Week 11 Chapter 10 5 questions: 10.26, 10.27, 10.29, 10.

34,
10.36
10.26 Inventory valuation
(a) An auditor tests for NRV (net realisable value) because the accounting standards (AASB
102 Inventories) require inventory items to be measured and disclosed at the lower of cost and
NRV.

(b) A key item in this context is an inventory item that has a major effect on the total inventory
balance. The switches are a key item because there are 2000 in stock, with a total stock value
of 10,000. The other items selected for testing are also listed. The auditor has taken a
representative sample of each of these to determine if they are fairly priced. The auditor tests
the selling price less distribution costs against the unit price (cost). For example, for covers
the unit price is 15, the selling price is 45, less distribution costs of 1. This means that the items
cost is below NRV.

(c) One item has an NRV below cost. Routers have a unit cost of 540, and there are 25 items
in stock, giving a total value at cost of 13,500. In this case, the selling price is only 420. The
total variance (difference) is 121, including the cost of distribution shown in column
Distribution costs. Therefore, the routers have a NRV below cost. The total inventory should
be written down by 3,025. Note A in the comments shows that the amount for the
obsolescence or write-down of the routers is included with other stock items, and that the
amount was correctly provided for by the client.

10.27 PPE additions and disposals

(a) Additions and disposals are directly linked to the PPE asset account, so evidence on the
assertions for additions and disposals is also relevant to the asset account.

For key assertions relating to additions to PPE:

Occurrence (additions which are recorded during the period are PPE acquired
during the period).
Cut-off (additions are recorded in the correct period).
Classification (additions are recorded at the correct asset (PPE) account).
Completeness (additions that occurred during the period have been included or
recorded).
Accuracy (additions are correctly journalised or posted).

For key assertions relating to disposals to PPE:

Occurrence (disposals which are recorded during the period are PPE disposed
during the period).
Cut-off (disposals are recorded in the correct period).
Classification & Understandability (disposals are recorded in the correct account
and disclosed in the financial report).
Completeness (disposals that occurred during the period have been included or
recorded).
Accuracy (disposals are correctly journalised or posted).
(b) The additions relate to the purchase of a new delivery van and work on an asset under
construction. The asset under construction will not be depreciated until it is ready for use,
however, the depreciation of delivery van commences from its purchase date.

(c) The disposal relates to a delivery van. It had a gross book value of 420 and an accumulated
depreciation of 280 which left a net book value equal to 140. If the selling price was 75, this
resulted in a loss on disposal of 65. The auditor has made a note that the loss on disposal of the
van is material. This is relevant because as the note suggests, it provides evidence that the
company may not be using a reasonable depreciation rate. Therefore, the auditor is not
confident that the depreciation expense is neither understated nor overstated for the period.
More testing of depreciation is required.

10.29 Designing audit procedures for cash

(a) Controls should include:

Separate bank deposit books and cheque books for each cash account.
Bank reconciliations for each bank account.
Segregation of duties banking, reconciliations, cheque authorisation, posting to
customer ledger accounts, and segregation of these duties from staff performing
tenancy search and management services.
Accountability/reconciliation of numerical sequence of all forms (cheques, deposits,
vouchers).
Mail opening procedures (for any amounts received by post) two people, listing,
reconciliation with bank deposits.
Supervision of customer ledger postings.
Specific procedures for dealing with trust account additional authorisation
procedures.

(b) Cash is a significant account balance for this business substantive procedures include:
Bank confirmations of all bank accounts and liens.
Testing bank reconciliations.
Confirm signatures on cheques for correct authorisation.
Testing cut-off for cheques remitted to customers (reconcile with customer accounts)
and transfers between cash accounts (especially to ensure that withdrawals and deposits
for account transfers are recognised on the same day).
Correlate cash receipts and cheques to movements in customer accounts.
Compare paid cheques and supporting documents with cash payments ledger confirm
dates, payees, amounts, account classifications, and cancelling of supporting
documents.
Compare entries in cash payments ledger with paid cheques and supporting documents
to confirm dates, payees, amounts, account classifications, and cancelling of supporting
documents.
Compare entries in cash receipts ledger and supporting documents to tenants accounts.
Test calculations of commission before remittance of rental payments to landlord
customer.
Investigate for any unusual delays in remitting rental payments to landlord customers.
Test mathematical accuracy of cash receipts, cash payments ledger.
 Test supervision reports for evidence of timely review, authorisation, and evidence of
follow-up of differences.

