ACCOUNTANCY A LEVEL(FORM SIX) NOTES – COMPANY ACCOUNT 1.7

COST CLASSIFICATION

Costs may be classified under three main categories:

1. Fixed and variable costs
2. Direct and indirect costs
3. Cost classification by function

FIXED AND VARIABLE COST

Fixed Cost

Fixed cost is the cost that remains the same at various levels of output. This cost does not change with changes in output; it remains constant even at zero level of output.

Fixed costs are usually incurred on a periodic basis.

Examples include rent of premises and salaries of permanent employees.

Variable Cost

Variable cost is the cost that changes with the level of production or output.

When production increases, variable cost also increases proportionally.

Examples of variable costs include raw materials, direct wages, and other related costs.

DIRECT AND INDIRECT COST

Direct Cost

Direct cost is the cost that can be identified with the production of specific products. Examples include raw materials and labor costs. Since these costs can be charged and identified to the production of specific outputs, they are considered direct costs.

These costs are directly associated with the production of goods or outputs.

Indirect Cost

Indirect cost is the cost that cannot be identified with the production of specific products or outputs. Examples include water charges, interest rates, indirect materials, and communication charges.

Cost Classification by Function

Costs may also be classified by their functions or activities, such as production cost, administration cost, and selling and distribution cost.

• Production cost includes raw materials, labor, rent of factories, etc.
• Administration cost involves office expenses such as office rent, postage, telephone, electricity, etc.
• Selling and distribution cost includes costs incurred to promote the selling of goods and deliver them to customers, such as advertisement, salesmen commission, depreciation of delivery vans, carriage outward, and carriage inward.

ANALYSIS OF COST

The total cost incurred by a manufacturing firm may be analyzed by the cost accountant as follows:

• Direct raw materials (D.R.M) xx
• Direct labor/Direct wages xx
• Direct any other cost xx

Total direct cost = prime cost xx

Add:

Production overhead (manufacturing overhead)

• Indirect wages xx
• Indirect factory wages xx

Manufacturing/production cost xxx

In case of profit or loss:

COST STATEMENT FOR THE YEAR ENDED

Selling price – total costs = profit/loss on production

Direct raw materials involve the cost of raw materials, opening stock of raw materials, closing stock of raw materials, carriage inwards of raw materials, etc.

ILLUSTRATION 1

Prepare a cost statement from the following information:

• Raw material 300,000
• Direct labor 80,000
• Factory rent 15,000
• Supervision salary 20,000
• Administration expenses 40,000
• Selling and distribution expenses 15,000

NOTE: Profit margin is 50% on cost; calculate selling price.

COST STATEMENT FOR THE YEAR ENDED

Since profit = cost x 50%

= 470,000 x 50%

= 235,000

Cost of goods sold = 470,000

Add profit margin = 235,000

Selling price = 705,000

ILLUSTRATION 2

From the following information, prepare a cost statement:

• R.M 80,000
• D.L 35,000
• Factory rent 5,000
• Power 3,000
• Indirect wages 2,000
• Administration expenses 4,000
• Selling and distribution expenses 3,000

Profit is 25% on sales.

COST STATEMENT FOR THE YEAR ENDED

NOTE:

1. WIP (Work in Progress) is the cost of items that remain incomplete at the end of a specific period.
2. These are semi-finished goods.
3. WIP may be valued at prime cost or factory cost.

ILLUSTRATION 3

From the following information, prepare a cost statement:

• Stock on 1^st Jan 2006 R.M 45,000
• W.I.P 22,000
• Stock on 31^st Dec 2006 R.M 65,000
• W.I.P 19,000
• Purchases of R.M 670,000
• Carriage inward 25,000
• Returns of R.M 15,000
• Direct wages 280,000
• Factory rent 60,000
• Factory power 48,000
• Depreciation of plant 15,000
• Supervision salary (factory) 55,000
• Office salaries 70,000
• Office expenses 12,000
• Depreciation of office equipment 5,000
• Salesman salaries 68,000
• Delivery van expenses 27,000
• Depreciation of delivery van 18,000
• Advertisement 12,000

NOTE:

1. If there is office salary and supervisor’s salary, normally supervisor’s salary is for the factory.
2. If the question is silent and the amount of W.I.P is very little compared to R.M or purchase of R.M, it means it is in the final stage and should be finalized in the factory overhead level.
3. Sometimes you may be informed if W.I.P is at prime level (early stage) or factory overhead level (final stage).

