1. The document provides steps for developing audit objectives including understanding audit responsibilities and objectives, dividing financial statements into cycles, understanding management assertions and general/specific audit objectives. 2. It then provides examples of applying the audit cycle approach to a sample company, Hillsburg Hardware, outlining the general ledger accounts and journals included in each cycle. 3. Finally, it discusses key audit planning activities like understanding the client's business, assessing risks, developing the overall audit approach and audit program.

1. Steps to Develop Audit Objectives
Understands objectives and
responsibilities for the audit
Divide financial statements
into cycles
Know management assertions
about financial statements
Know general audit objectives
for classes of transactions,
accounts, and disclousers
Know specific audit objectives
for classes of transactions,
accounts and disclousers

2. Transaction Flow from Journal to Financial Statements
TRANSACTIONS JOURNALS LEDGERS , TRIAL BALANCE,
AND FINANCIAL STATEMENTS
Sales Sales journal
Cash Receipts Cash receipts General ledger and
journal subsidiary records
Acquisition of Acquisitions
goods and services journal General ledger trial
balance
Cash Cash disbursements
Disbursements journal
Financial statements
Payroll Services Payroll Journal
and disbursements
Allocation and General Journal
adjusments

3. Cycles Applied to Hillsburg Hardware Co.
General Ledger Accounts Included in the Cycle (See Figure 6-4)
Journals Included in the
Cycle (See Figure 6-3, p.
Cycle 170) Balance Sheet Income Statement
s
Sales and Sales Journal Cash In bank Advertising
s
Colection Cash disbursement journal Inventories Travel and entertainment
s
General Journal Prepaid expenses Sales meetings and training
s
Land Miscellaneous sales expense
s
Building Sales and promotial literature
A
Computer and other equipment Travel and entertainment
A
Furniture and fixtures Stationery and supplies
A
Accumulated despreciation Postage
A
Trade accounts payable Telephone and fax
A
Other accrued payables Computer maintence and supplies
A
Accrued income tax Depreciation
Deferred tax Rent A
Legal fees and retainers A
A
Auditing and related services
A
Insurerance
A
Office repairs and maintenace expense
A
Expense
A
Miscellaneous office expense
A
Miscellaneous general expense
Gain on sale of assets
Income taxes
Payroll Payroll journal Cash in bank Salaries and commisions S
and personnel General journal Accrued payroll Sales payroll taxes S
A
Accrued payroll taxes Executive and office salaries
Adminastrative payroll taxes A
Inventory Acquisitions journal Inventories cost of goods sold
and warehousing Sales journal
Capital Acquisition Acquisition journal Cash in bank Interest expense
and repayment Cash disbursements journal Nites payable
General journal Long-term notes payable
Accrued interest
Capital stock
capital in excess of par value
Retained earnings
Devidens
Devidens payable

4. Relationships Among Transaction Cycles
General
cash
Capital acquisition and
repayment cycle
Sales and Acquisition and Payroll and
collection cycle payment cycle personel cycle
Inventory and
warehousing cycle

5. Four Phase of a Financial Statement Audit
Phase l Plan and design
an audit approach
Phase ll Perform tests of controls and
substantive tests of transactions
Phase lll Perform analytical procedures
and tests of details of balance
Phase lV Complete the audit and
issue an audit report

6. Relationships Among Auditing Standards, Types of Evidence,
and the Four Audit Evidence Decisions
Broad guidelines concerning
Auditing auditor qualifications and
standards conduct, evidence,
accumulation, and reporting
Qualifications Evidence Reporting
and conduct accumulation
Physical examination Broad categories of
confirmation Types of
evidence available for the
documentation evidence
auditor’s accumulation
analytical procedures
inquiries of client
recalculation Specific instructions for
reperformance Audit
the accumulation of types
observation procedures
of evidence
FOUR
AUDIT
EVIDENCE Sample size and Timing of
DECISIONS items to select tests

