SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 7. DESIGNING SUBSTANTIVE AUDIT TESTS: COMPENSATION

PLANS

DISCUSSION QUESTIONS

1. A company profit-sharing arrangement is a matter of auditor concern because it provides

an incentive for employees to generate artificially high income figures. These individuals
can receive direct financial benefits from the manipulation of reported earnings. This
potential problem is even more of a concern in the Lakeside engagement because controls
are weak and each store is geographically isolated from the oversight provided by the
administrative offices.

2. Designing substantive audit tests (compensation plans) tend to describes the payroll
system used by the Lakeside Company. Tests of controls are designed by the auditor to
verify that specific control features identified as possible strengths are operating
effectively. A sample of such tests would include the following:
a. Compare the payroll records produced by Sarah Sweet to time tickets completed by
hourly employees noting agreement as to hours worked;

b. Verify that time tickets have been appropriately authorized;

c. Recalculate salaried employees' monthly pay and compare to the payroll records;

d. Recalculate salesmen's commissions and compare to payroll records;

e. Recalculate payroll deductions based on government payroll tables and the data listed
on the W-4 form filed by each employee. Compare these deductions to the
company's payroll records;

f. Recompute Lakeside's payroll taxes and compare to total reported balance;

g. Verify mathematical accuracy of net wage figures (salary less deductions);

h. Foot the payroll record;

i. Verify that each payroll record has been properly authorized by Mark Hayes;
 j. Compare the payroll transfer made from the general fund each period to the total
payment computed on the payroll record;

k. Review canceled checks for proper signature, amount, payee, date, and endorsement;

l. Review payments made for withholdings and payroll taxes. Compare these amounts
to payroll records kept for each of these items.

3. How Existence or Occurrence - For payroll expense, the auditor would want to determine
that all employees do, indeed, work for the company. If 48 employees are paid each
period, the auditor needs to ensure that 48 individuals are working for Lakeside. The
auditor should be concerned that one or more employees are stealing money by receiving
more than one check. A review of the payroll records completed by the employees before
they begin work provides some evidence that the individuals do exist. In addition, the
auditor can accompany the paymaster (or whoever serves in this capacity) when
paychecks are distributed. This procedure allows the auditor to identify the person
receiving each check to ensure that the employee is the same as is listed on the check
itself.

Completeness - Completeness is not usually a major problem in the area of payroll

expense where misstatements most often result from having extra expense recorded
(because of theft) rather than from having transactions omitted. However, the auditor still
wants to ascertain that the $1.1 million figure to be reported contains all applicable
payroll expenses. Thus, for example, verifying that a year-end expense accrual has been
made helps to prove that all expenses were recorded. Furthermore, if payroll taxes and
other costs are to be reported within the payroll expense figure, the auditors should
determine that all such costs (Social Security, unemployment taxes, medical insurance
premiums, etc.) have been properly included in the final balance to be presented.

Rights and Obligations - For payroll expense, the auditor would want to ascertain that
work did occur during the period for which the company does have a legal obligation to
pay. The auditor would review the time tickets to make sure that they seem proper and
then recompute the amounts to be paid based on the hours worked. These calculations
provide evidence that the payments were, indeed, the actual obligations of the client
company.

Valuation or Allocation - Since an expense rather than an asset is involved, the auditor
is more interested in allocation than valuation. Verification should be made that the
proper expense is being allocated to the current year. Hence, the auditor should
recompute the cut-off made of the payroll calculation at both the beginning and ending
of the fiscal year. Determination needs to be made that the figure being reported is for
2006 only.
 Presentation and Disclosure - The auditor wants to make certain that the financial
statements fairly present the payroll expense figure. As shown in Exhibit 3-1, a balance
for "Salaries, Commissions, Bonuses" is reported for both the stores and the
distributorship. The auditor needs to determine that the separation into these two
classifications is properly performed. In addition, the specific accounts included within
this single category should be consistent from year to year so that comparability is
enhanced. Since the company does not manufacture its inventory, no portion of the
payroll expense should be assigned to Cost of Goods Sold.

