Lecture on Audit Cycle- Revenue, Collection, Acquisition,

Payment, Payroll And PPE

Audit Procedure of Revenue and Collection

The sales and collections transactions cycle deals with business activities through
which a company provides goods or services to a customer and receives payment.
The cycle can also be defined in a broader way called a revenue cycle and include all
revenues, such as investment income, in addition to operating revenues. This
chapter begins with overviews of the health-care provider and retail industries, and
then presents details of sales, billing, and collection processes that are found in
most businesses. Next, the chapter discusses audit activities that apply to the
revenue cycle. Finally, the chapter ends by discussing auditing the revenue cycle in
the context of health-care provider and retail industries.

Virtually all businesses have a revenue and collection function that is fundamental
to the primary productive activity of a company. As a result, the revenue cycle
interacts with and depends on other cycles. A company must either purchase or
manufacture the goods it sells, and it must have the human resources to produce
goods and provide services. The customer may take possession of goods at the
time of the sale, or the transaction may require a process to deliver the goods
separate from the point of sale. The receipt of payment in the cycle may result from
sales for cash at the point of sale or sales on credit. Sales on credit require a billing
and collection function in addition to the activities that occur at the time of the sale.
The process of granting credit and handling bad debt must be managed. All sellers
of goods and services also have some policies and provisions that address and deal
with sales returns and allowances. Typical transaction activities for sales, billing,
and cash receipts are as follows:
Sales for cash and for accounts receivable
Cash receipts Sales returns and allowances
Writing off uncollectible accounts receivable
Estimating bad debt expense
Accounts involved in the cycle are: Cash, Accounts Receivable, Allowance for
Uncollectible, Accounts Sales Sales returns and allowances, Bad debt expense.
The customer order is a request from the customer indicating the quantity and the
description of the merchandise ordered.

A sales invoice is a document indicating the description and quantity of goods sold,
the price including freight, insurance, terms, and other relevant data. It is the method
of indicating to the customer the amount owed for the sale and the due date of the
payments. The original is sent to the customer and one or more copies are retained.
The sales invoice is the document for recording sales in the accounting records.
A prelisting of cash receipts is a list prepared when cash is received by someone
who has no responsibility for recording sales, accounts receivable, or cash and who
has no access to accounting records. It is used to verify whether cash received was
recorded and deposited at the correct amounts and on a timely basis.

The monthly statement to customers is the document prepared monthly and sent to
each customer indicating the beginning balance of that customer’s accounts
receivable, the amount and date of each sale, cash payments received, credit
memos issued, and the ending balance due. It is, in essence, a copy of the
customer’s portion of the accounts receivable master file.

A shipping document is prepared at the time of shipment indicating the quantity and
description of goods ordered. It is used to generate an invoice to the customer.
Assuring that all shipments are recorded and billed is important to addressing the
completeness assertion, as well as the accuracy of the quantities billed.
The bill of lading is a document prepared at the time of shipment of goods to a
customer indicating the description of the merchandise, the quantity shipped, and
other data. Formally, it is a written contract of the shipment and receipt of goods
between the seller and carrier. It is also used as a signal to bill the client. The
original is sent to the customer and one or more copies are retained.
The credit memo is a document indicating a reduction in the amount due from a
customer because of returned goods or an allowance granted. It often takes the
same general form as a sales invoice, but it reduces the customer’s accounts
receivable balance rather than increasing it.

A remittance advice is a document mailed to the customer and typically returned to

the seller with the customer’s payment. It indicates the customer name, the sales
invoice number, and the amount of the invoice. A remittance advice is used as a
record of the payment received to permit the immediate deposit of checks received
and to improve control over the custody of assets.
The accounts receivable trial balance is a report from the accounts receivable
master file that shows the amount receivable from each customer at a point in time.
An aged trial balance includes the total balance outstanding and the number of days
the receivable has been outstanding, grouped by category of days (such as less than
30 days, 31 to 60 days, and so on).

Proper credit approval for sales helps minimize the amount of bad debts and the
collection effort for accounts receivable by requiring that each sale be evaluated for
collection potential.

Adequate controls in the credit function enable the auditor to place more reliance on
the client’s estimate of uncollectible accounts. Without these controls, the auditor
would have to make his or her own credit checks on the customers in order to be
convinced that the allowance for uncollectible accounts is reasonable.

The sales journal contains the record of each sales transaction that includes the
customer name, date, amount, and the account classification for each transaction.
The sales journal generally represents the record of each individual transaction.
Typically, the sales journal accumulates transactions for a period of time, which is
often monthly. Transactions recorded in the sales journal are then posted to the
general ledger, and if the transaction is for sales on account, the accounts
receivable master file is updated for each transaction.
The accounts receivable master file is used to record individual sales, cash receipts,
and sales returns and allowances for each customer and to maintain customer
account balances. The master file is updated using data from the sales journal,
sales return journal, and cash receipts journal. The total in the accounts receivable
master file equals the total in the accounts receivable general ledger account.
Tests of Controls for Sales.

Sales activity controls are intended to ensure that transactions recorded as sales
are bona fide sales. Either the cash was collected or invoices were sent so that the
cash will be collected at a later time. Furthermore, the amounts recorded in the
financial statements rep- resent the correct dollar amount of sales. Tests of controls
for sales address: Credit approval Billing evidence for all items shipped
Completeness of recorded sales Actual occurrence and validity of any transactions
recorded as sales Tests of controls for proper recording of sales transactions
address whether sales are posted to the correct account, in the correct period and
for the correct amount.
Tests of Controls for Cash Receipts Controls over cash receipts focus on
safeguarding cash and on cash-related documentation procedures. Tests of
controls for cash receipts address how the company safeguards the cash both
physically and with documentation. Safeguarding begins at the time the cash comes
in and continues through the deposit in the bank. Controls cover processes through
which the company updates its records for cash received, and reconciles its records
with a reliable external record—typically a bank statement.