7. Information Often Confirmed
Information Source
Assets
Cash In bank Bank
Marketable securities Investment custodian
Accounts receivable Customer
Notes receivable Maker
Owned inventory out on consignment Consignee
Inventory held in public warehouses Public warehouse
Cash surrender value of life insurance Insurance company
Liabilities
Accounts payable Creditor
Notes payable Lender
Advances from customers Customer
Mortgages payable Mortagagor
Bonds payable Bondholder
Owners Equity
Shares outstanding Registar and transfer agent
Other Information
Insurance coverage Insurance company
Contingent liabilities Bank, lender, and client's legal counsel
bond indenture agreements Bondholder
Collateral held by creditors Creditor

8. Terms, Audit Procedures, and Types of Evidence
Term and Definition Illustrative Audit Procedure Type of Evidence
Examine a sample of vendor's inboices to determine Documentation
Examine-A reasonably detailed study of a document
whetever the goods or services received are
or record to determine specific facts about it.
reasonable and of the type normally used by the
client's business.
Scan the sales journal, looking for large and unusual Analytical procedures
Scan-A less-detailed examination of a document or transactions.
record to determine whetever there is something
unusual warranting further investigation.
Read -An examination of written information to Read the minutes of a board of directors meeting and Documentation
determaine facts pertinent to the audit. summarize all information that is pertinent to the
financial statements in an audit file.
Compute -A calculation done by the auditor Compute inventory turnover ratios and compare with Analytical procedures
independent of the client. those of previous years as a test of inventory
obsolescence.
Recompute -A calculation done to determine Recompute the unit sales price times the number of Recalculation
whetever a client's calculation is correct. units for a sample of duplicate sales invoices and
compare the totals with the calculations.
Foot the sales journal for a 1-month period and Recalculation
Foot -Addition of a column of numbers to determine compare all totals with the general ledger.
whetever the total is the same as the client's.
Trace- An instruction normally associated with Trace a sample of sales transactions from sales Documentation
documentation or reperformance. The instruction invoices to the sales journal, and compare customer
should state what the auditor is tracing and where it name, date and the dollar value of the sale.
is being traced from and to. Often, an audit
procedure that includes the term trace will also Trace postings from the sales journal to the general Reperformance
include a second instruction, such as compare or ledger accounts.
recalculate.
Compare -A comparison of information in two Select a sample of sales invoices and compare the Documentation.
different locations. The instruction should state unit selling price as stated on the invoice to the list of
which information is being compared in as much unit selling prices authorized by management.
detail as pratical.
Count-A determination of assets on hand at a given Count a sample 100 inventory items and compare Physical examination
time. This term should be associated with the type quantity and description to client's counts.
of evidence defined as physical examination.
Observe- The act of observation should be Observe whetever the two inventory caount teams Observation
associated with the type of evidence defined as independently count and record invntory counts.
observation.
Inquire-The act of inquiry should be associated with Inquire of management whetever there is any Inquiries of client
the type of evidence defined as inquiry. obsolete inventory on hand at the balance sheet
date.
Vouch -The use of documents to verify recorded Vouch a sample of recorded acquisition transactions Documentation
transactions or amounts. to vendor's invoices and receiving reports.

9. Audit File Contents and Organization
Financial statements
and audit report
Working trial balance
Adjusting journal entries
Contingent liabilities
Robinson associate
trial balance 12/31/11 Operations
Cash $ 165,237
Account 275,050 Liabilities and equity
Receivable 37,795
Prepaid Insurance 20,493
Assets
Interest Receivable
Analytical procedures
Tests of controls &
substantive TOT
Internal control
General Information
Audit programs
Permanent files

10. Planning an Audit and Designing an Audit Approach
Accept client and perform
initial audit plainnng
Understand the client’s
business and industry
Asses client
business risk
Perform preliminary
analytical procedures
Set materiality and assess
acceptable audit risk and
inherent risk
Understand internal
control and assess control
risk
Gather information to
assess fraud risks
Develop overall audit plan
and audit program

