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Module 9: Inventory and capital asset balances, production and payroll cycles, and finance and investment cycle
Overview
This module continues with the specific transaction cycles using the balance sheet audit approach. You learn about the main activities, significant assertions, and the substantive procedures used to support these assertions for inventory and capital assets as well as the production, payroll, and finance and investment cycles. When you have completed this module, you should have a good foundation knowledge of the audit concepts and procedures relating to these cycles. As you work through the module, you apply what you have learned by responding to questions on audit procedures. Assignment reminder: Assignment 3 in Module 9 is due this week (see Course Schedule). Remember to allocate time to complete and submit the assignment by the deadline.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives
9.1 Inventory Knowledge of the business Explain the knowledge of the entitys business that is relevant to the audit of inventory, and describe the types of analysis used to audit inventory. (Level 1) Identify the most significant assertions with respect to inventory, and explain the substantive procedures used to support these assertions. (Level 2) Identify the issues related to the observation of physical inventory counts. (Level 1) Describe the knowledge of the entitys business that is relevant for the audit of manufacturing inventory, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2) Summarize how knowledge of the entitys business is relevant to the audit of capital assets, and describe the analytical procedures used to audit such assets. (Level 2) Summarize the most significant assertions with respect to capital assets, and describe the substantive procedures used to support these assertions with examples of specific substantive procedures. (Level 2) Describe the main activities, accounts, segregation of functional responsibilities, and sources of evidence for the production and payroll cycles. (Level 2)

9.2 Inventory Substantive procedures

9.3 Inventory Observation 9.4 Manufacturing inventory Substantive procedures

9.5 Capital assets Knowledge of the business

9.6 Capital assets Substantive procedures

9.7 Production and payroll cycles The basics

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9.8 Production and payroll cycles Tests of controls Summarize the control objectives and test of controls procedures for the production and payroll cycles. (Level 2) 9.9 Payroll Substantive procedures Explain the knowledge of the entitys business that is relevant for the audit of payroll, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2) Identify the activities, accounts, segregation of functional responsibilities, and sources of evidence for the finance and investment cycle. (Level 1) Describe the control objectives and test of controls procedures for the finance and investment cycle. (Level 2)

9.10 Finance and investment cycle The basics

9.11 Finance and investment cycle Tests of controls Module summary Print this module

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9.1 Inventory Knowledge of the business

Learning objective

Explain the knowledge of the entitys business that is relevant to the audit of inventory, and describe the types of analysis used to audit inventory. (Level 1)

No required reading LEVEL 1

Risks and sources of error

Inventory is frequently the most material current asset in an audit and can require the most time to verify. The risks involved in auditing this balance will vary depending on the nature of the company being audited. For large manufacturing companies, auditing the inventory will be complex, while the inventories of small retail companies will present fewer difficulties. In Topics 9.1, 9.2, and 9.3, you focus on finished goods inventory; that is, inventory available for sale. The other aspects of manufacturing inventory, such as raw materials and work in process, are covered in Topic 9.4. When assessing inventory, the auditor needs to be aware of issues that may result in the potential for misstatements and affect the time required for auditing inventory. These include the following:

Physical characteristics of the products: The physical characteristics of the products held in inventory may be problematic for the auditor. For example, how do you ascertain the quantity of mountains of rocks and gravel held in a gravel pit? And how can you differentiate between different grades of rocks, unless you are a geological expert in addition to being an auditor? Large variety of inventory: There may be a large variety of inventory items held in stock whose saleable value or potential for obsolescence may be difficult to determine. Think, for example, of a hardware company that has 375 bins containing thousands of different types of bolts. How do you know which ones are obsolete and will never sell? This situation creates a valuation problem. Largest current asset: Because inventory is often the largest current asset, a material misstatement in this balance will usually produce significantly misleading financial results.

In addition, the inherent risk of material error in inventory is usually very high. One reason is that the physical count done at year-end may present some significant problems. Possible errors in inventory may arise unintentionally or as a result of intentional manipulation. Because it is difficult to audit inventory, the inventory account is a likely target for manipulating net income.
Scenario 9.1-1: Mighty Steel Inc.

Pam, CGA, is in charge of creating the audit plan for the inventory of a large company, Mighty Steel Inc. The tour of the premises revealed that the storeroom is poorly organized. What are the possible errors that could result because of this? Solution

Knowledge of the business

It is important to be aware of managements attitudes and biases when auditing inventory, as with other account balances. In addition, a good knowledge of the business environment, particularly of those factors that would provide an incentive to overstate income (such as declining demand, increased competition, and so on), is absolutely essential to evaluate the extent of inherent risks for the inventory account.

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To properly plan and execute the audit of inventory, and hopefully reduce the time it takes to do it, the auditor should be aware of the companys products and their locations, its distribution networks, and its internal controls over inventory records. The auditor should also be aware of the methods and policies used to account for inventory, and whether the company uses a perpetual or periodic inventory system. Finally, the auditor should know the identity of the major vendors and customers that the client does business with on a regular basis.

Analysis
The following procedures are included in the analytical procedures for inventory:

Reviewing the gross profit figures and comparing them to prior years and industry standards Unexplained increased gross profits are indicative of possible inventory overstatements. To illustrate this point, suppose sales revenue is exactly the same in the current and the prior year, yet gross profit is higher in the current year. This may imply that cost of goods sold is lower than it should be, and therefore, inventory and income could be overstated. (It is of course possible that price increases and more economic sourcing have resulted in the increased gross profit, but the auditor should verify any management statement to that effect.)

Reviewing inventory turnover and comparing it to prior years and industry standards Changes in inventory turnover may point to valuation problems. For example, a lower turnover ratio may suggest that some inventory items have become obsolete, and therefore, inventory is overstated.

Scanning the accounting entries made to inventory accounts and investigating entries from unusual sources, normal entries that are absent, and uncommonly large entries Scanning the entries made to the inventory account may reveal a number of problems. For example, many large adjusting entries to agree the inventory control account to the records would point to weak controls in the inventory system; a large entry may indicate a deliberate attempt to overstate the assets; and the absence of a year-end adjusting entry could suggest that the year-end physical count was not taken.

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9.2

Inventory Substantive procedures

Learning objective

Identify the most significant assertions with respect to inventory, and explain the substantive procedures used to support these assertions. (Level 2)

Required reading

Chapter 12, Exhibit 12B-1 in Appendix 12B (page 507 in the textbook) CAS 501.4.8 and CAS 501.A1.A16 (CICA Handbook

, section 6030)

LEVEL 2

Key assertions for inventory

Existence, valuation, and ownership are without doubt the most important assertions for finished goods inventory. Given the high inherent risk of overstatement as pointed out earlier, the majority of auditing procedures, including the observation of the physical count, are directed at supporting these assertions. Other assertions, such as completeness and presentation, will also be audited, but these assertions are not as critical. Exhibit 12-B1 provides an example of an audit program for inventory, outlining some specific substantive procedures.

