.)

Provisions (Constructive Obligating Event) Assurance-Type Warranties

Problem 6: Provision (Assurance-Type Warranties) Accounting Entries

1.

2.

Problem 7: Unearned Income (Service Type Warranties)

1 and 2.

3.

Problem 8: Unearned Income Customer Loyalty Award/Credit

1.

2.

PAS 19: EMPLOYEE BENEFITS

SHORT TERM EMPLOYEE BENEFITS: COMPENSATED ABSENCES

PROFIT SHARING BONUS

METHODS: B = b%(NI) B = b%(NI-B) B = b%(NI-Tx)

Tx = Tx%(NI-B)

B = b%(NI-Tx-B)

Tx = Tx%(NI-B)

Problem 9: ST – Employee Benefits 1.

Adjusting Journal Entry: (1) Salaries Expenses 222,300 (2,854,800 – 2,632,500) Salaries Payable 222,300 (2) Salaries Payable 14,543 (794,824 – 809,367) 14,543 (3) Income Tax Expense 3,406,389 (12,149,453 – 794,824)*30% Income Tax Payable 3,406,389 2. B = 10% (NI - B -Tx) Tx = 30% (NI – B) B = 10% (NI – B – 30% (NI – B)) Bonus per books 809,367 809,367 = 10% (NI – 809,367 – 30%(NI – 809,367)) 809,367 = 10% (0.70NI – 566,557) 809,367 = 0.07NI – 56,656 866,023 = 0.07NI NI = 12,371,753 (Net income before bonus per books) NI per books 12,371,753 Adjustment 1 (comp. abs) ( 222,300 ) NI per audit (before bonus) 12,149,453 B = 10% (NI – B – 30%(NI – B))

B = 10% (12,149,453 – B – 30%(12,149,453 – B)) B = 850,462 – 0.70B B = 850,462/1.07 B = 794,824 To check: B = 10% (12,149,453 – 794,824 – 30%(12,149,453 – 794,824)) AUDIT OF CASH Receipt/Disbursement Cycle RECEIPT (Audit of Cash) 1. Customer Remittance Control Objective: Protection from CASH LOSS Use of Imprest System Request customers to pay directly to the bank All collections should be deposited in-tact (on a daily basis) Request customers to pay through checks (restrictively endorsed) Regular bank reconciliation statement preparation (pre-numbering of receipt) What could go wrong (risk): Cash Loss FS assertion affected: Existence of cash (if collection was recorded) Existence of AR (if collection was not recorded) 2. Collection Deposit 3. Recording

DISBURSEMENT 1. Payment Approval; Check preparation and release (Treasury Department) Control Objective: To ensure that only valid purchases are being approved for payment Agreeing documents in the voucher package (PO, RR, SI) For significant purchases – 2 signatories Check release by the person who last signs the checks Cancellation of the voucher documents by the one who signs the checks last and releases the checks Use of imprest system: All disbursements should be made through checks

What could go wrong: Misappropriation of disbursements Unauthorized payments Payments made for invalid purchases Payment of vouchers twice Vouchers being paid after cash discount period and even after due dates Un...