F8: Illustrative case study

- relevant to F8

Arnold Scwarzenegger was blur (just about everything) about how to explain to his nephew Donald Duck on audit of payroll section in his Californian government departments. The muscle man has asked you:

a) ummmm... duh* what should auditors look to achieve in audit assertion work relating to payroll? [4]

b) Descibe the procedures that can be used to ensure for a better payroll system. Demonstrate situations on improving the system. [4]

SUGGESTED ANSWER GUIDELINES
a) auditors seek to :
- wages are properly calculated
- employees are paid ensuring no phantom employees
-proper recordings are made and accounted for in the ledger payroll and correct classification
- proper deductions that are authorised and approved by employees and required by government

b) Exam approach : state on controls systems can be improved looking at Control Environment

state on control objectives / procedures to have stronger internal operations that is correct, accurate, appropriate, segregation of duties, authorised.

Demonstrations:

Control environment :
Competence match to employees salary

Application to PAYMENT : compare specific employee salary to industry average by enquiring of managers or industry expert for reasonableness test.

Control objectives :

Correct amount are paid to the respective employees.

Application to SETTING SALARIES & WAGES: check that all amount paid to employees that are banked in correspond with the payroll summary sheet generated from payroll department.

ISA 315 : Understanding Control Environment and Control Activities

- relevant to F8 (ACCA)





WARRIOR :
Macro approach (Control Culture) : Alert to dangers. Suspicious of enemies
Micro approach (Control activities) : He puts many guard soldiers, spies and dispatchers to secure his army

ISA 315 Understanding the entity and its environment and assessing the risks of material misstatement deals with the whole area of controls. It requires that auditors 'obtain an understanding of the entity and its environment, including its internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures'.
The ISA states that internal control has five elements:
1. The control environment
2. The control activities
3. The entity's risk assessment process
4. The information system
5. Monitoring of controls

control environment above looks at the management "CULTURE" as to controls assessing management's toleration level of poor controls

contrasts with

control activities are "PROCEDURES" which are micro managing internal controls

CONTROL ENVIRONMENT – management’s attitude and firm’s culture toward controls

Control environment is governance and management functions and the attitudes, awareness and actions of those charged with governance and management concerning the entity's internal control and its importance in the entity.
The ISA requires auditors to 'obtain an understanding of the control environment'.

CONTROL ENVIRONMENT

COMMUNICATION ENFORCEMENT - ethical values
Essential elements which influence the effectiveness of the design, administration and monitoring of controls
COMMITMENT COMPETENCE
Management's consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge
GOVERNANCE
Independence from management, their experience and stature, the extent of their involvement and scrutiny of activities, the information which they receive, the degree to which difficult questions are raised and pursued with management and their interaction with internal and external auditors
MANAGEMENT'S PHILOSOPHY
Management's approach to taking and managing business risks, and management's attitudes and actions toward financial reporting, information processing and accounting functions and personnel
ORGANISATIONAL STRUCTURE
The framework within which an entity's activities for achieving its objectives are planned, executed, controlled and reviewed
AUTHORITY AND RESPONSIBILITY
How authority and responsibility for operating activities are assigned and how reporting relationships and authorisation hierarchies are established
POLICIES AND PRACTICES
Recruitment, orientation, training, evaluating, counselling, promoting, compensating and remedial actions


CONTROL ACTIVITIES - POLICIES AND PROCEDURES
PURPOSE : Control activities include those designed to prevent or to detect and correct errors. Examples include activities relating to authorisation, performance reviews, information processing, physical controls, segregation of duties.

CONTROL
Transactions should be approved by an appropriate person.
For example, overtime should be approved by departmental managers.
CONTROLS
The ISA requires the auditor to 'obtain an understanding of how the entity has responded to risks arising from IT'. We shall look at computer controls
CHECKING & ACCURACY
checking to see if individual invoices have been added up correctly.
MAINTAINING REVIEWING
Control accounts bring together transactions in individual ledgers. Trial balances bring together unusual transactions for the organisation as a whole. Preparing these can highlight unusual transactions or accounts.
RECONCILIATIONS
Reconciliations involve comparison of a specific balance in the
accounting records with what another source says the balance should be, for example, a bank reconciliation. Differences between the two figures should only be reconciling items.
COMPARING the results of cash, security and inventory counts with accounting records
in a physical count of petty cash, the balance shown in the cash book should be the same as the amount in the tin.
COMPARING internal data with external sources of information
For example, comparing records of goods dispatched to customers with customers' acknowledgement of goods that have been received.
AUTHORISED physical access to assets and records
Only authorised personnel should have access to certain assets
(particularly valuable or portable ones).
-ensuring that the inventory store is only open when the store personnel are there and is otherwise locked.
This can be a particular problem in computerised systems.
SEGREGATION OF DUTIES
(a) Segregation of function. The key functions that should be segregated are the carrying out of a transaction, recording that transaction in the accounting records and maintaining custody of assets that arise from the transaction.
(b) Segregation of various steps in carrying out the transaction should also be segregated.
(c) Segregation of accounting operations - the same staff should not record transactions and carry out the reconciliations at the period-end.