Existence
The existence of inventory is normally established through the following steps:

A review of inventory-taking procedures and attendance at the inventory count Inventory is one of the very few areas for which the Canadian Auditing Standards makes specific recommendations regarding the general (CICA Handbook) substantive procedures to be used. These are contained in CAS 501 (CICA Handbook, section 6030). Most of these recommendations relate to the physical inventory observation and the requirement for the auditor to attend the count and perform specific procedures during the count. The details of physical inventory observation are explained in Topic 9.3.

Investigation of any adjusting entries made to bring book values to actual inventory values If an adjusting entry has been made to increase inventory book values to agree to actual value, the auditor needs to make sure the items for which the adjustment was made do indeed exist. Normally, this type of entry would be made after the inventory count to adjust for discrepancies between the physical inventory and the accounting records. If adjusting entries are made at any other time, the likelihood of fictitious inventory being recorded would probably be higher, unless periodic counts are made throughout the year. In any case, significant adjustments should be investigated.

Confirmation of inventory that is held by third parties In some cases, particularly when a company uses a distribution network of third-party distributors to facilitate sales over a large region, the auditor will need to confirm the existence of any inventory held by the third parties. The auditor should also review the agreements between the client and the third party to ensure the terms of ownership are not affected by the distribution arrangements. If the amounts are highly material, the auditor should consider attending the inventory count at such third-party sites.

Performance of cut-off procedures Finally, cut-off procedures are very important. Cut-off procedures include vouching from the last shipping and

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receiving numbers obtained at the year-end inventory count to the related documents and records and the first ones after the count, to ensure inventory is recorded in the proper period.

Valuation
The risk of obsolescence of inventory may affect its value. Certain estimates and methods are used to arrive at the value of inventory, particularly for manufactured finished goods that embody the value added of each process in the costing system.
Activity 9.2-1

The value of retailed goods is also subject to valuation estimates, depending on the accounting methods used to record inventory. What are some of these methods? Solution The general substantive procedures normally used to support valuation include:

Enquiring of management and personnel about the valuation methods used As was the case for the estimation of the allowance for doubtful accounts, the auditor should understand the methods used to value inventory, assess whether the methods are reasonable, and perform recalculations to ascertain that the amounts recorded are appropriate. The auditor must also evaluate the methods used to establish allowances for obsolete items.

Tracing inventory purchase costs to suppliers invoices By tracing from inventory to suppliers invoices, the auditor can determine whether the inventory on hand has been properly valued. Testing for prices can be tricky because prices for a given item may fluctuate during the year, and in the absence of a perpetual inventory system, it would be difficult to determine at what price each item was purchased.

Testing whether the inventory is recorded at the lower of cost or market An auditor must also perform comparisons of recorded costs to market costs and selling prices to ensure, to an acceptable extent, that inventory is carried at the lower of cost or market. Or where inventories have become obsolete and their selling prices have declined, it may be necessary to write inventory down to a net realizable value.

Identifying slow moving inventory items Finally, identifying slow moving inventory items enables the auditor to determine if the items are obsolete and whether proper allowances for obsolescence have been made.

Ownership (rights and obligations)

Ownership is a particularly important assertion with inventory (in contrast to most other assets). Unlike cash balances, ownership of inventory cannot necessarily be inferred from its physical presence on the clients premises. The inventory may be on consignment, or it may have already been sold and not yet shipped to the customer although the sale has been recorded.
Activity 9.2-2

A number of agreements and contracts affect the ownership of inventory at any given point in time. Why is this so? Solution
Activity 9.2-3

What is the difference between FOB shipping point and FOB destination? Solution
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9.3

Inventory Observation

Learning objective

Identify the issues related to the observation of physical inventory counts. (Level 1)

Required reading

Chapter 12, pages 481483 CAS 501.4.8 and CAS 501.A1.A16 (CICA Handbook,

section 6030)

LEVEL 1

Physical inventory observation

Physical inventory observation is covered on pages 481 to 483. Under current auditing standards (e.g., CAS 501.4), the auditor must observe the year-end physical inventory count unless it is not feasible to do so. The auditor should coordinate with the client to receive a copy of the count instructions and location(s) prior to stock taking. The inventory count can then be observed by the auditor to evaluate the effectiveness of the clients inventory count procedures. In effect, this is a type of reliance on internal control for inventory. Clients generally plan to perform their counts at the low point of their business cycles for two reasons: inventory levels are lowest right after the clients busy season and more client staff are available for this task because it is the slowest part of the year. Ideally, auditors should be able to rely on the clients count procedures as much as possible. This involves planning and coordination. Pages 481482 list instructions the client should use in a well-designed inventory count. Auditors will rely on their observation of this count (test of controls), as well as on substantive procedures that they perform during the count, as described on pages 482483. The more effective the clients count, the less detailed substantive procedures the auditor needs to do. These substantive procedures include the following:

Performing test counts: Since there are usually hundreds and even thousands of types of inventory, the auditor counts only a small sample of all the types, which is called a test count. Some inventory items may be challenging to count and may require specialized expertise. (For instance, how many tons of coal are there in a pile 15 metres high?) The table on page 483 lists examples of items that are a challenge to identify, value, and measure. Controlling the tags (cards or sheets) used for summarizing the count of each type of inventory: For example, this may be done by numbering the tags, making sure all inventory is tagged, and controlling the unused tags. Noting obsolete or damaged items Observing the completeness of the inventory count Reviewing the accuracy of the count sheets relative to the tag information Obtaining information on the last shipping and receiving numbers, and using the information in performing cut-off tests

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9.4

Manufacturing inventory Substantive procedures

Learning objective

Describe the knowledge of the entitys business that is relevant for the audit of manufacturing inventory, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2)

Required reading

Chapter 12, pages 486487 and 487488 (Audit 12.2 and 12.3) Forms C-240, C-240C, and C-240S: Inventories audit program

LEVEL 2

Manufacturing inventory, as you learned in your cost accounting courses, consists of three components:

raw materials work in process finished goods

The procedures for the audit of finished goods inventory (covered in Topics 9.1 to 9.3) can be generally applied to finished goods for a manufacturing operation, as well as to retail inventory for a retail or wholesale operation. In this topic, you focus on the other two components of inventory that relate specifically to a manufacturing company raw materials and work in process.

Knowledge of the business

The auditor should enquire of management and other personnel regarding the valuation methods used. Knowledge of the business that is especially useful in price tests of inventory includes

an awareness of market values of comparable goods produced by competitors, and prospects for price changes based on inventory levels in the industry and due to foreign competition.

Inventory has to be valued at the lower of cost or market; therefore, knowledge of market conditions is indispensable to verifying the valuation assertion. This verification of valuation also requires an awareness of the potential for obsolescence in inventory. For new products, the auditor will need to consider managements track record in developing previous new products and selling them above cost. In addition, the auditors familiarity with cost accounting techniques in the industry can be very useful (for example, the extent to which development costs are capitalized and treated as part of overhead). Again, managements track record in eventually recovering such overhead through sales is an important consideration in valuation of inventory.