SOLUTION FOR ILLUSTRATION 3

COST STATEMENT FOR THE YEAR ENDED 31.12.2006

ILLUSTRATION 4

ABC manufacturing company provides the following information for the month of October 2011:

• 1^st October 2011:
• Raw materials 40,000
• W.I.P 12,000
• Finished goods 20,000
• Stock on 31^st October 2012:
• Raw materials 35,000
• Work in progress 17,000
• Finished goods 23,000
• Purchases of raw materials 250,000
• Factory wages 80,000
• Salaries of supervisors 30,000
• Factory rent 10,000
• Factory power 5,000
• Sundry factory expenses 15,000
• Office salary 13,000
• Sundry office expenses 7,000
• Salesmen salary 18,000
• Sundry selling expenses 6,000
• Sales 500,000

Required:

1. Prepare a production cost statement
2. Prepare a profit/loss statement

I) COST STATEMENT FOR 30^th SEPT 2012

II) PROFIT/LOSS STATEMENT FOR 30^th SEPT 2012

BREAK EVEN POINT (B.E.P)

The break-even point is the level of activity at which total sales revenue equals total cost (TR = TC). At this point, profit is zero, meaning there is no profit and no loss.

ASSUMPTIONS OF B.E.P CHART

The following assumptions apply to the break-even chart:

1. Selling price and variable cost per unit remain constant at various levels of output.
2. Fixed cost remains constant at all levels of activity within the relevant range.
3. The chart shows the relationship between cost and sales of a single product only.
4. Production techniques remain unchanged.

ILLUSTRATION

You are required to prepare from the following information:

1. A break-even chart
2. A contribution/sales graph or profit volume graph
3. Show the margin of safety on this chart if the actual level of output is 20,000 units

Selling price per unit is 100/=

Variable cost per unit is 50/=

Fixed cost is 600,000/=

BREAK EVEN CHART

MARGIN OF SAFETY

Margin of safety represents the difference between the actual level of activity and the break-even level of activity.

• For example, if the actual level of activity is 80% and the break-even level is 30%, calculate the margin of safety.

= Margin of safety = Actual sales – B.E.P sales

= Margin of safety = 80% – 30%

Margin of safety = 50%

ANGLE OF INCIDENCE

The angle of incidence is the angle formed at the break-even point between the sales curve and the total cost curve.

• This angle indicates the rate of increase in profit after the break-even point.
• If this angle is wider, profit will increase at a higher rate after the break-even point.

CALCULATION OF BREAK EVEN POINT

ILLUSTRATION 1

State the formula to calculate the break-even point in terms of units to be produced and sold.

We use the following abbreviations:

• S.P = Selling price
• C.P = Cost price
• P = Profit
• C.M = Contribution margin; contribution margin per unit = CM/U

S.P = C.P + P

C.P = F.C + V.C

Contribution margin = S.P – V.C

B.E.P in terms of units produced = (F.C) / (Contribution margin per unit)

B.E.P in terms of sales value = (F.C) / (CM/C) × (S.P)/U

Contribution margin per unit = (S.P)/U – (V.C)/U

Sometimes variable cost = material + labour

Contribution margin ratio = (C.M) / (S.P) or (F.C) / (1 – V.C / S.P)

ILLUSTRATION 2

Star manufactures a product called plate in his own factory. Fixed cost per month is 45,000. Each unit of plate costs 8/= for material and 17/= for direct labor. The selling price per unit is 40/=. How many units must he manufacture and sell per month to break even?