Substantive procedures provide the auditor with evidence on financial statement

amounts and disclosures. The three categories of substantive procedures are
discussed in the remain- der of the chapter: dual purpose tests, substantive
analytical procedures, and tests of details of balances. The extent to which the
auditor uses substantive procedures is affected by the auditor’s assessment of risk
and resulting reliance on ICFR- Internal Control of financial reporting. Substantive
procedures of some type are performed for all relevant assertions on all significant
accounts and disclosures. For certain accounts and disclosures, the auditor may
choose to perform more extensive substantive tests and procedures rather than rely
on controls. The auditor might choose a substantive approach even after concluding
that ICFR was functioning effectively as of management’s report date. For example,
suppose ICFR was not functioning effectively early in the year. Consequently,
management made changes, and ICFR was functioning effectively at fiscal year end.
In this situation the auditor could not rely on ICFR during the period of time before it
was improved. For that time frame the auditor must rely on substantive procedures
for audit evidence.
The term analytical procedures covers a wide variety of audit steps. Regardless of
the spe- cific step, the overall purpose of any analytical procedure is to collect audit
evidence that is based on relationships among items. For example, looking at the
aggregated amount of all sales transactions for the current year compared to the
prior year tells the auditor whether the dollar amount of sales have increased or
decreased. Noting this type of change, or lack thereof, has no real value in isolation.
But the auditor can evaluate the result of an analyt- ical procedure using other
information and come to conclusions.

https://farhatlectures.com/auditing-sales-and-cash-collection-cycle-auditing-and-
attestation-cpa-exam-auditing-and-attestation/

Republic Central Colleges

Angeles City
Exercises in Auditing 2- 3

(Audit in Revenue and Collection)

Multiple Choice: Use separate sheet of paper to answer. No Erasures.

10,000 15,000
1.Which of the following would be the best protection for a company that wishes
to prevent the “lapping” of trade accounts receivable?
a.Segregate duties so that the bookkeeper in charge of the general ledger
has no access to incoming mail
b.Segregate duties so that no employee has access to both checks from
customers and currency from daily cash receipts
 c.Have customers send payments directly to the company’s depository
bank
d.Request that customer’s payment checks be made payable to the
company and addressed to the treasurer
C
2.Which of the following would the auditor consider to be an incompatible
operation if the cashier receives remittances from the mailroom?
a.The cashier prepares the daily deposit
b.The cashier makes the daily deposit at a local bank
c.The cashier posts the receipts to the accounts receivable subsidiary
ledger cards
d.The cashier endorses the checks
C
3.Which of the following might be detected by an auditor’s cutoff review and
examination of sales journal entries for several days prior to the balance sheet
date?
a.Lapping year-end accounts receivable
b.Inflating sales for the year
c.Kiting bank balances
d.Misappropriating merchandise
B
100,000 - 10,000= 90,000
4.To conceal defalcations involving receivables, the auditor would expect an
experienced bookkeeper to charge which of the following accounts?
a.miscellaneous income
b.petty cash
c.miscellaneous expense
d.sales returns
D
5.Confirmation of individual accounts receivable balances directly with debtors
will, of itself, normally provide evidence concerning the –
a.Collectability of the balances confirmed
b.Ownership of the balances confirmed
c.Existence of the balances confirmed
d.Internal control over balances confirmed
C
6.An auditor should perform alternative procedures to substantiate the existence
of accounts receivable when-
a.No reply to a positive or negative
confirmation request is received
b.No reply to a negative confirmation request is received
c.Collectability of receivables is in doubt
d.Pledging of the receivables is probable
A
7.Which of the following procedures would an auditor most likely perform for
year-end accounts receivable confirmations when the auditor did not receive
replies to second request?
a.Review the cash receipts journal for the month prior to the year- end
b.Intensify the study of internal control concerning the revenue cycle
c.Increase the assessed level of detection risk for the existence assertion
d. Inspect the shipping records documenting the merchandise sold to the
debtors
D

8.Cutoff tests designed to detect credit sales made before the end of the year
that have been recorded in the subsequent year provide assurance about
management’s assertion of –
a. accuracy c. rights and obligation
b. classification d. cutoff
D
9.Which of the following is not a principal objective in auditing accounts
receivable?
a.To determine whether receivable are carried at their net realizable value
b.To determine whether receivables are properly classified, described and
disclosed in the financial statements, including notes, in conformity with
GAAP
c.To determine whether the entity has real claims in all receivables on the
balance sheet
d.To determine whether the accounts are collected by the balance sheet
date
D
10.To reduce the risks associated with accepting fax responses to requests for
confirmations of accounts receivable, an auditor most likely would-
a.Inspect the faxes for forgeries or alterations and consider them to be
acceptable if none are noted
b.Consider the faxes to be non-responses and evaluate them as
unadjusted differences
c.Verify the sources and contents of the faxes in telephone calls to the
senders
d.Examine the shipping documents that provide evidence for the
existence assertion
C
11.The audit working papers often include a client-prepared, aged trial balance of
accounts receivable as of the balance sheet date. The aging is best used by the
auditor to-
a.Evaluate internal control over credit sales
b.Test the accuracy of recorded charge sales
c.Estimate credit losses
d.Verify the existence of the recorded receivables

12. The physical count of inventory of a retailer was higher than shown by the
perpetual records. Which of the following could explain the difference?
a.Inventory items had been counted but the tags placed on the items had
not been taken off the items and added to the inventory accumulation
sheets
b.Credit memos for several items returned by customers had not been
recorded
c.No journal entry had been made on the retailer’s books for several items
returned to its suppliers
d.An item purchased “FOB shipping point” had not arrived at the date of
the inventory count and had not been reflected in the perpetual records
B
13. In every audit it is necessary to perform some clerical accuracy tests by
footing the journals and tracing the totals to the general ledger. The only effect
which the quality of internal control will have on this process is on-
a.Sample size
b.The skills of the audit staff needed
c.Designing the tests of controls
d.The determination of the materiality level
A