Analysis
The analytical procedures outlined in Topic 9.1 would also be used for manufacturing inventory. That is, auditors would make comparisons of gross profit margins and inventory turnover, as well as perform reviews of accounting entries made in the inventory accounts. For a manufacturing company, however, analysis is also directed at the periodic cost accounting reports prepared for management control purposes.
Activity 9.4-1

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In a standard costing system, where would auditors focus their attention? Solution

Substantive procedures
For a manufacturing company, valuation is a big issue from an audit standpoint because the value of the entire inventory depends on the cost accounting methods used for the production process. In a retail situation, the valuation of inventory is more easily verified partly because suppliers invoices confirm the price paid for the inventory on hand. For manufacturing inventory, raw materials can be verified from suppliers invoices, but work in process and finished goods cannot.
Activity 9.4-2

To support valuation, the auditor would perform audit procedures aimed at verifying the unit cost of a manufactured item. Can you outline these procedures? Hint: Think of the components that make up the unit cost of a manufactured item. Solution

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9.5 Capital assets Knowledge of the business

Learning objective

Summarize how knowledge of the entitys business is relevant to the audit of capital assets, and describe the analytical procedures used to audit such assets. (Level 2)

No required reading LEVEL 2

What must the auditor consider?

Scenario 9.5-1: Mighty Steel Inc.

Pam, auditor for Mighty Steel Inc., is allocating time estimates for the major activities identified in the audit plan. Based on past experience, she knows that in general, capital assets, unlike inventory, are usually easy to audit and would not normally require a significant amount of audit time, despite the fact that capital assets are typically material in amount and are often the largest single balance on the balance sheet. As a result, the time allocated for the audit of capital assets for Mighty Steel Inc. is not significant. Would you agree or disagree with Pam? Why? Solution

Knowledge of the business

Knowledge of the entitys business specific to the audit of capital assets would normally involve

knowing the types of assets used by the client and their location knowing about assets likely to have been acquired under lease agreements, and understanding managements estimates regarding the fair market value and economic life of those assets understanding the companys policies for capital acquisitions and amortization being aware of any plans for major expansion or downsizing that would likely affect the amounts for capital assets

Analysis
The following exhibit summarizes the analytical procedures used in connection with capital assets.
Exhibit 9.5-1: Analysis of capital assets

Type of analysis Comparing capital asset balances to prior years

Purpose Mainly to identify any changes in capital assets during the year, and whether the level of changes is consistent with the auditors expectations based on their knowledge of the business. To indicate whether amortization expense has been calculated consistently from year to year, and whether capital assets may be overstated or understated.

Comparing amortization expense/capital assets ratio to prior years

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Comparing the balance of repairs and maintenance expense to prior years

Normally used to indicate the likelihood that some capital assets may have been improperly recorded. For example, a large number of repairs relative to prior years might suggest that some transactions that have been expensed should have been capitalized. To see whether the company has spent more on capital projects than they planned to.

Comparing total additions to capital budgets

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9.6 Capital assets Substantive procedures

Learning objective

Summarize the most significant assertions with respect to capital assets, and describe the substantive procedures used to support these assertions with examples of specific substantive procedures. (Level 2)

Required reading

Chapter 12, pages 484485 (Audit 12.1) and 489490 (Audit 12.4), and Exhibit 12B-2 in Appendix 12B (page 508 in the textbook) Forms C-270, C-270C, and C-270S: Property, plant and equipment (BUS) audit program

LEVEL 2

Key assertions for capital assets

Although existence is usually easy to verify for capital assets, it is still an important assertion. The auditor should tour the companys facilities to obtain evidence as to the existence of machinery, equipment, buildings, and so on.
Activity 9.6-1

Unlike for other assets, completeness is important for capital assets. Do you know why? Solution Naturally, the auditor would also give great consideration to ownership. Valuation needs to be examined because the amortization of capital assets should reflect the estimated useful life of the assets and their expected disposal proceeds. Form C-270 and Exhibit 12B-2 provide examples of specific audit procedures for capital assets.

Existence and completeness

To obtain evidence to support existence and completeness, the auditor would accomplish the following:

Obtain a continuity schedule for capital assets and vouch additions and disposals to supporting documentation. A continuity schedule shows the opening balance for each class of assets, the additions and disposals made during the year, the closing balance, and the accumulated amortization for each class of assets. The auditor would agree the opening balance to the prior years audited ending balances, vouch additions to ascertain existence, vouch disposals to ascertain completeness, and agree the closing balances to the general ledger. Review the details of repairs and maintenance for large or unusual items to see if they should be reclassified as capital assets. Tour the plant and other facilities to physically inspect the existence of capital assets.

Ownership
Substantive procedures to support ownership can be summarized as follows:

Review the title documents for significant assets purchased during the year. Enquire of management about liens on capital assets, and review the terms of mortgages, bond indentures, and

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equipment trust certificates.

Review insurance policies to ensure that recorded assets are properly insured. (If clients do not own an asset, they would be unlikely to insure it.)

Valuation
Scenario 9.6-1: Mighty Steel Inc.

Pam, CGA and auditor for Mighty Steel Inc., assigns the responsibility of performing substantive procedures for capital assets to Bob, one of her staff. As part of her instructions, Pam tells Bob, Dont forget, the majority of issues concerning the valuation of capital assets relate to the amortization taken on those assets. Can you help Bob in describing the procedures that can be used to support valuation of capital asset for Mighty Steel Inc.? Solution

Assets under capital lease

Scenario 9.6-2: Mighty Steel Inc.

As part of the procedures for auditing Mighty Steel Inc.s capital assets, Pam is reviewing the leasing agreements for leased assets. Upon review of leasing agreements, Pam finds that there are some capital leases and some operating leases. Why must Pam determine if these leased assets are properly accounted for? What are the main procedures that Pam could perform for her audit of leased assets for Mighty Steel? Hint: Recall the unique features and issues pertaining to capital leases from your intermediate accounting course. Solution

Topic summary
This topic completes the coverage of the acquisition and expenditure cycle started in Module 8. To reinforce what you learned in this module, read through Audit 12.1 (pages 484485) and Audit 12.4 (pages 489490).

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9.7

Production and payroll cycles The basics

Learning objective

Describe the main activities, accounts, segregation of functional responsibilities, and sources of evidence for the production and payroll cycles. (Level 2)

Required reading

Chapter 13, pages 511517 and 523528

LEVEL 2

Production cycle
The production cycle applies mainly to manufacturing operations as they relate to production and payroll. Pages 523 to 525 of the text provide an overview of the main activities and controls in the production cycle. As pointed out in the text, the production cycle interacts extensively with other cycles. Once production planning is set, goods and materials are acquired through the acquisition and expenditure cycle; machinery and factory are obtained through the finance and investment cycle; labour is acquired through the payroll cycle; and inventory is sold through the revenue and collection cycle.
Activity 9.7-1

Exhibit 13-1 on page 513 provides an overview of the main activities of the production cycle. Can you highlight the primary activities for the production cycle? Solution

Functional responsibilities
The functional responsibilities for authorization, custody, recording, and reconciliation of transactions relating to the production of inventory are explained on pages 513 to 515.

