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Auditing defined

Auditing is a systematic process by which a competent , independent person

objectively obtain and evaluates evidence regarding assertions about economic
action and events to ascertain the degree of correspondence between those
assertions and established criteria and communicating the result to interested

Objective and General Principles Governing an audit of Financial Statement

(PSA 200) (Amended as a Result of Revision of PSA 700)


The purpose of this Philippine standard on auditing (PSA) is establish

standard and provide guidance on the objective and general principle governing
an audit of financial statement . It also describes management `s responsibility for
then preparation and presentation of the financial statement and for identifying
the financial reporting framework to be used in preparing for the financial
statements, referred to in the PSAs as “applicable financial reporting framework.”

Objective of an Audit of Financial Statement

The objective of an audit of financial statement is to enable the auditor to

express an opinion whether the financial statement are prepared, in all material
respect, in accordance with an identified financial reporting framework.

An audit of financial statement is an assurance engagement, as define in the

Philippine Framework for Assurance Engagement. The framework defines and
describes the elements and objectives of an assurance engagement .The PSAs
apply the framework in the context of an audit of financial statements and
contain the basic principles and essential procedures, together with related
guidance , to be applied in such an audit .Paragraph 34-35 in this PSA discuss the
meaning of the term “Financial Statement “ and management `S responsibility for
such statements. As discussed in the Framework ,A condition for acceptance of
an assurance engagement is that criteria referred to in the definition are
“suitable criteria “ and available to intended user .Paragraph 37-48 in the PSA
discuss suitable criteria and their availability to intended users for an audit of
financial statements through the auditor’s consideration of the acceptability of
the financial reporting Framework .

Ethical Requirements Relating to an Audit of Financial Statements

The auditor should comply with relevant ethical requirements relating to audit

As discussed in PSA 220 (REVISED ),”Quality Control for Audit of Historical

Financial Information ,” ethical requirements relating to audits of financial
statements ordinarily comprise Parts A and B of the code of ethics for
professional accountants in the Philippines (ethics code ) issued by the Philippine
institute of certified public accountant and adopted and promulgated by the
Board of Accountancy . PSA 220 (revised ) identifies the fundamental principle of
professional ethics and established by Parts A and B of Ethics Code and sets
out the engagement partners’ responsibilities with respect to ethical
requirement .PSA 220 (REVISED ) recognizes that the engagement team titled to
rely on a firm ‘s system in meeting its responsibilities with respect to quality
control procedures applicable to the invidual audit engagement ( for example ,in
relation to capabilities and competence of personnel through their recruitment
and formal training ; independence through the accumulation and
communication of relevant independence information ; maintenance of client
relationships through requirement through monitoring process .)Unless
information provided by the firm or other parties suggests otherwise. Accordingly
,Philippine Standard on Quality Control (PSQC) 1, ‘ Quality Control for Firms that
perform audits and Reviews of Historical Financial Information , and other
Assurance and Related Services Engagement,’’ requires the firm to establish
policies and procedures designed to provide it with reasonable assurance that
the firm and its personnel comply with relevant ethical requirements.

Conduct of an Audit of Financial Statement

The auditor should conduct an audit in accordance with Philippine Standards on

PSAs contain basic principles and essential procedures together with related
guidance in the form of explanatory and other material, including appendices. The
context of explanatory and other material that provide guidance for their
application. The text of whole Standard is considered in order to understand and
apply the basic principle and essential procedures.

Substantially the same as Code of ethics for Professional Accountants issued by the International
Federation of Accountants.

In conducting an audit in accordance with PSAs, the auditor is also aware of

and considers Philippine Auditing Practice Statement (PAPSs ) applicable to the
audit engagement ,PAPSs provide interpretative guidance and practical
assistance to auditors in implementing PSAs . An auditor who does not apply the
guidance included in relevant PAPS needs to be prepared to explain how the
basic principles and essential procedures in the standard addressed by the PAPS
have been complied with.

The auditor may also conduct the audit in accordance with both ISAs and
PSAs. however, there are currently no fundamental differences between the
IAASB pronouncement and corresponding requirements issued by the AASC and
no such differences are expected in the future .

Scope of an Audit of Financial Statement

The term ‘’scope of an audit ‘’ refer to the audit procedures deemed necessary
in the circumstances to achieve the objective of the audit. In determining the
audit procedures to be performed in conducting an audit in accordance with
Philippine Standards on Auditing ,the auditor should comply with each of the
Philippine Standards on Auditing relevant to the audit .

The auditor should not represent compliance with Philippine Standards on

Auditing unless the auditor has complied fully with all the Philippine Standards on
Auditing relevant to the audit . The auditor may, in exceptional circumstances,
judge it necessary to depart from a basic principle or an essential procedure that
is relevant in the circumstances of audit ,in order achieve the objective of the
audit . In such a case, the auditor is not precluded from representing compliance
with PSAs, provided the departure is appropriately documented as require by
PSA 230 .’’ Audit Documentation.’’

Professional Skepticism

The auditor should plan and perform an audit with an attitude of professional
skepticism recognizing that circumstances may exist that cause the financial
statement to be materially misstated.


As stated in the preface to the Philippine Standards on Quality Control,

Auditing ,Review , and other Assurance and Related Services .it is the stated
policy of the AASC to make the international Standards and Practice Statements
issued by the IAASB the applicable standards and practice statements in the
Philippine . to implement such policy , the AASC make Philippine – specific those
paragraph or sections in International Standard and Practice Statements that are
addressed in broad term to the international community as a whole to make
them clearly applicable in the Philippines, or provides additional information in
certain paragraphs or section , whenever necessary ,to facilitate and clearly
establish their application in the Philippines.

An attitude of professional skepticism means the auditor makes a critical

assessment , with a questioning mind, of the validity of audit evidence obtained
and is alert to audit evidence that contradicts or brings into question the
reliability of documents and responses to inquiries and other information
obtained from management and those charged with governance . For example ,
an attitude of professional skepticism is necessary throughout the audit process
for the auditor to reduce the risk of overlooking unusual circumstances , of over
generalizing when drawing conclusions from audit observations, and of using
faulty assumptions in determining the nature , timing and extent of the audit
procedures and evaluating the results thereof . When making inquiries and
performing other audit procedures, the auditor is not satisfied with less- than-
persuasive audit evidence based on a belief that management and those
charged with governance are honest and have integrity . Accordingly ,
representations from management are not a substitute for obtaining sufficient
appropriate audit evidence to be able to draw reasonable conclusions on
which to base the auditor’s opinion .

Reasonable Assurance

An auditor conducting an adult in accordance with PSAs obtains reasonable

assurance that the financial statements taken as a whole are free from material
misstatement, whether due to fraud or error. Reasonable Assurance is a concept
relating to the accumulation of the audit evidence necessary for the auditor to
conclude that there are no material misstatements in the financial statement s
taken as a whole. Reasonable assurance relates to the whole audit process.

An auditor cannot obtain absolute assurance because there are inherent

limitations in an audit that affect the auditor’s ability to detect material
misstatement. These limitation result from factors such as the following:

 The use of texting

 The inherent limitation of internal control (for example, the possibility of
management override or collusion.)
 The fact that most audit evidence is persuasive rather than conclusive.

Also, the work undertaken by the auditor to form an opinion is permeated by

judgment, in particular regarding.

(a) The gathering of audit evidence , for example , in deciding the nature,
timing and extent of audit procedures ; and
(b) The drawing of conclusion based on the audit evidence gathered, for
example, assessing the reasonableness of the estimates made by
management in preparing the financial statements.

Further, other limitations may affect the persuasiveness of evidence

available to draw conclusions on particular assertion (for example,
transactions between related parties). In these cases, certain PSAs identify
specified audit procedures which will, because of the nature of the
particular assertions, provide sufficient appropriate audit evidence in the
absence of.:

(a) Unusual circumstances which increase the risk of material

misstatement beyond that which would ordinarily be expected ;
(b) Any indication that a material misstatement has occurred .

Audit Risk and Materiality

The auditor obtain and evaluates audit evidence to obtain

reasonable assurance about whether the financial statements give a
true and fair view or are presented fairly in all material respect, in
accordance with the applicable financial reporting framework . The
concept of reasonable assurance acknowledges. That there is a risk the
audit opinion is inappropriate. The risks that the auditor expresses an
inappropriate audit opinion when the financial statements are
materially misstated is known as ‘’audit risk’’.

The auditor should plan and perform the audit to reduce audit risk
to an acceptably low level that is consistent with the objective of an
audit. The auditor reduces audit risk by designing and performing audit
procedures to obtain sufficient appropriate audit evidence to be able to
draw reasonable conclusions on which to base an audit opinion.
Reasonable assurance is obtained when the auditor has reduced audit
risk to an acceptably low level.

Paragraphs 15-18 of PSA 500 (revised ) ‘’Audit Evidence ,’’Discuss the use of assertions in
obtaining audit evidence .
This definition of audit risk does not include the risk that the auditor might erroneously
express an opinion that the financial statement are materially misstated .

Responsibility for the financial statement

While the auditor is responsible for forming and expressing an opinion

on the financial statements , the responsibility for the preparation and
presentation of the financial statements in accordance with the applicable
financial reporting framework is that of the management of the entity , with
oversight from those charged with governance of their responsibility.

Determining the Acceptability of the Financial Reporting Framework

The auditor should determine whether the financial reporting framework

adopted by management in preparing the financial statements is acceptable. The
auditor ordinarily makes this determination when considering whether to accept
the audit engagement, as discussed in PSA 210,’’ Terms of Audit Engagements.’’

An acceptable financial of the financial reporting frame work is referred

to in the PSAs as the ‘’applicable financial reporting framework.”

The auditor determines whether the financial reporting adopted

management is acceptable in view of the nature of entity (for example,
whether it is a business enterprise, a public sector entity or a not for
profit organization) and the objective of the financial statement .

Expressing an Opinion on the Financial Statements

When the auditor is expressing an opinion on a complete set of general

purpose financial statements prepared in accordance with a financial reporting
framework that is designed to achieve fair presentation ,the auditor refers to PSA
700, The Independent Auditor ‘s Report on a Complete Set of General Purpose
Financial Statement ,’’ for standards and guidance on the matter the auditor
considers in forming an opinion on such financial statement and on the form and
content of the auditor’s report . The auditor also refer to PSA 701 when
expressing a modified audit opinion including an emphasis of matter , a qualified
opinion , a disclaimer of opinion or an adverse opinion.


The term ‘’management ‘’ has been used in this PSA to describe those reasonable
for the preparation and presentation of the financial statement. Other terms may
be appropriate under certain circumstances, for example, the appropriate
reference may be those charged with governance (such as the directors).

The auditor refers to PSA 800 when expressing an opinion on:

(a) A complete set of financial statements prepared in accordance with

another comprehensive basis of accounting;
(b) A component of a complete set of general purpose or special purpose
financial statements, such as a single financial statement, specified
accounts, or items in a financial statement;
(c) Compliance with contractual agreements: and
(d) Summarized financial statements.

Major Steps in the Systematic Process of Financial Statements Audit

Figure 1.1 presents in highly condensed form the overview and major
components of an audit.

Phase I Pre-engagement and Audit Planning Activities

Audit process begins with the preliminary arrangements with the client.
Once the client has signed the engagement letter, the planning process starts as
the auditors concentrates his efforts in obtaining a detailed understanding of the
client’s business and an overall audit strategy. The auditor should PSA 300
(Revised) on “Planning an Audit of Financial Statements.” Basically, audit planning
includes understanding the client’s (1) industry environment, (2) business and
management, (3) accounting and reporting systems, and (4) internal control.

On the basis of the initial information gathered by the auditor, he then

assesses the “audit risk” relative to the engagement.

Based on the initial understanding, the auditor may decide assess control
risk at the maximum level for some assertions and below maximum for others.
Maximum control risk is defined at the greatest probability that a material
misstatement that could occur in an assertion will not be prevented or detected
on a timely basis by the entity’s internal control structure.

Assessment of materiality, acceptable audit risk, inherent risk and control

risk are used to develop an overall audit plan and audit program.

A more detailed discussion of this place is found in Chapter 2.

Phase II Gathering and Evaluating Audit Evidence

When gathering and evaluating audit evidence, auditors perform two basic
types of audit tests: test of controls and substantive tests.


In this phase, auditor focuses his attention on both the design and
operation of aspects of the internal control structure to determine whether the
necessary controls were functioning as intended.

When the auditors’ preliminary assessment of control risk is below the

maximum level, they may decide to perform tests of controls to establish the
effectiveness of controls in preventing or detecting material misstatements in a
financial statement assertion. When auditors assess control risk at the maximum
level, they are not required to perform any tests of controls. Tests of controls are
performed to determine whether a control is working. Tests of controls many
require inquiry, observation, or inspection of documents.

The tests of controls involve the following procedures:

1) Inquiries of client personnel

2) Inspection of documents and records
3) Observation of the application of specific policies and procedures
4) Re performance of the application of specific policies and

The compliance tests of controls over the basic transaction cycles, namely, (1)
revenue and collection cycle, (2) expenditure cycle, and (3) financing and
investing cycle may be done in this stage. Tests of controls precede substantive
testing and performed to reduce the assessed level of control risk below the
maximum level.