11. Strategic Systems Understanding of the Client’s Business and Industry
Understand Client’s
Business and lnustry
Industry and External
Environment
Objectives and
Strategies
Bussines Operations
and Processes
Measurement and
Performance
Management and
Governance

12. Understanding the Client’s Business and Industry, Client Business Risk, and Risk of Material
Misstatement
Industry and External Environment
Bussines Operations and Processes
Understand Cleint’s
Business and Industry
Management and Governance
Asess Client Business Objectives and Strategies
Risk
Measurement and Performance
Assess Risk of Material
Misstatements

13. New client acceptance Hillsburg is a continuing audit client. No circumstances were
and continuance identified in the conticuation review to cause discontinuance
Iddentify client’s There are two primary reasons. Company is publicly traded
reasons for audit and audit is required by bank due to large notes payable
Accept client and outstanding
perform initial
panning
Obtain an Obtained an engagement letter before starting field work.
understanding with
the client
Partner - Joe Anthony
Staff the engagement Manager - Leslie Franklin
Senior - Fran Moore
Assistant – Mich Bray and one person ro be named later
Understand client’s Anthony and Franklin subscride to industry publications.
industry and external Moore reviewed industry data and reports in several
environment database and online sources
Understand the
client’s business and
industry Understand client’s See Figure 8-3 (p. 217). Moore discussed with CEO and CFO,
operations, strategies, read minutes, and reviewed other key reports and
and performance performance indicators
system
Assess client business Moore used her understanding of the client and industry to
risk evaluate business risk.
Evaluate management Moore reviewed management and governance controls and
Assess client controls affecting their effct on business risk.
business risk business risk
Assess risk of material Moore used her assessment of client business risk and
misstatements management controls to identify audit areas with increased
risk of misstatement.
Perform Moore compared 12-31-11 anaudited balances to the prior
preliminary year. She calculated key ratios and compared them with
prior years and industry averages. All significant differences
analytical were identified for follow-up.
procedures

14. Timing and Purposes of Analytical Procedures
Phase
Purpose (Required) Planning (Required)
Phase Testing Phase Completion Phase
Understand the client's business
Primary purpose
and industry
Assess going concern Secondary purpose Secondary puprpose
Indicate possible misstatements
Primary purpose Secondary purpose Primary purpose
(attetion directing)
Reduce detailed tests Secondary purpose Primary purpose

15. Internal Comparisons and Relationships
Ratio or Comparison Possible Misstatement
Mistatement of inventory or cost of goods
Raw material turnover a
sold or obolance of raw meterial
manufacturing company
inventory
Sales commissions devided by Misstatement of sales commissions
net sales
Sales rerturns and allowances Misclassified sales return and allowances
devided by gross sales or unrecorded returns or allowances
subsequent to yeear-end
Bad debt expense devided by Misstatement in the allowance for bad
net sales debts
Each of the individual
Significant misstatement of individual
manufacturing expenses as a
expenses within a total
percent of total

16. Hilssburg Hardware Overall Test of Interest Expense December 31, 2011
Hilssburg Hardware Co.
Overall Test of Interest Expense Schedule N-3 date
12/13/2011 Prepared by TM 3/06/12
Approved by JW 3/12/12
Expectation of recorded interest eexpense :
Shrt-terms loans :
Month Month & Balance 1 Rate 2
Jan. $ 5,900,000.00 5.50%
Feb 6,368,000 5.50%
Mar. 6,824,000 5.75%
Apr. 7,536,000 5.75%
May 5,208,000 5.25%
June 3,748,000 5.50%
July 2,800,000 5.25%
Aug. 2,490,000 5.50%
Sept. 2,092,000 5.25%
Oct. 1,708,000 5.50%
Nov. 5,062,000 5.75%
Dec. 4,180,000 5.50%
Total 53,916,000 66.00%
Average Monthly Balance $ 4.493.000 5.50% $ 247.115
And Interest Rate
(Total 12 )
Long-Term Loans :
Beginning Balance $ 26.520.000
Ending Balance 24.120.000
$ 50.640.000 8.50%
Average $ 25.320.000 8.50% 2.152.200
Auditor expectation of interest expense 2.399.315
Recorded interest expense per general ledger 2.408.642
Difference-over (under) expectation 9.327
Conclusion : Interest expense appears fairly stated as recorded
Amount is within 9.327 (4.%) of expected amount.
Tickmark Legend :
1. Monthly balances obtained from general ledger for each month
2. Estimated based on examination of several notes outsanding each month
3. Agreed to prior year audit workpapers
4. Agrees with December 31, 2011 general ledger and working trial balance
5. Agrees with permanent file schedule of long-term debt.