14.It is sometimes impracticable or impossible for an auditor to use normal

accounts receivable confirmation procedures. In such situations the best
alternative procedure the auditor might resort to would be-
a.Examining subsequent receipts of year-end accounts receivable
b.Reviewing accounts receivable aging schedules prepared at the balance
sheet date and at a subsequent date
c.Requesting that management increase the allowance for uncollectible
accounts by an amount equal to some percentage of the balance in those
accounts that cannot be confirmed
d.Performing an overall analytical review of accounts receivable and sales
on a year to year basis
A

15.The overall objective in the audit of the sales and collection cycle is to
evaluate whether-
a.The sales account and accounts receivable account are free of errors
b.The sales account and accounts receivable account are free of material
errors
c.The sales account and accounts receivable account are presented fairly
in accordance with PFRS
d.The account balances affected by the cycle are fairly presented in
accordance with PFRS
D
16.To test for recorded sales for which there were no actual shipments, the
auditor traces from the-
 a.Bill of lading to the sales journal
b.Sales of journal to bill of lading
c.Sales journal to the accounts receivable subsidiary ledger
d.Bill of lading to the supporting customer order and sales order
B
END

Audit on Acquisition and payment

Purchasing Goods and Services

The expenditure cycle begins when an individual or department needs supplies,
materials, equipment, or services. The individual or department requests these items
by sending a purchase requisition to the purchasing department. The purchase
requisition will include the name of the department asking for the items, a listing of
the items being requested, an account number where the cost of the material is to
be charged when received, and an authorization signature from someone with the
authority to commit the department to that amount of expense. The requisition may
also include a recommended vendor.
The purchasing department reviews the purchase requisition and, if everything is in
order, seeks to order the items where the best price, quality, and appropriate delivery
can be obtained. Generally, the vendor must be on the approved vendor list. The
approved vendor list includes only vendors that have been inspected by the
organization and are authorized for purchases. It often requires several departments
to approve a vendor. Purchasing usually approves the vendor for appropriate pricing,
payment terms, and delivery; quality control may approve a vendor for both the
quality of the product it makes and its system of quality control used during the
vendor’s manufacturing process; and production (or engineering) may approve the
items as appropriate for its purposes on the purchasing company’s production line.
There have been several frauds where only one person approved a vendor for
inclusion on the approved vendor list. The individual was able to add to the list
fictitious companies or disreputable firms willing to provide kickbacks to the
individual.
There are three important assertions for accounts payable: completeness, cutoff,
and valuation. Completeness and cutoff go hand-in-hand because management may
desire to improve the books by not recording an obligation in the correct period. An
incomplete listing of accounts payable at the end of the period lowers current
liabilities (and corresponding expenses). Because vendors do need to be paid
eventually, management may accomplish this by delaying the recording of accounts
payable until the subsequent period—in other words, by closing the books early so
end-of-period obligations become the obligations of the subsequent period.
Accounts payable may also be understated. Obligations may not reflect the total
cost of the purchase such as freight, tariff, and taxes. On large purchases, this may
be substantial and may be the result of an error or an intentional act to reduce the
accounts payable liability.

Unmatched Receiving Reports

Liabilities should be recorded on the date the goods and services are received and
accepted by the receiving department or by another responsible person. Sometimes,
however, vendor invoices arrive later. In the meantime, the accounts payable
department holds the purchase order and receiving reports unmatched with invoices,
awaiting enough information to record an accounting entry. Auditors can inspect the
unmatched receiving report file to determine whether the company has material
unrecorded liabilities on the financial statement date for goods that were received
but not matched to invoices.

Unmatched Vendor Invoices

Sometimes vendor invoices arrive in the accounts payable department before the
receiving activity is complete. Such invoices are held unmatched with receiving
reports, awaiting information that the goods and services were actually received and
accepted. Auditors can inspect the unmatched invoice file and compare it with the
unmatched receiving report file to determine whether liabilities that have been
incurred are unrecorded. Systems failures and human coding errors can cause
unmatched invoices and related unmatched receiving reports to sit around
unnoticed when all of the information for recording a liability is actually in hand.
Sometimes, however, unmatched invoices are indicators of fraudsters looking for an
easy score, as noted in the following Auditing Insight.

Audit on Payroll

1. Documents and Records

1.1 Personnel records – a document that records an employee’s data such as the date of
employment, rates of pay, authorized deductions, performance appraisal and termination of
employment, etc.
1.2 Deductions authorization form – a form signed by the employee authorizing deduction from his
wages or salaries for contribution to superannuation (退休金) plan, loan repayment or others.
1.3 Rate authorization form – a document authorizing the rate of pay (per hour, day, month) of
the employee by management, or, in the case of top management, by the board of directors.
1.4 Time card – a document indicating the starting and the ending time within which the worker
works each day. It is usually used for daily or hourly paid worker for calculating the total hours of
work each day.
1.5 Job time card – a document indicating the particular job on which the worker has spent on
during a given period of time.
1.6 Payroll cheque – It is usually issued for factory workers whose wages are not fixed monthly.
1.7 Bank transfer advice – a written advice to the company’s bank showing the names of
employees, their respective monthly salaries, bank account numbers and the total amount to be
transferred from the company’s payroll account to the employees’ accounts.
1.8 Payroll journal – a journal for posting total payroll expense for the period to general ledger
account.
1.9 Payslip/salary slip – a document prepared individually for all employees for a particular
week or month showing the gross pay, deductions and net pay.

2. Control Risks Assessment of Payroll and Personnel Cycle

2.1.1 The payroll and personnel cycle is important for several reasons:
(a) Salaries, wages and other staff costs are one of the major expenses in most companies.
(b) Labour cost is one of the components of inventory costs in manufacturing and
construction companies.
(c) The improper classification and allocation of labour cost may have material
misstatement of net income.
(d) Significant resources can be lost because inefficiency or are susceptible to fraud.
2.2 Assertions used by the auditor in payroll and personnel cycle
2.2.1 Classes of payroll transactions

Assertions Descriptions

1. Occurrence Wages and salaries are only paid to non-fictitious employees

and for their work performed.