Sources of evidence
The manufacturing environment and the cost accounting system provide internal reports on a regular basis. These reports are used by management to assess the production processs adherence to budgets and forecasts. The information produced by the cost accounting system is the basis for estimating the cost of producing inventory, and it is necessary for management to make the appropriate pricing decisions. The reports produced by the cost accounting system provide a source of evidence for the auditors.
Activity 9.7-2

What are the sources of evidence for the production cycle? Solution

Payroll cycle
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The activities of the payroll cycle are described on pages 523 to 525. Exhibit 13-6 on page 523 shows the activities and the functional responsibilities in this cycle and how they interact with other cycles. Payroll is considered a separate transaction cycle because it is present in all organizations and is often large enough to require a separate payroll department. Payroll not only includes salaries and wages, but all the expenses that relate to them, such as employer contributions to EI and CPP, pension benefits, and health care benefits.

Functional responsibilities
As in every cycle, a key element of good internal control is to separate incompatible functional responsibilities. Exhibit 9.7-1 summarizes the functions and responsibilities of payroll.
Exhibit 9.7-1: Payroll functions

Function Personnel and labour relations

Responsibilities Investigate the competence and trustworthiness of potential employees, and authorize hiring and termination, pay rates, and benefits. Supervision Approve and verify time. Timekeeping and cost accounting Prepare and reconcile payroll with production records. Payroll accounting Prepare cheques, employment withholdings, and benefits forms. Payroll distribution Keep physical custody of and distribute cheques to employees.
Scenario 9.7-1: Mighty Steel Inc.

After reviewing the payroll organization chart and functional responsibilities, Pam, CGA and auditor for Mighty Steel Inc., made the following comment to her staff: It is easy to see why these payroll functions should be separated. Why would Pam make this comment? Solution

Sources of evidence
The sources of evidence for the audit of the payroll cycle are described on pages 526 to 528. Other sources of evidence used in conjunction with other cycles, such as cash disbursement journals, bank reconciliations, and cancelled cheques, could also be used in the audit of payroll transactions.

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9.8

Production and payroll cycles Tests of controls

Learning objective

Summarize the control objectives and test of controls procedures for the production and payroll cycles. (Level 2)

Required reading

Chapter 13, pages 517522, 529533, and Appendix 13A, page 547

LEVEL 2

Production cycle
Good internal control over the production cycle is important because it affects the accuracy of the cost of inventory. This cost calculation will ultimately influence pricing decisions, especially where a company follows a policy of achieving a predetermined margin. Poor control over the cost calculations in the production cycle may cause a company to lose its competitiveness because of bad pricing decisions. General control considerations for the production cycle are explained on pages 518 and 519. A significant issue relating to internal control over the production process is proper segregation of duties. To the extent possible (as was the case for the acquisition and payment cycle), purchasing, receiving, and recording should be performed by separate individuals or departments. In addition, receiving and stores should be separate from the other functions as well as from each other. In a manufacturing environment, the stores function is responsible for control over issuance of material to produce finished goods. The key to appropriate control over production, however, is the existence and effectiveness of a cost accounting system. On page 518, the text explains that such a system should include specific procedures designed to cross-check the validity and accuracy of production information. The auditor must gain a good understanding of internal control over manufacturing inventory and the related cost accounting process. In doing so, the auditor would make enquiries of management using an internal control questionnaire such as the one shown in Exhibit 13A-1 on page 547 of the text.
Test of controls procedures

Test of controls procedures are explained on pages 519 to 521. General control objectives relevant to the production cycle are shown in Exhibit 13-2 (page 519), along with examples of corresponding specific procedures. With well-defined control objectives and an understanding of internal control, detailed test of controls procedures such as those in Exhibit 13-3 (page 520) would be designed to test for specific control objectives. Read pages 519-521, which explain the nature of dual direction in the context of the production cycle. Exhibits 13-4 on page 520 and 13-5 on page 521 show how validity and completeness can be verified through the direction of the test.

Payroll cycle
General control considerations for the payroll cycle are explained on page 529. While internal control over the production cycle seems to focus on the accuracy of cost information, internal control over the payroll cycle may need to focus on fraud prevention and detection.
Activity 9.8-1

Payroll fraud can be very significant because payroll is often the largest expense in a company. What are two other reasons why having good internal control in the payroll cycle is important?

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Solution As explained in the text, internal control over the payroll cycle should include an adequate segregation of duties. Also, some control checking procedures should be built into the process. These control procedures include those listed on page 529. Exhibit 13A-2 on page 548 provides an example of an internal control questionnaire that the auditor can use to gain an understanding of the internal controls within the payroll cycle.
Test of controls procedures

General control objectives and examples of specific objectives are listed in Exhibit 13-7 (page 530) and detailed test of controls procedures to support the objectives are presented in Exhibit 13-8 (page 531). The dual-direction aspect of tests of controls is described on pages 530 to 532. As the text explains, the payroll process is usually computerized for most organizations. In testing internal controls, the auditor should develop specific procedures to check the completeness, validity, accuracy, and existence of information contained in reference files and dynamic files.

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9.9

Payroll Substantive procedures

Learning objective

Explain the knowledge of the entity's business that is relevant for the audit of payroll, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2)

Required reading

Chapter 13, pages 533536 (including Audit 13.113.3)

LEVEL 2

Knowledge of the business

As explained in the previous topic, the main issues relating to the audit of payroll centre largely on the existence and effectiveness of internal controls over payroll processing.
Scenario 9.9-1: Mighty Steel Inc.

Pam, CGA, has been assigned to audit Mighty Steel Inc. Pam is trying to determine how critical internal controls are for Mighty Steels payroll processes. In order to do this, she will need to find out more about the business as it relates to payroll. What types of information should she find out in order to make a sound assessment? Hint: For example, the number of employees and the dollar value of payroll. Solution

Analysis
Analytical procedures for payroll consist of comparing payroll accruals/expense to budgets and prior periods, and recomputing payroll accruals and expenses based on other payroll data. For example, the auditor could verify the reasonableness of payroll expense and the year-end accrual by multiplying the number of employees by their average rate. In a situation where payroll is not significant, that procedure alone may provide sufficient evidence of the existence and completeness of payroll. In comparing payroll expense to budgets and to prior periods, the auditor would have to consider any changes in circumstances that might affect wage costs (such as sales and production volume, improvement in technology or investment in productive assets, and so on). For instance, the auditor would need to investigate further if payroll expense is significantly higher than the previous year, yet production and sales are significantly lower than the previous year.

Substantive procedures
Scenario 9.9-2: Mighty Steel Inc.