Performance of the substantive tests of transactions may also be conducted at

this stage. In fact, many of both types of tests, tests of controls and tests of
transactions are done simultaneously on the same transactions. When controls
are not considered effective, or when control deviations are discovered,
substantive tests can be expanded in this phase or in the final audit phase.

Results of the auditor’s tests of controls whether obtained through

reprocessing of transactions, observation or document testing and examination
must be fully documented. Documentation is a necessary part of the overall
evidence describing the thought processes leading to the design of substantive
tests and this is especially critical when the auditor assesses control risk to be
below the maximum level.


The phase involves substantive tests of details of balances and analytical

procedures. Substantive audit testing is the process of obtaining evidence in
support of transactions and balance. The nature, timing and extent of substantive
testing is a function of the auditor’s judgment concerning audit risk and

Nature of Substantive Tests

Test of balances refer to

a) Substantive tests of transactions and balances, and

b) Analytical review procedures performed at or near the balance
sheet date that are directed at the verification of an account

In designing audit programs for tests of balances in a typical audit

engagement, the following approaches are often used:

1. When internal control over specific class of transactions are

effective, tests of balances are applied to resulting balance sheet
account balances and reliance is placed primarily on internal
controls and on analytical review procedures for related income
statement account balances.
2. When internal control over a specific class of transactions are not
tested or cannot be relied upon, tests of balances sheet and income
statement account balances.

In performing substantive tests, the auditor aims to detect errors in account

balances that are large enough, individually or in the aggregate, to be material to
the financial statements. These tests relate to “detection risk” that is a key part of
audit risk.

Substantive tests may be performed before the balance sheet date when the
auditor can

1) Control the added audit risk that errors existing in the account at the
balance sheet date will not be detected and
2) Reduce the cost of substantive tests at the statement date.

Audit Objectives for Substantive Tests

In performing substantive tests, the auditor aims to substantiate

management’s assertions relative to (1) existence or occurrence, (2)
completeness, (3) rights and obligation, (4) valuation, and (5) presentation and
disclosure of the items in the financial statements.

The specific and audit objectives for substantive tests are to determine:

1. Existence or occurrence and validity

This relates to whether specific assets and liabilities exist at a given
point in time and whether recorded transactions represent economic
events that occurred during the year.
2. Completeness and accuracy
This involves determining whether all transactions that should have
been recorded by the client are accurately included in the accounts.
3. Rights and obligations
This requires the auditor to obtain evidence that the clients has
rights to existing assets and that existing liabilities and owners ‘ equity
claims against the entity are valid.
4. Proper valuation or allocation
This involves determining whether financial statement elements are
stated at the proper amount in accordance with GAAP.
5. Proper statement presentation and disclosure
This involves determining whether statement items are properly
identified, classified and arranged in the statements and whether
accompanying disclosure are adequate.

The nature, timing, and extent of the procedures performed in the substantive
tests depend upon the auditor’s assessed level of control risk and the resulting
detection risks he or she accepts for each assertion. For example, a minimum level
of control risk would result in a higher acceptable detection risk and therefore, in
less extensive substantive test.

The final audit phase will also include accumulation of some additional
evidence for the financial statements, summarization of the results that will
enable the auditor to prepare his audit report. This will include review for
contingent liabilities, review for subsequent events performing final analytical
procedures, evaluating the going concern assumption and obtaining a client
representation letter.

Chapters 3 to 19 present the detailed discussion of this phase.

Phase III Issuing the Audit Report

The culminating step in the audit process is the preparation of the audit
report. Expressing an audit opinion is the auditor’s overriding goal. The type of
audit report issued depends on the evidence accumulated and the audit findings.

The audit report concisely describes the auditor’s responsibility, the nature
of the examination, the audit finding and his opinion on the financial statements.
If upon completion of the audit field work, the auditor decides that an opinion can
not be rendered, he must clearly disclaim an opinion and give reasons for the
disclaimer. If an opinion can be rendered, the auditor must decide whether to
issue an unqualified, qualified or adverse opinion.

This phase is discussed more thoroughly in chapter 20.

Figure 1.2 presents the Auditor’s Report Expressing an Unqualified Opinion

Figure 1.2 Auditor’s Report Expressing an Unqualified Opinion

[Appropriate Addressee]

Report on the Financial Statements

We have audited the accompanying financial statements of ABC Company, which

comprise the balance sheet as at December 31, 20x7, and the income statement,
statement of changes in equity and cash flow statement for the year ended, and a
summary of significant accounting policies and other explanatory notes.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these

financial statements in accordance with Philippine Financial Standards. This
responsibility includes: designing, implementing and maintaining internal control
relevant to the preparation and fair presentation of financial statement that are
free from material misstatement, whether due to fraud or error, selecting and
applying appropriate accounting policies; and making accounting estimates that
are reasonable in the circumstances.

Auditor’s Responsibility

Our responsibility is to express an opinion on this financial statement based on

our audit. We conducted our audit in accordance with Philippine Standards on
Auditing. Those standards require that we comply with ethical requirements and
plan and perform the audit to obtain reasonable assurance whether the financial
statements are free from material misstatement. An audit involves performing
procedures to obtain audit evidence about the amounts and disclosures in the
financial statements. The procedures selected depend on the auditor’s judgment,
including the assessment of the risk of material misstatement of the financial
statements, whether due to fraud or error. In making those risk assessments, the
auditor considers internal control relevant to the entity’s preparation and fair
presentation of the financial statements in order to design audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the entity’s internal control.7 an audit also
includes evaluating the appropriateness of accounting policies used and the
reasonableness of accounting estimates made by management, as well as
evaluating the overall presentation of the financial statements.
We believe that the audit evidence we have obtained is sufficient and appropriate
to provide a basis for our audit opinion.


In our opinion, the financial statements present fairly, in all material respects,
The financial position of ABC company as December 31, 20X7 and of its
financial performance and its cash flow for the year ended in accordance with
Philip[pine Financial Reporting Standard s.

Report on Other Legal and Regulatory Requirements

[Form and content of this section of the auditor’s report will vary depending on
the nature of the auditor’s other reporting responsibilities.]

[ Auditor’s signature ]

[Date of the Auditor’s report]

[Auditor’s address]

This sentence would be worded as follows: “ In making those risk

assessments , the auditor considers internal control relevant to the
entity’s preparation of the financial statements in order to design audit
procedures that are appropriate in the circumstances .”

In the Philippine, the SEC requires a separate auditor’s opinion on

supplementary schedules required to be submitted by certain issuers
(such as public or listed companies) in addition to the financial
statements. A sample wording in connection with the submission of SEC
supplementary schedules is as follows: Our audit was conducted for
the purpose of forming an opinion on the basic financial statements as
a whole. The supplementary information shown in schedules
A,B,C,D,E,F,G,H and I is presented for purpose of additional analysis
and is not a required part of the basic financial statements. Such
information has been subjected to the auditing procedures applied in
the audit of the basic financial statements and , in our opinion , is
fairly stated in all material respects in relation to the basic financial
statements taken as a whole .”

Chapter 2

Learning objectives after studying this chapter, you should be able to;

 Know the nature of objectives of audit planning.

 Described the considerations in audit planning.
 Explain the basics of audit planning
 Described the work involved in audit planning

Once the client has been obtained and the engagement letter signed by both
parties ( auditor and client ) , the planning process intensifies as the auditors
concentrate their efforts in obtaining a detailed understanding of the client’s
business in developing an overall audit strategy and assess the risks of material
misstatement of the financial statements.

PSA 200 ,’’ Objectives and General Principles Governing an Audit of Financial
Statement ‘’, paragraph 15 requires that
‘’ The auditor should plan and perform an audit with an attitude of professional
skepticism recognizing that circumstances may exist that cause the financial
statements to be materially misstated .”

PSA 300 (REVISED) .” planning an audit of financial statements” establishes

standards and provides guidance on the considerations and activities applicable
to planning an audit of financial statements. It states that the auditor should plan
the audit so that the engagement will be performed in an effective manner .

The auditor-in –charge must develop a ‘’ plan of action ‘’to organize, coordinate,
and schedule activities of the audit staff. An audit plan is normally drafted prior to
starting the work at the client’s offices.

Nature and Scope of 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. Planning involves the engagement partner and other key
members of the engagement team to benefit from their experience and insight
and to enhance the effectiveness and efficiency of the planning process .

The nature of extent of planning activities will vary according to the size and
complexity of the entity, the auditor’s previous experience with entity, and
changes in circumstances that occur during the audit engagement.

Planning is a continuous and iterative process that often begins shortly after or in
connection with the completion of the previous audit and continues until the
completion of the current audit engagement. However, in planning an audit, the
auditor considers the timing of certain planning activities and audit procedures
that need to be completed prior to the performance of further audit procedures.
For example, the auditor plans the discussion among engagement team
members, the analytical procedures to be applied as risk assessment procedures ,
the obtaining of a general understanding of the legal and regulatory framework
applicable to the entity and how the entity is complying with that framework ,
the determination of materiality , the involvement of experts and the
performance of other risk assessment procedures prior to identifying and
assessing the risks of material misstatement and performing further audit
procedures at the assertion level for classes of transactions, account balances ,
disclosures that are responsive to those risks .
Benefits of Audit Planning

Audit planning generally involves the determination of the expected nature,

timing and extent of the audit. Among the benefits derived from audit planning
are the following:

(a) It helps ensure that appropriate attention is devoted to important areas of

the audit.
(b) It aids in identifying potential problems and revolving them on a timely
(c) It helps ensure that the audit is properly organized, managed and perform
in an effective and efficient manner.
(d) It assists in the proper assignment and review of the work of the
engagement team members.
(e) It helps coordinate the work to be done by auditors of components and
other parties involved such as experts, specialists, etc.

Initial Engagement Activities

At the beginning of the current audit engagement, the auditor should

perform following activities:


PSA 315 ‘’Understanding the entity and its Environment and Assessing the
Risks of Material Misstatement “ paragraph 14-19 provide guidance on
the engagement term ‘s discussion of the susceptibility of the entity to
material misstatements of the financial statements . PSA 240 (revised) ‘’
The Auditor’s Responsibility to consider fraud in an Audit of Financial
Statement “paragraphs 24-27 provide guidance on the emphasis given
during this discussion to the susceptibility of the entity’s financial
statements to material misstatement due to fraud.

a. Perform procedures regarding the continuance of the client relationship

and specific audit engagement.
b. Evaluate compliance with ethical requirements, including independence.
c. Establish an understanding of the terms of engagement.

The auditor’s consideration of the client continuance and ethical requirements,

including independence, occurs throughout the performance of the audit
engagement as conditions and changes in circumstance occur. However, the
auditor’s initial procedures on both client continuance and evaluation of ethical
requirements (including independence) are performed prior to performing other
significant activities for the current audit engagement. For continuing audit
engagements, such initial procedures often occur shortly after (or in connection
with) the completion of the previous audit.

The purpose of performing these preliminary engagement activities is to help

ensure that the auditor has considered any events or circumstances that may
adversely affect the auditor’s ability to plan and perform the audit engagements
to reduce audit risks to an acceptably low level. Performing these preliminary
engagement activities helps to ensure the auditor plans an audit engagement for

 The auditor maintains the necessary independence and ability to perform

the engagement.
 There are no issues with management integrity that may affect the
auditor’s willingness to continue the engagement.
 There is no misunderstanding with the client as to the terms of the

Planning Activities

The overall audit strategies

PSA 300 (revised) requires that the auditor establish the overall
strategy for the audit. This overall audit strategy sets the scope, timing and
direction of the audit and guides the development of the more detailed
audit plan. In developing the audit strategy, the auditor considers the
results of the preliminary activities described in the preceding paragraph.
The process of establishing the audit strategy involves.

a. Determining the characteristics of the engagement that define its scope.

Examples are :

1. The financial reporting framework

2. Industry specific reporting requirement ,and
3. The locations of the components of the entity

b. Ascertaining the reporting objectives of the engagement to plan the

timing of the audit and the nature of the communication required such
1. Deadlines for interim and final reporting , and
2. Key dates for expected communications with management and those
charged with governance.

c. Considering the important factor that will determine the focus of the
engagement teams efforts , such as

1. Determination of appropriate materiality levels

2. Preliminary identification of areas where there may be higher risks of
material misstatement.
3. Preliminary identification of material components and account
4. Evaluation of whether the auditor may plan to obtain evidence
regarding the effectiveness of internal control, and
5. Identification of recent significant entity- specific, industry, financial
reporting or other relevant developments.

Other Benefits of Developing the Audit Strategy

The process of developing the audit strategy helps the auditor to
ascertain the nature , timing and extent of resources necessary to
perform the engagement .The audit strategy sets out clearly, in
response to the matters identified in the above –mentioned process ,
and subject to the completion of the auditor’s risks assessment

(a) The resources to deploy for specific audit areas, such as the use of
appropriately experienced team members for high risk areas or the
involvement of experts on complex matters:

(b) The amount of resources to allocate to specific audit areas, such


1. The number of team members assigned to observe the inventory

count at material location,
2. The extent of review of the other auditors’ work in the case of
group audits, or
3. The audit budget in hours to allocate to high risk areas ;

(c) When these resources are deployed, such as whether at an

interim audit stage or at key cut –off dates : and

(d) How such resources are managed , directed and supervised, such
as when team briefing and debriefing meeting are expected to be
held, how engagement partner and manager reviews are expected
to take place ( for example , on site or off site ) , and whether to
complete engagement quality control reviews.