SOLUTION

GIVEN DATA

• Fixed cost = 45,000
• Selling price/unit = 40/=
• Unit cost of plate by material = 8/=
• Unit cost of plate by direct labor = 17/=
• Contribution margin = selling price – variable cost
• Variable cost = material + labor = 8 + 17 = 25
• Contribution margin = 40 – 25 = 15

STATEMENT OF PROFIT / LOSS

The above presentation verifies that sales of 120,000 result in zero profit.

ILLUSTRATION 3

Assuming the company wishes to make a profit of 6,000 per month, calculate the number of units that must be produced and sold to attain this profit. Also calculate the sales revenue required to generate this profit.

Solution

(Fixed cost + desired profit) / (contribution margin per unit)

Sales revenue = Quantity to be produced × SP/U

• DM/U = 8
• DL/U = 17
• F.C = 45,000
• Desired profit = 6,000
• Contribution margin = 15
• SP/U = 40/=

Quantity to be produced = (F.C + Desired profit) / CM/U = (45,000 + 6,000) / 15 = 3,400 units

Sales revenue = 3,400 × 40 = 136,000

STATEMENT OF PROFIT/LOSS

ILLUSTRATION 4

P.LTD manufactures a standard product called Pipi. The following is a summary of their costs incurred in 2008:

• Fixed factory cost 24,000
• Fixed administration cost 10,800
• Direct labour 48,000
• Depreciation of plant (variable cost) 8,000
• In 2008, a total of 40,000 units of Pipi were produced/manufactured at a standard price of £5.20 per unit.
• The company has been approached by a manufacturer to supply annually 5,000 units of Pipi at £4.50 per unit. Currently, the whole of P.LTD’s plant capacity is being used, so to produce the additional 5,000 units, the company will need to acquire plants at a cost of £20,000 with a useful life of 10 years and no residual value. Additional production will also increase factory cost by 5% and selling distribution cost by 10%.

Required:

Would you recommend that P.LTD should accept the order?

Solution:

STATEMENT OF PROFIT OR LOSS BEFORE ACCEPTING ORDER

STATEMENT OF PROFIT/LOSS AFTER ACCEPTING THE ORDER

Recommendation: P.LTD should accept the order since it results in an additional profit of Tshs. 6,330 (66,330 – 60,000).

WORKINGS

RAW MATERIALS

Material before order = 54,000

Units produced before order = 40,000

54,000 / 40,000 = 1.35 units per product

Units produced before order + Additional units for order = 40,000 + 5,000 = 45,000

DIRECT LABOUR

Direct labor before order = 48,000

Units produced before order = 40,000

48,000 / 40,000 = 1.2 units per product

Units produced before order + Additional units for order = 40,000 + 5,000 = 45,000

CASH BUDGET

CONCEPT

BUDGET

A budget is a plan of action expressed in quantitative terms or a financial and quantitative statement prepared and approved prior to a defined period of time. It may include income, expenditure, and the employment of capital.

Budgets may be prepared for the business as a whole, for departments, or for functions such as:

• Sales and production
• Financial and resource items such as cash, capital, expenditures, purchases, manpower, etc.

Examples of budgets include:

• Sales budget
• Production budget
• Purchases budget
• Production cost budget
• Selling and distribution cost budget
• Cash budget
• Budgeted profit and loss account and balance sheet

Benefits of Budget

1. Budgets provide a compiled plan; with budgets, a firm has clear guidelines and financial and human resources can be utilized to achieve specific targets or objectives.
2. Budgets help improve communication and coordination among management and employees.
3. Budgets are used to determine and evaluate the performance of the business enterprise.
4. Budgets help clarify the authority and responsibility of departmental managers and other staff members.

CASH BUDGET

What is it?

A cash budget is prepared to show the expected cash receipts and payments over the next few months or a one-year period.

The main functions of a cash budget are to:

1. Ensure that cash is available for revenue expenditure.
2. Indicate when, where, and how much cash will be needed and whether this is permanent or temporary.
3. Preserve liquidity throughout the year.
4. Reveal surplus cash for investment or expansion of facilities.
5. Guide management on financing capital expenditure internally or externally. capital

The cash budget is affected by the following:

1. Expansion or construction of investment in fixed assets.
2. Increase or decrease in stocks and debtors.
3. Rate of inflation anticipated.
4. Policy decisions like credit controls, dividends, and taxation.