2. Completeness All existing payroll transactions are recorded in the payroll

and accounting records.

3. Accuracy Wages and salaries should be calculated based on work

performed and terms of employment.
 4. Cut-off Payroll transactions should be recorded in the correct period.

5. Classification Payroll transactions should be properly classified.

2.2.2 Classes of payroll expenses and related accruals

Assertions Descriptions

1. Existence Payroll expenses are valid and related accruals are valid
liabilities.

2. Rights and Recorded payroll expenses and related accruals are

obligations expenses and obligations of the entity.

3. Completeness All payroll expenses and related accruals have been

recorded.

4. Valuation and Payroll expenses and related accruals are properly valued
allocation and allocated in accordance with accounting standards.

2.2.3 Payroll presentation and disclosure

Assertions Descriptions

1. Rights and All disclosed transactions relating to payroll expense and

obligations related accruals have occurred and pertain to the entity.

2. Completeness All payroll expenses and related accruals have been recorded
in the financial statements.

3. Classifications Financial information relating to payroll expense and related

accruals is appropriately presented and disclosed.

4. Valuation and Payroll expenses and related accruals are disclosed fairly
 allocation and at appropriate amounts.

2.3 Internal controls and test of controls

2.3.1 Examples of internal control procedures for payroll and personnel cycle are as follows:

Internal Control Procedures Test of control

Assertions

1. Occurrence ● Proper segregation of ● Observe and evaluate

duties between processing proper segregation of
and personnel functions; duties; e.g. persons
adequate personnel files are authorizing employee
maintained; and work/time benefits costs are not
record are approved by responsible for recording.
person of appropriate level. ● Check the authorization by
appropriate for all additions,
changes and deletions of
personnel records and the
authorization for payments of
employee benefit costs.

2. Completeness ● Updated record for starters ● Check the numerical

and leavers should be sequence of the time/work
maintained by personnel records and the
office and payroll processing reconciliation of payroll
function is provided with summary and starters and
updated information about leavers recorded in
leavers. personnel records.

3. Accuracy ● Internal verification to ● Examine the client’s record

ensure that the calculation to see whether the client has
of wages and salaries is in checked the arithmetical
agreement with records of accuracy of employee
work performed and terms of benefit costs to ensure the
employment. amounts are in accordance
with employment contracts.

4. Cut-off ● Notices of additions, ● Examine indication of

terminations, and changes internal verification and
in pay rates, and deductions test procedures for
reported promptly to payroll processing time/work record
processing function. and for recording liabilities.

5. Classification ● Proper internal verification ● Review client’s procedures

and approval for accounts and inspect their records to
verify there has been proper
 charged to payroll. classification of employee
benefit costs.

https://www.summaryplanet.com/industrial-economics/Payroll-and-
Personnel-Cycle.html

Methodology For Designing Substantive Analytical Procedures and

Tests of Details of Balances

Design and perform substantive analytical procedures and tests of

details for accounts in the payroll and personnel cycle.

During the first two phases of the audit, auditors assess control risk
and perform tests of controls and substantive tests of transactions.
After completing these tests and assessing the likelihood of
misstatement in financial statement accounts in the payroll and
personnel cycle, the auditor follows the methodology for designing
tests of details of balances.

Auditing payroll and personnel cycle

Set Performance Materiality and Assess Inherent Risk (Phase I)
Most companies have a large number of transactions involving payroll,
often with large total amounts. However, balance sheet accounts are
normally insignificant, except for labor charged to inventory.
Aside from the potential for fraud, inherent risk is typically low for all
balance-related audit objectives. There is inherent risk of payroll fraud
because most transactions involve cash. Therefore, auditors often
consider the occurrence transaction-related objective important. Also,
for manufacturing companies with significant labor charged to
inventory, the potential exists for misclassification between payroll
expense and inventory, or among categories of inventory. As a part of
gaining an understanding of the client, the auditor may identify
complex payroll-related issues, such as stock-based compensation
plans, that may increase inherent risks related to the accounting and
disclosure of those arrangements.

Assess Control Risk and Perform Related Tests (Phases I and II)
Earlier in this chapter, we discussed assessing control risk and the
related tests of controls and substantive tests of transactions.

Perform Substantive Analytical Procedures (Phase III)

The use of substantive analytical procedures is as important in the
payroll and personnel cycle as it is in every other cycle.

Design and Perform Tests of Details of Balances for Liability and

Expense Accounts (Phase III)
The verification of the liability accounts associated with payroll, often
termed accrued payroll expenses, is ordinarily straightforward if
internal controls are operating effectively. When the auditor is satisfied
that payroll transactions are being correctly recorded in the payroll
journal and the related payroll tax forms are being accurately prepared
and taxes promptly paid, the tests of details of balances should not be
time consuming.

The two major balance-related audit objectives in testing payroll

liabilities are:
Accruals in the trial balance are stated at the correct amounts
(accuracy).

Transactions in the payroll and personnel cycle are recorded in the

proper period (cutoff).

The primary concern in both objectives is to make sure that there are
no understated or omitted accruals. Next, we examine the major
liability accounts in the payroll and personnel cycle.

Amounts Withheld from Employees’ Pay as part of auditing payroll

and personnel cycle
Payroll taxes withheld but not yet paid to the government can be
tested by comparing the balance with the payroll journal, the payroll
tax form prepared in the subsequent period, and the subsequent
period cash disbursements. Other withheld items such as retirement
savings, union dues, savings bonds, and insurance can be verified in
the same manner. If internal controls are operating effectively, cutoff
and accuracy can easily be tested at the same time by these
procedures.

Accrued Salaries and Wages

The accrual for salaries and wages arises whenever employees are
not paid for the last few days or hours of earned wages until the
subsequent period. Salaried personnel usually receive all of their pay
except overtime on the last day of the month, but often, several days
of wages for hourly employees are unpaid at the end of the year.