17. Short Term Debt Paying Ability
Cash + marketable securities 8,28
Cash Ratio =
Current liabilities 13,216
Cash + marketable + securities +
net accounts receivable 828 + 18,957 + 945
Quick ratio = = 157
Current liabilities 13,126
Current assets 51,027
Current ratio = = 3.86
current liabilities 13,216

18. Liquidity Activity Ratios
Account receivable Net sales 143,086
= = 7.59
turnover average gross receivable ((18,957 + 1,240) + (16,210 + 1,311)) /2
Days to collect 365 days 365 days 48.09
= =
receivable account receivable turnover 7.59 days
Inventory Cost of goods sold 103,241
= = 3
Turnover Average inventoy (29,865 + 31,600) /2
Days to sell Current assets 365 days 108.63
= =
inventory Current liabilities 3.36 days

19. Ability to Meet Long-term Debt Obligations
Total liabilities 13,216 + 25,688
Debt to equity = = 1.73
Total equity 22,463
Times interset operating income 7,370
= = 3.06
earned interest expense 2,409

20. Earning per Net income 3,934
= = 0,79
share Average common shares outstanding 5,000
Gross profit Net sales - cost of goods sold 143,086 - 103,241
= = 27.85%
percent Net sales 143,086
Profit Operating Income 7,370
= = 0.05
Margin Net sales 143,086
Return on Income before taxes 5,681
= = 0.09
assets Average total assets (91,367 + 60,791)/2
Common Income before taxes-preferred dividends 5,681 - 0
= = 0.26
equity Average stockholders equity (22,463 + 20,429)/2

21. Steps in Applying Materiality
Set preminary judgement
Step 1 about materiality
Planning extent
of tests
Allocate preliminary judgment
Step 2 about materiality to segemnts
Estimate total misstatement in
Step 3 segment
Estimate the combined
Step 4 misstatement Evaluating results
Compare combined estimate
Step 5 with preliminary or revised
judgment about materiality

22. Audit Risk Model and Understanding the Client’s Business and Industry
Industry and External Environment
Business Operations and Processes
Understand Client’s
Management and Governance
Business and Industry
Objectives and Strategies
Understand Client’s
Business and Industry Measurenment and Performance
Understand Client’s
Business and Industry
AUDIT RISK MODEL
Inherent Risk Control Risk AAR
PDR =
(IR) (CR) IR x CR

23. Illustration of Differing Evidence Among Cycles
Sales and Acquisition and Payroll and Inventory and Capital Acquisition
Collection Cycle Payment Cycle Personel Cycle Warehousing and Repaymeny
Cycle Cycle
Auditor's assessment of
expectation of material Expect some Expect many Expect few Expect many Expect few
A mistatement before misstatemens misstatements misstatements misstatements misstatements
considering internal control
(inherent risk) (medium) (high) (Low) (high) (low)
Auditor's assessment of
effectiveness of internal Medium High High Medium
low effectiveness
B controls to prevent or effectiveness effectiveness effectiveness effectiveness
detect material
misstatements (control risk) (medium) (Low) (Low) (high) (medium)
Auditor's willingness to
permit material Low willingness Low willingness Low willingness Low willingness Low willingness
C misstatements to exist after
completing the audit
(Low) (Low) (Low) (Low) (Low)
(acceptable audit risk)
Extent of evidence the Medium level Medium level Low level High level Medium level
D auditor plan accumulate
(planned detection risk)
(medium) (medium) (high) (Low) (medium)