4. Audit Types of evidence-gathering procedures that are used by an auditor during an

examination would include the following. (One method for approaching this question is
to ask the students to identify the accounts that could be tested through each procedure.)
a. Observation of activities and conditions - usually a test of controls to provide
evidence of operating efficiency.
b. Physical examination and count - used to prove that an item physically exists and
agrees with the ledger balance.
c. Confirmation - proves existence of a balance by communication directly with an
outside party.
d. Inspection of documents - demonstrates that control procedures have been performed
or provides support for reported balances.
e. Recomputation (including footings, cross-footings, extensions, recalculations, etc.) -
demonstrates that control procedures have been performed or provides support for
reported balances.
f. Retracing transactions from origination to final reporting - ensures that accounting
system is functioning properly so that balances will be correctly reported.
g. Scanning accounting records - an analytical procedure designed to highlight
significant or unusual differences.
h. Inquiry (including discussion, questioning, etc.) - helps auditors to learn design of
accounting systems and internal control and to evaluate efficiency of operations
i. Examination and corroboration of subsidiary records - serves as support for reported
balances.
j. Correlation with related information (including ratio and trend analysis) - another
analytical procedure to identify possible problem areas.
k. Review of subsequent events - provides support for year-end balances and identifies
happenings that require disclosure.
l. Reliance on outside experts - used for evidence-gathering purposes that go beyond
purely auditing and accounting skills such as inventory valuations and engineering
estimates.
m. Examination of legal letters and confirmations - helps to identify, assess, and value
significant events and contingencies.
n. Obtaining a representation letter from the client's senior management - management
acknowledges responsibility for statements and provides evidence in areas where
other evidence may not be available.
 This question also asks about the competence (significance and reliability) of these
procedures. Each test is potentially quite important and produces reliable evidence but
only if used in the appropriate circumstances. For example, confirmation is one of the
most important steps in auditing cash bank balances but is rarely used in connection with
an account such as land. Physical examination is essential in auditing marketable
securities where ownership and value can often be ascertained visually. This same
procedure is much less of a factor in examining equipment. An audit procedure must
match an account and the type of evidence needed.

5. Maintaining a separate payroll bank account is a common control procedure encountered

by auditors. Having a separate payroll account:

Allows for easier application of control procedures such as limit tests, item counts,
and validity checks;
Operates as a safety measure. By setting aside sufficient cash for payroll, the
company guards against spending money required for that purpose;
Allows for additional control over unclaimed checks, uncashed checks, etc.;
Facilitates the audit function in that the payroll balances are easier to verify;
Limits the amount of money that would be subject to theft in a payroll system;
Facilitates reconciliation of the bank account. Some organizations even use 12
bank accounts - one for each month - to limit the problems associated with the
bank reconciliation process.

6. Some of the more critical potential problems involving payroll include:

A. Checks are issued to fictitious employees or to former employees who have left
Lakeside, with the checks being diverted and fraudulently cashed.

Substantive tests that may disclose this problem:

Observe distribution of payroll checks.

Review personnel files for a sample of employees to verify current
status is maintained.
Compare names in files to time tickets and verify authorization of
time tickets.
Review company's system for removing names of employees who no
longer work for the company.
Compare current number of employees to previous years for unusual
differences.

B. Payroll deductions are recorded or computed incorrectly, through error or as part of

a defalcation scheme.
 Substantive tests that may disclose this problem:
Review W-4 forms, voluntary deduction forms, and employee
contracts for completeness.
Compare payroll registerto W-4 forms recomputing
appropriate deductions.
Mathematically verify payroll deductions (foot and cross-foot) and
compare payroll balance to canceled payroll checks.
Review payroll tax forms for agreement with computed balances and
with payroll register.

C. Year-end accrual may be ignored or incorrectly computed.

Substantive tests that may disclose this problem:

Review last payroll for the year to verify that recording was made in
proper period.
Recalculate accrual and verify against the first payroll of the
subsequent period.
EXERCISES

1. This problem extends the students' introduction to working paper construction by

placing them in the role of supervisor. A number of errors exist in the example
presented in Exhibit 7-1 and the students should be able to identify most of them.