The correct cutoff and accuracy of accrued salaries and wages

depend on company policy, which should be followed consistently
from year to year. Some companies calculate the exact hours of pay
that were earned in the current period and paid in the subsequent
period, whereas others compute an approximate proportion. For
example, if the subsequent payroll results from three days of
employment during the current year and two days of employment
during the subsequent year, the use of 60 percent of the subsequent
period’s gross pay as the accrual is an example of an approximation.

After the auditor has determined the company’s policy for accruing
wages and knows that it is consistent with that of previous years, the
appropriate audit procedure to test for cutoff and accuracy is to
recalculate the client’s accrual. The most likely misstatement of any
significance in the balance is the failure to include the proper number
of days of earned-but-unpaid wages.

Accrued Commissions as part of auditing payroll and personnel cycle

The same concepts used in verifying accrued salaries and wages are
applicable to accrued commissions, but the accrual is often more
difficult to verify because companies often have several different types
of agreements with salespeople and other commission employees.
For example, some salespeople might be paid a commission every
month and earn no salary, whereas others will get a monthly salary
plus a commission paid quarterly. In verifying accrued commissions, it
is necessary first to determine the nature of the commission
agreement and then test the calculations based on the agreement.
The auditor should compare the method of accruing commissions with
that of previous years for purposes of consistency.

Accrued Bonuses as part of auditing payroll and personnel cycle

In many companies, the year-end unpaid bonuses to officers and
employees are such a major item that the failure to record them will
result in a material misstatement. The verification of the recorded
accrual can usually be accomplished by comparing it with the amount
authorized in the board minutes.

Accrued Vacation Pay, Sick Pay, or Other Benefits

The consistent accrual of these liabilities relative to those of the
preceding year is the most important consideration in evaluating the
fairness of the amounts. The company policy for recording the liability
must first be determined, and then the recorded amounts must be
recalculated. The company policy should be in accordance with
accounting standards for compensated absences.

Accrued Payroll Taxes as part of auditing payroll and personnel cycle

Payroll taxes, such as FICA and state and federal unemployment
taxes, can be verified by examining tax forms prepared in the
subsequent period to determine the amount that should have been
recorded as a liability at the balance sheet date.

Tests of Details of Balances for Expense Accounts as part of auditing

payroll and personnel cycle
Several accounts on the income statement are affected by payroll
transactions. The most important are officers’ salaries and bonuses,
office salaries, sales salaries and commissions, and direct
manufacturing labor. Often, costs may be broken down further by
division, product, or branch. Fringe benefits such as medical
insurance may also be included in the expenses.

Auditors should need to do relatively little additional testing of the

income statement accounts in most audits beyond substantive
analytical procedures, tests of controls, substantive tests of
transactions, and related tests of liability accounts already discussed.
Extensive additional testing should be necessary only when auditors
uncover significant deficiencies or material weaknesses in internal
control, significant misstatements in the liability tests, or major
unexplained variances in the substantive analytical procedures.
Nevertheless, some income statement accounts are often tested in
the payroll and personnel cycle. These include officers’ compensation,
commissions, payroll tax expense, total payroll, and contract labor.

Officers’ Compensation
It is common to verify whether the total compensation of officers is the
amount authorized by the board of directors, because their salaries
and bonuses must be included in the company’s Form 10-K filed with
the SEC and federal income tax return. Verification of officers’
compensation is also warranted because some individuals may be in
a position to pay themselves more than the authorized amount. The
usual audit test is to obtain the authorized salary of each officer from
the minutes of the board of directors meetings and compare it with the
related earnings record.

Commissions
Auditors can verify commission expenses with relative ease if the
commission rate is the same for each type of sale and the necessary
sales information is available in the accounting records. The total
commission expense can be verified by multiplying the commission
rate for each type of sale by the amount of sales in that category. If
the desired information is not available, it may be necessary to test the
annual or monthly commission payments for selected salespeople and
trace those to the total commission payments.

Payroll Tax Expense as part of auditing payroll and personnel cycle

Payroll tax expense for the year can be tested by first reconciling the
total payroll on each payroll tax form with the total payroll for the entire
year. Total payroll taxes can then be recomputed by multiplying the
appropriate rate by the taxable payroll. The calculation is often time-
consuming because the tax is usually applicable on only a portion of
the payroll and the rate may change partway through the year if the
taxpayer’s financial statements are not on a calendar-year basis. On
most audits, the calculation is costly and is not necessary unless
substantive analytical procedures indicate a problem that cannot be
resolved through other procedures. When necessary, the test is
ordinarily done in conjunction with tests of payroll tax accruals.
Total Payroll as part of auditing payroll and personnel cycle
A test closely related to the one for payroll taxes is the reconciliation of
total payroll expense in the general ledger with the payroll tax returns
and the W-2 forms. The objectives of the test are to determine
whether payroll transactions were charged to a non-payroll account or
not recorded in the payroll journal at all. Because the payroll tax
records and the payroll are both usually prepared directly from the
payroll master file, the misstatements, if any, are likely to be in both
records. Tests of controls and substantive tests of transactions are a
better means of uncovering these two types of misstatements in most
audits.

Contract Labor as part of auditing payroll and personnel cycle

To reduce payroll costs, many organizations contract with outside
organizations to provide staffing. The individuals providing the
services are employed by the outside organization. For example,
companies frequently contract with information technology services
firms to handle the company’s IT management and staffing functions.
The fees paid to the outside organization are tested by comparing the
amounts with the signed contract arrangement between the company
and the outside services firm.