24. Relationship of Factors Influencing Risks to Risks and Risks to Planned Evidence
Reliance by external users Acceptable
Likelihood of financial failure audit risk
Intergrity of management
Nature of business
Results of previous audit
Initial versus repeat
engagement D D
Related parteis l
Nonroutine transactions Planned Planned
l l
Judgement required Inherent detection audit
Makeup of population risk risk evidence
Factors related to
misstatements arising from l D
fraudelent financial
reporting *
Susceptibility of assets to
misappropriation*
Effectiveness of internal
controls Control
risk
Planned reliance
D = Direct relationship ; l = inverse relationship
*Fraud risk factors. These may also affect acceptable audit risk and controls risk

25. Relationships of Risk to Evidence
Planned Amount of
Acceptable Inherent Control Detection Evidence
Situation Audit Risk Risk Risk Risk Required
1 High Low Low High Low
2 Low Low Low Medium Medium
3 Low High High Low High
4 Medium Medium Medium Medium Medium
5 High Low Medium Medium Medium

26. Evidence-Planning Worksheet to decide Tests of Details of Blances for Hillsburg
Hardware CO. - Accounts Receivable
Realizable value
Completensess
Classification
Detail tie-in
Accurancy
Existence
Cutoff
Rights
Acceptable audit
Medium Medium Medium Medium Medium Medium Medium Medium
risk
inherent risk Low Medium Low Low Low Medium Medium Low
Control risk-
sales
Control risk-
cash receipts
Control risk-
Additional controls
Subtantive tests of
transaction-sales
Subtantive tests of
transactions-cash receipts
Analytical
procedures
Planned detection risk for
tests of details of balances
Planned audit evidence for
tests of details of balances

27. Relationship of Tolerable Misstatement and Riks to Planned Evidence
TOLERABLE MISSTATEMENT PLANNED
AND RISKS AUDIT
EVIDENCE
Acceptable
audit risk
D D I
Inherent I Planned I Planned audit
Risk detection risk evidence
I D I
Control
Risk
Tolerable
misstatement
D = Direct Relationship ; l = Inerverse relationship

28. Five Components of Internal Control
Control Environment
Risk Control Information and Monitoring
Assesment Activities Communication

29. COSO Components of Internal Control
INTERNAL CONTROL
Component Description of Component Further Subdivision (if applicable)
Control Enivronment Actions, policies and Subcomponents of the control environment :
procedures that reflect the Intergrity and ethical values
overall attitude of top Commutment to competence
management, directors, and Board of director and audit committee participation
owners of an entity about Management's philosophy and operating style
internal control and its Organizational sturture
importance Human Resource policies and practices
Riks Assessment Management's identification Risk assessment processes :
and analysis of risks relevant Identify factors affecting risks
to the preparation of financial Assess significance of risks and likelihood of occurrence
statements in accordance with Determine actions necesarry to manage risks
appropriate accounting
frameworks such as GAAP or Categories of management assertions that must be satisfied :
IFRS Assertions about classes of transactions and other events
Assertions about account balances
Assertions about presentation and disclosure
Control Activities Policies and procedures that Types of specific control activities :
management has established Adequate separation of duties
to meet its objectives for Proper authorization of transaction and other occurence
financial reporting Adequate documents and records
Physical control over assets and records
Independent checks on performance
Information and Methods used to initiate, Transaction-related audit objectives that must be satisfied :
communication record, process, and report an Occurrence
entity's transactions and to Completeness
maintain accountability for Accuracy
related assets Posting and summarization
Classification
Timing
Monitoring Management's on going and Not Applicable
periodic assessment of the
quality of internal control
performance to determine
whether contorls are
operating as intended and are
modified when needed

