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Exploring the Four Stages of the Audit Process: Case Study

Internal Audit is an independent function that provides an objective assurance and consultancy activity to improve and add value on an organization’s operation. The auditors aim to help the Merami Berhad accomplish its objectives by evaluating the effectiveness of its risk management, control, and governance processes by bringing a discipline, systematic approach. The audit process is divided into four stages which are Planning (Preliminary Review), Fieldwork, Audit Report, and Follow-up Review. One of the main key objectives to carry out an audit is to minimize the time and avoid disrupting ongoing activities.
As we are a public accounting firm for Merami Berhad for the past five years. Meramin Berhad is a public listed company, whose sales for the year 2009 were over RM 25 million. The audit fees we normally charge to Merami Berhad are RM 50,000. Before an audit is assigned to staff, the auditor must consider a few matters such as the size of the company to be audited. If it is a Public Listed Company, 3 or 4 staff will be required. Besides that, the budget is very important as the auditor are always advised to stay within the budget so that the audit fees is sufficient to cover all the cost incurred especially the disbursements. The auditor should also consider about the deadline. An audit assignment usually has very tight deadlines and therefore staff must ensure that the Audit Report is submitted to the Partner of Review on time so that the signing of accounts is not delayed.
When the audit manager assigns a job to the senior, the first thing the senior does is to meet with his team members to discuss about the job and to delegate duties to the respective members. The audit assistant will normally be asked to retrieve the previous year’s file of the company from the filling room. The previous year file is always used as a guide only. Staff must always tailor-make the audit for the year according to the events that occurred during the year. Once the last year’s file is retrieved, a new file will be opened for the current year’s audit.
STAGE 1: PLANNING (PREMILIRARY REVIEW) Planning is essential as this is the first time we understand Merami Berhad business and their controls in the company. During the planning stage of the audit, the auditorwill contact the client to notifythem of an upcoming audit and to schedule a time during the year that is most convenient for the audit to commence and take place. The auditor will send them a preliminary checklist. This is a list of documents (e.g. organization charts, financial statements) that will help the auditor learn about their unit before planning the audit. After reviewing the information, the auditor will plan the review, conduct a risk workshop primarily to identify key risks and raise risk awareness, draft an audit plan, and schedule an opening meeting.
Engagement Letter
Merami Berhad is informed of the audit through anannouncement or engagementletter from the Internal Audit Director. This letter communicates the scope and objectives of the audit, the auditors assigned to the audit, the audit methodology used in the audit and other relevant information. This letter serves as a contract which outlines the responsibilities of the auditor and client to prevent any unnecessary misunderstanding of what is expected or required of the other party. The auditor and the client must also agree on the terms of the engagement.
Opening Conference
Nearer the start of the audit, the auditor will arrange a meeting with Merami Berhad to discuss the scope and objectives of the audit. The opening conference should be held to gather information about the mission, critical processes, and control procedures of the unit to be used in the preliminary survey process. The opening meeting should include senior management and any administrative staff that may be involved in the audit. Merami Berhad describes the unit or system to be reviewed, the organization, available resources (personnel, facilities, equipment, funds), and other relevant information.
The audit senior usually discusses with the client about the company’s performance for the year in terms of increase or decrease in profitability. This may due to factors ranging from launching of new products during the year to high-position staffs leaving the company. These will all be documented in the Business Understanding Document.
The internal auditor meets with the senior officer directly responsible for the unit under review and any staff members he wishes to include. It is important that the client identify issues or areas of special concern that should be addressed. The time frame of the audit will be determined, and we should discuss any potential timing issues (e.g. vacations, deadlines) that could impact the audit. The opening conference is an important step in a regular audit. It is an opportunity to establish the proper tone and to begin building good relationships.
Preliminary Survey
In thisphasethe auditor gathers relevant information that they have gained from the opening conference is used in conjunction with other relevant information about the unit in order to obtain a general overview of operations. He talks with key personnel and reviews reports, files, and other sources of information. This may include information on budgets and strategic plans as well as past audit reports. There are certain risks that the auditor will always review to ensure that they are being adequately controlled and managed – these include financial transactions, local risk management and business continuity planning.
Internal Control Review
All of this information is then used to make a preliminary assessment of the risks and controls for Merami Berhad unit. The auditor will review the unit’s internal control structure, a process which is usually time-consuming. In doing this, the auditor uses a variety of tools and techniques to gather and analyze information about the operation. The review of internal controls helps the auditor determine the areas of highest risk and design tests to be performed in the fieldwork section. In the interests of quality and consistency, the Head of Internal Audit reviews this work and agrees the scope of work to be carried out.