In assigning tasks for performing substantive procedures for payroll, three of the most important assertions have been identified by Pam, CGA and auditor for Mighty Steel Inc.:

Occurrence: Wages have been paid for work that was actually performed. Valuation: Payroll expense has been calculated using the appropriate wage rates and salaries. Completeness: All payroll liabilities (such as remittances payable, vacation accruals, and benefit accruals) have

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been recorded. Pam will describe the substantive procedures for the occurrence and valuation assertions. Donovan, a member of the audit team, needs to describe the procedures for the completeness assertion. Can you assist Pam and Donovan in their respective tasks? Hint: Completeness is not a primary audit concern insofar as payroll expense is concerned because an employee who is not paid would complain. The concern over completeness is to ensure that payroll-related liabilities are properly recorded. Solution To reinforce what you learned in Topics 9.7 to 9.9, read through Audit 13.1 to 13.3 on pages 533 to 537.

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9.10

Finance and investment cycle The basics

Learning objective

Identify the activities, accounts, segregation of functional responsibilities, and sources of evidence for the finance and investment cycle. (Level 1)

Required reading

Chapter 14, pages 551558

LEVEL 1

The main activities in the finance and investment cycle are financial planning, investing, and acquiring and repaying funds. Funds may have been acquired through financial instruments such as bank loans, bonds issues, and mortgages, or through the issue of company shares. As illustrated in Exhibit 14-1 on text page 554, the activities of this cycle involve interacting with the other cycles. The finance and investment cycle obtains the financial resources to fund the acquisition and expenditure cycle and the production and payroll cycle, and invests the excess funds resulting from the revenue and collection cycle. The accounts included in this cycle are listed in Exhibit 14-1. These accounts are numerous and varied, and may entail complex accounting and reporting issues. For example, financial instruments involve complex recognition, classification, and presentation and disclosure recommendations. These complexities can make this cycle difficult to audit.

Functional responsibilities
The text divides its description of the functional responsibilities for this cycle into two categories:

Sources of funds, such as debt and shareholders capital (text pages 553 to 556 explain the control-related duties for financing) Use of funds, such as investments and intangibles (text pages 556 to 558 explain the control-related duties for investing)

For debt and share capital, the text points out that the transactions involved in borrowing money or selling shares are generally few and for large amounts. For these reasons, all financing transactions during the period may be audited.
Activity 9.10-1

The functional responsibilities for authorization, custody, recordkeeping, and periodic reconciliation should be segregated for this cycle as for the other cycles. Why is segregating the duty for authorization from the other duties and responsibilities a crucial control in this cycle? Solution Another area of risk in this cycle involves recordkeeping. As explained on pages 557 and 558, many account balances are based on management estimates that may be difficult to verify and involve large (therefore material) recorded amounts. Examples include

off-balance-sheet transactions goodwill pension plans future income taxes capital leases, and sale and leaseback capital transactions

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financial instruments, hedging, and derivatives related party capital transactions (for example, loans to management)

All of these transactions or balances represent difficult accounting issues and the auditor needs to review the calculations to ensure that the substance of the transaction is presented in accordance with GAAP if it differs from the legal form of the transaction.

Sources of evidence
The text describes the documents and records associated with the activities in the finance and investment cycle. The documents and records relevant to the audit of this cycle as sources of evidence include the following:

cash flow forecast capital budget minutes of the board of directors meetings corporate code of conduct (if any) contracts, agreements, guarantees, and other commitments shareholder records share certificate book bonds and notes outstanding patents, trademarks investment certificates venture and partnership agreements security certificates

After looking at the control objectives and tests of controls for this cycle, you will learn in Module 10 about the substantive procedures for three account balances in this cycle: investments, long-term debt, and owners equity.

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9.11 Finance and investment cycle Tests of controls

Learning objective

Describe the control objectives and test of controls procedures for the finance and investment cycle. (Level 2)

Required reading

Chapter 14, pages 559565 CAS 402 (CICA Handbook

, section 5310)

LEVEL 2

General controls
In this cycle, the general controls are most at risk because of poor corporate governance practices in many Canadian companies (that is, lack of a competent, independent board of directors). Furthermore, because most of the finance and investment functions are performed by the same few members of high-level management, key functions are not properly separated. Reliance on management to make many critical estimates in this cycle is a source of inherent risk. One way the auditor can get assurance for these estimates is to evaluate the quality of the system for making the estimates. Key procedures that could be part of a companys control over accounting estimates are listed on pages 559 and 560. Control evaluation is explained on pages 559 to 565.
Scenario 9.11-1: Mighty Steel Inc.

Pam, CGA and auditor for Mighty Steel Inc., explains to the CEO that in most large corporations, a major control consideration is the ability of high-level management to circumvent traditional internal controls for the finance and investment functions. Pam asks the CEO, Does Mighty Steel have any compensating controls to address this issue? What compensating controls might the company have in place? Solution A key sign of appropriate separation of duties is who appoints the external auditors. If management does so, then problems may arise. If an independent board of directors representing shareholders interests does so, then less inherent risk is associated with the finance and investment functions. As already stated, a key feature of good internal controls is having an independent board of directors. A major problem in Canada, however, is that such boards are relatively rare, although the trend is toward having such boards, especially in larger companies. For most private companies, the audit time spent on this cycle is minimal because of the small number of transactions and the fact that the owners are also the managers, and therefore, are normally intimately familiar with company operations. For large public or widely-held private companies, there may be a large number of financing and investing transactions of which the board may have limited knowledge. A complicating factor for many audits is the use by a company of a service organization for stock transactions. The existence of an independent registrar and stock transfer agent requires a different approach by the auditor.

CAS 402 (CICA Handbook, section 5310) and service organizations

CAS 402 (CICA Handbook, section 5310) details the audit evidence considerations when an enterprise uses a service organization. Basically, the auditor must decide whether to audit the service organization or whether to rely on the service organizations controls.

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As CAS 402 (CICA Handbook, section 5310) points out, the service organization may have an audit performed on its internal controls; if that is done, the auditor of the enterprise using the service organization will consider relying on the auditors report issued by the service organizations auditor (under section 5970, which is not required reading).

Test of controls procedures

Most transactions related to accounts in the owners equity section must be authorized by the enterprises board of directors. The auditor will verify that the transactions were authorized by examining the minutes of the meetings of the board of directors. Typical transactions include the issue of company shares and the declaration of dividends. With respect to the issuance of debt, Exhibits 14-2 and 14-3 on page 561 outline the control objectives and test of controls procedures for notes and loans payable. As with other liabilities, the completeness objective usually has the highest risk, with the result that auditors tend to focus most of their efforts in corroborating the completeness assertion. If individual transactions are material in amount, each transaction would be audited in detail. However, if there are numerous notes payable, a sample of transactions may be selected for detailed test of controls procedures such as those listed in Exhibit 14-3. As the text points out on pages 559 and 560, tests of controls generally comprise enquiries and observations as to the segregation of duties.
Activity 9.11-1

Why does reliance on internal control have the least impact on substantive tests in the finance and investment cycle? Solution

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Module 9 summary
Explain the knowledge of the entitys business that is relevant to the audit of inventory and describe the types of analysis used to audit inventory.