30. Process for Understanding Internal Control and Assessing
Control Risk
Obtain and document
Phase 1 understanding of internal
control desihn and operation
Phase 2 Assess control risk
Design, perform and evaluate
Phase 3 tests of controls
Decide planned detection
Phase 4 risk and substantive tests

31. Control Risk Matrix for Hillsburg Hardware Co.-Sales
SALES TRANSACTION-RELATED AUDIT OBJECTIVES
accounts receivable master file and are correctly
Recorded sales are for shipments actually made
Sales are recorded on the correct dates (timing)
Sales transactions are correctly included in the
shipped and are correctly billed and recorded
Recorded sales are for the amount of goods
summarized (posting and summarization)
Sales transaction are correctly classified
Existing sales transaction are recorded
to notictitions customers (occurrence)
(completeness)
(classification)
(accuracy)
INTERNAL CONTROL
Credit is approved automatically by computer by comparison
to authorized credit limits (C1).
C
Recorded sales are supported by authorized shipping
documents and approved customer orders (C2).
C C
Separation of duties exists among billing, recording of sales,
and handling of cash receipts (C3).
C C C
Shipping documents are forwarded to billing daily and are
billed the subsequent day (C4).
C C
Shipping documents are prenumbered and accounted for
weekly (C5).
C C
CONTROLS
Batch totals of quantities shipped are compared with
quantities biled (C6).
C C C
Unit selling prices are obtained from the price list master file
of approved prices (C7).
C
Sales Transaction are internally verified (C8).
C
Statements are mailed to customers each month (C9).
C C C
Computer automatically posts transactions to the accounts
receivable subsidiary records and to the general ledger (C10).
C
Account receivable master file is reconciled to the general
ledger on monthly basis (C11).
C
There is lack of internal verification for the possibility of sales
DEFICIENCES
invoices being recorded more than once (D1).
D
There is a lack of control to test for timely recording (D2).
Med. Low Low Low Low * Med.
Assessed control risk

32. Evaluating Significant Control Deficiencies
SIGNIFICANCE
Material
Material Weakness
LIKELIHOOD
Remote Reasonably Possible
Immaterial
Source : Adapted from Michael Ramos,”Section 404 Compliance in
the Annual Report,”Journal of accountancy, October 2004, pp. 43-48

33. Differences in Scope of Controls Tested in an Audit of Internal Control and an
Audit of Financial Statements
Internal Controls Over Financial Reporting
Internal Controls Used to Assess Control
Risk Below Maximum
Controls that must be tested in an Controls that must be tested in an
audit of internal controls audit of financial statements

34. Summary of Understanding Internal Control and Assessing Control Risk
Intergrated Audit of
Financial Statements and
Internal Control over
Financial Statement Audit Financial Reporting
Obtain an understanding
Sufficient to audit
of internal control design PHASE 1
Sufficient to audit financial internal control over
and operation
statements financial reporting
Varies depending on Decide low for all
Decide control risk at the
extent and effectiveness objectives unless there
objective level for each
of controls and the are significant
transaction type
auditor’s planned deficiencies or material
reliance on controls weaknesses
Three alternatives
PHASE 2
Maximum Intermediate Low
Varies depending on
Plan and perform tests of Extensive tests for all
assessed level of controls
controls and evaluate objectives
risk
results
Revise for tests of Revise for tests of PHASE 3
Revise assessed control
controls results controls results
risk if appropriate
Likely to be more reliance on Likely to be less reliance
substantive tests, depending Plan detection risk and
on substantive tests due
on assessed control risk perform substantive tests
to extentive tests of
option selected considering control risks
controls
and other audit risk
model factors PHASE 4
Must communicate in
writing to those charged Must issue report on
Issue internal control internal control over
with governance describsing
report or letter financial reporting and
significant deficiencies or
material weaknesses issue a written
communication to audit
commutte describing
significant deficiencies or
material weakness