Audit Program
Preparation of theaudit programconcludes the preliminary review phase. The audit program establishes theproceduresnecessary to complete an efficient and effective audit. It includes a detailed plan of the work to be performed as well as the steps required to achieve the audit objectives. There should be sufficient detail for less experienced staff to perform the steps however it should not be overly detailed whereby it might cause auditors to execute steps routinely and override their judgment.
STAGE 2: FIELDWORK Transaction Testing Revenue Cycle
Sales procedure and cash receipt transaction are the 2 checking procedures under revenue cycle.
Sales Procedure
A sales quotation provides a pre-sales processing environment which allows prospective buyers to examine the costs involved for a completion of work. A sales quotation typically consists of information like quantity, item and its description, unit prices and etc. Many businesses cannot have an upfront price for the service they provide. Thus, sale quotation should be provided by companies to its customers to give them an estimate of the cost involved.
In addition, a delivery order is written directions from a consignor or shipper of a shipment to a carrier or freight forwarder to release the shipment to the named delivery party in freight-prepaid shipment. It allows direct delivery of goods to the carrier or warehouseman.
Invoices are essentially a detailed bill left by vendors and outside supplier for goods or services rendered to a company under sales procedure. The document may be called a “Sales Invoice”, from the point of view of the vendor, or a “Purchase Invoice” by the buyer. A typical invoice might list the quantity of each item, prices, billable hours, service description and a contact address for payment. While some expenses may be paid through an accounts payable department by the posted due date.
Besides, cash sale can be used in several different contexts. A cash sale has to do with the purchase of goods or services and involves the immediate possession of the new owner, without any delay in time between purchase and assuming full ownership in just about every situation. In the world of finance and in retail situations, people are engage in cash sales on a delay basis,
Segregation of duties is critical to effective internal control. It reduces the risk of both erroneous and inappropriate actions. The handling of cash receipts and accounting for such receipt need to segregate. This is to reduce the likelihood that errors will remain undetected by providing an accounting check over the receipt of cash. For example, those who handle cash receipts would not have the authority to prepare or sign cheques, would not have access to accounting records and would not be involved in reconciling bank accounts. If a person has access to both the cash receipts and the accounts receivable records, it is possible for cash to be diverted and the shortage of cash in the accounting records to be covered which can result in theft of the entity’s cash. In the other hand, for those who perform sales activity including those who maintain contact with customers and issue sales orders, would not perform any credit approval, billing, shipping, credit memo, cash receipts and accounting activities.
Cash Receipt Transaction
Most business customers pay by cheque or electronically. Cash receipts are only given to acknowledge cash payments; which are rarely made by business customers. Cash register and lockboxes are often used as safeguards here. In order to prevent fraud and error, different employees should be responsible for receiving and recording cash collections here.
The purpose of preventing fraud and error is the validity, completeness, timeliness, authorization, valuation, classification, posting and summarization. It’s very important to the cash receipt transaction.
The auditor can check monthly bank reconciliation to prevent any recorded cash receipts not deposited in order to ensure the validity of the cash receipt transaction. For instance, misstatement in sales that may occur includes fictitious sale being recorded in the account o f a regular customer.
Expenditure Cycle
There are two checking procedures under expenditure cycle, which are purchasing procedure and cash disbursement transaction.
Purchasing Procedure
A purchasing transaction normally begins with a purchase requisition generated by a department or support function. A purchasing order is then the purchase of goods or services from a supplier. As soon as the goods and services have been rendered, the entity records a liability to the supplier and pays later.
Basically, there are three types of for purchase transactions which are the purchase of goods or services on cash or credit, payment of the liabilities arising from such purchases and return of goods or services. The second type is cash disbursement transaction to clear liabilities resulting from purchase of goods or services. The final type is a purchase return transaction which involves the return of goods previously purchased to supplier for cash or credit.
Good segregation of duties must be done in order to prevent embezzlement or any fraudulent activities. Firstly, a purchaser who orders should not be the person who receives goods. This can prevent the purchaser from placing excessive orders and keeping the rest of goods. Next, a person who purchases items should not be the person who writes the cheques for it. This can avoid the person from creating orders and make payments to fictitious companies. Then, the person who writes cheques should not handle the reconciliation. This is because nobody will aware even if he writes cheques to himself or relatives.
Cash Disbursement Transaction
Cash disbursement can be defined as paying out of funds in a discharge of a debt or expense. Transaction Related Audit Objective (TRAO) is used here to evaluating the existence and quality of controls. The auditor’s transaction-related audit objectives follow and are closely related to management assertion. That is because the auditor’s primary responsibility is to determine whether management assertions about financial statements are justified. These transaction-related audit objectives help the auditor accumulate sufficient competent evidence required by the standard of fieldwork and decide proper evidence to accumulate for classes of transactions with a framework.