The working paper is not properly dated so that a reviewing auditor cannot be
certain that this testing applies to 2009.

The columns are not labeled. No method exists for identifying the information
that has been gathered.

In the first three columns, abbreviations such as "SM," "M-2," and "Salar." are
used without explanation, which makes possible the erroneous usage of the
information.

In the column that starts with $388, the seventh item and two items in the next
column do not have tickmarks, which may indicate that they have not been tested.
No indication is given as to the significance of these three omissions.

According to the working paper, none of the items in the column that begins with
$39 has undergone any testing. That possibility seems unlikely, since an exception
has been found at point A.

Comment A is vague and does not indicate any reason for the exception nor does
it discuss the significance of the problem. In addition, the note makes no
mention of potential testing that may be required because of the exception.
Two canceled checks could not be found at point B, but no reason is given nor is
any suggestion included for further testing.

One tickmark (a caret) was used for two different tests. The reviewer has no
method of distinguishing the actual procedure performed.

Several of the auditing procedures listed at the bottom (on the left) use vague
terms such as "company records," "government records," and "calculations"
without any specific identification. Thus, determining the procedures actually
performed and the specific documents analyzed would be virtually impossible.

The working paper does not contain objectives, scope, or conclusion (see Exhibit
6-1). Therefore, it does not clearly spell out what was done or what was found.
No indication is presented as to the method of selecting the employee names that
have been used.
2. Attached
a. Exhibit 7
Lakeside Company

Account 585, Estimated Bonus Expense, for Nine Months ended September 30, 2008
and 2009

2008 Bonus Plan

STO STORE STORE STORE STORE STORE TOTAL

RE
No.1 No.2 No.3 No.4 No.5 No.6 STORES
Sales $273, $397,80 $236,10 $242,30 $373,00 $110,80 $1,633,5
-Sales 000
7,900 0
25,190 0
11,950 0
14,050 0
30,010 0
11,300 00
100,400
Returns
-Cost of 162,6 239,300 138,200 137,200 229,000 68,100 974,400
Sales Sal.
-Dir. 00
45,20 59,200 39,300 38,600 54,800 32,300 269,400
Exp.
-Rent 9,6000 28,400 12,000 13,200 30,000 12,000 105,200
=Bonus 48,20 45,710 34,650 39,250 29,190 (12,900) 184,100
xBasis
Bonus % 2%0 2% 2% 2% 2% 2% 2%
=Bonus 964 914 693 785 584 0 3,940

2009 Bonus Plan

STO STORE STORE STORE STORE STORE TOTAL

RE
No.1 No.2 No.3 No.4 No.5 No.6 STORES
Sales $319, $398,90 $458,80 $265,40 $364,60 $121,20 $1,928,8
-Sales 900
12,20 0
29,900 0
49,500 0
19,850 0
48,250 0
13,700 00
173,400
Returns
-Cost of 185,30 228,400 231,100 152,400 218,000 73,800 1,088,9
Sales Sal.
-Dir. 00
51,20 59,300 40,400 41,200 55,100 32,300 00
279,400
Exp.
-Rent 10,500 33,000 13,200 14,000 32,000 12,200 114,700
=Bonus 60,700 48,300 124,700 37,950 11,250 (10,500) 272,400
xBasis
Bonus % 4%0 4% 4% 4% 4% 4% 4%
=Bonus 2,428 1,932 4,988 1,518 450 0 11,316

Notes: Lakeside makes an "imputed rent" charge to Store No. 6 for the purpose of determining this bonus. Sales (A/C
500); Sales Returns (Prepared by Client); Cost of Sales (A/C 550); Direct Salary Expense (A/C 580); Rent (Prepared
by Client).

b. It appears that the 2008 bonus expense account is overstated (actual balance =
$6,000 v. estimated balance = $3,940); however, the amount of overstatement
($1,060) does not seem material. The 2009 expense appears to be overstated
by $8,184 (= $19,500 recorded - $11,316 estimated). This overstatement
represents approximately 6% to 7% of net income and, thus, is fairly
significant; however, since it overstates an expense, it understates net income.
The auditor could either accept the balance or suggest that the client make an
adjustment.