The auditor should be aware of r the companys raw material and finished goods inventories and their related controls r any motivation to overstate or understate inventories r the life cycle of the products that the entity deals with in order to assess the adequacy of any provision for obsolescence Analysis for inventory includes comparison of gross profit and inventory turnover ratios with the same ratios from prior periods and industry statistics. The auditor should also scan the inventory accounts for unusual or large entries and review the entries to ensure the book figures agree with the quantities on hand.

Identify the most significant assertions with respect to inventory, and explain the substantive procedures used to support these assertions.

The most significant assertions are existence, valuation, and ownership. The auditor establishes the inventorys existence by attending stock-taking and test counting. Inventory held off-site can be confirmed with the holders. Cut-off tests at the end of the period help to verify both existence and completeness. Valuation of inventory is one of the more difficult (and highest risk) areas of audit work. Valuation methods must be established and their consistent application verified. Tests must also be conducted to ensure that the inventory is not valued at amounts in excess of its net realizable value. Documentary evidence should be reviewed to verify ownership of inventories. The most important substantive audit procedure for the audit of inventory is attendance by the auditor at the annual stock taking. The auditor must observe the stock taking unless it is impractical to do so. The auditor should r conduct test counts r verify that all inventory has been counted and included in the inventory summary r verify the cut-off and the condition of the inventory Other substantive procedures involve the auditors verification of the inventory valuation at the lower of cost or net realizable value in accordance with generally accepted accounting principles.

Identify the issues related to the observation of physical inventory counts.

The Canadian Auditing Standards and the CICA Handbook Assurance require that the auditor attend the stock taking and test the quantities, pricing, and clerical accuracy of the inventory, unless it is impractical to do so. After examining the evidence, the auditor must be satisfied that the inventories physically exist in good condition and are owned by the clients business. The auditor must also be satisfied that the declared basis of valuation is being followed and is consistent with the previous periods method of valuation.

Describe the knowledge of the entitys business that is relevant to the audit of manufacturing inventory, and describe the analytical and substantive procedures used to support the most significant assertions.

The auditor should know enough about the business to review adequately the appropriateness and consistency of the methods of valuation.

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Knowing the business also helps alert the auditor to any obsolete inventory. The auditor reviews margins and inventory turnover ratios. The auditor also reviews the manufacturing variance accounts. Large or erratic fluctuations in variances may indicate some valuation problems with manufacturing inventory. The auditors main concern is usually the valuation of the inventory. The auditor must understand the valuation methods and test their consistent application. The auditor also has to verify that inventory is valued at the lower of cost and net realizable value and on a basis consistent with that of prior periods.

Summarize how knowledge of the entitys business is relevant to the audit of capital assets, and describe the analytical procedures used to audit such assets.

Knowledge of the clients business helps the auditor know what types of assets are likely to have been acquired or disposed of. This knowledge also helps when reviewing the adequacy of disclosure regarding lease obligations and capital commitments. Knowing the business helps the auditor verify that the net book value of the capital assets does not exceed their fair value to the business. For purposes of calculating amortization, knowledge of the business helps the auditor when assessing the reasonableness of estimated residual values and asset lives. Analysis connected with capital assets might include r comparing capital asset balances to prior years r comparing the ratio of amortization expense to capital assets to prior years r comparing the balance of maintenance and repair expenses to prior years r scanning maintenance and repair expense for items that should have been capitalized r comparing total additions to capital budgets

Summarize the most significant assertions with respect to capital assets, and describe the substantive procedures used to support these assertions with examples of specific substantive procedures.

The auditor is most concerned with existence, ownership, and valuation of capital assets. The auditor usually obtains a continuity schedule and vouches additions and disposals with supporting documentation. The auditor may physically inspect significant additions. Documentary evidence should be reviewed to establish ownership. The auditor also verifies that disclosure of capital assets is in accordance with Handbook requirements. Typical audit procedures in this area include r vouching additions and disposals r physically inspecting assets r verifying that leases are appropriately accounted for r reviewing amortization calculations and gains/losses on disposal r ensuring that disclosure meets the requirements of generally accepted accounting principles

Describe the main activities, accounts, segregation of functional responsibilities, and sources of evidence in the production and payroll cycles.

The main activities in the production cycle include production planning, authorization, production of goods or services, custody of inventory, recordkeeping, issue of goods, and reconciliation of various records.

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The main activities in the payroll cycle include maintaining personnel records, timekeeping, calculation of payroll, approval of payroll, payment of payroll, remittance of deductions, filing of statutory returns, as well as reconciling pay and production records. The main accounts affected by the production cycle are inventory accounts (including work in process), overhead accounts, variance accounts, labour and material costs, and cost of goods sold. The main accounts affected by the payroll cycle are labour costs, benefits, accrued payroll costs, and bank accounts. The responsibilities for authorization, custody, and accountability should be separated. Combinations of two or more of the duties of authorization, custody, or cost accounting in one person may open the door for errors or fraud. In the payroll cycle, the following five responsibilities should be performed by separate people or departments: r personnel and labour relations r approval of time worked r timekeeping and cost accounting r payroll accounting r payroll distribution Sources of evidence (documentation) in the production cycle may consist of sales forecasts, purchase documents, production schedules, material requisitions, job or product costing records, variance analyses, inventory records, and asset amortization schedules. Sources of evidence in the payroll cycle usually include hiring authorizations, time cards, union agreements, payroll summaries, employee deduction records, labour analyses, and statutory reports (such as T-4 summaries). General control considerations in these cycles include r adequate segregation of duties r proper authorization procedures r appropriate records and documents r preparation of reconciliations r management review of summary documents

Summarize the control objectives and test of controls procedures for the production and payroll cycles.

Control objectives for these cycles include the following: r Recorded production and payroll transactions are valid and documented. r All production and payroll transactions are recorded. r Production and payroll transactions are authorized. r Production job cost records and payroll transactions are accurately calculated. r Labour and material costs are correctly classified as direct or indirect costs. r Production and payroll accounting are complete. r Production and payroll transactions are recorded in the proper period. The auditor should identify the key control procedures established by management to ensure that the control objectives for the production and payroll cycles are achieved. The auditor should assess the extent to which the designed control procedures, if operating effectively, could be relied upon to reduce the risk of material misstatement at the assertion level. The auditor must design test of controls procedures to evaluate the operating effectiveness of those key controls which the auditor proposes to rely upon in the assessment of the risk of material misstatement at the assertion level.

Explain the knowledge of the entitys business that is relevant to the audit of payroll, and describe the analytical and substantive procedures used to support the most significant assertions.

The auditor should have information about the following items related to payroll: r number of employees and dollar value of payroll r frequency and method of payment r compensation structure, including bonuses, commissions, and so on

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r r r

extent of use of casual labour existence of a collective agreement and its terms use of an outside payroll service

Payroll costs should be compared to budgets and prior periods. Fluctuations from month to month should be investigated and verified. The methods of calculating accruals should be reviewed, and the accrued amounts compared to those of the previous year. The auditor is most concerned with validity, completeness, and valuation. Validity is established by tracing employees to personnel records and verifying hours worked from approved timecards, for example. Completeness is verified by testing the cut-off and accruals. Valuation must be tested by tracing rates of pay to collective agreements or approved wage/salary listings.