The appendix of PSA 300 (Revised) lists examples of matters the

auditor may consider in establishing the overall audit strategy for
an engagement. Many of these matters will also influence the
auditor’s detailed audit plan. The examples provided cover a broad
range of matters applicable to many engagement s. While some of
the matters referred to below may be required to be performed by
other PSAs, not all matters are relevant to every audit engagement
and the list is not necessarily complete. In addition, the auditor
may consider these matters in an order different from that shown

Scope of the Audit Engagement

The auditor may consider the following matters when establishing

the scope of the audit engagement;

 The financial reporting framework on which the financial information to

be audited has been prepared, including any need for reconciliations to
another financial reporting framework.
 Industry - specific reporting requirements such as reports mandated by
industry regulators.
 The expected audit coverage, including the number and locations of
components to be included.
 The nature of the control relationships between a parent and its
components that determine how the group is to be consolidated.
 The extent to which components are audited by other auditors.
 The nature of the business segments to be audited, including the need
for specialized knowledge.
 The reporting currency to be used, including any need for currency
translation for the financial information audited.
 The need for a statutory audit of standalone financial statements in
addition to an audit for consolidation purposes.
 The availability of the work of internal auditors and the extent of the
auditor’s potential reliance on such work.
 The entity’s use of service organizations and how the auditor may obtain
evidence concerning the design or operation of controls performed by
 The expected use of audit evidence obtained in prior audits, for
example, audit evidence related to risk assessment procedures and test
of controls.
 The effect of information technology on the audit procedures, including
the availability of data and the expected use of computer- assisted audit
 The coordination of the expected coverage and timing of the audit work
with any review of interim financial information and the effect on the
audit of the information obtained during such review.
 The discussion of matters that may affect the audit with firm personnel
responsible for performing other services to the entity.
 The availability of client personnel and data.

Reporting Objectives, Timing of the Audit and Communication’s Required

The auditor may consider the following matters when ascertaining the
reporting objectives of the engagement, the timing of the audit and the
nature of communications required:

 The entity’s timetable for reporting, such as at interim and final stages.
 The organization of meetings with management and those charged
with governance to discuss the nature, extent and timing of the audit
 The discussion with management and those charged with governance
regarding the expected type and timing of reports to be issued and
other communications, both written and oral, including the auditor’s
report , management letters and communications to those charged
with governance .
 The discussion with management regarding the expected
communications on the status of audit work throughout the
engagement and the expected deliverables resulting from the audit
 Communication with auditors of components regarding the expected
types and timing of reports to be issued and other communications in
connection with the audit of components.
 The expected nature and timing of communications among
engagement team members, including the nature and timing of team
meetings and timing of the review of work performed.
 Whether there are any other expected communications with third
parties, including any statutory or contractual reporting
responsibilities arising from the audit.

Direction of the Audit

The auditor may consider the following matters when setting the
direction of the audit:

 with respect to materiality

- Setting materiality for planning purposes.
- Setting and communicating materiality for auditors of components.
- Reconsidering materiality as audit procedures are performed during
the course of the audit.
- identifying the material components and account balances.

 Audit areas where there is a higher risk of material misstatement.

 The impact of assessed risks of material misstatement at the overall
financial statement level on direction, supervision and review.
 The selection of the engagement team (including, where necessary,
the engagement quality control reviewer) and the assignment of
appropriately experienced team members to areas where there may
be higher risks of material misstatement.
 Engagement budgeting, including considering the appropriate amount
of time to set aside for areas where there may be higher risks of
material misstatement.
 The manner in which the auditor emphasizes to engagement team
members the need to maintain a questioning mind and to exercise
professional skepticism in gathering and evaluating audit evidence.
 Results of previous audits that involved evaluating the operating
effectiveness of internal control, including the nature of identified
weaknesses and action taken to address them.
 Evidence of management’s commitment to the design and operation
of sound internal control, including evidence of appropriate
documentation of such internal control.
 Volume of transactions, which may determine whether it is more
efficient for the auditor to rely on internal control.
 Importance attached to internal control throughout the entity to the
successful operation of the business.
 Significant business developments affecting the entity , including
changes in information technology and business processes, changes in
key management , and acquisitions, mergers and divestments.,
 Significant industry developments such as changes in industry
regulations and new reporting requirements.
 Significant changes in the financial reporting framework, such as
changes in accounting standards.
 Other significant relevant developments, such as changes in the legal
environment affecting the entity.

The Audit Plan

The auditor should develop an audit plan for the audit in order to reduce
audit risk to an acceptably low level.
Once the audit strategy has been established , the auditor is able to start
the development of a more detailed audit plan to address the various matter
identified in the audit strategy , taking in to account the need to achieve the
audit objectives through the efficient use of the auditor’s resources. Although
the auditor ordinarily establishes the audit strategy before developing the
detailed audit plan, the two planning activities are not necessarily discrete or
sequential changes to the other. Paragraphs 14 and 15 provide further guidance
on developing the audit plan.

The audit plan is more detailed than the audit strategy and includes the nature,
timing and extent of audit procedures to be performed by engagement team
members in order to obtain sufficient appropriate audit evidence to reduce audit
risk to an acceptably low level. Documentation of the audit plan also serves as a
record of the proper planning and performance of the audit procedures that can
be reviewed and approved prior to the performance of further audit procedures.

The Audit Plan Includes:

 A description of the nature, timing and extent of planned risk assessment

procedures sufficient to assess the risks of material misstatement , as
determined under PSA 315 ‘’ Understanding the entity and its Environment
and Assessing the Risks of Material Misstatement.’’
 A description of the nature , timing and extent of planned further audit
procedures at the assertion level for each material class of transactions,
account balance , and disclosure, as determined under PSA300 . ‘’ The
Auditor’s Procedures in Response to assessed Risks.’’ The plan for further
audit procedures reflects the auditor’s decision whether to test the
operating effectiveness of controls and the nature, timing and extent of
planned substantive procedures; and

 Such other audit procedures required to be carried out for the engagement
in order to comply with PSAs (for example, seeking direct communication
with the entity’s lawyers).

Planning for these audit procedures takes place over the course of the audit
as the audit plan for the engagement develops. For example, planning of
the auditor’s risk assessment procedures ordinarily occurs early in the
audit process. However, planning of the nature, timing and extent of
specific further audit procedures depends on the outcome of those risk
assessment procedures. In addition, the auditor may begin the execution of
further audit procedures for some classes of transactions, account balances
and disclosures before completing the more detailed audit plan of all
remaining further audit procedures.

Changes to Planning Decisions During the Course of the Audit

The overall audit strategy and the audit plan should be updated and
changed as necessary during the course of the audit.

Planning an audit is continual and iterative process throughout the audit

engagement. As a result of unexpected events, changes in conditions , or
the audit evidence obtained from the results of audit procedures, the
auditor may need to modify the overall audit strategy and audit plan, and
thereby the resulting planned nature, timing and extent of further audit
procedures. Information may come to the auditor’s attention that differs
significantly from the information available when the auditor planned the
audit procedures. For example, the auditor may obtain audit evidence
through the performance of substantive procedures that contradicts the
audit evidence obtained with respect to the testing of the operating
effectiveness of controls. In such circumstances, the auditor re-evaluates
the planned audit procedures, based on the revised consideration of
assessed risk at the assertion level for all or some of the classes of
transactions, account balances or disclosures.

Direction, Supervision and Review

The auditor should plan the nature, timing and extent of direction and
supervision of engagement team members and review of their work.

The nature, timing and extent of the direction and supervision of

engagement team members and review of their work vary depending on
my factors, including the size and complexity of the entity, the area of
audit, the risk of material misstatement, and the capabilities and
competence of personnel performing the audit work. PSA 220 contains
detailed guidance on the direction, supervision and review if audit work.

The auditor plans the nature, timing and extent of direction and supervision
of engagement team members based on the assessed risk of material
misstatement. As the assessed risk of material misstatement increases, for
the area of audit risk, the auditor ordinarily increases the extent and
timelines of direction and supervision of engagement team members and
performs a more detailed review of their work. Similarly, the auditor plans
the nature, timing and extent of review of the engagement team’s work
based on the capabilities and competence of the individual team members
performing the audit work.

In audit of small entities, an audit may be carried out entirely by the audit
engagement partner (who may be a sole practitioner). In such situations,
questions of direction and supervision of engagement partner, having
personally conducted all aspects of the work, is aware of all material issues.
The audit engagement partner (or sole practitioner) nevertheless needs to
be satisfied that the audit has been conducted in accordance with PSAs.
Forming an objective view on the appropriateness of the judgments made
in the course of the audit can present practical problems when the same
individual also performed by a sole practitioner, it may be desirable to plan
to consult with other suitably-experienced auditors or the auditor’s
professional body.

The auditor should document the overall audit strategy and the audit plan,
including any significant changes made during the audit engagement.

The auditor’s documentation of the overall audit strategy records the key
decisions considered necessary to properly plan the audit and to
communicate significant matters to the engagement team. For example,
the auditor may summarize the overall audit strategy in the form of a
memorandum that contains key decisions regarding to overall scope, timing
and conduct of the audit.
The auditor’s documentation of the audit plan is sufficient to demonstrate
the planned nature, timing and extent of risk assessment procedures, and
further audit procedures at the assertion level for each material class of
transaction, account balance, and disclosure in response to the assessed
risk. The auditor may use standard audit programs or audit completion
checklist. However, when such standard audit programs or checklist are
used, the auditor appropriately tailors them to reflect the particular
engagement circumstances.

The auditor’s documentation of any significant changes to the originally

planned overall audit strategy and to the detailed audit plan includes the
reason for the significant changes and the auditor’s response to the events,
conditions, or results of audit procedures that resulted in such changes.
For example, the auditor may significantly change the planned overall audit
strategy and the audit plan as a result of a material business combination or
the identification of a material misstatement of the financial statements. A
record of a the significant changes to the overall audit strategy and audit
plan, and resulting changes to the planned nature, timing and extent of
audit procedures, explains the overall strategy and audit plan finally
adopted for the audit and demonstrate the appropriate response to
significant changes occurring during the audit.

The form and extent of documentation depend on such matters as the size
and complexity of the entity, materiality, the extent of other
documentation, and the circumstances of the specific audit engagement.

Communications With Those Charged With Governance and Management

The auditor may discuss elements of planning with those charged with
governance and the entity’s management. These discussions may be a part
of overall communications required to be made to those charged with
governance of the entity improve the effectiveness and efficiency of the
audit. Discussions with those charged with governance ordinarily include
the overall audit strategy and timing of the audit, including any limitations
thereon, or any additional requirements. Discussions with management
often occur to facilitate the conduct and management of the audit
engagement (for example, to coordinate some of the planned audit
procedures with the work of the entity’s personnel). Although these
discussions often occur, the overall audit strategy and the audit plan
remain the auditor’s responsibility. When discussions of matters included in
the overall audit strategy or audit plan occur, care is required in order to
not compromise the effectiveness of the audit. For example, the auditor
considers whether discussing the nature and timing of detailed audit
procedures with management compromises the effectiveness of the audit
by making the audit procedures too predictable.

Additional Considerations in Initial Audit Engagements

The auditor should perform the following activities prior to starting an

initial audit:
(a) Perform procedures regarding the acceptance of the client
relationship and the specific audit engagement (see PSA 220
for additional guidance).

(b) Communicate with the previous auditor, where there has

been a change of auditors, in compliance with relevant ethical

The purpose and objective of planning the audit are the same whether the audit
is an initial or recurring engagement. However, for an initial audit, the auditor
may need to expand the planning activities because the auditor does not
ordinarily have the previous experience with the entity that is considered when
planning recurring engagements. For initial audits, additional matters the auditor
may consider in developing the overall audit strategy and audit plan include the
 Unless prohibited by law or regulation, an arrangement to be made with
the previous auditor, for example, to review the previous auditor’s working
 Any major issues (including the application of accounting principles or of
auditing and reporting standards) discussed with management in
connection with the initial selection as auditors, the communication of
these matters to those charged with governance and how these matters
affect the overall audit strategy and audit plan.
 The planned audit procedures to obtained sufficient appropriate audit
evidence regarding opening balances (see paragraph 2 of PSA 510, “Initial
Engagements-Opening Balances”).
 The assignment of firm personnel with appropriate levels of capabilities and
competence to respond to anticipated significant risk.
 Other procedures required by the firm’s system of quality control for initial
audit engagements ( for example, the firm’s system of quality control may
require the involvement of another partner or senior individual to review
the overall audit strategy prior to commencing significant audit procedures
or to review reports prior to their issuance).