In order to ensure the validity of the cash disbursement transaction, the auditor tests the validity of purchase transactions whether there is any fictitious or non-existent purchases may have been recorded in the client’s records. Assets or expenses will be overstated if fraudulent transactions are recorded.
As for Completeness, auditor must ensure that purchase that has been made in recorded accordingly. If fail to do so will lead to understating of assets or expenses, and the corresponding accounts payable will also be understated.
As for Timing, a timing error occurs if transactions are not recorded on the dates the transaction took place.
As for Authorization, the person who has authority to approve purchase should not have access to cash disbursement for the purchase.
As for Valuation, appropriate methodology is used to calculate transactions and to review various reconciliations. The valuation of accruals depends on the type and the nature of the accrued expenses.
As for Classifications, the major issues related to the presentation and disclosure assertions are identifying and reclassifying any material debits contained in accounts payable. For instance, segregation of purchasing and cash disbursement journal is crucial to ensure that correct amount would be allocated properly. If purchase transactions are not properly classified, assets and expenses will be misstated.
As for Posting and summarization, control tools should be used to reconcile vouchers to the daily accounts payable listing or else the daily postings to the purchases journal should be reconciled to the accounts payable subsidiary records.
Income Statement or Profit and Loss Account
First of all, the auditor should determine and try to find out the major changes or the modification that would affect the normal relationship has been made in the production and sales area. Audit assistant are responsible to handle on detect the significant adjustment in the policies of company that would affect the item stated in the income statement. After analyze on such adjustment to ensure that no material error is found then it will continue proceed to the final stage of the audit section. For example, significant changes in employee benefits might affect salaries and employee compensation and have an effect on the income statement.
Other than checking in the income statement of a company, the auditor would also look into the balance sheet on the assets and liabilities. Before the auditor start to work on it, a copy of client’s balance sheet should be prepared to working papers.
There are procedures of carrying out an audit on assets and liabilities. Auditors should categorize each item in the balance sheet accordingly to the audit checklist.
All of these are the components of assets.
For Cash in Bank
To ensure the information that stated in the column of the balance is complied what it really had in the bank, a confirmation request letter will be sent to all the related bank which the entity had dealing with within the financial period. In addition to get confirm to relevant bank that the balance in the bank of the company, the auditors also can get an opportunity to request the bank to provide other information such as the securities that the company held in the safekeeping.
The response from the bank give the company a gold evidence to prove that cash at bank that stated in the balance sheet is complied with the real amount in bank at the balance sheet date. With the cooperation of bank, the confirmation of cash on deposit provides evidence to the existence of cash at bank and as to rights and obligations. If the balance per bank statement is different, bank reconciliation would have to be done by the audit assistants.
For Account Receivable
A details list of account receivables balances of the customer should be obtain before the auditor and access to the balance. The auditor will trace totals to comparative summary of accounts receivables balance and randomly select customers’ account from the listing to send itemized statements to get the response or confirmation of the balance. Review the confirmation replies letter from them and test accounts where there are no replies. Keep track with the potential bad debts to be written off, if exist, check the opening balances again.
For Inventories
When inventory is material to the financial statements, the auditor is required to attend the entity’s physical inventory counting unless it is impracticable. Examine client’s physical inventories count determine whether the client’s counting methods are effective. The purpose of inventory attendance is to enable the auditor to obtain audit evidence regarding the existence and condition of the inventory and consider if there is any obsolescence in it. The auditor may select a sample of inventory items from the client count records and trace them to the perpetual inventory records for checking purposes.
For Prepayment expenses
Randomly choose the official receipts or documents that can support prepayment expenses and test on it. Then, send conformation letter to conform the amount due.
For Non – Current Assets
The auditor should obtain a list of fixed asset’s expenses that register under the client’s company such as depreciation charges, loss or gain on the disposal of the fixed asset, net book value, revaluation amount and etc. The revaluation done should be back by the evidence or documentation authorized by the professional. Check to invoice and agree to the description, price, date and etc. The physical existence and the condition of the assets should be check and determine whether it is located at company’s premises. As for disposal of fixed assets, ensure that there is proper authorization and that profit or loss on disposal is properly recorded.
For Short – Term Notes Payable
A bank conformation letter should be sent out to inquire loan balance status of the company. Auditors have to calculate the principal and interest paid to check whether it comply with the figure in the balance sheet.