The cash budget is not affected by the following:

1. Provision for bad and doubtful debts.
2. Provision for depreciation.
3. Anything that does not involve movement of money does not affect the cash budget.

Illustration 1

The following information was extracted from the books of Box Ltd., a company which started trading one year ago:

Debtors pay their accounts three months after the month in which sales are made.

c) Production in units

d) Direct labour costs of Tshs. 8 per unit are payable in the month of production.

e) Raw materials used in production cost Tshs 5 per unit; of this, 80% are paid in the month of production.

f) Variable expenses are Tshs. 2 per unit, paid half in the same month as production and half in the month following production.

g) Will receive a legacy of Tshs 1,250 in December 2012.

h) Fixed expenses of Tshs 200 per month payable each month.

i) Drawing is to be Tshs 150 per month.

j) Machinery costing Tshs 1,000 to be paid for in October 2012.

SOLUTION ILLUSTRATION

Workings

PAYMENTS SCHEDULE

July August

Raw materials: 160 (July) × 4 Tshs = 640; 175 (Aug) × 4 Tshs = 700

150 (June) × 1 Tshs = 150; 160 (July) × 1 Tshs = 160

Direct labour: 160 × 8 Tshs = 1,280; 175 × 8 Tshs = 1,400

Variable: (150 × 1 Tshs) + (160 × 1 Tshs) = 310; (175 × 1 Tshs) + (160 × 1 Tshs) = 335

Fixed expenses = 200 = 200

Drawings = 150 = 150

Total = 2,730; 2,945

September October

Raw materials: 185 (Sept) × 4 Tshs = 740; 190 (Oct) × 4 Tshs = 760

175 (Aug) × 1 Tshs = 175; 185 (Sept) × 1 Tshs = 185

Direct labour: 175 × 8 Tshs = 1,480; 190 × 8 Tshs = 1,520

Variable: (185 × 1 Tshs) + (175 × 1 Tshs) = 360; (190 × 1 Tshs) + (185 × 1 Tshs) = 375

Fixed expenses = 200 = 200

Drawings = 150 = 150

Machinery = 1,000

Total = 3,105; 4,190

November December

Raw materials: 170 (Nov) × 4 Tshs = 680; 155 (Dec) × 4 Tshs = 620

190 (Oct) × 1 Tshs = 190; 170 (Nov) × 1 Tshs = 170

Direct labour: 170 × 8 Tshs = 1,360; 155 × 8 Tshs = 1,240

Variable: (170 × 1 Tshs) + (190 × 1 Tshs) = 360; (155 × 1 Tshs) + (170 × 1 Tshs) = 325

Fixed expenses = 200 = 200

Drawings = 150 = 150

Total = 2,940; 2,705

Receipt Schedule

COMPUTERIZED ACCOUNTING

The word computer comes from the word “compute,” which means to calculate.

• The initial objective of inventing the computer was to create a fast calculating machine.
• Nowadays, more than 80% of work done by computers is non-mathematical in nature. In reality, a computer may be defined as a device that processes information or data. Data can be of various types, such as when a computer is used for recruiting personnel or preparing results.
• Data may come in various shapes and sizes depending on the type of computer application. A computer can store, process, and retrieve data as and when desired. For this reason, computers are also known as data processors. Data processors can gather data from various incoming sources, merge (process) them, sort them in desired order, and print them in the desired format.

FEATURES OF A COMPUTER

HIGH SPEED OF OPERATION

The special feature of a computer is its high speed. Computers work at electronic speeds measurable in millionths of a second. A computer can make millions of calculations without errors within a few minutes.

ECONOMY

Every effort should be made to keep costs to a minimum level. The use of computers saves money for users and ensures production of quality goods at the least possible cost.

DILIGENCE

Computers are particularly desirable for repetitive work because they provide correct information continuously, whereas humans are bound to make more errors as they get tired.