Presentation and Disclosure Objectives

Required disclosures for payroll and personnel cycle transactions and
balances are not extensive. However, some complex transactions,
such as stock options and other executive officer compensation plans,
may require footnote disclosure. Auditors may combine audit
procedures related to the four presentation and disclosure objectives
with tests of details of balances for liability and expense accounts.

https://farhatlectures.com/auditing-the-payroll-cycle-and-auditing-
personnel-cycle/

Audit of Property, Plant, and

Equipment
https://hahuzone.com/audit-property-plant-and-equipment

Overview of property, plant and equipment

The term property, plant and equipment (fixed assets) include all tangible assets with a
service life of more than one year that are used in the operation of the business and are
not acquired for the purpose of resale. Three major subgroups of such assets are
generally recognized.
1. Land, such as property used in the operation of the business, has the significant
characteristics of not being subject to depreciation.
2. Building machinery, equipment and land improvements, such as fences and
parking lots, have limited service lives and are subject to depreciation.
3. Natural resources (wasting assets), such as oil wells, coal mines, and tracts of
timber, are subject to depletion as the natural resources are extracted or
removed.
Fixed asset constitute a significant proportion of the total assets of many organizations
particularly those engaged in manufacturing activities. Audit of fixed asset is, therefore
generally considered to be an important part of an independent financial audit. Though
the number of transactions involving fixed assets is smaller in number, the amount
involved in these transactions will be very high. Hence the auditor has to give more
attention while auditing the transactions relating to fixed asset.

4.2. Auditors’ objectives in auditing property, plant and equipment

The auditor’s objectives in the audit of fixed assets are
1. Consider internal control over property, plant and equipments.
2. Determine the existence of recorded property, plant and equipment.
3. Establish the completeness of recorded property, plant and equipment.
4. Establish that the client has ownership rights to the recorded property, plant
and equipments
5. Establish the clerical accuracy of schedules of property, plant, and equipment.
6. Determine that the valuation or allocation of the cost of property, plant, and
equipment is in accordance with generally accepted accounting principles.
7. Determine that the presentation and disclosures of property, plant, and
equipment, including disclosure of depreciation methods is appropriate.
In conjunction with the audit of property, plant, and equipment, the auditors also obtain
evidence about the related accounts of depreciation expenses, accumulated
depreciation, and repair and maintenance expenses.

4.3. Internal controls relating to fixed assets

The auditor studies and evaluates the accounting system and the effectiveness of
internal control relating to fixed assets. The auditor’s study and evaluation of internal
control relating to fixed assets covers the following aspects:
1. Segregation and rotation of duties.
2. Authorization of acquisition, transfer and disposal of fixed assets
3. Maintenance and record of documents.
4. Accountability for and safeguarding of fixed assets.
5. Independent checks.