Discussion of Other Critical Matters in Engagement Planning

1. Application of Analytical Procedures in Planning the Audit

The purpose of applying analytical procedures in planning the audit is to

assist in understanding the business and in identifying areas of potential
risk. It will therefore assist the auditor in planning the nature, time, and
extent of auditing procedures that will be used to obtained evidential
matter for specific account balances or classes of transactions. By
identifying such things as the existence of unusual transaction and events,
and amount ratios and trends, matters that have financial statement and
audit planning ramifications might be brought to light. Likewise, relevant
non-financial information such as number of employees, area of selling
space, volume of goods produced may also contribute to the
accomplishment of the purpose of the analytical procedures.

When used for planning purposes, analytical procedures assist the auditors
in planning the nature, timing, and extent of audit procedures that will be
used for the specific accounts. The approach used is one of obtaining an
understanding of the client’s business and transactions, and identifying
areas that may present higher risks. The auditors will then plan a more
thorough investigation of these potential problems areas, and perform a
more effective audit. PSA 520 requires the auditors to perform analytical
procedures as a part of the planning process for every audit.

2. Establishment of an Engagement or Audit Team

An audit team consists of people with different levels of expertise and

experience. The team usually is composed of an engagement partner, a
manager, a least one senior, and one or more staff auditors. In determining
the number of people who will be assigned to an engagement, an auditor
normally considers the auditor’s size and complexity, the availability and
experience of personnel, the necessity for special expertise, the
opportunity to train personnel, and the continuity and rotation of
personnel. The audit team assembled for a larger engagement typically is
larger than that needed for a smaller engagement. An engagement
involving an entity in a regulated industry, such as banking, also requires
that the major members of the audit team have necessary knowledge and
experience in that industry.

3. Consideration of Work Performed by Other Auditors/Parties

The following should be considered

 The involvement of other auditors in the audit of components, for example,
subsidiaries, branches and divisions.
 The involvement of experts.
 The number of locations.

a. Predecessor Auditor

The successor auditor’s examination may be greatly facilitated by

consulting with the predecessor auditors and reviewing the predecessor’s
working papers. Communication with the predecessor auditors can provide
the successor CPA with background information about the client, details
about the client’s system of internal control, and evidence as to the
account balances at the beginning of the year under audit.

Auditors are ethically prohibited from disclosing confidential information

obtained in the course of an audit without the consent of the client. The
successor auditor should therefore obtain the client’s consent before
making inquiries form the predecessor auditors.

If the auditor is unable to obtain cooperation from the preceding auditors,

or if he feels that the work done by the preceding auditors does not meet
the requirements of generally accepted auditing standards, he may have to
treat the audit of the new client, previously audited by other accountants,
just as he would the first audit of a client who has never been audited

b. Other CPAs

When a portion of the client (e.g., subsidiary in a distant city) is audited by

another CPA firm, efforts may be coordinated. For example, if the accounts
of the subsidiary are to be consolidated with the overall enterprise, and if
that subsidiary is audited by another CPA firm, the auditors must
coordinate timing of necessary reports and procedures to be performed.

c. Specialist

CPAs may lack the qualifications necessary to perform certain technical

tasks relating to the audit. A specialist brings unique knowledge and
judgment in a field other than accounting and auditing. An auditor might
decide to have an art appraiser place values on works of art, a mineralogist
determine the physical characteristics of mineral reserves, or an actuary
provide data related to a groups life expectancy. Effective planning
involves arranging for the appropriate use of specialists both inside and
outside of the client organization.

d. Use of Client’s Staff

The auditors should obtain an understanding with the client as to the

extent to which the client’s staff, including the internal auditors, can help
prepare for the audit. The client’s staff should have the accounting records
up-to-date when the auditors arrive. In addition, many audit working
papers can be prepared for the auditors by the client’s staff, thus reducing
the cost of the audit and freeing the auditors from routine work. The
auditors may setup the columnar heading for such working papers and give
instructions to the client’s staff as to the information to be gathered. These
working papers should bear the Prepare by Client, or PBC, and also initials
of the auditor who verifies the work performed by the client’s staff.
Working papers prepared by the client should never be accepted at face
value; such papers must be reviewed and tested by the auditors.
Among the task that may be assigned to the client’s employees are the
preparation of a trial balance of the general ledger, preparation of an aged
trial balance of accounts receivable, analyses of accounts receivable written
off, lists of property additions and retirements during the year, and
analyses of various revenue and expense accounts. Many of these
“working papers” may be in the form of computer spreadsheets and other
computerized data files.

e. Internal Auditors

Internal auditors can affect the audit in two ways. First, they can enhance
internal control. For example, if internal auditors determined that bank
reconciliations were properly prepared and all cash receipts were
deposited, the entity’s controls would enhance the reliability of the
accounting records. In such cases, independent auditors would be able to
reduce the extent of substantive testing. In deciding whether to reduce the
amount of testing for specific assertions because of work performed by
internal auditors, the independent auditor should consider (1) the
materiality of the amount, (2) the risk of misstatement, and (3) the degree
of subjectivity involved in evaluating the accumulated audit evidence. As
these factors increase, the auditor is less likely to rely on the internal
auditor’s work.

4. Assessment of Going Concern Assumption

PSA 570 requires auditors to evaluate whether substantial doubt exist

about an entity’s ability to continue as a going concern, based on
procedures planned and performed to obtain evidence about the
management assertions embodied in the financial statements. That is, an
auditor is not required to design specific procedures to evaluate whether
an entity is a going concern. But when information obtained during the
audit raises substantial doubt about the entity’s ability to continue in
operation for a year following the date of the financial statements being
audited, the auditor, the auditor should add a paragraph calling attention
to the fact that the statements have been prepared assuming that the
entity will continue as a going concern.
When planning and performing audit procedures and in evaluating the
results thereof, the auditor should consider the appropriateness of
management’s use of the going concern assumption in the preparation of
the financial statements.

Examples of events or conditions, which individually or collectively, may

cast significant doubt about the going concern assumption are set out
below. This listing is not all-inclusive nor does the existence of one or more
of the items always signify that a material uncertainty exists.

The phrase “material uncertainty” is used in PAS No. 1 in discussing the uncertainties related to events
or conditions which may cast significant doubt on the enterprise’s ability to continue as a going concern
that should be disclosed in the financial statements. In other financial reporting frameworks, and
elsewhere in the PAS’s, the phrase “significant uncertainties” is used in similar

 Net liability or net current liability position.
 Fixed-term borrowings approaching maturity without realistic prospects of
renewal or repayment: or excessive reliance on short-term borrowings to
finance long-term assets.
 Indications of withdrawal of financial support by debtors and other
 Negative operating cash flows indicated by historical and prospective
financial statements.
 Adverse key financial ratios.
 Substantial operating losses or significant deterioration in the value of
assets used to generate cash flows.
 Arrears or discontinuance of dividends.
 Inability to pay creditors on due dates.
 Inability to comply with the terms of loan agreements.
 Change from credit to cash-on-delivery transactions with suppliers.
 Inability to obtain financing for essential new product development or
other essential investments.
 Loss of key management without replacement.
 Loss of a major market, franchise, license, or principal supplier.
 Labor difficulties or shortages of important supplies.

 Non-compliance with capital or other statutory requirements.
 Pending legal or regulatory proceedings against the entity that may, if
successful, result in claims that are unlikely to be satisfied.
 Changes in legislation or government policy expected to adversely affect
the entity.

Budget is used to measure the efficiency of the staff and to determine at each
stage of the engagement whether the work is progressing at a satisfactory rate.
An illustration of an Audit Budget and Time Summary is shown in
Figure 2.1

For repeat engagement, the development of time budget is facilitated by

reference to the preceding year’s detailed time record.

Managing time is an important consideration because billing is often based

on the amount of time charged to the engagement. Indeed, the most costly
element of an engagement is the auditor’s time. Time budgets con
motivate staff to perform efficiently, and one criterion by which audit
personnel are evaluate is their ability to complete assignments within the
allotted time. (However, placing too much emphasis on time management
can lower the quality of the audit.)

A special concern in auditing has been the “underreporting of time, “in

which a staff member reports only a fraction of the actual time spent
performing a particular audit procedure. Some auditors take work home,
complete it in the evening, and do not charge that time. staff members
may feel that they will look bad if they cannot complete a procedure
within an allocate time , or they may want to impress their supervisor
by finishing ( or appearing to finish ) below budgeted time. However, such
practices can create several problems, both for the firm and for the
following year’s audit team. If the firm bases its charges on the staff hours
worked, underreporting causes the firm to lose revenue to which it is
entitled. Underreporting causes the firm unrealistic basis for the following
years’ time budget. In addition, if completing an assignment requires staff
members to work additional hours for which they are not compensated,
they may experience burnout.

A periodic accounting of time and budget may be prepared as a basis for

determining the causes (s) of the variance between actual and budgeted
hours. This is illustrated in figure 2.2 . This report will also serve as a
guide in projecting the audit time for the succeeding audits.

Figure 2.1 portions of an Audit Budget and Time Summary

Total hours: Total Actual

Partner Budgeted Weekly Hours (by date)
Manager Hours
Senior staff

Hours by type of work

Preparation of audit program
Trial balances and adjusting entries
Permanent file
Financial statement comparisons
Transactions subsequent to year end
Preparation of reports
Sales and collection cycle
Study and evaluation of internal control
Tests of controls –sales
Substantive tests- sales
Test of controls- collections

The development of time budget s is facilitated in repeat engagements by

reference to the preceding year’s detailed time records. Sometimes time
budgets prove quite unattainable because the client’s records are not in
satisfactory condition, or because of the specials circumstances that arise.
Even when time estimates are exceeded, there can be no compromise with
qualitative standards in the performance of the field work. The CPA firm’s
professional reputation and its legal liability to clients and third parties do
not permit any shortcutting or omission of audit procedures to meet a
predetermined time estimate.

9. Assignment of personnel to the engagement

Staff must, therefore, be assigned with that standard in mind. On larger

engagements, there are likely to be one or more partners and staff at
several experience level doing the audit. Specialists in such technical areas
as statistical sampling and computer auditing may also be assigned. On
smaller audits there may be only one or two staff members.

A major consideration affecting staff is the need for continuity from year to
year. An inexperience staff assistant is likely to become the most
experienced non partner on the engagement within a few years.
Continuity helps the CPA firm maintain familiarity with the technical
requirements and closer interpersonal relations with client personnel.

Another consideration is that the persons assigned be familiar with the

client’s industry.

In PSA 220( Revised ), “ quality control for audit of historical financial

information, “ the auditor, and assistants with supervisory responsibilities,
will consider the professional competence of assistants performing work
delegated to them when deciding the extent of direction, supervision and
review appropriate for each assistant.

Any delegation of work to assistants would be in a manner that provides

reasonable assurance that such work will be performed with due care by
persons having the degree of professional competence required in the
To illustrate the importance of assigning appropriate staff to engagement,
consider a computer parts. Inherent risk for inventory has been assessed
as high. It is essential for the staff person doing the inventory portion of
the audit to be experienced in auditing inventory. In addition, he or she
should have a good understanding of the computer manufacturing

10. Scheduling of Work

Audit work that can always be performed during the interim period
includes the consideration of internal control, issuance of management
letter, and substantive tests of transactions that have occurred to interim

Interim tests of certain financial statement balances, such as accounts

receivable, may also be performed, but this significant errors or
irregularities could arise in these accounts during the remaining period
between the time that the interim test was performed and the balance
sheet date. Thus to rely on the interim test of significant account balance,
the auditors must perform additional tests of the account during the
remaining period.

Performing audit work during the interim period has numerous advantages
in addition to facilitating the timely release of the audited financial
statements. The independent auditors may be able to assess internal
control more effectively by observing and testing controls at various times
throughout the year. Also, they can give early consideration to accounting
problems. Another advantage is that interim auditing creates a more
uniform work load for CPA firm. With a large client, such as San Miguel
Corporation, the auditors may have office space within the client’s
buildings and perform auditing procedures throughout the entire year.

Performance of other substantive tests is scheduled near at, and after year-
end. Consideration should be given to such factors as:

a) Deadline for submitting final audit report and filing of income tax
b) Ability of the client’s staff to submit required schedules
c) Other audit clients

Documentation of Audit Plan / Audit Program

The auditor should develop and document an audit program setting out the
nature, timing and extent of planned audit procedures required to
implement the overall audit plan. The audit program serves as a set of
instructions to assistants involved in the audit plan and as a means to
control and record the proper execution of the work. The audit program
may also contain the audit objectives for each area and a time budget in
which hours are budgeted for the various audit areas or procedures.

The overall audit plan and the audit program should be revised as
necessary during the course of the audit. Planning is continuous throughout
the engagement because of changes in conditions or expected results of
audit procedures. The reasons for significant changes would be recorded.

The significant of such events or conditions often can be mitigated by other

factors. For example , the effect of an entity being unable to make its
normal debt repayments may be counter-balanced by management’s plans
to maintain adequate cash flows by alternative means, such as by disposal
of assets, rescheduling of loan repayments , or obtaining additional capital.
Similarly, the loss of a principal supplier may be mitigated by the availability
of a suitable alternative source of supply.