STORAGE OF DATA

A computer has memory like human beings. Unlike human memory, computers have very large and accurate memory. The storage unit in the computer is called memory. It can recall any bit of information stored as and when needed without much loss of time.

DECISION MAKING

Computers can make decisions based on pre-defined criteria and can solve problems in different fields. A computer can take logical decisions and perform any job that can be split into logical decisions.

ENSURES FLEXIBILITY

A computer can modify stored programs if desired, ensuring flexibility.

CONTROL

A mechanized system with the help of a computer provides up-to-date information to management, enabling sound managerial decisions.

SCIENTIFIC RESEARCH

Computers have greatly aided scientific research by processing large volumes of data quickly and accurately.

COMPONENTS OF COMPUTER

The basic components of a computer are:

1. Input unit
2. Memory or storage unit
3. Arithmetic and logic unit
4. Output unit
5. Control unit

BASIC ORGANIZATION OF COMPUTER SYSTEM

The various functions performed by each unit are as follows:

INPUT UNIT

This unit transfers information from outside to the memory or storage unit by methods such as:

• Punched cards passed through a punched card reader
• Punched paper tape passed through a punched card reader
• Magnetic tape or disc passed through a magnetic tape or disc reader
• Magnetic tape works like a domestic tape recorder with two reels and a mechanism for reading and writing data. Data recorded on the tape may be retained permanently or erased by recording other data over it. Data can be inserted after punching, which is not possible with punched cards or paper tape.

MEMORY OR STORAGE UNIT

This unit stores figures and releases them at electronic speed for calculations. It retains temporary results of sub-calculations and final results before passing them to the output unit. The cost and size of a computer depend on its internal storage capacity.

ARITHMETIC AND LOGIC UNIT

Required calculations and logical operations are done in this unit by taking necessary information from the memory unit. It performs addition, subtraction, multiplication, and division at high speed. The logic unit makes decisions based on instructions requiring yes/no answers.

OUTPUT UNIT

This unit produces the end product, such as reports or final information, and transfers it to outside documents like printed papers, punched cards, or magnetic tape.

CONTROL UNIT

Also called the program controller, it supervises each unit of the computer. Once data is fed into the input unit, the control unit manages the data as instructed by the computer program.

The main component of the computer is the CENTRAL PROCESSING UNIT (CPU), which contains:

1. Control unit
2. Arithmetic and logic unit

HARDWARE

Hardware is the physical computer itself, including the machine, keyboard, mouse, printer, and related equipment used in electronic data processing.

SOFTWARE

Software includes all materials used in selecting, installing, and operating the electronic data processing system (except personnel). Software includes computer programs (instructions) and everything that helps the computer and its equipment perform their functions. Software is integral to hardware; one cannot function without the other.

DATA PROCESSING

Data refers to figures or statistics about any phenomenon. In accounting, data are usually expressed in monetary units. Data may also include non-monetary units such as quantities produced, number of workers, etc. Raw data are inputs that, after processing, become useful information.

DEVELOPMENT IN COMPUTERIZED ACCOUNTING

The use of computers in commercial applications has revolutionized the industrial environment. Most businesses, except the very smallest, now use computers to handle accounting data.

ADVANTAGES OF COMPUTERIZED ACCOUNTING SYSTEM

• Elimination of substantial manual work involved in posting entries.
• Quick availability of information regarding debtors, creditors, funds position, etc.
• Saving of substantial time in updating books of accounts.
• Easy availability of information as per statutory or other requirements.
• Saving storage space required for voluminous data.
• Easy preparation of final accounts and reconciliation.
• Reduction in operational costs by automating clerical work.

ACCOUNTING PACKAGING AND SOFTWARE

Software packages are sets of pre-designed programs since basic commercial activities remain the same. Some commonly used are:

I. PERSONAL COMPUTER

• a) Spreadsheet
• b) Database
• c) Word processor

(A) Spreadsheet

A software designed to facilitate creation and revision of mathematical models, analysis, and reports, usually for business applications. It is a computerized matrix or grid made up of 254 rows and 63 columns. Any item may be changed at any time and results are updated automatically. It can be used to seek goals such as specific profit figures.