1. Segregation and rotation of duties: The auditor has to see whether there is
proper segregation of various duties relating to fixed assets such as
● Authorization of acquisition and disposals
● Execution of transactions relating to execution and disposals
● Recording of transactions
● Physical custody of items.
The auditor also has to see whether the duties of various persons relating to fixed assets
are rotated periodically or not.
2. Authorization of acquisition, transfer and disposal of fixed assets:
a. The auditor has to check the internal control relating to capital budgeting. i.e.,
whether the proposal for capital expenditure has been received in time in the
proper format, approved by the top management and whether it is properly
communicated to the various departments after the approval.
b. Whether a written authorization from a senior level of the management is
included in the budget.
c. Whether the organization have laid down proper procedures for acquisition of
fixed assets i.e. for inviting quotations, selection of suppliers, approval of prices,
payment terms, safeguard for timely delivery etc.
d. Whether the purchases are made on the basis of competitive bids. And whether
there is requirement for documenting the reasons for making purchases other
than at lowest price.
e. Whether the control over receipt of fixed assets are effective ie., whether the
technical specifications of the assets received are verified with the purchase
orders before accepting and if rejected whether the debit notes are raised
promptly.
f. Whether periodic comparisons of the actual expenditures of the fixed assets are
compared with the capital expenditure budget and whether approval from the
competent authority is received if there is a deviation form the budget.
g. Whether there any system of getting prior approval from the competent authority
in case of transfer of fixed assets from one department to another?
h. Whether adequate controls exist for disposal of fixed assets i.e. with proper
authorization, invitation of quotations, approval of prices, proper documentation
etc
3. Maintenance of records and documents
a. The auditor has to check whether the company maintains proper records of fixed
assets including those items, which are fully depreciated.
b. Whether the organization maintains the record of assets given on lease or used
by the organization but owned by others.
c. Whether a register containing title deeds of the assets are maintained properly.
d. Whether the title deeds or registration documents are kept in safe custody and
verified periodically.
e. Whether the organization maintained a detail record of projects which are in
progress.
f. Whether the expenditures incurred are properly allocated between capital and
revenue.
4. Accountability for and safeguarding of fixed assets
a. Whether there is any system for identification of fixed assets.
b. Whether adequate safeguards are made to protect the fixed assets from fire, theft
accessibility to unauthorized persons, and use of locks burglar alarms etc.
c. Whether the fixed assets are properly insured and the auditor has to check
regarding the adequacy of the cover the time period, etc.
 d. Whether the fixed assets are physically verified on a periodic basis including
those assets lying with third parties.
e. Whether follow up action has been taken for the discrepancies between the
record books and physical verifications.
f. Whether there is any system for identifying and reporting damaged, obsolete and
idle fixed assets.
5. Independent checks:
The auditor has to see whether there is any internal audit for fixed assets and
determining the coverage and effectiveness of the internal audit. The auditor has to
examine the scope of the work of the internal auditors and their reports.
Substantive procedures for fixed assets
The auditor determines the nature timing and extent of substantive procedures relating
to fixed assets after evaluating the effectiveness of internal controls. The procedures
normally followed are the following
(A). Examination of records and documents.
1. Verify the opening balances from the previous years financial statements or
ledger accounts.
2. Verify the additions made during the year from the approval of appropriate
authority copies of purchase orders, invoices receiving reports, acknowledgement
form the supplier and bank statement.
3. Verify the assets constructed during the year by examining work order records,
statement of allocation and apportionments of costs, certificate of work
performed, contractors bills, invoices of suppliers of materials, bank statement
etc.
4. Verify the major repairs and maintenance to ensure no revenue expenditure
related to the capital assets is included.
5. Verify the disposal or retirement of fixed assets by examining the approval of
appropriate authority, quotations invited from buyers, contract with the buyer,
copy of the sale bills, evidence of physical deliveries etc.
6. Examine whether the book values and accumulated depreciation of the fixed
assets disposed or discarded are properly adjusted accounting the resulting gains
or losses properly.
7. Verify the minutes of the board of directors, agreements, and correspondence
with lawyers to identify any charges or encumbrances on the fixed assets.
8. Verify the arithmetical accuracy of the fixed asset records.
9. Verify whether the value shown in the financial statement is after charging
adequate depreciation.
10. Examine the evidence of ownership of fixed assets.
(B). Review or observation of a second verification
Though the physical verification is the duty of the management, the auditor can review
or observe the verification by examining the documents relating to the physical
verification.
The procedures followed are:
1. Review the instructions issued to the staff entrusted with the responsibility of
physical verification and judges the appropriateness and adequacy of the
instructions.
2. Assess the competence of the personnel conducting the physical verification.
3. Examine the frequency of the verification and verify whether it is reasonable in
the circumstances of the case.
4. When direct physical verification is not possible examine any indirect evidence of
the existence of the fixed assets.
5. Tests check the fixed asset record with the physical verification records.
6. Examine the appropriate follow up action taken for the discrepancies revealed by
physical verification with the fixed asset records.
7. Examine whether appropriate adjustments have been made in the fixed asset
records and financial accounts for obsolescence, damage, or other losses reveled
by the physical verification.
(C). Examination of Valuation and disclosure
1. Examine whether the fixed assets have been valued according to the generally
accepted accounting principles.
2. Examine whether adequate depreciation have been provided.
3. Examine whether the fixed assets have been revalued in a systematic/ scientific/
appraisal basis considering the future life and the possibility of obsolescence.
4. Examine the basis on which the consideration has been approportionated to
various assets when several assets have been purchased for a consolidated price.
5. Examine the relevant documents such as title deeds agreements etc in order to
ascertain the extent of the shares of the organization when the organization owns
assets jointly with others.
(D). Analytical Procedures: -The analytical procedures employed by the auditors in
the audit of fixed assets are the following:
1. Compare the additions or disposals of fixed assets made during the year with the
budgeted figures.
2. Compare the ratio of depreciation for the current year to the average book value
of the fixed assets with the corresponding figures of the previous year.
3. Compare the amount of repairs and maintenance of the current year with the
figures of the previous year.
4. Compare the ratio of actual capacity utilization with the installed capacity of the
current year with the figures of the previous year.
(E). Obtaining Management Representation
The auditor has to obtain an appropriate representation form the management
concerning the fixed assets stating that the fixed assets shown in the balance sheet are
arrived at after considering all capital expenditures on additions, eliminating the cost
and accumulated depreciation relating to the items discarded, destroyed and disposed
off and adequate depreciation has been provided for during the current year.
4.4. Audit program for auditing fixed assets
The following procedures are typical of the work required in many engagements for the
verification of property, plant and equipments.
A) Consider internal control over property, plant and equipment
1. Obtain an understanding of internal control over property, plant and equipment
Auditors may use written description, flow chart or internal control questionnaire to
describe the nature of client’s internal control structure. After preparing description of
internal control, the auditors will determine whether the controls as described to
them have been placed in operation, whether there is appropriate segregation of duties
and considered the misstatements that may occur.
2. Assess control risk and design additional tests of control for the assertions about
property, plant, and equipment.
Based on an understanding of the client’s internal control over property, plant and
equipment, the auditors develop their planned assessed level of control risk for the
various financial statement assertion assertions and obtain additional evidences of the
operating effectiveness of the client’s controls by designating additional tests of control.
3. Perform additional tests of controls for those controls that the auditors plant to
consider to support their planned assessed levels of control risk.
As auditors obtain an understanding of the client’s internal control; certain tests of
control are performed.
E.g. select a sample of purchase of plant and equipment to test the control related to
authorization, receipts and proper recording of the transactions.
4. Reassess control risk for each of the major financial statements assertions about
property, plant, and equipments based on the results of tests of controls and, if
necessary, modify substantive tests.
The final step in the auditor’s consideration of internal control involves a reassessment
of control risk based on the results of the tests of control. On the basis of the reassessed
level of control risk auditor modify their planned program of substantive testing
procedures for property, plant, and equipment assertions.

B) Perform substantive tests of property, plant and equipments and

related depreciation transactions and balances
The objective of major substantive testing procedures of property, plant
and equipment balances are given in the following table.
Subjective Test Primary audit
objective to be
addressed
5. Obtain a summary analysis of changes in Clerical accuracy
property owned and reconcile to ledgers -The
summary analysis shows the beginning balances
of property, plant, and equipment, additions to
and/or retirement from property, plant, and
equipments and ending balances of property
plant and equipments. Auditors reconcile
subsidiary ledgers with the Controlling accounts
6. Vouch additions to property, plant and Existence and right
equipment during year – The vouching process
utilizes a working paper analysis of the general valuation or
ledger controlling accounts and includes the allocation
tracing of entries through the journal to original
documents such as contracts, construction work
orders, invoices canceled checks authorization by
appropriate individuals
7. Make physical inspection of major acquisitions
● The auditors usually make a physical
inspection of major units of plant and
equipment acquired during the year under
audit by comparing the physical assets
with underlying records.
● Helps to maintain good working
knowledge of the Client’s operations and
also in interpreting the accounting entries
for both additions and retirements.