5. Identification of related parties

Transactions with related parties are important to auditors because they

will be disclosed in the financial statement if they are material. Generally
accepted accounting principles require disclosure of the nature of the
related party relationship: a description of transactions, including peso
amounts: and amounts due from and to related parties. Most auditor
assess inherent risk as high for related parties and related party
transactions, both because of the accounting disclosure requirements and
the lack of independence between the parties involved in the transaction.

A related party is defined as an affiliated company, a principal owner of the

client company, or any other party with which the client deals where one of
the parties can influence the management or operating policies of the
other. a related party transaction is any transaction between the client and
a related party. Common examples include sales or purchase transactions
between a parent company and its subsidiary, exchanges of requirement
between two companies owned by the same person, and loans to officers.
A less common example is the exercise of significant management influence
on an audit client by its most important customers.

Because material related party transaction must be disclosure, it is

important that all related parties be identified and included in the
permanent files early in the engagement. Finding undisclosed related party
transactions is thereby enhanced. Common ways of identifying related
parties include inquiry of management, review of SEC filings, and
examination of stockholders’ listings to identify principal stockholders.

6. Client’s Legal Obligation

Pertinent current year information that auditors should review includes (1)
minutes of directors’ and stockholders’ meeting, (2) changes to articles of
incorporation or by laws, and (3) any significant contracts executed during
the year . By reading the minutes, an auditor will obtain information about
significant events that have or will have an impact on the client. For
examples, an auditor should be alert to the following:

 Major contacts or agreements, including merger and acquisition

agreements, debt agreements, compensation agreements, and asset
purchase agreement.
 Information about current situations and future business plans
 Authorization of dividends.

For new clients for which historical information relating to these matters is
unavailable, the auditor should review information relating to prior years. For
example, instead of reading only the changes to the articles of incorporation and
by –laws, the auditor should read the articles of incorporation and by-laws since
the inception of the entity, maki8ng appropriate summaries for the permanent
file. The auditor should also read all contacts having an impact on the current

7. Completion of the Initial Audit Program

An audit program is a set of audit procedures specifically designed for each audit.
The program which includes both substantive tests and tests of controls will
enable the auditor to express an opinion on the financial statement taken as a

The auditor should develop and document an audit program setting pout the
nature, timing and extent of planned audit procedures required to implement the
overall audit plan. The audit program serves as a set of instructions to assistants
involved in the audit and as a means to control and record the proper execution
of the work. The audit program may also contain the objectives for each area and
a time budget in which hours are budgeted for the various audit areas or

Considering materiality, risk of misstatement, and the relative cost of performing

audit procedures, auditors determine the procedure to test the assertion
embodied in the financial statements. The audit program is a list of audit
procedures to be performed so that the auditor will have evidence as a basis for
expressing an opinion on the financial statements. For example, an auditor might
include the following two steps in the initial audit program to test the existence of

1. For a sample of entries in the sales journal, compare data in the sales
journal to the approved customer order, the sales order, the shipping
document, and the sales invoice.
2. Confirm a sample of accounts receivable at year- end.

Auditing standards require that a written audit program be prepared as a

part of each engagement.

In preparing the audit program, the auditor would consider the specific
assessment of inherent and control risks and the required level of
assurance to be provided by substantive procedures. The auditor would
also consider the timing of tests of controls and substantive procedures,
the coordination of any assistance expected from the entity, the
availability of assistants and the involvement of other auditors or experts
.; other matters may also need to be considered in more detailed during
the development of the audit program.
On initial engagements, the audit program typically will develop in three

(1) The broad phases of the program can be outlined at the time of
engagement :
(2) Other details of the program can be identified after the review of
internal control structure and accounting procedures has begun; and
(3) Procedures on specific phases of the audit can be further challenged and
revised as the work progresses.

On recurring engagement, the program for the preceding audit should

be studied before preparing the program for the current audit. The
program for the current audit should reflect modifications or are
required by the experience gained in the business, internal control or
accounting methods of the clients.

In planning his examination, the auditor should consider the nature,

extent, and timing of the work to be performed and should prepare a
written audit program (or a set of written audit program). An audit
program aids in instructing assistants in the work to be done. It should
set forth to reasonable detailed the audit procedures that the auditor
believes are necessary to accomplish the objectives of the examination.
The form of the audit program and the extent of its detail will vary. In
developing the program the auditor should be guided by the results of
the planning considerations and procedures. As the examination
progresses, changed condition or unexpected result of audit
procedures applied may make it necessary to modify planned audit

In preparing the audit program, the auditor, having an understanding of

the accounting system and related internal control, may wish to rely on
certain controls in determining the nature, timing, and extent of
required auditing procedures. The auditor may conclude that relying on
certain internal controls is an effective and efficient way conduct his
audit .however , the auditor may decide not to rely on internal controls
when there are other more efficient ways of obtaining sufficient
appropriate audit evidence. The auditor should also consider the timing
of the procedures, the coordination of any assistance expected from the
client, the availability of assistance, and the involvement of the other
auditors or experts.

The auditor normally has flexibility in deciding when to perform audit

procedures, as very few of them have to be carried out within specific
time limits. For example, procedure carried out on transaction can be
performed at any time after the transactions have been recorded. On
the other hand, the auditor may have no discretion as to timing, for
example, when observing the taking of inventories by client personnel.
8. Preparation of a Time Budget

A time budget is an estimate of the total hours an audit is expected to

take. It is based on the information obtained in the first major step in
the audit that is, obtaining an understanding of the client. It takes into
consideration such things as:

(a) The client’s size as indicated by its gross assets, sales, number of
(b) Location of client facilities.
(c) The anticipate accounting and auditing problems.
(d) The competence and experience of staff available.

The total time must be allocated by the preparation of work

schedules indicating who is to do what how long it should take. Thus,
Total hours are budgeted by major categories and may be scheduled
on a weekly basis Time Budget also serves as the basis for estimating
fees. It is also an important tool to communicate to the audit staff
those areas the manager or partner believes are critical and require
more time. Furthermore, a time



Flash Technologies and Networks, Inc.(FTN) design , develop,

manufactures, markets, services and supports a wide range of
computer systems and networking hardware and software.
The CPA firm of Villa or & Co. has audited the financial statement s of
FTN for the past three years. For this year’s audit, the staff of the firm
has prepared audit planning working papers.

Read through the information for you to obtain an understanding of

the nature of the information that is important to planning an audit

The selective audit planning working papers include:

 The balance sheet and income statement for the company for
 A trial balance for December 31,2008 , with comparative
amounts for 2007
 The analytical ratios working paper that is partially completed.
(The ratios for 2008 have been left off.)
 The audit plan for the audit of the financial statement for the
year ended December 31, 2008.
 A fraud risk assessment.

Flash Technologies and Network, Inc.

Balance sheet
December 31, 2007
(In Ᵽ000’s)

Current assets
Cash Ᵽ 27
Trade receivables, less allowance for doubtful accounts of 844
Account receivable –officers 57
Inventory 696
Prepaid expenses 40
Total current assets Ᵽ1,664
Noncurrent Assets
Equipment and leasehold equipment, at cost
Office equipment Ᵽ281
Leasehold improvement 17
Less accumulated depreciation Ᵽ 172
Total fixed assets Ᵽ 1836

Liabilities and shareholders’ equity

Current Liabilities
Note payable Ᵽ 309
Accounts payable 505
Current maturities of capital lease obligation 20
Accrued expenses 115
Total current liabilities Ᵽ 949

Capital lease obligation, less current maturities 135

Total liabilities Ᵽ1,084

Shareholders’ equity
Ordinary shares, Ᵽ1 par value; 100000 shares authorized; 20000 Ᵽ20
Share issued and outstanding 42
Additional paid-in capital 690
Retained earnings Ᵽ752

Flash technologies and network, Inc.

Statements of income and Retained Earnings
Year ended December 31,2007
(In Ᵽ000’s)

Net sales Ᵽ10,227

Cost of goods sold 6,867
Gross profit Ᵽ3360
Selling expenses: Ᵽ513
Salaries 97
Payroll benefits and taxes 82
Advertising and promotion 38
Travel and entertainment 16 Ᵽ746
Operating and administration expenses
Operating salaries Ᵽ803
Administrative salaries 428
Payroll benefits and taxes 223
Rent 124
Utilities 92
Insurance 110
Legal and accounting 73
Bad debt 34
Supplies 93
Depreciation 25
Software development 83
Miscellaneous 42
Total selling 2,140 Ᵽ2886
Administrative expenses Ᵽ474
Operating income 69
Interest expense Ᵽ405
Income before income taxes
Income taxes:
Current Ᵽ71
Deferred 3
Net income Ᵽ331
Retained earnings, January 1, 2007 Ᵽ358
Retained earnings, December 31, 2007 Ᵽ689

Documentation of the planning process is done through the preparation of

working papers showing:
(1) Audit plans (discussed in this section)
(2) Audit programs ( see chapters 23 and 24 for examples)
(3) Time budget (refer to page 382)

An audit plan contains the overview of the engagement, outlining the nature and
characteristics of the client’s business operations and the overall audit strategy.

The following information are included in a typical audit plan:

(1) Description of the client company-its structure, nature of business and

(2) Audit objectives ( i.e., if the audit is for stockholders, creditors or it is a
special –purpose audit)
(3) Description of the nature and extent of other services such as tax
returns preparation, etc.
(4) Timetable of the audit work
(5) Work to be done by the client’s employer
(6) Assignment of audit staff
(7) Target completion dates of the major segments of the engagement
(8) Preliminary evaluation and judgment about materiality level for the
(9) Any special problems to be resolved during the engagement particularly
those revealed by analytical procedures
(10) Condition that may require changes in audit test

Normally, the audit plan is prepared before starting work at the client’s office. It
may, however be modified throughout the engagement as the auditor deem as
necessary depending on his consideration of internal control or as special
problems are encountered .

The auditor may wish to prepare a memorandum setting forth the preliminary
audit plan, particularly for large and complex entity.

Planning a Repeat Engagement

It is far easier to plan for a repeat engagement than planning for a first audit of a
new client. The working papers in the previous year’s audit provide a wealth of
information useful in planning the recurring engagement. Of course, the auditor-
in-charge of a repeat engagement would have good working knowledge of the
client’s business. The auditor however should not merely duplicate last year’s
audit program but should modify his approach to the audit for any changes in the
clients’ operations, internal control structure, or business environment.

Special Consideration in the Audit of Small Entities (PAPS 1105)

The Philippine standards on Auditing (PSAs) contain basic principles and essential
procedures together with related guidance that apply to the audit of the financial
statements of any entity, irrespective of its size, Its legal from, ownership or
management structure , or the nature of its activities. The AASC recognizes that
small entities give rise to a number of special audit considerations.

The Philippine Auditing Practice Statement 1005 , “ special consideration in the

audit of small entities , “ which was made effective on June 30 , 2004 describes
the characteristics commonly found in small entities and indicates how they may
affect the application of PSAs. Reference may therefore be made by the auditor
to PAPS 1005 when handling audit of small entities.

Consideration of Environmental Matters in the Audit of Financial Statements

(PAPS 1010)

Environmental matters are becoming significant to an increasing number of

entities and may, in certain circumstances, have a material impact on their
financial statements. These issues are of growing interest to the users of financial
statements. The recognition, measurement, and disclosure of these matters is the
responsibility of management.
For some entities, environmental matters are not significant, however , when
environmental matters are significant to an entity , there may be a risk of material
misstatement (including inadequate disclosure) in the financial statements arising
from such matters; in these circumstances , in auditor needs to give consideration
to environmental matters in the audit of the financial statements.

PAPS 1010, “consideration of environmental matters in the audit of financial

statements, “provides practical; assistance to auditors by describing;

(a) The auditor’s main considerations in an audit of financial statements

with respect to environmental matters;
(b) Examples of possible impacts of environmental matters on financial
statements: and
(c) Guidance that the auditor may consider when exercising professional
judgment in this context to determine the nature, timing, and extent of
audit procedures with respect to ;
 Understanding the entity and its environment and assessing
the risks of material misstatement (PSA 315):
 Consideration of laws and regulation (PSA 250); And
 Other substantive procedures (PSA 620 and some others).