For Long – Term Debts
Review the loan agreement and direct the attention to the relevant information to acquire the accurate interest charged based on the nominal interest rate calculation and auditor have to be ensuring that the interest rate stated in the income statement same with the result of calculation.
For Income Tax Account
The documentation of the transaction of the company is required to keep for minimum 7 year required by law. Client is required to show documentation and support for every aspects of company’s tax return. For example, if the client claims itemized deductions, receipts for those deductions must be produced. In addition, to justifications for why the taxpayer felt that those deductions were legitimate. Besides that, taxpayers must open their accounting methods to inspection and demonstrate that all of their income was in fact properly documented and claimed on the tax return. This can be done through proper recording and classification for provision for taxation and deferred taxation.

Principles-Based Accounting Advantages

The primary advantage of principles-based accounting rests in its broad guidelines that can be applied to numerous situations. Broad principles avoid the pitfalls associated with precise requirements that allow contracts to be written specifically to manipulate their intent.
A 1981 study sponsored by FASB found evidence that managers purposefully try to structure leases as operating leases to avoid incurring additional liabilities. Providing broad guidelines may improve the representational faithfulness of financial statements.
Principles-based accounting standards allow accountants to apply professional judgement in assessing the substance of a transaction. This approach is substantially different from the underlying “box-ticking” approach common in rules-based accounting standards.
FASB Chair Robert Herz has stated that he believes the professionalism of financial statements would be enhanced if accountants are required to utilize their judgment instead of relying on detailed rules.
A principles-based system would result in simpler standards. Herz has claimed that a principles-based system would lead to standards that would be less than 12 pages long, instead of over 100 pages (BusinessWeek online, 2002). Principles would be easier to comprehend and apply to a broad range of transactions.
Harvey Pitt, former SEC chairman, explained this as follows: “Because standards are developed based on rules … they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent.”
The use of principles-based accounting standards may provide accounting statements that more accurately reflect a company’s actual performance. It can be proved by the statement made by Australian Securities and Investments Commission Chair David Knott – “an increase in principles-based accounting standards would reduce manipulations of the rules” (Nationwide News, 2002).
Financial statements that are prepared under accounting standards that clearly state the accounting objectives, have few, if any, exceptions, and do not include bright-line tests should benefit users. They should be easier to understand, more meaningful and informative, are likely to result in similar transactions and events being accounted for similarly, and more likely to reflect the economic substance of a transaction, in part, because there will be less opportunity for financial engineering. (Heffes, Ellen M ,2004)
Disadvantages: A lack of precise guidelines could create unreliable and inconsistent information in the application of standards across organizations and make it difficult to compare one entity to another. For example, companies are required to recognize both an expense and a liability for a contingent liability that is probable and estimable. On the other hand, a contingent liability that is reasonably possible is only reported in the footnotes. With no precise guidelines, how should companies determine if liabilities are probable or only reasonably possible? The lack of bright-light standards would reduce the financial statement’s comparability and consistency.
For example, how much income will General Electric actually recognize on a multiyear defense contract under the percentage of completion method of accounting? Will this be comparable to the income reported by its competitors? And most importantly, will the auditors, many of whom have been caught behaving badly recently, abuse their trust and fail to apply the principles in “good faith consistent with the intent and spirit of the standards.”
Principles-based accounting system generally requires preparers and auditors to apply professional judgment to implement and interpret the standards in the absence of sufficient guidance to exercise that judgment. There is a danger because they can be used to manipulate financial results. Since they have often set low standards for themselves in this regard (even failing to meet those), it is a big question if they will rise to the occasion.
Advantages and Disadvantages of Rules-based Accounting Standard: Advantages: Rule-based standards are generally considered easier to audit for compliance purposes, and may produce more consistent and comparable financial reports across entities.
Requirements are set out in detail and compliance with the rules can be more easily monitored and enforced.
Disadvantages: Entities may search for loopholes that meet the literal wording of the standard but violate the intent of the standards.
Rules-based accounting has not worked in practice. Critics argue that the present U.S. system does not produce accurate reporting. It focuses on “checking the boxes” more than portraying an underlying economic reality. It filled with specific details in an attempt to address as many possible contingencies as possible. This has made standards longer and complicated, and has led to arbitrary criteria for accounting treatments that allows companies to structure transactions to circumvent unfavourable reporting.
For instance, lease accounting contains hundreds of pages of rules and interpretations while almost no leased assets appear on corporate balance sheets. The system has created an industry of financial engineering and structured transactions designed to circumvent the rules. Many believe that rules closing structuring loopholes will only result in more elaborate ways to evade them. (Raymond Thompson, 2009)