Benefits of Spreadsheet

• Saves time by performing calculations across rows and columns within seconds.
• Simple tool to learn.
• Provides flexibility for playing with numbers.
• Eliminates recalculations by automatically modifying the spreadsheet for changes.

(B) Database

An organized collection of information. A computer program or group of programs that organize, store, retrieve, and allow entry and updating of data is called a Database Management System. It allows multiple users to access organized information for multiple uses. Examples include payroll and mailing lists.

(C) Word Processor

Tools designed to simplify writing tasks. It is powerful for:

• Document presentation
• Formatting documents
• Saving edited versions

A word processor combines computer hardware and software, benefiting users by eliminating the need to retype entire pages and allowing major changes without retyping.

(B) SOFTWARE PACKAGES FOR ACCOUNTING

There are many ready-made software packages available. Accounting applications are standard, so packages provide similar features. Areas covered include:

• General ledger
• Accounts payable
• Accounts receivable

(I) General ledger

Helps manage financial accounting, serving operational, statutory, and management information needs. Reports include day books, journals, and subsidiary ledgers.

(II) Accounts Payable

Monitors supplier bills, payments, and outstanding amounts. Reports include bill register, payment register, credit/debit notes, and list of outstanding.

Packages can be used as-is or modified per user requirements. Standard packages facilitate computerization of commercial applications such as trial balance, balance sheet, profit and loss statement, budget variance, funds flow statement, and ratio analysis.

(III) Accounts Receivable

Helps reduce money collection periods and minimize bad debts. Details customer invoices, receipts, and outstanding balances. Reports include invoice register, receipts register, credit/debit notes register, customer journal, customer ledger, customer statements, receipts due, interest receivable on overdue invoices, ageing reports, and customer directory.

AUDITING

Meaning of Auditing

An audit is an examination by an auditor of the final accounts (trading account, profit and loss account, and balance sheet) of a business enterprise. It involves checking supporting documents from which these accounts are prepared. The main purpose is to ascertain whether these accounts present a true and fair view of the financial position of the business.

IAG3 defines audit as an independent examination of an expression of opinion on the financial statements of an entity by an appointed auditor in pursuance of that appointment and in compliance with relevant statutory provisions including Tanzania Statements of Standard Accounting Practice (TSSAPs) and auditing standards.

Auditor: The word auditor comes from Latin ‘Audire’ meaning to hear. An auditor is an independent person appointed by business enterprises to audit its accounts. The auditor may be an individual or a firm.

The auditor’s duty is to form an opinion and report on the financial statements of a business enterprise for a specific period.

Auditing is the process of examination of financial statements covering transactions over a period to enable the auditor to issue a report.

It means auditing is the application of auditing principles.

TYPES OF AUDITING

The following are types of auditing:

Statutory Auditing

Conducted under the provisions of the law. According to the Companies Act of Tanzania, all limited companies are required to have their accounts audited. Similarly, cooperative societies, banks, insurance companies, and financial institutions are also required to have audits as per respective Acts.

Private Audit

Private or voluntary audit is not legally required. Examples include audits of sole traders, partnerships, and management audits of limited companies.

Internal Audit

Conducted by an internal auditor who is an employee of the organization. The main purpose is to find out whether the internal control system is working successfully. The report is used by management for improvement. The internal auditor has some independence to perform duties efficiently.

External Audit

Conducted by an independent auditor not employed by the organization. Appointed by the owner or shareholders. The main purpose is to determine the accuracy of financial statements and form an independent opinion on whether they show a true and fair view.

Procedural Audit

Examination and review of internal procedures and records to ascertain reliability. It improves efficiency and ensures implementation of management procedures. It is expensive and used where owners suspect duplication of internal policies.

Management Audit

Investigates management aspects of a business, reporting on effectiveness from profitability and efficiency perspectives. Reveals strengths and weaknesses of management.

Standard Audit

Conducted to ascertain compliance with accounting standards set by professional bodies such as TSSAPs, IAS, and GAAPs.