The guidance under (c) reflects the typical sequence of the audit process. Having
acquired a sufficient knowledge of the business the auditor assesses the risk of a
material misstatement in the financial statements. This assessment includes
consideration of environmental laws and regulations that may pertain to the
entity, and provides a basis for the auditor to decide whether there is a need to
pay attention to environmental matters in the course of the audit of financial

Reference should be made by the auditor in addressing environmental matters

that are significant to the financial statement of the entity. The extent to which
any of the audit procedure described in PAPS 1010 may be appropriate in a
particular case requires the exercise of the auditor’s judgment in the light of the
requirement of the PSAs and the circumstances of the entity.
Flash Technologies and Networks, Inc.
Analytical Review Ratios
For the Year Ended December 31, 2008

Ending Ending
Ratio 12/31/08 12/31/07 Industry

Current ratio 1.752 1.300

Day’s sales in accounts receivable, computed

With average accounts receivable 33.224 37.000

Allowance for doubtful accounts / accounts

Receivable 0.01 -
Bad debt expense / net sales 0.003 -
Inventory turnover computed with average
Inventory 10.397 10.000

Day’s inventory on hand computed with

Average inventory 35.222 36.000
Total liabilities / net worth 1.444 2.900
Return on total assets 0.180 0.090
Return on net worth 0.441 0.290
Return on net sales 0.032 0.023
Gross profit / net sales 0.329 0.240

Selling, operating, and administrative expense /

net sales 0.282 0.239
Times interest earned 6.902 5.500

Prepared by Reviewed by
Initial Date Initial Date
Flash Technologies and Networks, Inc.
Audit Plan
December 31, 2008

Prepared by: KC Lopez (Senior) August 14, 2008
Reviewed by: Jo Hernandez (Manager) August 28, 2008
Reviewed by: Ela Hector (Partner) September 5, 2008


Audit of the financial statements of Flash Technologies and Networks, Inc. (FTN) for
the year ended December 31, 2008. Also, the company’s debt agreement with
Eastern Financial Services requires the company to furnish the lender a report by
our firm on FTN’s compliance with various restrictive debt covenants.

Business and Industry


FTN sells and installs microcomputers and networking hardware and software to
business customers. The company’s primary competitive strategy is to maintain a
high level of technical expertise and a broad range of service. The company
provides repair, maintenance, training, and software customization services. FTN
has also begun developing its own computer networking software to be sold as a
product to its customer and FTN competes with large retailers of microcomputers.
The market for microcomputers and related products is extremely competitive. The
company also competed with other value-added resellers who provide
microcomputers and software products directly to customers. To effectively
compete, the company must be able to obtain inventories of state-of-the-art
equipment on a timely basis. Because the company does not have the buying
power of some of its competitors, it generally must charge ah higher price for its
products. Its customers are willing to pay the higher price because of the high level
of expertise and service that the company provides.


On July 20, Jo Hernadez and I met with Janelle Santos, controller, and Gian Basco,
president, of FTN to discuss the planning of the audit for the current year. On
August 2, a planning meeting was held in our office with all members of the
engagement team assigned to the audit.

The company has had no significant changes in its internal control from the prior
year. Therefore, consistent with the approach used in last year’s audit, we plan to
perform tests of controls to access control risk at less than the maximum for most
financial statement assertions.


Several factors affect the risk of this engagement, including:

 As described above, FTN is in a very competitive business that is sensitive to
economic conditions.
 FTN is a closely held company owned by five shareholders, Miguel Lee,
Patrick Lee, Francis Lee, Rain Young, and JC Young. Miguel and Patrick are
active members of the company’s board of directors. None of the other
owners take an active part in management of the business.
 Audited financial statements are required by Bank of the Philippine Islands as
a part of the company’s line of credit agreement.
 The officers receive significant bonuses based on quarterly results. (see P-10
for implications of this risk).

These factors indicate that the engagement to audit FTN has high risk.

Significant Accounting and Auditing


The company began offering for sale extended warranties on computers during the
current year. We need to review the method of revenue recognition to determine
whether it complies with the requirements of Pas 18, Revenue.

In the prior year, FTN began developing networking software products for sale. This
year the company has started capitalizing certain costs of development. We need
to review the method of accounting for the cost of software development to
determine whether it complies with the requirements of PAS 38, Intangibles.


Because the firm has experienced steady growth in sales and earnings over the last
three years, we believe that operating results are the most appropriate basis for
estimating planning materiality as described below:

Comparison of Bases Computation of Planning Materiality

Financial Annualized
Statement Base for 12/31/08 Base Amount Percentage
Sales P11,000,000 Sales P11,000,000 1%
Total assets 2,000,000 Total assets 2,000,000 1
Pretax net income 525,000 Pretax net income 525,000 10

The range for planning materiality is from P20,000 to P110,000. Based on the
company’s steady growth in sales and earnings and the fact that the company is not
a public company, we have selected P70,000 as a reasonable materiality amount
for planning purposes.

Scheduling and Staffing


Based on discussions with Ms. Santos, the following are tentative dates of
importance for the audit:

Begin interim audit work November 10,

2008 Complete interim audit work By November
15, 2008
Issue management letter on interim work By November 30,
Observe physical inventory December 31,
Begin year-end audit work February 12,
Complete field work By February 25,
Closing conference February 25,
Issue audit report By March 5,
Issue letter required by financing agreement By March 5,
Issued updated management letter By March 10,

Staffing time requirements for the engagement are described below:

Assistant Senior Manager Partner Total

Interim 40 40 10 10 100
Final 40 30 10 10 90
80 70 20 20 190
Fraud Risk

Client : Flash Technologies and Networks,


Financial Statement Date:


Procedure Performed by
1. Consider the results of the discussion among See WP-21
engagement personnel about the risk of material the
misstatement due to fraud. EH
2. Consider results of inquiries of management about
the risks of fraud and how they are addressed. EH
3. Consider the results of planning analytical
procedures. EH
4. Consider the existence of fraud risk factors listed on
WP-30 through WP-35. EH
5. Consider any other information that might be relevant
to the risk of material misstatement due to fraud. EH

Risk of Material Misstatement Due to Fraud

Management may be motivated to misstate financial

results due to performance bonuses. Specifically,
management may be attempt to:
1. Provide inappropriate incentives to sign sales
contracts near quarter-end and year-end.
2. Overstate revenue at quarter-end and year-end.
3. Overstate inventories, quantities or pricing.

Overall Responses

Risks were considered in staffing the engagement

and determining the appropriate level of supervision.

Alternation of the Nature , Timing, And Extent of


Risks were considered in designing audit procedures for

sales and accounts receivable and inventories.

Procedures were performed to address the risk of

management override of internal controls. (See WP-23 – WP-24).

1. The audit plan for the audit of Flash Technologies and Networks,
Inc. appears on pages 45F through 45I. Review each major section
of the audit plan and briefly describe the purpose and content of
the section.
Organize your presentation in the following manner:

Section Purpose Content

Objectives of the To describe the services that the objectives are (1) audit
Engagement are to be rendered to the of FTN’s financial
client for the year ended
(2) issuance of a letter on
compliance with covenants of the
client’s letter of credit agreement

Business and Industry


2. In the audit plan for the audit Flash Technologies and Networks, Inc.,
there is a section on significant accounting and auditing matters. The
first of the matters described in this section involves the appropriate
accounting for the sale of extended warranty contracts. Research this
accounting issue and write a brief memorandum for the working
papers describing the issue and summarizing the appropriate method
of accounting for the revenue received from these contracts.

3. In the audit of Flash Technologies and Networks Inc., there is a section

on significant accounting and auditing matters. The second matter
described involves capitalizing the costs of developing a software
program for sale.

a. Research this issue and write a brief memorandum for the working papers
describing the issue and summarizing the appropriate method of
accounting for the development costs.
b. Based on your research, describe the major audit issue that you believe
will be involved in auditing the software development costs.

4. A partially completed analytical ratio working paper for Flash

Technologies and Networks, Inc. is presented on page 56.
a. Complete the working paper by computing the financial ratios for
b. After completing part (a), review the ratios and identify financial
statement accounts that should be investigated because the related
ratios are not comparable to prior-year ratios and industry averages.
c. For each account identified in part (b), list potential reasons for the
unexpected account balances and related ratios.


Requirement (1) Analysis of Audit Plan for FTN

Section Purpose Content

OBJECTIVES OF THE To describe the The objectives are (1)
ENGAGEMENT services that is to be audit of FTN’s financial
rendered to the client. statements for the year
ended 12/31/08, and (2)
issuance of a letter on
compliance with
covenants of the client’s
letter of credit
BUSINESS AND INDUSTRY To describe the nature FTN sells and services
CONDITIONS of FTN’s business and micro-computers,
industry. networking hardware
and software to business
customers. The industry
is sensitive to economic
conditions and very
competitive, with FTN
competing with
companies much larger
that itself.
Section Purpose Content
PLANNING MEETINGS To indicate meeting As the point, one
held with client and meeting has been held
with CPA engagement with client personnel and
team. one with the
engagement team.
AUDIT APPROACH To describe the overall Consistent with the
approach to be taken on previous year’s audit, the
the audit. CPAs will plan to perform
tests of controls to
assess control risk at less
than the maximum for
most assertions.
RISKS To describe factors The engagement has
affecting the risks of the high risk. The primary
engagement. risk factors are: (1)
management domination
by a few individuals, (2)
existence of a line of
credit agreement, and
(3) the owners have
entered into an
agreement to sell the
business and the audited
financial results will
significantly affect the
sales price. This last risk
results in a fraud risk.
SIGNIFICANT To describe particular Two particular concerns
ACCOUNTING AND accounting and auditing exist: (1) proper
AUDITING MATTERS matters of concern. accounting for extended
warranties and (2)
capitalization of software
PLANNING MATERIALITY To identify an amount to Based on an analysis of
be used as a measure for sales, total assets, and
planning materiality. pretax net income, an
amount of 70,000 will be
used as a measure of
planning materiality
SCHEDULING AND To provide the schedule The section includes
STAFFING PLAN for major portions of the major dates beginning
audit, and the staffing with interim audit work
through the issuance of
an updated management
letter. A total of 118
hours are budgeted for
the audit.

Requirement (2) Research made on FTN extended Warranty Contracts


December 31, 2008

Memorandum on Accounting Issues – Accounting for Extended Warranties

FTN began offering extended warranties on computers during the current year.
We must determine that both revenues and expenses relating to these warranties are
properly accounted for. PAS 18, Revenue and PAS 37, Provisions, Contingent Liabilities
and Contingent Assets, provide guidance in this area both for accrual of revenue and
amortization of costs.

The Philippine accounting standards require that revenue from extended

warranties be deferred and recognized in income on a straight-line basis over the
contract period, except when sufficient historical evidence indicates that the costs of
performing services under the contract are incurred on other a straight-line basis. In
those circumstances, revenue should be recognized over the contract period in
proportion to the costs expected to be incurred in performing the services. Because the
company has no historical experience with these warranties, revenue should be
deferred and recognized on a straight-line basis.

The costs related to extended warranties include those directly related to

acquisition of the warranty and other costs. Costs directly related to the acquisition of a
warranty conta

Related to acquisition of the warranty contract that would not have been incurred but
for the acquisition of the contract should be deferred and charged to expense in
proportion to the revenue recognized. All other costs (e.g., costs of services performed,
general and administrative, advertising expenses) should be charged to expense as

In circumstances in which the sum of expected costs of providing services and

unamortized acquisition costs exceed unearned revenue a different approach is
appropriate- a loss should be recognized first by charging any unamortized acquisition
costs to expense. If the loss is greater that unamortized costs, a liability should be
recognized for the excess amount of costs.
Requirement (3) Research made on Capitalization of Software Development

December 31, 2008

Memorandum on Accounting Issues-Capitalization of software development costs

In 2007 FTN began developing networking software product for sale. This year the company has started capitalizing
certain costs of development. PAS 38, Intangibles, provides guidance in this area. PAS makes clear that the nature of
the activity for which the software is being developed should be considered in determining whether software costs
should be include or excluded in research and development. PAS 38 indicates that to the extent that the acquisition,
development, or improvement of a process by an enterprise for use in its selling or administrative activities includes
costs for computer software, those costs are not research and development costs. Examples of such costs include
development of a general management information system and the computerized reservation system of an airline.
This does not appear to be the type of costs involved in this situation.

PAS 38 further clarifies the issues by stating that all costs incurred to establish the technological feasibility of a
computer software product to be sold, leased or otherwise marketed are research and development costs. The cost
technological feasibility of a product is established when the enterpriser has completed all planning, designing, coding,
and testing activities that are necessary to establish that the product can be produced to meet its design specifications
including functions, features and technological performance requirement. PAS 38 provides a summary of tests to
indicate whether technological feasibility has been established.

Costs incurred subsequent to establishing technological feasibility are to be capitalized. The capitalization of computer
software costs ceases when the

Product is available for general release to customers. Costs of maintenance and customer support should be charged to
expense when related revenue is recognized or when the costs are incurred, whichever occurs first.

KC Lopez

(October 15, 2008)

(B) The major audit issue involved will be determining that the client has properly categorized costs
between research and development (those costs involved in establishing technological feasibility) and
those costs that should be capitalized. The auditors will have to determine at what point the software
product reached the point of technological feasibility.

Flash Technologies & Networks, Inc. Analytical

Review Ratios for the Period
Ended December 31, 2008

12/31/08 12/31/07 industry

Current ratio 1.858 1.752 1.300

Days’ Sales in Accounts Receivable Compute

with Average Accounts Receivable
29.524 33.224 37.000

Allowance for Doubtful Accounts/ Accounts

Receivable .010 .011 …..

Bad Debt Expense/Net Sales .005 .003 …..