Identify the activities, accounts, segregation of functional responsibilities, and sources of evidence for the finance and investment cycle.

The main activities in the finance and investment cycle are financial planning, investing, borrowing, and repayment. The accounts affected are short-term and long-term investments, short-term and long-term debts, investment income accounts, interest expenses, accrued interest, and accrued dividends. The functional responsibilities that should be separated are r authorization of investments and borrowing r custody of investments r recordkeeping for investments r periodic reconciliation activities A board of directors independent of management should approve major financing and investing decisions. Sources of evidence for this cycle include r cashflow forecasts r capital budgets r contracts and agreements r shareholder records and share certificate registers r bonds and notes outstanding r joint venture and partnership agreements r investment certificates r registration documents for intangibles, such as patents and trademarks r minutes of the board of directors, authorizing activities within this cycle

Describe the control objectives and tests of controls procedures for the finance and investment cycle.

The control objectives for this cycle are as follows: r Recorded investment and financing transactions are valid and documented. r All finance and investment transactions are recorded. r Finance and investment transactions are authorized. r Finance and investment transactions are accurately calculated. r Finance and investment transactions are correctly classified. r Finance and investment transaction accounting is complete. r Finance and investment transactions are recorded in the proper period. The auditor should identify the key control procedures established by management to ensure that the control objectives for the finance and investment cycle are achieved. The auditor should assess the extent to which the designed control procedures, if operating effectively, could be

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relied upon to reduce the risk of material misstatement at the assertion level.

The auditor must design test of controls procedures to evaluate the operating effectiveness of those key controls which the auditor proposes to rely upon in the assessment of the risk of material misstatement at the assertion level.

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Scenario 9.1-1 solution

If a storeroom is poorly organized, the likelihood of missing important items or double-counting some items could be high. During a physical count, items on consignment may be included in the count when they should not be; items that have been sold and are sitting in the shipping department may be counted when they should be excluded; items purchased and in transit may be omitted from the count when they should be included.

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Activity 9.2-1 solution

For example, a company may use the FIFO or weighted-average method, and/or a periodic or perpetual system; the choice of the method would affect the companys ability to keep track of individual inventory items. Under Handbook recommendations, the basis for the valuation of inventory must be consistently followed from year to year unless the change is caused by a change in accounting standards.

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Activity 9.2-2 solution

For example, a contract may stipulate that all the risks and benefits of ownership pass to the buyer once the merchandise is delivered, while other contracts may stipulate that items not sold within an agreed period will be returned to the seller for a full credit. In addition, goods may be held on consignment, in which case ownership remains with the original owner, not with the company in possession of the goods. In establishing ownership, the auditor will have to review the contracts and agreements under which inventory is acquired and sold. The basic rule is that if legal title for the goods has passed to the client by the year-end date, then the related purchases should be included.

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Activity 9.2-3 solution

FOB shipping point means that the title passes to the buyer (client) as soon as the goods are in transit, whereas FOB destination implies that title passes when the buyer (client) actually receives the goods. The auditor needs to look at the shipping terms and the shipping records in order to establish which inventory in transit belongs to the client. Also, as was the case for other assets, the auditor will have to ensure that there are no liens on inventory, nor that inventory has been pledged as collateral. The auditor would review minutes, loan agreements, and bond indentures for evidence that inventory has been pledged as security.

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Activity 9.4-1 solution

In a standard costing system, auditors would focus their attention on the extent of price and quantity variances revealed in monthly management reports. Consistent large variances or erratic fluctuations in variances may indicate some valuation problems with respect to finished goods and work-in-process inventory. (Large variances should be apportioned between cost of goods sold and ending inventory so that the inventory valuation approximates actual cost.)

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Activity 9.4-2 solution

These procedures include

verifying the quantity and description of raw materials used by reviewing the production reports and the material requisitions for a given item verifying the cost of materials by referring to suppliers invoices verifying the labour hours by referring to production reports and time cards verifying the labour rate applied by referring to payroll records evaluating the reasonableness and consistency of methods used to apply overhead

Once the auditor has verified the unit cost for each type of inventory item using these procedures, the auditor can then proceed to perform pricing tests such as those described in the previous topic. Forms C-240, C-240C, and C-240S list substantive procedures that could be used in auditing manufacturing inventory.

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Scenario 9.5-1 solution

Pam is correct. There are several reasons for this. First, although the balance is large, it is mostly made up of assets that were acquired in prior years and would consequently have been audited in those years. The only amounts to audit in the current year consist of transactions made in the current year, which would normally be few. Also, capital assets are not as easily misappropriated and manipulated as other assets. It is difficult to steal a building without anyone noticing it, or flow fictitious entries through capital assets (to increase or decrease expenses) because these entries would be obvious in an account with a low volume of transactions. Normally, a substantive approach should be used for capital assets, and all significant transactions should be audited. This approach is most efficient because there are few transactions to audit, and testing controls for such a small amount of transactions would take more time than to audit them all directly.

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Activity 9.6-1 solution

Completeness is important for capital assets because an unrecorded capital asset may very well be expensed in an effort to manipulate net income or reduce income taxes.

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Scenario 9.6-1 solution

Valuation can be supported by the following procedures:

Review invoices and contracts to ensure that the recorded value of assets corresponds to the costs and prices shown on the documents. Assess the adequacy of the clients procedures to determine the estimated useful lives and residual values of capital assets, and vouch the useful lives used to supporting documentation. Assess the adequacy of methods used to calculate amortization, and recompute amortization using those methods to ascertain the amount of amortization is reasonable. Determine whether disposed assets are properly removed from the records. Ensure leased assets and obligations are properly accounted for. Determine that assets without future benefits have been written off for impairment. Review property tax assessments (for ownership and valuation).

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Scenario 9.6-2 solution

Pam must determine whether a leased asset should be treated as a capital or an operating lease. The primary concern is that a client may be inclined to do some off-balance-sheet financing by recording lease payments for capital leases as operating expenses. The main procedures that should be used for leased assets include the following:

Determine whether the lease terms meet the criteria for a capital lease. Consider the estimates made regarding the useful life of the assets under lease. Determine the reasonableness of estimates for the fair market value of assets under lease. Determine the appropriate discount rate to be used in the calculations. Ensure that the disclosure requirements of the Handbook have been adhered to.