10.34 Substantive testing of PPE

(a) An increase in PPE acquisitions suggests that the risk would be related to overstatement of
PPE (existence and valuation and allocation assertions). The analytical procedures have
detected a fluctuation which could be explained by the large investment in a new manufacturing
process. The auditor needs to consider if the increase is consistent with this investment. It is
possible, for example, that old equipment is being disposed of and the overall balance of PPE
is not excessive. The acquisitions need to be assessed for their appropriate valuation in the
accounts. Are the acquisition costs to be treated as capital, or are there costs associated with
the acquisitions that should be expensed? Is any part of the cost of purchase to be written off
as an impairment charge to recognise the recoverable value?

Another assertion that is at risk when there are increased PPE acquisitions is rights and
obligations. Are the new acquisitions being purchased or are they being acquired under lease
or other forms of finance? Are there additional disclosures required to recognise these financing
arrangements?

(b) Substantive tests of details that would be appropriate include:

Recalculation of new depreciation charges, consideration of underlying assumptions of
useful life, residual value etc. (V&A).
Inspect authorisations for acquisitions (R&O).
Examine cash payments, invoices for new acquisitions (V&A).
Compare actual costs with authorised costs (E, V&A).
Inspect assets (E) and vouch entries in fixed asset register (E).
Test mathematical accuracy of fixed asset register (V&A).
Review documents relating to finance for fixed asset acquisitions (R&O, V&A),
evidence of ownership (R&O) and review financial report disclosures (C&U).
Consider likelihood of continued production using new assets (V&A).

(c) If the PPE additions have been manufactured in-house the auditor should focus on the
process of assigning costs to the assets. Therefore, instead of reviewing documents relating to
evidence of ownership of the asset or its purchase, the auditor would focus on testing the data
and assumptions supporting the manufacturing cost allocations. The auditor would still be
concerned with gathering evidence to support the existence and valuation and allocation
assertions.

10.36 Accounts receivable ledger

(a) Internally generated documents are often numbered consecutively. The numbers provide a
convenient reference for the audit trail. For example, the sales invoice number is used to
identify the document underlying the transaction entered into the sales journal. In addition, a
missing number(s) reveals a document has been omitted from the records, or duplicated
numbers reveal that a document has been entered twice in the records.

The control is stronger if the numbers are pre-printed on the forms or automatically numbered
in sequence by the software program when the invoice is generated. This will prevent from
duplication. For example, when sales invoices are entered consecutively in the sales journal
and a number appears twice, there is an error because two valid invoices cannot have the same
number. If the sales invoices in the sales journal omit a number, the original document should
be accounted for (i.e. the document is cancelled and filed in a cancelled document file).

The numerical sequence is also useful for testing cut-off assertion. The auditor should establish
the last valid number for the current financial year and ensure that all documents for previous
numbers are recorded in the current year, and all subsequent numbered documents are recorded
in the next financial year.

All documents mentioned are internally generated documents and should be pre-printed on
forms which are completed manually or pre-numbered by the computer software when the
electronic form is generated.

(b) Credit memos are the documentary basis for a credit to debtors and a corresponding debit
to sales returns and allowances. These adjustments result in a decrease in debtors balances,
increase in expense or decrease in revenue. The effect of this reverses a recorded sale. The
greater audit risk for debtors and sales relates to their overstatement, thus the auditors are
particularly interested in any evidence of an invalid recorded sale.

Victoria would ensure that credit adjustment resulting from credits to debtors and debits to
sales returns and allowance are made following the year-end to reverse invalid sales recorded
in the current financial year. These reversals could be posted after year-end (perhaps the month
after year end which is July) Therefore, evidence about the validity of sales returns in July will
also provide evidence about the validity of sales prior to year-end.

(c) Victoria would undertake some substantive testing herself due to the following reasons:
Audit assistants are inexperienced and less likely to detect unusual relationships
because they are not familiar.
Lack the experience of identifying with what are usual and unusual items.
In some cases, a lack of fluctuation in an account raises more doubts than a
fluctuation because other evidence suggests that the account balance should be
different.
A more senior or experienced auditor would have a better understanding of how
non-financial information relates to financial data.

Other tasks usually performed by more senior auditors would be:

interviewing senior client personnel, including directors to obtain access to confidential
documents and board meeting minutes. A junior auditor may have difficulty
understanding discussions regarding corporate governance matters
communicating with external parties such as solicitors about complex matters
making judgement estimates, such as the provision for doubtful debts
speaking to experts about valuations
auditing complex accounts, such as derivatives,
auditing disclosures such as related parties,
reading contracts between the client and its customers/suppliers/employees
reading contracts for leasing of PPE.