Continuous Audit/Detailed Audit

Involves regular intervals of audit (e.g., quarterly). The auditor visits clients regularly to check transactions.

Balance Sheet Audit

Verification of values of assets, liabilities, reserves, provisions, and profit or loss for a year. The auditor reports only on the balance sheet and may not verify supporting accounts. More common in USA and Canada.

Vouching Audit

Checks each transaction from origin to final accounts. Requires extensive work. Less popular in large organizations with good internal controls. Common in UK, Kenya, and East Africa.

Government Audit

Conducted in government authorities by the Controller and Auditor General (CAG) as per Exchequer and Audit Ordinance or Act.

Financial Audit

Verifies accuracy of financial statements and forms an opinion on their fairness. Mostly conducted by external auditors.

Final Audit

Conducted at the end of the financial year after preparation of financial statements.

Advantages of Final Audit

1. Reduces chances of changing figures in final accounts.
2. Less expensive and suitable for small businesses.
3. Convenient to client staff.
4. Makes auditing easier.

Disadvantages of Final Audit

1. Not advisable for large entities.
2. Delays in auditor’s report due to short audit period.
3. Possibility of errors and frauds even after audit.

INTERIM AUDIT

Conducted before the end of the year, usually between accounting periods (e.g., quarterly). Mainly for determining profit to declare interim dividends.

Advantages of Interim Audit

1. Makes audit work easier at year-end.
2. Easy to detect errors and frauds.
3. Can be completed quickly.

Disadvantages of Interim Audit

1. Figures may be altered after audit.
2. Inconvenient to client staff.
3. Additional work.

Partial Audit

Conducted for specific purposes on instructions of the owner.

Complete Audit

Examines every transaction through checking vouchers, documents, financial statements, letters, and minutes. Suitable for firms with weak internal controls.

Note: Types of audit can be classified according to form of organization, nature of work, time factor, and method of approach.

OBJECTIVES OF AUDITING

Objectives may be classified as:

1. Primary objectives
2. Secondary or subsidiary objectives

PRIMARY OBJECTIVES

The primary objective is to determine the accuracy of financial statements or accounts and form an opinion on whether they show a true and fair view.

Statutory objectives include:

1. Prove the true and fair view of the company’s financial state.
2. Confirm proper books of accounts are kept.
3. Communicate findings to shareholders in a report with opinion.

SECONDARY OBJECTIVES

1. Detect errors and frauds.
2. Prevent errors and frauds through internal controls.
3. Assist clients to improve accounting systems.
4. Determine if internal control systems work properly.

It is not the auditor’s duty to discover frauds, but if found, they should be reported.

FUNCTIONS OF AUDITING

1. Studying the accounting system to determine nature, timing, and extent of audit procedures.
2. Evaluating internal control systems to ensure management policies are followed and assets safeguarded.
3. Vouching to determine accuracy of accounting of assets.
4. Legal requirement compliance.
5. Verification of liabilities.
6. Distinguishing capital and revenue items.
7. Valuation of liabilities and assets with expert assistance.

INTERNAL CONTROL

The system of controls established by management to carry on business orderly, safeguard assets, and ensure completeness and accuracy of records.

Types of internal control include:

1. Control on purchases and creditors
2. Control on stock and work in progress
3. Control on cash receipts and payments
4. Control on wages payments
5. Control on sales and debtors
6. Other controls

DETAILED INTERNAL CONTROL OBJECTIVES

Internal controls should ensure the following:

1. Validity – Only valid transactions are recorded; no fictitious transactions.
2. Authorization – Transactions are authorized to prevent fraud.
3. Completeness – All existing transactions are recorded.
4. Valuation – Procedures avoid errors in transaction amounts.
5. Classification – Proper classification of accounts for accurate financial statements.
6. Timing – Transactions recorded at proper times to avoid misstatements.
7. Posting and summarization – Transactions properly recorded and included in subsidiary records.
8. Promote operational efficiency by preventing duplication and waste.
9. Encourage adherence to prescribed policies.
10. Safeguard physical and non-physical assets.
11. Provide reliable data for management decisions.