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Activity 9.7-1 solution

The primary activities of the production cycle are

production planning, usually starting with sales forecasts inventory planning, including the purchase of material and the allocation of overhead cost accounting to determine the unit cost of finished goods and work in process, and the production of units

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Activity 9.7-2 solution

Sources of evidence for the production cycle include

sales forecasts production plans and reports on cost variances amortization schedules for capital assets material requisition forms suppliers invoices for raw materials, and payroll records to determine the application of labour to inventory

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Scenario 9.7-1 solution

If a supervisor was allowed to hire people, authorize the time worked, and distribute the cheques, there would be no way to control the hiring of a relative and paying for non-existent work. Or if an employee was to quit and the supervisor failed to report it, the two of them could share the employees pay for work not being performed. Payroll fraud can be as simple as someone punching in a time card for a co-worker who comes in late or leaves early.

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Activity 9.8-1 solution

Payroll processes a large amount of detailed information in a very short period of time. The outcome of the process must be timely and accurate; that is, employees must receive their pay on time. A number of statutory remittances, such as income taxes, EI, and CPP, must be calculated on the basis of payroll information. Again, these amounts must be accurate and remitted on a timely basis.

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Scenario 9.9-1 solution

In gaining the appropriate knowledge of business for payroll, Pam would consider

the size of payroll and the number of employees in the company the frequency of payment used by the company and the industry, such as bi-weekly, semi-monthly, and monthly payrolls the compensation structure in the company and the industry, such as the existence of commissions and bonuses the extent to which casual labour is used by the company and the industry the existence of a collective agreement and the nature of the bargaining process, and the use of outside payroll services.

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Scenario 9.9-2 solution

Pams answer: Occurrence and valuation The substantive procedures to support the occurrence and valuation assertions are as follows:

Verify authorized wage and salary lists to approved time records, production analyses, employment contracts, and collective agreements to ensure employees are paid at the correct rate. Ensure correct deductions have been taken by reviewing TD1s and documents relating to benefits premiums in employee personnel files. Agree cancelled cheques to payroll records to ensure that names, addresses, and amounts correspond to employee files. Enquire about employees who have left during the year and verify that those individuals have been properly removed from payroll records. Observe an actual distribution of payroll cheques (or pay stubs if payroll is directly deposited to the employees bank accounts) to ensure that employees actually exist.

Donovans answer: Completeness Since the concern over completeness is to ensure that payroll-related liabilities are properly recorded, these are the main substantive procedure for completeness:

Review external documents from Canada Revenue Agency (such as form PD7A Statement of account for current source deductions). Verify the methods used to calculate payroll accruals. Perform recalculations to ensure the amounts are reasonable.

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Activity 9.10-1 solution

First, consider managements obligation to act in the best interest of owners and shareholders. Specifically, failure to appoint an independent board of directors (that is, independent of management), whose function is to serve the owners interest (shareholders) and to monitor management, can result in significant risks of management not necessarily acting in the best interests of the owners. For this reason, major financial and investing decisions by management should be approved by an independent board to make sure they are undertaken in the shareholders best interest. Second, consider the possibility that the auditors may disagree with management on a reporting issue. Auditors can be put in an untenable position if they disagree with management on a reporting issue and have no independent board of directors or audit committee to turn to in order to resolve the matter. Finally, consider a situation where the auditor thinks management is involved in defrauding shareholders and the auditor can only report this to a board or audit committee filled with management or friends of management. This underscores why management integrity should be one of the first considerations before the auditor accepts the engagement.

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Scenario 9.11-1 solution

The CEOs answer: Our compensating control is to have an independent board of directors with the expertise and resources to monitor management more closely. This approach includes having an independent audit committee reporting separately to an independent board and various other committees, such as a compensation committee and an investment committee that also report directly to the board.

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Activity 9.11-1 solution

Reliance on internal control has the least impact on substantive tests in the finance and investment cycle. This is because most substantive procedures involve testing all of the transactions and balances as individual transactions are usually material in amount. However, the text explains on page 564 and 565 that the nature and timing of substantive procedures may be affected by poor controls. For example, increased audit effort may be required to develop the auditors own estimates when managements estimation process is considered unreliable.

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Module 9 self-test
Question 1
Lyson Ltd.s internal control procedures require an employee from the treasurers office to periodically hand out all payroll cheques. Employees who are not there to receive their cheques must pick them up at the treasurers office. Explain the purpose of this control. Solution

Question 2
Review checkpoint 13, page 522 Solution

Question 3
Review checkpoint 10, page 522 Solution

Question 4
Review checkpoint 9, page 565 Solution

Question 5
Review checkpoint 6, page 558 Solution

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Self-test 9 Solution 1

The purpose of this control is to ensure that employees receiving payroll cheques are bona fide employees. If there is a lack of segregation of duties between the personnel department, timekeeping and payroll preparation, and the payment of payroll, there is a danger that a dishonest employee or employees could be collecting pay for fictitious employees. Requiring the treasurers office to distribute the payroll on a random basis provides a separation of duties and helps guard against this type of fraud. All uncollected cheques should be investigated.

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Self-test 9 Solution 2

Obviously, auditors must be knowledgeable about cost accounting to audit a manufacturing company. The first general standard requires adequate technical training and proficiency as an auditor and the third general standard requires due professional care. In a manufacturing company, inventory will most likely be a major asset that will require substantial audit work. A proficient auditor must be knowledgeable in all phases of the business, including production, marketing, and finance, as well as accounting data processing and cost accounting.

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Self-test 9 Solution 3

These are the primary functions that should be segregated in the production process:

Authorization (production planning and inventory planning) should be performed by persons who do not have custody, recording, or cost accounting and reconciliation duties. Custody of inventories (raw materials, work in process, and finished goods) should be in the hands of persons who do not authorize the amount or timing of production or the purchase of materials and labour, do not perform the cost accounting recordkeeping, or do not prepare cost analyses (reconciliations). Cost accounting (a recording function) should be performed by persons who do not authorize production or have custody of assets in the process of production. (However, you will usually find that the cost accountants prepare various analyses and reconciliations directly related to production activities.)

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Self-test 9 Solution 4

A compensating control is a control that is used when a standard control procedure (such as strict segregation of functional responsibilities) is not implemented by the company. In the area of finance and investment, a compensating control feature is the involvement of two or more persons in each kind of important functional responsibility. If involvement by multiple persons is not possible, then oversight or review can be substituted. For example, the board of directors can authorize purchase of securities or creation of a partnership. The CFO or CEO can carry out the transactions, have custody of certificates and agreements, manage the partnership or the portfolio of securities, oversee the recordkeeping, and make the decisions about valuations and accounting (authorizing the journal entries). These are normal management activities, and they combine several responsibilities. The compensating control can exist in the form of periodic reports to the board of directors, oversight by the investment committee of the board, and internal audit involvement in making a periodic reconciliation of securities certificates in a portfolio with the amounts and descriptions recorded in the accounts.

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Self-test 9 Solution 5

To obtain relevant audit data about investment securities, auditors procedures include the following steps:

Inspect the securities in the presence of a responsible client officer. Personally examine the securities while other negotiable fund sources are sealed off or are being examined simultaneously. Obtain a written statement from the clients representative that the securities were returned intact. Obtain the information by confirmation from an independent party (for instance, trustee) who holds the securities.

Also see Exhibit 14A-3 on text page 588.

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