the above are crucial to APPLY say in a payroll environment :
1. auditors need to assess if the control [culture] is appropriate when handling cash payment for wages
2. auditors need to assess if the control policies of say in
(i) PAYMENT OF WAGES : all total hourly wages paid are verified by supervisors, hours claimed overtime are authorised, time sheets reviewed and reasonable hours claimed.
(ii) DEDUCTIONS : review of pay deductions printouts and checked and casted for accurate deductions

Note that the control activities are applied in the context of the 4 boxes of logical payroll sequence. Alan Lewin can easily apply the same control environment and control activities in other scenarios like client's receivables and payables sections .

CONCLUSION
exam could test you on what AUDIT PROCEDURES i need to take as in "TESTING OF CONTROLS" ensuring that you are satisfied that wages processes are adequately carried out like you are satisfied with degree of authorisation and segregation of duties to reduce fraud and minimise errors. In short, what steps should an auditor do to assert the payroll system adequacy?

However, another question style is "Can you investigate if you are satisfied with its current internal controls which is this case tell me what is the management culture and the type of policies they use?" examiner takes a step further as "Now you found so many weaknesses in the (lazy and lousy) management, can you suggest improvements?" This type of question is on test of controls based on ISA 315. (please see notes 9 & 10).

Please practice questions on Test of Controls on Payroll, Purchases and Sales system that we have done in our tutorials

AUDITORS' PROCEDURES : TESTS OF CONTROLS ON PAYROLL

-relevant to F8 (ACCA)



If you are asked as to what steps you would take to ensure that payroll system is adequately installed of its internal controls, as an AUDITOR you could systematically take following steps. Remember, use key items like payroll lists, bank statements and specific documents to tailor made in your "application". merely regurgitating the following carries little or no marks.



STEP 1 : SETTING SALARIES & WAGES
AGREEING calculation of gross pay with:
· Authorised rates of pay
· Production records. See that production bonuses have been authorised and properly calculated
· Clock cards, time sheets or other evidence of hours worked.
·Verify that overtime has been authorised

VERIFY that gross salaries and bonuses are in accordance with
· personnel records,
· letters of engagement and
· increases in pay have been properly authorised.

STEP 2 : PAYMENTS
wages paid in cash
• Arrange to attend the pay-out of wages to confirm that the official procedures are being followed
• Examine receipts given by employees: check unclaimed wages are recorded in unclaimed wages book
• Check that unclaimed wages are banked regularly by inspection of bank statements and supporting documentation
• Inspect that unclaimed wages books to check it shows reasons why wages are unclaimed
• Review pattern of unclaimed wages in unclaimed wages book; variations may indicate failure to record
Holiday pay
• Verify a sample of payments with the underlying records and check the calculation of the amounts paid

For salaries, auditors should test that comparisons are being made between payment records and they should themselves examine paid cheques or a certified copy of the bank list for employees paid by cheque of banks transfer.

STEP 3: RECORDING
WAGES, reconciliations with:
· The previous week's payroll
· Clock cards/time sheets/job cards
· Costing analyses, production budgets

POINTS TO NOTE:
üThe total of salaries should be reconciled with the previous week/month or the standard payroll.
üconfirm that important calculations have been checked by the clients and re-perform those calculations.

REVIEW wages for a number of weeks:
· Additions of payroll sheets
· Totals of wages sheets selected to summary
· Additions and cross casts of summary
· Postings of summary to general ledger (including control accounts)
· Casts of net cash column to cash book

STEP 4: DEDUCTIONS
RE-PERFORM the calculations of taxation and non-statutory deductions. For income tax they should carry out the following tests.
· Scrutinize the control accounts maintained to see appropriate deductions have been made
· Agree that the payments to the taxation bodies are correct

POINTS TO NOTE
üThey hould agree other deductions to appropriate records.
üFor voluntary deductions, they should inspect the authority completed by the relevant employees.