INTERNAL AUDIT

An independent appraisal function established by management to review internal control systems as a service to management.

Main objectives:

1. Safeguard company’s fixed assets.
2. Assist management to run business efficiently and orderly.
3. Act as consulting department to other departments.
4. Detect and prevent errors and frauds by client staff.
5. Help maintain strong internal control systems.
6. Help reduce audit fees of internal auditor.

EXTERNAL AUDIT

Conducted by an independent auditor appointed by the owner or shareholders. Main objective is to determine accuracy of financial statements and form an independent opinion.

Other objectives:

1. Confirm proper books of accounts are kept.
2. Detect errors and frauds.
3. Present findings with opinion to owner.
4. Assist clients to improve accounting systems.
5. Find weaknesses or strengths of internal control systems.

IMPORTANCE/SIGNIFICANCE OF INTERNAL AND EXTERNAL AUDIT

1. Determines effectiveness of internal control systems.
2. Reduces work and cost of external audit.
3. Helps prevent frauds.
4. Facilitates maintenance of proper accounting records and timely financial statements.
5. Reviews implementation of corporate policies and procedures.
6. Examines financial and operating information for management.
7. Conducts special investigations.

SIMILARITIES BETWEEN INTERNAL AND EXTERNAL AUDIT

1. Both ensure operation of effective internal control systems.
2. Both use similar audit techniques.
3. Both safeguard company assets.
4. Both follow professional ethics.

DIFFERENCES BETWEEN INTERNAL AND EXTERNAL AUDIT

AUDITOR’S WORKING PAPER

Nature and Definition

Introduction: The efficiency of audit work is enhanced through careful compilation and maintenance of audit work documentation, done through preparation of audit working papers.

Meaning: Working papers are records kept by auditors of procedures applied, tests performed, evidence gathered, and conclusions reached during the audit.

Audit working papers should be prepared as the audit proceeds to avoid omission of details and problems.

Each working paper should be properly identified with client’s name, period covered, description of contents, preparer’s initials, date, and index code.

FORMS/TYPES OF AUDITOR’S WORKING PAPER

Audit working papers are classified into two categories, each assembled in a separate file:

1. Permanent Audit file for the same client
2. Current Audit file

A. PERMANENT AUDIT FILE

Essential for continuous audits, valuable for successive audits. Acts as a constant reference source, avoiding repeated questions. Typically contains:

• Memoranda and Articles of association and other statutory/legal regulations
• Copies of important agreements (leases, debenture deeds, contracts)
• Brief description of business type
• Details of physical locations (factories, offices, shops)
• Details of accounting system and internal audit procedures
• Organization chart of client’s staff
• Names and addresses of client’s advisers (bankers, brokers, management)
• Lists of accounting records and responsible officials

Permanent audit files should be updated appropriately.

B. CURRENT AUDIT FILE

Holds all working papers applicable to the year under audit. Should contain:

• Authenticated copy of statement on which auditor’s report is based
• Index covering all working papers
• Audit program
• Internal control questionnaire and records including flow charts
• Schedules for balance sheet items with comparative figures
• Schedules supporting profit and loss account items
• Checklist for statutory disclosure compliance
• Record of queries and their disposal
• Schedule of important statistics or working ratios
• Record or extract of minutes of meetings
• Copies of letters to clients regarding weaknesses or dissatisfaction
• Letter representations

Matters not of permanent importance but requiring attention should be listed with references and transferred to the next current file.

AUDIT REPORT AND OPINION

Audit report: Prepared by an independent auditor after examining financial statements, including auditor’s opinion on true and fair view.

Audit opinion: View given as a recommendation by auditor after auditing financial statements.

TYPES OF AUDIT OPINION

1. Unqualified opinion: Given when auditor is satisfied that financial statements show true and fair view and comply with international accounting standards.
2. Qualified opinion: Given when auditor cannot give full opinion due to some items not presented properly.
3. Disclaimer opinion: Given when there is limitation of scope, e.g., management limits auditor’s access to documents or physical stock.