8. Analyze repair and maintenance expenses Valuation and

accounts allocation
● The auditors principal objective in in
analyzing repair and maintenance
expense accounts is to discover items that
should have capitalized
● To determine that there is proper repair
and maintenance charges, the auditors
will trace the ledger expenditures to
written authorizations for the
transactions.
9. Investigate the status of property, plant and Valuation and
equipment allocation
● Auditors investigate plant assets currently Presentation and
in use, plant assets not currently in use but
 expected to be used in the future operation disclosure
(depreciate at normal rate); and
plant assets dismantled, found to be
unsuitable for future operating use(should
be written down their net realizable value
and should not be classified as plant
assets.
10. Test the client’s provision for depreciations
Valuation and
● Review and test management’s process of allocation
developing the estimate
● Review subsequent events or transactions
bearing on the estimates
● Independently develop an estimate of the
amounts to compare to management’s
estimates
11. Investigate potential impairments of
property, plant, and equipments - Whenever
events or changes in circumstances indicate that
the carrying amount of long lived assets may not
be recoverable ie if the sum of the expected future
cash flows from the assets is less than its
carrying amounts, an impairments loss is
recognized.

12. Investigate retirement of property, plant and Existence and right

equipment during the year
● The principal purpose of this procedures is
to determine Whether any property has
been replaced, sold, dismantle or
abandoned without such actions being
reflected in the Accounting records.
13. Examine evidence of legal ownership
● To determine that plant assets are
property of the client, the auditors look for
such evidences as a deeds, title, insurance
policy, property tax bills, receipts, for
payments to mortgages and fire insurance
policies.
14. Review rental revenues-rental revenues from
land, building, equipments, machinery, and so on
should be reviewed and the party responsible to
pay cost of electricity, water, telephone should be
reconciled against with provisions of utility
expenses.

15. Examine lease agreements on property, plant Existence and right

and equipments i.e. lease to and/ or form other
party. The auditors should carefully examine Completeness
lease agreements to determine whether the Valuation or
accounting for assets involved in proper (in allocation
accordance with the requirements of GAAP)
E.G Capitalization of assets leased by the client
company.
16. Perform analytical procedures for property,
plant, and equipments
● Auditors may use trends and ratios to
judge the reasonableness of recorded
amounts for plant and equipments
e.g. - Cost of plant assets/ annual out put in
dollar or
other units
● Monthly repair and maintenance expense
to yearly amounts
● Compare acquisition and retirements of
current year to prior years.
17. Evaluate financial statements presentation Presentation and
and disclosure for property, plant and equipment disclosure
and for related revenues and expenses.
● The balance sheet or accompanying notes
should disclose balances of major classes
of depreciable assets, accumulated
depreciation, method(s) for computing
depreciation, base of valuation, property
pledged and property not in current use.

4.5 Auditors perspective towards depreciation

Depreciation is the decrease in the value of the asset due to wear and tear,
obsolescence, lapse of time etc. Fixed assets are to be disclosed in the balance sheet at
their cost or at the revalued amount less depreciation
Determining the annual depreciation expense involves two rather arbitrary decisions
by the client company: first, an estimate of the useful economic lives of various
groups of assets, and second, a choice among several depreciation methods, each of
which would lead to a different answers. The wide range of possible amounts for
annual depreciation expense because of these decisions by the client suggests that the
auditors should maintain a perspective of looking for assurance of overall
reasonableness. Specifically, overall tests of the year/s depreciation expense are of
special importance.

Accordingly, the auditor has to examine whether adequate depreciation has been
provided in the books in respect of all depreciable assets according to the provisions of
the relevant statutes.
While auditing depreciation, the auditor has to examine the following points in respect
of depreciation
1. Whether adequate depreciation has been provided during the current year.
2. Whether the depreciation has been calculated by appropriate methods.
3. Whether appropriate method has been selected after considering the useful life of
the asset and salvage value.
4. Whether the method of calculating depreciation has been consistent over the
years.
5. Whether any change in the method has been properly disclosed in the financial
statements.
6. Whether accumulated depreciation in respect of discarded or disposed assets
have been adjusted in the accumulated depreciation amount.
7. Whether depreciation has been provided properly on the assets added or
disposed of during the current year.
8. Whether depreciation has been provided on revalued assets
9. Whether the depreciation has been properly disclosed in the financial statements.
4.5.1 The auditors’ objectives in auditing depreciation
When evaluating the reasonableness of depreciation (with accounting estimate),
auditors use one or more of the following three basic approaches.
1). Review and test management’s process of developing the estimates
2). Review subsequent events or transactions that might have bearing on the estimate
to management’s estimate
3). Independently develop an estimate of the amounts to compare to managements
estimate.

4.5.2 Audit program-Depreciation expense and accumulated depreciation

The following outlines of substantive tests to be performed by the auditors in reviewing
depreciation are stated in sufficient detail to be largely self-explanatory.
 1. Review the depreciation policies set forth in company manuals or other management
directives. Determine whether the methods in use are designed to allocate costs of plant
and equipment assets systematically over their service lives.
a. Inquire whether any extra working shifts or other conditions of accelerated
production are present that might warrant adjustment of normal depreciation
rates.
b. Discuss with executives the possible need for recognition of obsolescence
resulting from technology or economic developments.
2. Obtain or prepare a summary analysis of accumulated depreciation for the major
property classification as shown by general ledger accounts, listing beginning balances,
provisions for depreciation during the year, retirements, and ending balances.
a. Compare beginning balances with the audited amounts in last year/s working
papers.
b. Determine that the totals accumulated depreciation recorded in the plant and
equipment subsidiary records agree with the applicable general ledger controlling
accounts.
3. Test the provisions for depreciations
a) Compare rates used in prior years and investigate any variance.
b) Test computations of depreciations for provisions for a representatives number of
units and trace to individuals records in the property ledger. Be alert for excessive
depreciation on fully depreciated assets.
c) Compare credits to accumulated depreciation accounts the year’s depreciation
provisions with debits entries in related depreciation expenses accounts.
4. Test deductions from accumulated depreciation for assets retired.
a) Trace deductions to the working paper analyzing retirements of assets during the
year.
b) Test the accuracy of accumulated depreciation to date of retirements.
5. Perform analytical procedures for depreciation
a) Compute the ratio of depreciation expenses to total cost of plant and compare with
prior years.
b) Compare the percentage relationships between accumulated depreciation and
related property accounts with that prevailing in prior years. Discuss significant
variations from normal depreciation program with appropriate members of
managements.