Inventory Turnover Computed with Average

Inventory 9.255 10.397 10.000

Day’s Inventory on Hand, Computed with Average

Inventory 39.436 35.222 36.000

Total Liabilities to Net worth 1.107 1.444 2.900

Return on Total Assets .194 .180 .090

Return on Net Worth .409 .441 .290

Return on Net Sales .040 .032 .023

Gross Profit /Net Sales .362 .329 .240

Selling, Operating and Administrative expense

.305 .282 .239

Time Interest Earned 8.541 6.902 5.500

Supporting Computations for 2008 ratios (Ᵽ000’)

Current Ratio Current Assets/Current Liabilities

Days Sales in A/R Computed Sales per day =Sales/365
with Average A/R =P11, 602/365=32
Average A/R = (Beg. A/R +End A/R)/2
Days sales =Average A/R/ Sales per day
Allowance for Bad Debts / A/R P10/P1,023=.010
Bad Debts Expense/ Net Sales 56/P11,602=.005
Inventory Turnover Computed Average Inventory =(Beg. Inv. +End Inventory )/2
With Average Inventory =(P695+P904)/2=P799
Inventory Turnover =Cost of goods Sold/Average inv.
=P7,397 / P799=9.255

Days Inventory computed with CGS per day = cost of goods sold /365
Average Inventory =P7,397 / 365=P20
Days inventory =Average Inventory / CGS per day
Total Liabilities to Net Worth Total liabilities / Shareholders’ Equity
P1,240 /P1,120=1.107
Return on Total assets Net Income / Total Assets
P458 /1,120=.194
Return on Net Worth Net Income / Shareholders’ Equity
P458 / 1,120=.409
Return on Net Sales Net Income / Net Sales
P458 /P11,602=.040
Gross Profit / Net Sales Gross Profit / Net Sales
P4,205 /P 11,602=.362
Selling, Operating and Admin. Selling, Operating and Admin. Exp./ Net Sales
Expense / net Sales P3,544 /P11,602=.305
Times Interest Earned Operating Income / Interest Expense
P661 /P 77=8.541
(b) And (c) This part of the case reveals how difficult ratio analysis is when these are no
major changes in ratios. However. The following might be considered in comparing the
current year’s ratios with those of last year’s.

Days Sales in Account Receivable

 Changes in credit policy

 Better economic conditions
 Change in customer mix
 Overstatement of sales
 Understatement of receivables

Inventory Turnover

 Change in inventory policy

 Inventory obsolescence
 Overstatement of inventory
 Understatement of purchases

Days Inventory on Hand

 Change in inventory policy

 Inventory obsolescence
 Overstatement of inventory
 Understatement of purchases

Gross Profit / Net Sales

 Change in sales mix

 Increase in sales pricing
 Reduction of costs
 Understatement of costs of goods sold and related
overstatement of inventory

A number of the other ratios show significant changes which seem due primarily to the
increased level of profitability.
Chapter 3 Audit of the Revenue and Collection
cycle: Tests of controls and substantive
tests of Transactions

This chapter begins with an explanation of the revenue and collection cycle
and the internal control environment and objectives pertaining thereto. Then,
consideration is given to compliance tests of controls over revenue and cash
receipts transactions.

In performing the audit of the revenue and collection cycle, the auditor
should be able to:

1. Identify the activities and types of transaction that occur in a company’s

revenue cycle;
2. Relate the effect of controls on the assertions embodied in the financial
statements, sales adjustments, and cash receipts transactions:
3. Determine the essential features of internal control over the transactions in
the revenue and collection cycle;
4. Prepare and perform the audit procedures for compliance tests of control
over these transactions; and
5. After evaluating the effectiveness of internal control, perform substantive
tests of transactions to meet transaction-related audit objectives for
revenue and collection cycle. These tests of transactions are not directly
related to the key controls exist and on the results of the tests of controls.
6. Design tests of detailed of accounts affected by the revenue and collection
cycle and analytical procedures to satisfy balance.

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. Different entities may have different
sources of revenue. The discussions and illustrations in this chapter are
based on a merchandising company. However, much of the commentary
can easily be adapted to other types of entities.

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-off);and
C. Cash receipts (collections on accounts and cash sales).

The following are typical; accounts affected by the revenue and

collection cycle:

1. Sales
2. Accounts and notes receivable
3. Sales returns and allowances
4. Cash in bank ( debits from cash receipts)
5. Sales discount
6. Allowance for uncollectible account
7. Uncollectible accounts expense
8. Inventories ( merchandise, finished goods)

Documents Used in the Revenue and Collection Cycle and their Audit

Several important documents and records are typically used in the revenue
and collection cycle.

Documents Audit Significance

Customer’s purchase order a written purchase order from

A request for merchandise by a a customer actually ordered

Customer. It may be received by the goods. Purchase order

Telephone, letter, a printed form numbers are generally

That has been sent to prospective and recorded on sales invoice

Existing customers, through relates. Sellers generally

Salespeople, or in other ways. Maintain a file of each

customer’s purchase orders.

Sales order a sales order contains the

A pre numbered document seller’s understanding of the

Recording the description, quantity, sales terms. A seller should

And related information for goods account for the numerical

Ordered by a customer. This is frequently sequence to help ensure that

Used to show credit approval and shipments are made for

authorized for shipment sales orders and that all sales

are billed.

Sipping document or bill of lading

A pre numbered document prepared to The signature of the carrier of

Initiated shipment of the goods, indicating or the customer on the

The description of the merchandise, the shipping document provides

Quantity shipped, and relevant data. Externally created. Evidence

that goods have been shipped.

evidence that goods have been

shipped. Seller should account
for the numerical sequence to
help ensure that all shipments
are recorded as sales.
A pre numbered document indicating a sales invoice indicates credit

The description and quantity of goods terms, shipping terms, and

Sold, the price including freight, insurance, price charged for merchandise.

Terms, and other relevant data. Seller should account for the
numerical sequence to help
ensure that all sales are

Credit memo

A pre numbered document indicating a A credit memo provides

Reduction in the amount due from a evidence that a seller has

Customer Because of returned goods reduced the amount previously

or an allowance granted. It often t billed to a customer. Sellers

takes the same general form as a sales should account for the

invoice, but it supports reductions in numerical sequence to help

accounts receivable rather than increases. Ensure that all credit memos
are recorded.

Remittance advice

a document that a customer attaches to a remittance advice usually

a check in payment of an invoice. The indicates the date and amount

document may be a turnaround document of payment and the invoices

, a part of a check, or a statement identifying paid. Sellers generally file

The invoices being paid. Remittance advices remittance advices by date.

Facilitate recording cash receipts. If a customer

Does not return a remittance advice, the employee

Opening the mail generally prepares one.

Uncollectible account authorization form

A pre numbered document used internally, Sellers should account for the

Indicating authority to write an account numerical sequence to ensure

Receivable off as uncollectible. That all write-offs recorded.

Monthly statement

A document sent to each customer a statement nailed to a

Indicating the beginning balance of customer reporting a beginning

Accounts receivable, the amount and balance and transaction that

Date of each sale, cash payments occurred during the period. if

Received, credit memos issued, and the statement is inaccurate,

ending balance due. Many customers would contact

the seller.

Accounting Records in the Revenue and Collection Cycle

Sales journal

a journal for recording sales transactions. A detailed sales journal includes each
sales transaction. It usually indicates gross sales for different classifications, such
as product lines, the entry to accounts receivable, and miscellaneous debits and
credits. The sales journal can also include sales returns and allowances
Sales return and allowances journal

A journal similar to the sales journal except the merchandisers uses it to record
returns of merchandise or adjustments to invoice prices.

Cash receipts journal

A journal for recording cash receipts from collections, each sales, and all other
cash receipts.

General journal

A journal in which are recorded all transactions for which a special journal has not
been created. Sales and collections cycle transactions frequently recorded in the
general journal include entries to estimate uncollectible accounts expense and
entries to write off accounts identified as uncollectible.

Accounts receivable master file/ subsidiary ledger

A file for recording individual sales, cash receipts, and sales returns allowances for
each customer and maintaining customer account balances.

Accounts receivable trial balance

A listing of the amount owed by each customer at a point in time.This is prepared

directly from the accounts receivable master file.


Typically, the sales transactions involve the following business activities.

a. Accepting sales order

b. Approving credit
c. Filling sales order
d. Shipping sales order
e. Billing customer
Figure 3.1 shows a flowchart of the manual system for executing sales
transactions. The purpose of the flowchart is to assist in identifying
control points and the necessary control features related to each point.
The presentation reflects the segregation of functions considered
characteristic of satisfactory internal control.

Information concerning specific controls over sales transactions is

obtained through inquiry, observation and review of documentation. Figure 3.2
shows a questionnaire for sales transactions. The questions relate to control
procedures that the auditor considers to be necessary for effective control over
sales. A “yes” answer to a question indicates that the client has good control; a
“No” response suggests a possible weakness in internal control over sales. In
addition to answers to questionnaires, the information gathered by the auditor
may be documented in flowcharts and narrative memoranda
Figure 3.2 Internal Control Questionnaires for Sales

Client__________________________________________________ Audit Date_________________

Client Personnel Interview:
Auditor_________________________________________ Date
Competed__________________________ reviewed by: _____________________________________
Date Reviewed_____________________ __ Type of Testing: Compliance

Cycle Revenue Class of Transactions: Sales

Executing Yes No NA REMARKS

1. Are customer orders compared to an approved
customer lists?
2. Is a pre numbered sales order issued for each
accepted customer order?
3. Is there internal verification of the agreement of
sales order with customer order?
4. Are all credit sales approved prior to the sales?
5. Is a sales order required before an order is filed?
6. Is there internal verification of the goods in filing a
sales order?
7. Are the goods compared with the sales order in
8. Is each shipment supported by a pre numbered
shipping document?
9. Are shipping documents and sales orders compared
in billing?
10. Are pre numbered sales invoices used in billing?
11. Is there internal verification of prices and
mathematical accuracy of sales invoices?
12. Are daily sales summaries prepared and agreed to
the invoices issued?

1. Are the daily sales journal entries agreed to daily
sales summaries?
2. Are invoices journalized in numerical sequence?
3. Is there periodic independent reconciliation of
accounts receivable control and the customers’
4. Are postings to the subsidiary ledgers made
independent of journalizing and posting the
general ledger?
1. Are there adequate physical controls over accounts
receivable records?
2. Is there independent mailing of monthly statements to


Controls are important because of their effect on the assertions embodied in the
financial statements. Auditors identify specific assertions for each general
assertion to be tested. The general and specific audit assertions for sales and
receivables are as follows:

General Specific

1. Existence or occurrence 1. Recorded sales are for shipments actually

Made to customers.
2. Completeness 2. All sales transactions that occurred
are recorded.
3. Right and obligation 3. Sales recorded represent only sales
4. Valuation or allocation 4. Sales are correctly billed and recorded.
5. Presentation and disclosure 5. Sales and accounts receivable are
recorded to result in presentation and
disclosure in accordance with PAS/PFRS.

A. Existence or occurrence: recorded sales are for shipments
actually made to customers.

Controls Tests of Controls

1. Recording of sales is supported To test this control, the
By customer orders, sales orders examines approved customer
Approved by the credit department order, sales order, shipping
And approved and executed shipping document and copy of sales
document. Invoice for a sample of entries
in the sales journal. The
documents should bear the
required approval, such that of
the credit manager’s approval.
The description, quantity of
goods shipped, name, address
and other details regarding the
transaction should be

2. A clerk independent of accounts The auditor can observe

Receivable prepares and mails whether a clerk independent of
Monthly statements to customers the accounts receivable
For all trade accounts receivable and bookkeeper prepares and
Follows up on any complaints. follows up any complaints. He
Can also examine files on
Complaints received for
Selected months.

B. Completeness: all sales transactions that occurred are recorded.

3. Pre numbered shipping The auditor can observe the

Documents are accounted for client performing the
To determine that a sales invoice procedure or select a sample
is prepared for all shipments. Shipping orders and examine
the invoice that bills the sale.
The presence of a sale invoice
copy indicates that the
shipment was billed.

4. Pre numbered sales invoice are the auditor can observe

Accounted for to determine that all the clerk recording sales
Sales are recorded. If he or she is accounting for
the numerical sequence of
invoices and determines why
any missing invoice have not
been processed. The auditor
can also select a sample of
sales invoice copies to trace
into the sales journal.

5. Procedures to ensures timely the auditor should inquire how

Recording if sales and proper procedures are followed,
Cut-off is established. Observe procedures are being
followed and inspect report on
the last shipments that the
sipping clerk sends to also
provides evidence about the
existence of transactions.

C. Right and Obligations: sales recorded represented only sales


6. Clerk should check sales orders the auditor should observe

And sales invoices for terms to that the control is being
Determine that transaction is performed.
A sale rather than a consignment.

D. Valuation or Allocation: Sales are correctly billed and recorded.

7. for all goods shipped, goods are the auditor observes

counted and descriptions and that the control is
quantities and descriptions on being performed and examines
sales orders and shipping a sample of shipping orders
documents prior to shipping. For the signature on the
Shipping documents that
indicates that the counting and
comparison occurred.

8. Customer credit is approved by a the auditor examines a sample

Responsible official prior to of sales order for credit
Merchandise shipment. Although approval prior to shipment.
Approval of credit prior to shipment
Does not guarantee absence of

9. Sales invoice are checked for to test these controls, the

a. Proper pricing auditor performs the following:
b. Mathematical accuracy a. inquiry about the updating
c. Terms and user of price lists.