EXAM TIPS : AUDIT EVIDENCE & GOING CONCERN

- Relevant to Paper 8 (CAT) and F8 (ACCA)




PIC 01: AUDIT EVIDENCE EXPERIMENTED


AUDIT EVIDENCE & GOING CONCERN
The primary objective of an audit of financial statements is to enable the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. The audit evidence he has gathered, which enables the auditor to express his opinion.
Auditors obtain sufficient, appropriate audit evidence. Evidence can be in the form of tests of controls or substantive procedures.

ISA 500 AUDIT EVIDENCE
The reliability of audit evidence is influenced by its source and by its nature.
ISA 500 Audit evidence requires auditors to 'obtain sufficient, appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion'.
· Sufficiency is the measure of the quantity of audit evidence.
· Appropriateness is the measure of the quality or reliability of the audit evidence.
The quantity of audit evidence required is affected by the level of risk in the area being audited. It is also affected by the quality of evidence obtained. If the evidence is high quality, the auditor may need less than if it were poor quality. However, obtaining a high quantity of poor quality evidence will not cancel out its poor quality.

Crucial to audit assertion work is that the company does not have evidence of financial distress that risk it as a going concern position.



PIC 02 & 03: Businessman is out of business. Are you aware?


ISA 570 : GOING CONCERN - AUDIT WORK
When planning and performing audit procedures and in evaluating the results thereof, auditors should consider the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements, and consider any relevant disclosures in the financial statements.
– Review management’s plans for future actions based on its going concern assessment.
– Gather additional sufficient and appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists regarding the going concern concept.
– Seek written representations from management regarding its plans for future action.
– Obtain information from company bankers regarding continuance of loan facilities.
– Review receivables ageing analysis to determine whether there is an increase in days which may also indicate cash flow problems.

ANSWERS RELEASED! Auditors Appointment & Professional Ethics

Oilcorp Berhad : Auditors professional ethics in practice.
- Relevant to F8(ACCA) and P1 (ACCA)
- PLEASE CAREFULLY CHECK THE ANSWERS "AFTER" YOU ATTEMPTED THEM



BTMH (Baker Tilly Monteiro Heng) asserts that Oilcorp client is overestimating its valuation of biofuel plant by RM10million to RM110million. The client insisted that was the fair valuation. However, BTMH replied that there was insufficient audit evidence and the sum in dispute of RM10 million is material that will impact on Oilcorp Berhad’s earnings.


Picture : Oilcorp's EGM to remove BTMH auditors

Oilcorp resorted to take another auditor, Horwath, to make an independent report on the findings. The latter gave a report consistent with company’s directors valuation of the asset. This pits both accounting firms against each other. BTMH countered that Horwath didn’t explain the inconsistencies it discovered.

Criticism from analysts is that Horwath has self-interest as it is given the offer to take the appointment as new auditors the client. The client announced that it wanted to replace BTMH through an EGM. Naturally, Horwath defended that their report is "strictly professional" and is ready to accept the appointment as Oilcorp’s new auditors. Shouldn’t the firm still decline the offer as they should also must be seen as independent?

Interesting twist to the ongoing politics, Horwath declined the new appointment as BTMH failed to give it professional clearance. Stating advice from the Malaysian Institute of Accountants, Howarth said a new external accountant must obtain the consent from the auditor it was replacing before it could take over.


Discursive issues:
a) What are the professional ethics principles that oblige auditors? Are there any threats? If so, are there any associated safeguards that you identified as threats? [12 marks]


b) What are the proper procedures for appointing new auditors? [8 marks]

Additional References :


Doreen Leong, 2008, theedegedaily.com, http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_4dcbdea3-cb73c03a-9c8c3f00-b27cccce, Visited on : 4th August


Doreen Leong & Jonathan Lim, theedegedaily.com, http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_48e5c0be-cb73c03a-d964af00-1b7200c3, Visited on : 4th August

Thestar, 2008, Bursa action against Oilcorp,
http://biz.thestar.com.my/news/story.asp?file=/2008/7/23/business/21895512&sec=business, Visited on : 4th August

Jagdev Singh Sidhu and Loong Tse Min, 2008, Oilcorp EGM Over Accounting Dispute Open To All, http://biz.thestar.com.my/news/story.asp?file=/2008/7/22/business/21884466&sec=business, Visited on : 4th August

Doreen Leong, 2008, BDO to take up role as Oilcorp’s auditor http://www.theedgedaily.com/cms/content.jsp?id=com.tms.cms.article.Article_bf127b3a-cb73c03a-cbd8dc00-e628a126 , 14th August