B . Examine a sample of invoice

copies to determine that they
contain a signature indicating
that the price, mathematical
accuracy and terms have been

10.The accounts receivable subsidiary to test these controls, the

Leger is balanced to the general auditor that is being
Ledger control account regularly. performed. The auditor may
The Absence of this control result in also foot the accounts
The possibility of careless record keeping Receivable subsidiary ledger
And omission of posting of sales And compare the total with the
or payment. Balance appearing in the
General ledger control
E. Presentation and disclosure: sales and accounts receivable are
recorded to result in presentation and disclosure in accordance
with PAS/PFRS.

11. Sales must be properly classified the auditor can test this
To generated accurate segment control by determining
Reporting. Entities may requires a that the invoice copy contains
Second person too independently the signature that indicates
Review or check the account approval of accounts
Coding on invoice. Classifications used.


An audit program for tests of controls for sales is presented in figure 3.3. the audit
procedures are those include in the foregoing discussion, but they have been
restated to enable the auditor to select a minimum number of samples for
testing. It will be noted that to test for existence or occurrence, the auditor tests
from accounting records back to underlying documents that indicate that the
transaction occurred. To test whether all transactions are recorded, an auditor
compares prenumbered documents to entries in the accounting records. The
auditor can also observe the presence of some controls, rather than examine a
sample of documents to obtain evidence about a control.

Figure 3.3 Audit Program for Tests of Controls over Sales Transactions

Happy Sounds Corporation

Test of Controls: Sales
December 31, 2006
WP Done

Audit Procedures Ref By Date

1. For a sample of entries in the sales journal,

a. Compare data in the sales journal to
approved costumer order, sales order,
shipping document, and copy of sales invoice
1. Costumer order number.
2. Invoice number.
3. Costumer name.
4. Date.
5. Description of goods.
6. Quantity.
7. Price.
8. Invoice amount.
9. Terms.
b. Determine credit approval.
c. Determine those signatures are on
invoices indicating independent
checking for
1. proper pricing.
2. Mathematical accuracy.
3. Terms.
d. Examine signature evidencing recheck
of account coding.
2. For a sample of shipping documents, examine
signatures indicating that for goods shipped,
goods are counted, quantities and
descriptions of the goods shipped are
compared to quantities and description on
sales orders and shipping documents prior to
shipping, and the transactions are recorded in
the sales journal.
3. Discuss the procedures followed with the
person (independent of the bookkeeper) who
mails to customers monthly statements for all
trade accounts receivable and follows up on
any complaints Review the client’s
correspondence files reflecting resolution of these
items .

4. Observe the procedures followed to ensure

a proper cutoff of sales at year-end.
5. Observe that the accounts receivable
subsidiary ledger is balanced to the general
ledger control account regularly.
6. Examine evidence of accounting for the
sequence of sales orders, shipping
documents, and sales invoice
Briefly, the foregoing tests of controls over sales transactions may reveal the
following weaknesses and possible errors:

Control Weakness Possible Errors

1. Inadequate documentation of sales 1. a. Customers billed for
transactions. goods not shipped.
b. Goods shipped and not
2. Lack numeric control over the 2. a. Failure to record
following forms: Sales orders, sales transactions.
Sales invoice, shipping orders, b. fictitious transactions
Bills of lading. Recorded.

c. Unauthorized use of
shipping orders or bills
of lading to remove
goods from premises.
3. Customer credit approval not 3. a. Goods shipped to
indicated on sales order. customers whose credit
has not been approved.
4. Selling prices not compared with 4. a. Goods billed to custome
masters price list. -ers at incorrect prices.
5. Accounting manual not used or 5. a. Transactions and events
account distribution not double- incorrectly recorded.

An illustrative audit program of Tests of Controls in an On-line Accounting

System is shown in Appendix A.


In deciding on substantive tests of transactions, some procedures are

commonly employed on every audit regardless of the circumstances whereas
others are dependent on the adequacy of the controls and the results of the
tests of controls. The following schedule shows the substantive audit procedures
for sales transactions, the related audit objectives and assertion:
Assertions Audit Objectives Audit Procedures

I. Occurrence and Validity A. To determine that 1. Review the sales journ

II. Rights and Obligations recorded sales are -al, general ledger and
authorized and are accounts receivable
for shipments actually master file or trial bala
made to nonfictitious -nce for large or unusu
customers. -al items.*
2. Trace sales journal entr
-ies to copies of sales
orders, sales invoice
and shipping
3. Trace shipping docume
-nts to entry of shipme
-nts perpetual invento
-ry records.
4. Compare prices on
sales invoice with
authorized price lists
or properly executed
III. Completeness B. To determine that 5. Trace shipping docume
recorded that existing -nts to resultant sales
sales transactions are invoice and entry into
recorded on a timely sales journal and accou
basis. -nts receivable master
6. Compare dates of recor
-ded sales transactions
with dates on shipping
records or perform
sales cutoff tests.
IV. Valuation or Allocation C. To determine that rec 7. Recompute infor-
-orded sales are for the mation on sales
amount of goods invoices.
shipped and are corre 8. Trace entries in sales
-ctly billed and record journal to sales
-ed. Invoices.
9. Trace details on sales
invoices to shipping
documents, price tests
and customer’s orders.
V. Presentation D. To determine that sales 10. Examine document
transactions are proper supporting sales tran
-ly classified. -sactions for proper
* This analytical procedure can also apply to other objectives including completeness, valuation
and proper cutoff.

Discussion of Audit Procedures

1-5. For a sample of entries in the sales journal, compare sales invoice copy,
customer order and shipping document.

To test the existence of sales, some auditors examine the sales invoice, the
customer’s order, the sales order bearing credit approval and the shipping
document for a sample of entries in the sales journal. If an entity has a
procedure to accumulate these documents before recording a sale, their
accumulation is an indication that the control was performed. Other
procedures may include

a) Trace from the entry removing the goods from inventory to

the perpetual inventory record.
b) Examine the cash receipts in payment for the sale.
c) Confirm the existence of individual transactions with the
6. For a sample of shipping documents, trace sales invoice and entry
into sales journal and accounts receivable subsidiary ledger.
Perform cutoff tests.

For a sample of shipping documents, the auditors may examine the

sales invoice and determine that an entry was made in the sales journal and
the accounts receivable subsidiary ledger. When testing to determine that
all transactions have been recorded, auditors start with a prenumbered
document, such as a bill of lading or a delivery ticket and trace it into the
journals and ledgers.
For a sample of sales invoices, examine the customer order and shipping
document to determine whether the transaction should have been
recorded as a consignment transaction rather than a sale.

To determine that the entity has a right to the receivable arising from
the sales transactions recorded, the auditor examines a sample of sales
transactions and be alert for indications of consigned shipments treated as
sales. Auditors should also investigate the procedure from recording
movements of merchandise among the various units of the company.

7-9. For sample of entries in the sales journal, (a) examine sales invoice,
shipping document, and customer order for consistency of descriptions
and quantities; (b) examine sales orders for credit approval; and (c) check
prices and extensions. Foot sales journal and general ledger account.

The audit procedure for verification of a sales transaction that has

been selected for testing may begin with a comparison of the customer’s
purchase order, the client’s sales order, and the duplicate copy of the sales
invoice. The descriptions and quantities of items are compared on these
three documents and traced to the duplicate copy of the related shipping
document. The credit manager’s signature denoting approval of the
customer’s credit should appear on the sales order.

The extensions and footings on each invoice in the sample should be

proved to be arithmetically correct. After proving the accuracy of selected
individual invoices, the auditors next trace the invoices to the sales journal
and to postings in the accounts receivable subsidiary ledger. In addition,
the date of each invoice should be compared with two other dates:

(1) the date on the related shipping document, and

(2) the date of entry in the accounts receivables subsidiary ledger.

10. For a sample of the entries in the sales journal, verify the accuracy of
account coding.

Auditors may review entries in the sales journal and the supporting
sales invoice to determine whether the sales invoice was coded correctly
and whether it results in proper presentation and disclosure of the
transaction in the financial statement.

Adjustments to sales may include:

a) granting cash discounts,

b) granting sales allowances or reductions in price
c) returns of merchandise,
d) volume rebates,
e) corrections of billing errors, and
f) uncollectible accounts.

FIGURE 3.4 shows the manual system for processing and recording
sales returns and account write-offs.



The auditor may use the following internal control questionnaire in

evaluating the effectiveness of the client’s system over the sales
adjustments transaction ( Figure 3.5 ).
Figure 3.5 Internal control Questionnaire for Sales adjustment

Cycle: Revenue Class of Transaction: Sales Adjustment

Questions answer
yes no NA
1. Are all the cash discount approved?
2. Are sales returns and allowances approved by
sales personnel?
3. Are prenumbered credit memos used for
sales returns and allowances?
4. Is there separation of duties between
approval of sales returns and allowances and
issuance of credit memos?
5. Are all bad debt write-offs approve in
writing ?
6. Is there separation of duties between the
approval of bad debt write-offs and collection
from customer?
A concern about these Transactions is that a transaction may be recorded to cover a material
misappropriation of cash receipts. Auditors generally pay little attention to these adjustment
are large.


Audit of Cash Discounts

Auditors often audit cash discount in connection with a test of cash receipts transactions and
sales return and allowances in connection with sales. Oftentimes, auditors perform only
substantive tests of account balances.

Audit of Sales Returns, Allowances, Corrections

For sales returns and allowances, the primary emphasis is normally on testing the existence
of recorded transactions as a means of uncovering any diversion of cash from the collection of
accounts receivable that has been covered up by a fictitious sales return or allowances is often
on testing the existence of recorded transactions, the completeness objective cannot be
ignored. Unrecorded sales returns and allowances can be material and can be used by
company’s management to overstate net income.

The other objectives, rights and obligations, valuation, and proper classification should not of
course be ignored. The same methodology for controls over sales transactions should be
applied to controls over sales returns and allowances.

Audit of Uncollectible Accounts

Existence of recorded write-offs in the most important transaction-related audit objective

that the auditor should keep in mind in the verification of the write-off of individuals
uncollectible accounts. This is because of the possibility of the client covering up a defalcation
by charging of accounts receivable that have been collected. The major control for preventing
this type of misstatement in proper authorization of the write-off of uncollectible accounts by a
designated level of management only after a thorough investigation of the reason the
customer has not paid.

Happy Sounds Corporation

Test of Controls: Sales Adjustments
December 31,2006

WP Done
Audit Procedures Ref By Date

1. Account for credit memoranda.

2. Prove the footing of credit memorandum to the

general ledger.

3. Trace the posting of credit memorandum to the

general ledger.

4. Review credit memoranda for approval.

5. Check credit memoranda concerning returned
goods for: (a) arithmetical accuracy; (b) quantities
returned ( by references to the original invoice or
record of the selling price.

6. Inspect credit files in support of accounts

written off as un collectible.

The foregoing test of controls over sales adjustments transaction may reveal the following weaknesses
and possible errors:

Control Weakness Possible Errors

1. Lack of numeric control over credit 1. Fictitious transaction recorded

2. a. Collectible accounts erroneously
2. Unauthorized write-off of accounts written off as uncollectible.
b. Customer account intentionally
3. Unauthorized returns and written off to conceal misappropriation
Allowances of customer remittances.

3. a. Credit memos issued for authorize

returns as well as for goods not
actually returned.

b. Credit memos written and

recorded to conceal misappropriation
of customer remittances.

The audit objectives are essentially the same for processing credit memos for returns and allowances
as those describe for sales, with two important differences.

1. The first relate to “materiality”. If the amount of sales returns and allowances are so immaterial,
they can be ignored in the audit altogether.

2. The second relates to “ emphasis on objective.” For sales returns and allowances , the primary
emphasis is normally on testing the validity of recorded transaction as a means of uncovering any
diversion of cash from the collection of accounts receivable that has been covered by a fictitious sales
return or allowance.

Naturally, the auditor also gives due attention to the other objectives and should be able to arrive at
suitable substantive tests of transaction which are essentially the same as for sales to verify amounts.

The audit procedures that may be used for substantive tests of controls for sales returns and
allowances include:

(1) Review the use and authorization of credit memoranda

All allowances to customers for returned or defective merchandise should be supported by serially
numbered credit memoranda signed by an officer or responsible employee having no duties relating to
handling cash or to the maintenance of customers’ ledger.

(2) Review credits for returned merchandise if supported by receiving report on the return shipment.

(3) Verify prices, extensions and footings and trace posting from the sales returns journal or other
accounting record to the customer’s accounts in subsidiary receivable ledger.



There are a variety of sources of cash receipts. Cash receipts may result from revenue transactions,
short and long term borrowing, issuance of share capital, and sale of marketable securities, long-term
investment and other assets. The scope of this chapter is limited to cash receipts from sales
transactions which include cash sales and collections from trade customer on credit sales. Other sources
of cash receipts are discussed in the investing and financing cycles in Chapters 6.

Executing cash receipts transactions generally involve:

a) Receiving mail receipts
b) Receiving over-the-counter receipts
c) Depositing cash in bank